Setser: "If trends continue…..Agencies won’t be able to rollover their debt"

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.

From Setser:

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.

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  1. doc holiday

    What happened to Treasury buying Fannie garbage??

    Re: “I think whatever Treasury is going to do, they’re going to try to protect the preferred shareholders. The collateral damage done by wiping them out would create other problems,” Gardner said.

    But other analysts say if Fannie and Freddie do end up needing a cash infusion from the Treasury Department, there’s no way that preferred shareholders won’t see their investment hit further, if not completely wiped out.

    FYI @ Wiki:

    In July of 2008, the government attempted to ease market fears by … (blah, blah, blah) removing the prohibition on the Treasury Department to own stock.

    Government-sponsored enterprises are costly to the government and taxpayers… the benefit is currently worth $6.5 billion annually.”[9]. Fannie Mae and Freddie Mac are required to hold less capital than normal financial institutions: e.g., it is allowed to sell mortgage-backed securities with only half as much capital backing them up as would be required of other financial institutions. Specifically, regulations exist through the FDIC Bank Holding Company Act that govern the solvency of financial institutions. The regulations require normal financial institutions to maintain a capital/asset ratio greater than or equal to 3%. The GSEs, Fannie Mae and Freddie Mac, are exempt from this capital/asset ratio requirement and can, and often do, maintain a capital/asset ratio less than 3%. The additional leverage allows for greater returns in good times, but put the companies at greater risk in bad times, such as during the current subprime mortgage crisis. FNMA is also exempt from state and local taxes. In addition, FNMA and FHLMC are exempt from SEC filing requirements.

  2. Anonymous

    Well, I don’t know about bumper stickers. But, thank goodness we can count on Sarah Palin’s executive experience and readiness from day one, if necessary, to step in and lead toward a resolution of the financial and economic challenges discussed on this blog.

  3. Matt Dubuque

    Anonymous, in terms of bumper sticker summaries of this post, that sounds a little “French” and “nuanced” for our target audience, the American voter. Your request smacks of elitism.

    Yves, how would you sum up this fine post in two words or less?

    Matt Dubuque

  4. Matt Dubuque


    Although this is clearly significant, I would not describe it as a “buyer’s strike” among central banks just yet.

    I would describe it more as a very troubling hole in a massive polyethylene dam that may well be possible to repair with duct tape until February.

    Along those lines, it seems likely to me that a key move soon will be the various members of the GCC (i.e. the Gulf Cooperation Council, that regional grouping of emirates including Dubai, UAE, Qatar, Bahrain, etc.) shifting some of their funds out of agency paper over the next few months.

    That could well be the final straw forcing Bush to show the 8 of clubs that he has been keeping as his hole card.

    After all, nothing gets the attention of the current crowd like a whiff of Emirate displeasure with their faithful servant.

    Matt Dubuque

  5. Matt Dubuque

    Good point Tom. Words are pretty much for liberals anyway; remember Stephen Colbert taught us that information itself has a liberal bias.

    Today’s FT informs us that the lovely Ms. Palin is a Pentecostalist.

    Pentecostalists are no ordinary evangelicals (which include Billy Graham).

    Pentecostalists, definitionally, speak in tongues…..glossolalia as it were….

    May we expect Ms. Palin to launch into speaking in tongues at a critical moment during the campaign?

    Also, the majority of Pentecostalists are of the political view that Armageddon must be ACCELERATED, because of course they are first in line at the Rapture.

    Various ways to hasten Armageddon, giving God a “little push” as it were, might be an orgasmic nuclear strike against Iran or perhaps provoking a nuclear spat in the Crimean against Russia (believed by Pentecostalists to be the “Magog” in the Book of Revelations).

    Combine this with her mayoral experience and she may do quite well in this Banana Republic.

    Matt Dubuque

  6. tyaresun


    Did you read the article saying that PIMCO, Loomis(sp?) and the treasury are going to come in? I think it was on Seeking Alpha.

  7. bondinvestor

    i'm not sure setser understands how the GSE's work. either that, or else your summary of his argument left some important things out.

    there is a HUGE difference between the MBS and agency debt markets. the agency debt markets are a fraction the size of the MBS market. central banks could stop purchasing agency debt tomorrow (many have already) and it would have minimal impact on mortgage rates. the reason is that mortgage rates are set by market participants who buy and hold MBS to maturity. these markets are dominated by banks, mutual funds, insurance companies, hedge funds and the agencies themselves. central banks have never been too keen on holding MBS because they haven't developed the skills to manage negatively convex mortgage portfolios.

    the widening of MBS OAS spreads has been driven by a fear in the market that the agencies will attempt to raise regulatory capital ratios by de-leveraging their retained portfolios. bond investors – who are highly risk averse right now, given what has happened in the past 12 months – are reluctant to commit large sums of money to the mortgage market in the face of this *potential* supply shock. that's the overhang that is creating the wide OAS spreads at the moment.

    the OAS spread is a far, far bigger driver of mortgage rates than the rate the GSE's pay on agency debt.

    now, to the specific point that setser and you make – which is that the GSE's might see their margin get squeezed by a funding crisis – that is highly unlikely to happen, for the following reasons:

    1. the agencies manage to a neutral duration gap. as a result, their assets and liabilities run off at a approximately the same rate. therefore if the agencies markes are shut to them, they can just stop making purchases for the retained portfolio and allow their balance sheets to shrink.

    2. by law, the agencies have to maintain at least 3 months of excess liquidity at all times. this is meant to be an insurance policy against a collapse of confidence in the agency markets. both companies have been raising liquidity for months now, and hold substantial cash reserves. they therefore can probably go 6-9 months without accessing the agency markets. note that this would have minimal impact on their activities in the MBS market. agency MBS would still get created – they just wouldn't be held in the retained portfolios.

    3. one thing that no one has mentioned is that while agency spreads to treasuries have risen – so have spreads of every other financial institution. the agencies are paying more on a relative basis than they ever have, yes. but so is everyone else. furthermore, mortgage OAS are at levels never before seen. therefore, while their funding costs are higher, it is actually HUGELY profitable for them to put capital to work buying MBS right now.

    it is just factually incorrect to say that foreign central bank purchases of agencies are central to the business model. in a *good* year, foreign central banks fund perhaps 10% of US mortgage originations (GSE's put 25% of new originations on balance sheet x 40% FCB participation = 10% of US mortgage originations are funded via FCB).

    it is also incorrect to surmise that the GSE's can't roll their portfolios if FCB pull out of the agency market. so far, the weekly auctions are seeing demand that is a multiple of supply due to the wide spreads. if the FCB want to sell agencies now that the relative to spread to treasuries is the widest it's ever been – god bless them. i believe they were doing the same thing with their gold reserves in 1999 at $250/oz.

    (side note: one very good rule of thumb for professional investors is to do the opposite of what the central banks around the world are doing. they are dumb, backwards-looking, herd-like investors who consistently destroy value for their "shareholders")

    now, none of this is to say that at some point in the future, demand won't evaporate. that's the risk here. clearly, everyone in the market would like the companies to have more capital to bring in spreads, improve sentiment, etc.

    however, the agencies are going to be shut out of the equity capital markets until there is more clarity on (a) the shape of the credit cycle; and (b) the long-term capital structure. unfortunately, treasury can't do anything about (a). however, they and the new OFHEO can address (b) in short order, if they so desire.

    if the long-term capital standards are promulgated soon (e.g., 2-3 months), the GSE stock prices will go back to book value. it's a pretty straightforward job to estimate the range of potential credit outcomes if you know *anything* about mortgages. suffice to say that the losses – while high – are not crippling to the franchises.

    what *is* crippling is the continued uncertainty about the capital structure. no one will invest more money in the agencies if they fear lockhart & demarco are going to use the statute to steal the companies from shareholders.

  8. doc holiday

    The market has not yet revisited the better levels seen pre-open, but is looking to take a crack at the 3.7% point on the 10-yr yield, but they’re getting close. As BMO’s Andy Busch noted earlier…”Lehman partially owns part of Ospraie Management LLC. As Art Hogan from Jefferies puts it: ‘The last thing Lehman needs while they are looking to raise new capital is to have skeletons like this falling out of the closet.'” Let the skeleton releasing begin…

    Re: “Not only as a portfolio manager, but as one of the largest investors in the Ospraie Fund, I have shared in the losses with you,” Anderson wrote. “After nine years of striving to be a good steward of your capital, I am very sorry for this outcome.” Ospraie Management still runs three other investment funds worth $4.0 billion, including a special-opportunities fund.

    Tuesday’s announcement is the last thing Lehman Brothers Holdings (nyse: LEH – news – people ) needs. The troubled brokerage bought a 20.0% stake in Ospraie Management in 2005. Lehman’s shares were down 0.4%, or 7 cents, at $16.06, at midday on Wednesday in New York.

  9. bingo


    under your point (1), if the GSE’s make less purchases, the law of supply and demand will cause home prices to further decline and mortgage rates to rise.

    As far as putting capital to work being profitable, that is nonesense. Putting more capital to work increases their leverage which increases the probability of disaster. It is politically unviable for them to increase in size.

    Finally, if the GSE’s are as healthy as you suggest, and spreads wide enough to compensate for risk, how do you explain that they need an implicit guarantee??

  10. Anonymous

    Treasury is worried about who will write mortgages next month, quarter, year. No one can do it at sufficiently low rates without some government support; U.S., Chinese, Russian or GCC.

  11. Matt Dubuque


    Do you have any citation at all in the literature (Journal of Finance, any NBER links, any Federal Reserve papers, etc.) that support your statement that:

    “the reason is that mortgage rates are set by market participants who buy and HOLD MBS TO MATURITY.”

    Or is statement about holding periods merely anecdotal and your opinion?

    For example, the average holding period for a 10-year Treasury is now well under 30 days.

    Matt Dubuque

  12. Matt Dubuque


    One reason for my strong doubt as to your claims of universality for this practice is that if this were true, why aren’t don’t all banks count them as Level III assets (no intention of trading, but increased capital required).

    The fact that so much MBS is NOT Level III capital seems to be clear evidence that banks DO intend to trade these, rather than hold to maturity as you claim.

    Matt Dubuque

  13. doc holiday

    Hot off the grill:

    Agency Bond Market: Freddie Floats $3B in 2-Yr Notes

    Maybe the agencies can survive in their present form if this process can become as embedded as was the old harsher process. Maybe the market will seek a new level which satisfies investors and which permits the orderly operation of FNMA and Freddie Mac. It seems that investors are trying to locate that level and are willing to buy GSE debt if there is some compensation for the effort.
    Separately, there was very good distribution of this issue. Central banks weighed in and bought 40 percent and investment managers purchased 37 percent.
    Asian demand has not completely evaporated as 34 percent of the bond will settle on that continent while 53 percent was place here in North America. Europe took 11 percent.
    In secondary market trading of agencies spreads were wider by 1 basis point to 2 basis points in the 2 year through 10 year sectors.

  14. dh

    Thought I’d add this from above link:

    Freddie Mac successfully offered, marketed and priced $3 billion 2 year notes today. The issue priced 97.5 basis points cheap to the benchmark 2 year Treasury and 6.5 basis points rich to Libor. Comparable paper closed trading last evening at Libor less 10 ½ basis points so this issue priced with nearly a 4 basis point concession. There was substantial demand for the issue and it traded quite well when it began its sojourn in the secondary markets.

    Now the tables have been turned and those once engorged with an overabundance of hubris turn to the market with a cloak of humility as the price they must pay to survive. The pricing of new issues is on the cheap side and represents the new degree of risk which investors discern in these entities, notwithstanding the potential for Hank Paulson to fire up the bazooka in his pocket.

  15. Francois

    bondinvestor wrote:
    “it is just factually incorrect to say that foreign central bank purchases of agencies are central to the business model. in a *good* year, foreign central banks fund perhaps 10% of US mortgage originations (GSE’s put 25% of new originations on balance sheet x 40% FCB participation = 10% of US mortgage originations are funded via FCB).”

    You obviously know much more about that than I do.

    That said, it would be prudent to remember these facts about central banks vs. the GSE’s:

    1) “China, according to the US data, has $422 billion of long-term Agency bonds. That is roughly 10% of China’s GDP. It is also almost certainly understates China’s holdings. Based on the pattern of revisions in past surveys and the scale of China’s foreign asset growth, I would guess that China now holds between $500 and $600b of Agencies — or about 10% of the outstanding stock.”

    2) “China’s holdings of Agencies are effectively holdings of Treasuries, and China’s combined holdings of Treasuries total at least $924 billion. In reality, given the pattern of revisions and the scale of China’s reserve growth, its current holdings of Treasuries and Agencies now easily tops $1 trillion. […] $1 trillion is roughly 25% of China’s GDP.

    “Russia, according to the US data, holds $90 billion of long-term Agencies. Russia also has a large portfolio of short-term Agency bonds (with a maturity of less than a year). Based on past survey data, I would guess that almost all of Russia’s holdings of “other short-term negotiable securities, negotiable CDs and other custodial securities” are short-term Agencies. That brings Russia’s total holdings of Agencies up to $156 billion — or roughly 10% of Russia’s GDP (a bit more actually).”

    In other words, we can hardly look at GSE’s finances from a strictly domestic point of view. And that may greatly complicate this whole matter.

  16. Matt Dubuque


    You stated that:

    “one very good rule of thumb for professional investors is to do the opposite of what the central banks around the world are doing. they are dumb, backwards-looking, herd-like investors who consistently destroy value for their “shareholders”)”.

    Again, do you have a shred of evidence from the professional literature (as opposed to anecdotes and speculation) to provide ANY empirical support for this bizarre and wild proposition?

    Any reputable peer-reviewed finance journal article or paper will do.

    Just one.

    Incidentally, I suppose you are heavily short Treasuries at the moment?

    Current reality and past experience directly contradict your wild and unsupported statements.

    Matt Dubuque

  17. Dean

    Matt D.’s french comment gave me an idea for a b-sticker:

    La consommation est notre juste ; nos dettes sont la responsabilité du reste du monde.

  18. Matt Dubuque


    I heard that during the Norman Conquest in 1066, the Norman warriors were shouting out lengthy and literate battle cries to inspire the future victors, while the soon to be defeated Anglos were shouting “Ut! UT!” (meaning “out!” out!”).

    Personally, I think I have some notion as to the meaning of your proposed bumper sticker:

    “La consommation est notre juste ; nos dettes sont la responsabilité du reste du monde.”

    But is there ANY WAY, you can provide a full and accurate translation in one word or less for the rest of us?

    Matt Dubuque

  19. Anonymous

    Re: Still too many words, and context not clear.

    Please make us whole and show us the way. Why are we here?

  20. Dean

    Matt Dubuque,

    Fully respectful of your (presumptuous) Norman ancestry I am delighted to provide you with an Anglo (shouting type) translation:

    My intention was to convey the following:

    “Consumption is our right, but our debt is the responsibility of the rest of the world”

    I am sure both sides of the English Chanel have fought over lesser reasons stemming from poor translation.

  21. Anonymous

    bond investor:

    1) I rather suspect that on a flow basis, central banks have been a bigger player in the Agency guaranteed MBS market than you let on … clearly they are still a small share of the stock, but China — based on the survey data — started buying large quantities of Agency pass-throughs in late 05 and really bought a lot ($100b) from mid 06 to mid 07. there isn’t good data available after that, but i don’t think much has changed.

    2) i would make a similar point about the GSE’s own debt issuance — looking at their share of the actions or the stock (and i agree that 35-40% is about right) — misses the fact that the rapid growth in their agency holdings has facilitated the expansion of the Agencies purchase of MBS for their own books.

    3) my concern was that directionally the agencies might move from being big net buyers on a flow basis to being net sellers — which i think you would agree would have a negative impact on the mortgage market, and by pushing rates up higher, push home values down and thus increase likely losses on the outstanding stock of MBS.

    4) I should have given more thought to the Agencies ability to hedge their duration mismatch — I am more of an analyst of capital flows than of the agencies book, and I take your point on this. I didn’t think that through. I was though thinking of more than rising funding costs of short-term debt v fixed returns on a longer-term portfolio. I was also thinking of rising funding costs and rising credit losses —

    today’s auction did seem to go reasonably well. I’ll be interested to see tho if the FRBNY data shows a rise in Agency holdings. that data series does seem to capture most central bank holdings, so i suspect it is a decent proxy for the aggregate actions of the central banks — not just their actions in the new issuance market.

    My core proposition was and is simple: if central banks keep reducing their agency holdings, the agencies will have difficulty surviving in their current form. But if i am underestimating the willingness of others to step in and finance the expansion of the agencies retained portfolio, that proposition could be off.


  22. John

    Dudes! These are REPUBLICAN bumper stickers. French ain’t gonna work!!

    You need something with a flag, an eagle, god, and SHORT!!!

    I donno… maybe: Jesus wants them foreigners to pay.

    (It’s even got a double meaning.)

  23. Dave Raithel

    I’ve really tried to work through the post and all commentary. Really. So I just want to make sure of this one point: If the GSE’s implode, none of the physically extant material reality disappears? Right? Have I got that right? Oh…that’s not the issue… for who?

    By the way, I do think Palin is one hot MILF, and I am grateful (to Allah, to God, the Zeitgeist, whatever) she can speak complete sentences expressing complete (obnoxious) thoughts (a marked improvement over The Idiot In Chief) but I suspect the similarity between her and her hubby and Tina Fey and a young Burt Ward is … Rovian…

  24. Stuart

    Ya, just what we need as VP. A bible thumping, gun touting ultra conservative who lands the job in a matter of hours after McCain’s 1st talk with her. Reckless. The whole system is almost a complete re-do.

  25. fan

    It is highly unlikely that the GSEs will be unable to roll over their debt, as illustrated repeatedly by the fact that every time in the last couple of weeks they’ve gone out to do so, they’ve been able to do so. The spreads have been high, but in line with the spreads they’ve had to pay in prior periods of stress. Money is fungible and if foreign central banks don’t want to provide it at any spread (highly unlikely), someone else will. In fact, the US central bank could buy the securities and make money on the deal, if that were necessary, which it probably will not be.

    Suppose however that the debt can’t be rolled over, then what? The GSE’s assets and liabilities are duration-matched. That means that cash is coming in at the same time as new funding is required. If the new funding is not there, they can simply allow their balance sheets to shrink accordingly. Now, maybe some politicians won’t be happy about that because they want the GSE’s out there supporting the mortgage market. Ok, let them go lean on treasury to buy the debt that no one else is buying.

    Also don’t forget that the GSEs have access to the discount window in the highly unlikely event they need it.

  26. Stuart

    “Ok, let them go lean on treasury to buy the debt that no one else is buying. “

    But with the Fed’s balance sheet largely spent already pawning, er, I mean swapping with the banks, where does the Treasury get the money from? There is no way given importance of the GSEs to the mortgage market and by extension, the mortgage market to home values and by extension, home values to the banks balance sheets, the Govt will let the GSE’s reduce their balance sheet. The ultimate dilemma, default or print is at hand IMO. This is what nobody wants to directly face down. Instead, kick the can down the road so it’s the next guy’s problem seems to be the MO.

  27. fan

    Fed and treasury are not the same thing; fed’s balance sheet is irrelevant to treasury’s ability to fund.

    Treasury would get the money from the same place it often gets money – the debt markets. Issue treasuries, buy GSE debt, make money on the spread.

  28. Stuart

    I know they’re not the same thing and I could not disagree more than the fed’s balance sheet is irrelevant to the treasury’s ability to fund. It’s the ultimate backstop and routinely steps in to fill the void left during previous auctions. Nevertheless, your underlying assumption is the “external” debt market will continue to be there for them. I think that assumption is worthy of inspection, in fact will become the central focal point of debate especially as the Treasury’s funding requirements are exploding at an accelerating pace placing even more strain on the debt market at the precise time of an expanding credit crunch.

  29. fan

    Stuart, I don’t think you understand how the fed works. The fed is not the ultimate backstop for the treasury. We are.

    Yes, my underlying assumption is that the US can continue to borrow. If you think that won’t be the case, you should also realize that when that happens, the GSEs will be the least of your problems.

    For the moment, however, the US still has a AAA credit rating and pretty darn cheap borrowing costs. That is not because of the fed.

  30. Stuart


    a. do know how the Fed works, thanks. You’re assuming the tax base is there. It’s failing.
    b. completely disagree about this assumption that world will continue to pick up the tab for our fiscal deficits. We’re not entitled to it anymore than anyone else is.
    c. 110% fully aware of repercussions of that failure. Been harping on implications for years.

    Ultimate end game is default or print.

    ’nuff said.

  31. fan

    Okey dokey, Stu, world as we know it may be coming to an end, but check back in a month or so and let’s see if for the time being the GSEs have managed to roll their debt. You may have a few more years of “harping on the implications” ahead of you.

  32. Matt Dubuque

    Thanks Dean!

    Hope you have had a chance to watch “Jesus Camp”. You can see the preview here:

    Looks like Ms. Palin is but the first wave of politicians, completely self assured and ignorant, coming from this movement.

    The movie deals with a Christian jihadi madrassa in North Dakota teaching preteens to be evangelical “Warriors of Jesus”.

    Matt Dubuque

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