Brad Setser is thoughtful and data driven, but he also isn’t shy about saying what numbers portend, even if he runs the risk of sounding a tad alarmist. We’ve had so much complacency, followed by concerted efforts to keep asset values and confidence aloft that an unvarnished presentation can come off as a dousing of cold water.
Specifically, some have argued that the hand-wringing about Freddie and Fannie is overdone, claiming that their expected losses do not threaten their statutory capital levels (or if worst came to worst, they could shrink their balance sheets, although that could be deemed to be a violation of their charters). Other analysts have looked at the same data and reached different conclusions, forecasting more serious losses that make a rescue necessary.
Setser puts himself in the “bailout is probable” camp, but for different reasons. Foreign central bank purchases of GSE debt is essential to their business model. Freddie and Fannie need ongoing access to cash at very favorable prices, otherwise their mortgages become too costly to appeal to customers and enable them fulfill their mission of facilitating transactions. We’ve written before about falling central bank purchases versus a large calendar between now and the end of September for GSE sales (see here, here, and here for more evidence of softening demand). While Freddie and Fannie may muddle through September, credit conditions look likely to deteriorate through the end of the year, keeping the agencies in a vulnerable position.
Setser shows that foreign central banks are shifting away from agencies into Treasuries, which is no doubt contributing to freakishly low yields (the ten year was at 3.74% today). Korea would very much like to sell dollars to support the won, but a good deal of its remaining FX reserves is in GSE paper deemed to be not-very-liquid. Any central bank aware of Korea’s plight might find that another reason (beside the open questions of how the US proposes to backstop Freddie and Fannie) to choose other vehicles.
In August, central banks added close to $46 billion ($45.92b) to their custodial holdings of Treasuries at the New York Fed. In August, they reduced their holdings of Agencies by a bit over $13 billion ($13.33b)…..
Yves here, Note that the decline in demand in January-February corresponded to the spike up in GSE spreads that led, among other things, to the creation of new liquidity facilities and the Bear Stearns rescue.
No wonder that the options market is now implies a significant probability that the Agencies existing common equity will be worth zero; look at this chart produced by Paul Swartz, a colleague of mine at the Center for Geoeconomic Studies.
If these trends continue for much longer, US Treasury Secretary Paulson will be forced to show his hand. The Agencies won’t be able to rollover their debt — at least not at a spread that works for them. The US government will then either have to step or let the Agencies fail. And, well, letting the Agencies fail, in the sense of default on their debt, is probably more than the US government is willing to consider right now.
….the world’s central banks have a fairly clear alternative to buying Agencies: buying Treasuries. Shifting from Treasuries to Agencies cost them a few basis points, but it didn’t require a wholesale change in the currency regimes. It doesn’t require any big policy decision on their part. It is just a technical decision about reserve management – and probably a prudent one at that….
The impact of such a shift, by contrast on the US is far more pronounced. Without central bank financing, the Agencies cannot exist in their current form. They certainly cannot be a conduit between the large pools of savings in the hands of emerging market governments and the US housing market. And right now, that is exactly what the US government wants them to do. Private demand for mortgages – and most other forms of household receivables – has dried up. The Agencies are the mortgage market.…..
Call it a buyers strike by central banks on assets other than Treasuries.
There’s more good material in the post; read it here.