Taiwan Insurers Directed to Limit Holdings of Agency MBS

Regulators in Taiwan ordered insurers to limit their holdings of Freddie, Fannie, and Ginnie Mae paper. The stated reason was that they could not assess the credit risk and could not rely on published ratings. The explicit repudiation of rating agency ratings seems to be the first move of this type. and may be the beginning of a trend.

This statement either shows considerable ignorance or is an early warning of worries about the creditworthiiness of the US government. One can argue that the Freddie and Fannie guarantees are now somewhat uncertain. The Treasury has promised to maintain a positive net worth at the GSEs, which would mean that any GSE insured paper should be sound as long as the Treasury back-stop is in place. The authority to fund Freddie and Fannie is limited only by the federal debt ceiling. The Taiwan regulator might legitimately worry that the Treasury’s authority, set to expire at the end of 2009, would not be renewed, but that seems extremely remote.

What calls this action into question, however, is that inclusion of Ginnie Mae on the list. Ginnies are full faith and credit obligations of the US government. If you are worried about the payment risk on Ginnies, then you are worried about the creditworthiness of the US government, period.

So we are either left to conclude that the Taiwanese regulator is badly out of its depth, or very shrewdly using a trumped up excuse to get its charges to cut back on US government paper. Reading between the lines, the regulator is seeing the rises in agency spreads as the result of credit risk, when other factors are at work (for instance, mortgage payments have a lot of optionality in terms of prepayment risk; more volatile conditions lead to greater uncertainty as to prepayment behavior, which leads to spread widening).

From Asian Investor (hat tip reader Matt D):

The FSC has not only limited insurance company exposure to Fannie, Freddie and Ginnie bonds and mortgage-backed securities, but has decided that existing credit ratings are meaningless.

The Insurance Bureau at the Financial Supervisory Commission in Taipei announced revised rules on how insurance companies can treat investments in mortgage-backed securities (MBS). The FSC says it cannot see how the United States will develop a valid mechanism to assess the credit quality of MBS issued by US federal housing loan agencies, namely Fannie Mae, Freddie Mac and Ginnie Mae.

Taiwanese insurers are now ordered to back off from investing in mortgage-backed securities arranged by the three institutions, or from holding their debt. The rules set maximum allowed exposures; beyond that, they don’t explicitly order insurers to sell their holdings, although the impression in reading the regulations is certainly one of disapproval.

Such a ruling will be a blow to US Treasury authorities, who are currently pointing out that in the case of the two mortgage bodies that have been bailed out with government cash and explicitly nationalised (Fannie and Freddie), bondholders have been protected. The US financial system needs to maintain the willingness of Asian investors to buy its assets.

Exposures to US agency MBS have created massive holes in Taiwanese insurers’ balance sheets, as their value has been in freefall. In response, the Insurance Bureau has rewritten rules on fair value accounting, on October 16. It has allowed Taiwan’s insurers to stop market MBS to market and reclassify securities deemed held for ‘trading purposes’ to be booked as ‘held to maturity’ or ‘assets for the purpose of sale’.

The October 16 move has drawn criticism from Taiwan’s public that the FSC actions will lower disclosure standards and deepen the opacity in Taiwan’s financial industry….

The FSC is responding by providing a transition period for insurance companies…

In doing so, the FSC has explicitly decided to ignore credit ratings on these issues, noting that it does not recognise any ratings of A-minus or above for agency MBS, or rating scores at 680 or above for their collateralised issues.

Insurers will need to figure out how they can meet their internal capitalisation ratios if the MBS issues they have on their hands no longer meet up to scores and rating requirements. AsianInvestor’s questions to sources at major life and reinsurance companies drew a blank – these investors are used to laying out thousands of assets and filling in allocation numbers on their books based on the A to C credit ratings by credit agencies.

The credibility of third-party credit rating agencies’ grades has hit an all-time low in Taiwan. The alphabet soup of A to C ratings used by Fitch, Moody’s Investor Services and Standard & Poor’s no longer holds any meaning. Where once upon a time, sell-side research was taken over by their supposedly impartial and fair analysis, the research function is now migrating back to the buy-side under the institutional investor scene in Taiwan.

Investors say they are hit by a double-whammy of investment losses plus the necessity to add costs from expanding their internal analyst coverage.

Ian Lui, CIO at Shin Kong Insurance, says his firm is still posting positive investment gains, but that few others can do so. He expects tough times ahead, as institutional investors must continue to revisit even the most basic assumptions about asset behaviour and portfolio modelling.

Update 3:00 AM Barron’s has an article up on this development (hat tip reader HeitYoas) which is their take of the same article:

Taiwan’s financial regulators reportedly have ordered that nation’s insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae (ticker: FNM), Freddie Mac (FRE) and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.

Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.

As a result, Fannie and Freddie debt has the “effective guarantee” of the U.S. government, a spokeswoman for the Federal Housing Finance agency, the regulator for the GSEs, said Thursday. (That was a “clarification” of FHFA director James Lockhart’s earlier declaration to the Senate Finance Committee that Fannie and Freddie debt had the “explicit” guarantee of the U.S. Treasury, Dow Jones Newswires reports.)

Moreover, Ginnie Mae securities have always been backed with the same full faith and credit guarantee as the U.S. Treasury.

In either case, the Taiwanese action is a blow to the reeling U.S. mortgage market, which has been supported by the Republic of China’s purchases of agency securities. According to U.S. Treasury data, Taiwan owned a very substantial $55 billion of U.S. agencies along with $43 billion of Treasuries as of June 30, 2007, the most recent date for which these data are available.

Despite the overwrought tone of the Barron’s story, this development appears more damaging as a precedent than an actual move (but given the size of the Barron’s readership here, do not discount the odds of a serious adverse reaction by US investors). Neither the Asian Investor article nor the Barron’s piece says how much the Taiwanese insurers hold in agency MBS or what their annual purchases are. Brad Setser’s work on international capital flows over the last year has shown that, except for a couple of months, private demand for abroad for US securities had evaporated, and the offshore buyers of Treasuries and agencies have been almost entirely central banks.

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  1. John Liberty

    This is quite surprising. Not because of the nationalization of the agencies, but because the U.S. government holds a lot of political and military leverage over the Taiwanese. I would expect the U.S. would exercise such leverage to prevent the dominoes from falling.

    I am almost sure this will lead to other azn countries following suit – the only reason it hasn’t happened yet was because of it being seen as a political snub and because of taboo.

  2. John Liberty

    GNMA primarily does two things. First, it provides a computer platform that efficiently pools mortgages into bonds from pre-approved lenders. Second, GNMA provides, for 6 basis points of the outstanding principal balance of a bond, a guarantee of timely payment of principal and interest; this is essentially a guarantee that the United States government will continue to pay investors even if the underlying collateral (government insured mortgages) defaults. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.

  3. Anonymous

    We are missing the point. The Island is looking to the future and sees the dollar value going down. They don’t want to be stuck holding the bag.

  4. doc holiday

    Bottom line for me is the fact that rating agencies have no way to model the future and to support their involvement in structured finance; they dropped the ball every time they got in this game, i.e, they dropped the integrity and honesty ball, the ability to model risk ball, the ability to understand collateral ball, the mis-understanding of all derivative interaction balls and, gosh damn it, anything they touch is tainted and reeks of conspiracy, fraud, collusion, misrepresentation, retardation and all that crap related to The Large Hadron Collider and chaos…. would you like fries and mayo with that magnet?

    Re: “existing credit ratings are meaningless”

  5. Jason

    That just sounds wrong to me. I agree with John Liberty. If you’re going to not allow MBS’s from Fannie Freddie and Ginnie (!), you have to throw out anything backed by the US government. Not to mention the inevitable political backlash. Just looks like a silly decision.

  6. misper

    Smart and nimble central bankers will discreetly begin selling their dollar reserves into the market’s dollar strength while effectively reducing or eliminating their treasury/GSE portfolio purchases. A country like Taiwan can probably get away with this and stick the price tag of the future reduced dollar value to their big brother (China).

  7. wintermute

    anon 2:35 is right. This is specifically a dollar credibility issue, not a US govt one. They must be concerned that the long-term exchange rate is weak dollar, strong won. So the FX risk is not worth the meagre interest earned on the GSE debt.

  8. Sergei

    Hi Yves,

    I am a Taiwanese, and now work in Hong Kong as a credit analyst covering banks in China, Hong Kong and Taiwan. I used be based in Taiwan covering Taiwanese banks. I can tell you the financial regulators in Taiwan are hopelessly incompetent, provincial, and wouldn’t be able to figure out the true creditworthiness of Fannie- and Freddie-backed paper. A number of taiwanese banks and insurance companies are hopelessly unprofitable and undercapitalized. The banking and insurance regulators have permited regulatory forebearance since 2002, allowing undercapitalised banks and insurance companies to regain balance sheet over time. Taiwanese insurance companies have been operating under very unfavourable conditions for years. Yields on TWD treasury securities have been below 2.5% for years, and spread on corporate bonds are less than 50 basis points. Consequently, insurance companies have been piling into USD fixed income securities, and regulators allows up to 45% of all insurance company investments abroad, which makes them vulnerable to large swings in the forex market. Well, you can imagine how well their investments have done in the past few quarters. Several insurance companies have reported large losses from the investments in CDOs, and their stock prices have fallen by between 50% and 75%. In my opinion, the regulator want to be seen to be doing something, so this is what they did.

  9. Matt Dubuque

    Matt Dubuque

    My first hat tip!

    Clearly this development deserves deep and thorough study.

    It is difficult to draw many conclusions at this time, as Yves pointed out.

    However, ONE conclusion that seems very safe is that the Taiwanese, who are large players, are stating that the outlook for the housing market in the US (which generates these cash flows supporting these structured products) is more dire than the consensus forecast.

    Matt Dubuque

  10. Anonymous

    Meanwhile, FT is reporting on negative swap spreads:

    “On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier this month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.”

  11. freude bud

    Even in terms of shutting down a loophole, to do this at this particular moment in time must have been cleared at the highest levels. I’d lean towards thinking it can only be explained as a message to Beijing and DC.

    How many goodly creatures are there here! / How beauteous mankind is! / O brave new world / That hath such people in’t!

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