CDOs: China to the Rescue?

Felix Salmon commented on an intriguing and colorful post by Steve Waldman that argues that it’s in China’s best interest to buy a few CDOs and save the Street and the hedge fund industry from a meltdown and possible jail time.

Here is the meat of Waldman’s argument:

Here’s where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States’ current account deficits were unsustainable, that developing countries like China would not be able to fund America’s huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China’s central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China’s Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.

Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are “orderly”, I think China will find it in its interest to be a “bagholder of last resort”, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That’s not really true, but we’ll let it go here.) China won’t buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.

Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let’s put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.

Salmon considers this scenario plausible, and I can’t disagree. However, I wouldn’t call it likely. The reason is that China’s purchases of US financial assets have almost entirely been US Treasuries. (I see the Blackstone investment as a brilliant stroke of political theater). To be blunt, they are way way behind the US in terms of sophistication (which is why they fought hard to keep the current restrictions on foreign firm entry in place. They want to give their domestic players the time to build skills so China will not cede control of its financial markets to foreign players).

The only time I can recall foreign firms coming to the rescue of the US was in a not-very-widely recognized chapter of the 1987 crash. The crash had two immediate triggers: an unexpectedly bad merchandise trade deficit which led to a sharp fall in Treasury prices, and a proposal to tax highly leveraged transactions (meaning LBOs) at higher rates, which led to a collapse of stocks of a number of takeover candidates.

The Dow fell 150 points on Friday October 16 and on Monday the 19th, 508 points (nearly 23% of market value). I was in Japan at the time. Other global equity markets fell, but not close to the same degree. In Japan, it felt like you were watching someone else’s house burn. However, just the way traffic on both sides of a highway slows down in a car wreck because everyone has to have a look, so too trading of all sorts ground to a halt, including Treasury trading.

The powers that be in the US began to see signs of a crash-precipitated liquidity crisis. Early the week after the crash (the week of October 26), the Fed called the Japanese central bank, which in turn called Japanese banks and told them to start buying Treasuries aggressively. They did, recognizing that their house might catch on fire if they failed to act. The rally in the Treasury market led to a resumption of normal bond and money market activity.

Now Waldman argues that the Chinese have more at stake here than the Japanese did in the 1980s, which should lead them to intervene. True enough, but that presupposes that the Chinese recognize the degree of danger and know what to do. Even now, the flow of information between economies is much worse than one might think. I have a Japanese colleague who oversees a nearly $100 billion portfolio in Japan and we have dinner a couple of times a year. He will without fail tell me of things that are widely known in Japan that I haven’t seen in the US press or the Financial Times. I have to assume the ignorance is mutual, and would apply to China as much as it does Japan.

Thus, if the Chinese knew what was afoot, it wouldn’t take much in the way of buying at all (a mere couple of hundred million might do) to legitimate higher CDO values. Remember, in the absence of margin calls, that stuff trades by appointment. But I doubt anyone is clued in, except perhaps a few middle level people (and educating senior people who aren’t savvy is a considerable and time-consuming undertaking).

Per the 1987 crash case, the Fed will reach out only if a liquidity crisis is in play. A CDO meltdown could set that in motion, but it would take more damage, and more sectors of the financial markets seizing up, before it would constitute a liquidity crunch.