Does moral hazard apply to SWFs?

Here's a question for you: should concerns about moral hazard apply to central bank reserve managers and sovereign wealth funds? The question arises after recent comments from Yu Yongding, a former advisor to PBOC, suggesting that a failure to redeem GSE debt at par would be "catastrophic". Implicit in the comment was the threat "give us our money back or else."

Now, the last time that Macro Man checked, no one stood with a gun to PBOC's head and told them to buy $50 billion a month to keep the RMB artificially weak. (He is willing to concede that Hu Jintao may well have done so, but it's not quite the same as Hank Paulson standing there with his finger on the trigger.) Similarly, Macro Man is not aware of any irresistible force that compelled Voldemort to buy Agency debt, thereby collecting the "free" yield premium over Treasuries.

Yet here we are, with Fannie and Freddie on the ropes, and comments from Mr. Yu that sound like nothing so much as Paulie from Goodfellas: **** you, give me my money.

As a US taxpayer, Macro Man is thrilled with the notion of bailing out the GSEs so that serial currency manipulators can be fully compensated for their nefarious activities. (As an aside, can any readers confirm or deny weather foreign CBs pay US income tax on the Treasury and Agency debt that the Fed holds in custody for them?) This is particularly the case given that the disruptive activities of PBOC, CBR, etc. in private-sector currency markets make it more difficult to earn the money which generates his tax bill...which now will, apparently, be spent to compensate these self-same serial piss-takers.

Policymakers the world round have been quite keen to tell those of us in the private sector that we must reap what we have sown (even if, ultimately, bail-outs are inevitable in the name of "avoiding systemic risk"); do they have the cojones to say the same thing to their official counterparts?

Elsewhere, yesterday's little ditty proved to be prophetic, as the latest dismal print from the German ifo survey has prompted the latest bout of dollar strength, taking the buck to new highs for the year against the AUD and GBP, and new trend highs against the euro.


Whether this can be maintained in the near-term remains to be seen, of course; at the risk of missing the forest for the trees, Macro Man is retaining a fairly nimble investment posture until he starts seeing things a bit more clearly.
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August 26, 2008 at 11:59 AM ×

Well, of course, the difference between the Chinese and most other holders of GSE debt is that they do have guns.

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Anonymous
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August 26, 2008 at 12:02 PM ×

mm,

foreign CBs do not pay US tax on treasuries and agencies held in the Fed custodial account.

Of course, if the SWF's or CBs get board with outside passive minority investments, and switch to doing something else, like extending loans in the ordinary course of business, operating businesses, etc, that is a different story.

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Anonymous
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August 26, 2008 at 12:24 PM ×

Interesting shot over the bow by Yongding-- hadn't seen it previously. I always learn something form your posts, MM. As far as I can tell by listening to the jungle drums on this issue-- the plan is to bail out the leaky USS Fred and USS Fan by buying debt that doesn't sell. As all this new debt is used to refinance Yongding et al they should be assured that the US Treasury is forming a bailing brigade, courtesy of the US taxpayer. However, the equity holders of Fred and Fan are SOOL. My only suggestion is that these hapless equity holders obtain stock certificates and hold them in the hopes that someday they will achieve a collectibles market value (it happened for bonds of the Confederacy after a 100 year wait...)Otherwise, the US markets continue their implosion , even as most traders are out on holiday. The planning of Lehman memorial services is well underway. Cheers-- Anon

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James
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August 26, 2008 at 12:33 PM ×

Only a nation run by total morons would amass over two trillions dollars in foreign exchange reserves. The chinese leadership still has to learn about allocation of resources and profit and loss. No investment professional would ever let that amount of risk build up.

Does anyone find china's economic growth far more artificial than the media gives it credit for?

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Anonymous
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August 26, 2008 at 12:33 PM ×

The underground economy is looking like the way to go on this one for this average Joe, there just isn't any sense working and getting paid in a depreciating currency and getting screwed on the tax end for the pleasure. Cash only please and no you can't have a receipt, of course just sitting on ones ass at the beach is also a good alternative if one has the means. Watching the likes of Gross at Pimp co front run a bailout and then call for it is some what sickening but the road to serfdom has many road signs.

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Macro Man
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August 26, 2008 at 12:42 PM ×

Anon@ 12.02....all the more reason for irritation1

Anon @ 12.24 Don't get me wrong, equity holders should get nowt. It does stick in the craw, however, that bondholders should have their risk socialized...especially when those bondholders are non-tax-paying foreign entities who've accrued the Agency debt via their currency manipulations.

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Anonymous
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August 26, 2008 at 1:45 PM ×

james@12.33 --- your premise is wrong: CBs don't operate to optimize returns and risk exposure on reserve holdings, they operate to implement domestic economic and social policies. Putting China's ex-farmers to work in factories has been needed to prevent a bloody revolution...

macro man --- as a fellow U.S. taxpayer and currency trader, I share your frustrations with China's mercantilist policies and GSE debt bailout. However, I would posit the following:

First, currency manipulation and stonewalling is an art form that was very successfully practiced by Japan for decades, as they implemented their "export-led" growth policies. China obviously learned from that real-world example.

Second, and even more important, it can be argued that China's currency manipulation, reserve accumulation, etc., fits perfectly with the profit goals of all the U.S. corporations that have engaged in massive overseas outsourcing of manufacturing jobs.
This has given a huge boost to corporate profits over the past decade --- as well as to enormous increases in compensation to the top executives, thank you very much. Labor in the U.S. has become powerless and politically irrelevant. And for all the talk about "moral hazard", re SWFs as well as Wall Street bankers and traders, the big-money lobbying has already begun in Washington to water down any serious attempt to reform regulatory policy and reduce future moral hazard. The taxpayer will always be on the hook...

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Macro Man
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August 26, 2008 at 1:51 PM ×

Anon, I absolutely concur with what you've written....US companies have been a huge beneficiary of the status quo.

However, without rendering normative judgment, I am starting to seriously wonder if the electorate in the US and other Western countries won't view the status quo as an abrogation of the social contract; while benefit from the China quid-pro-quo (to give a simple name to a very deep and complicated relationship that obviously comprises more nations than just the US and China) may accrue to society as a whole, it may not accrue to the median citizen voter.

Phrased another way, global imbalances are driving domestic imbalances, which may ultimately generate a swing towards populist policies that may harm society as a whole yet appear beneficial to the median voter.

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Anonymous
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August 26, 2008 at 1:54 PM ×

Well, GSE has implicit gurantee from US gov, whatever that means. That makes the GSE's bond price higher than private banks'. If you bought an insurance policy and later your insurance company told you: sorry, you just do not have the coverage that we told you when you bought it. What do you think?

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James
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August 26, 2008 at 2:46 PM ×

No anon. Your wrong because in long run this wont work for the US or china. They cant keep manipulating forever. Wait until the chinese leadership runs into new US leadership that has just been put into office by citizens that want an end to the status quo. in a democracy the people make the rules, not some poor POS foreign government on the other side of the world making carappy toys. If china is smart they would figure out ways to employ mass amounts of people not gigantic amounts of capital investment.

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Anonymous
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August 26, 2008 at 2:51 PM ×

MM- Your post has generated yet another fascinating set of responses. You certainly have struck a nerve. As a diehard free marketer, I think that CBs should be free to buy up GSE debt in large amounts. The Fed's actions to bail the GSEs are necessary to keep the overall US market from crashing and the CBs debt owners are the beneficiaries. However, as a US tax payer I find the whole mess very discouraging and resent the threats of Yu. I beleive that he knew was already holding a winning hand but must have wanted to talk tough just in case. Cheers- Anon

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m3
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August 26, 2008 at 2:59 PM ×

mm - I also wonder what this means for politics, specifically the U.S. election cycle. Presumably none of these issues will feature in the upcoming election, but the tide may turn as you suggest at some point during the next presidency. Increasingly it seems the next guy will be a one-time prez and the biggest challenge will be to deal with the financial system.

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Anonymous
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August 26, 2008 at 2:59 PM ×

No, James. People never rules. Cause people are always too divisive and uninformative to make decision. And your so called new leaders just will say anything to get elected. His people already said it: it is just the election language.

And those low end manufacturing jobs wont return to US. If it leaves China, it will go to Mexico, Vienam, Africa, anywhere but US and EU.

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Anonymous
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August 26, 2008 at 4:02 PM ×

Honestly, how tough would it be to let GNMA become the primary mortgage insurance provider (since I believe they already are government guaranteed) and just let fnm and fre go through run-down? An orderly liquidation spanning 30 years.

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Anonymous
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August 26, 2008 at 4:40 PM ×

Pretty much everyone in the bond business just assumes that agency debt is bullet proof... the chinese are not alone in this "moral hazard" problem. The problem is that the U.S. government created these hybrid entities and grew it to the point of no return. Note the chinese haven't threatened regarding their investment in Blackstone!

The biggest problem for the asia economies is that they import U.S. monetary policy. With the fed keeping rates already very low, they have to keep rates low while economy grows rapidly. This is the real hazard in the Asian economies.
If the chinese or any other quasi fixed currency regimes don't get their money back, bye bye dollar/rates/equities....

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James
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August 26, 2008 at 5:13 PM ×

I dont like how the world has built a system of globalization that has very little redundancy. This is exactly what the chinese are doing. Wouldnt we be in a far better place if china hadnt been manipulating their currency and allowed free market forces to let spreads widen and risk premiums rise a couple of years ago.

Chinese leadership is still beholden to central planning and the illusion that they can control the future.

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Anonymous
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August 26, 2008 at 6:31 PM ×

does anyone get the impression, after watching the majestic Beijing Olympics and Ceremonies and after watching the horror in the US financial system and economy on the screen every day, that China has but one way to go and US the exact opposite? Amazing how the macroeconomic and geopolitical arrangement has turned on its head from only a decade ago. I only read bad things about the US and good things about China in the media, and we trades know those clowns are always last to the trend-recognition party. How to trade this? Buy US financials vs Chinese financials? Of course that would probably require accrual accounting...

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Anonymous
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August 26, 2008 at 6:57 PM ×

anon @6:31 PM

What are you talking about? Maybe we read some negative about US financial. I do not remember I have read many positive news on China. When China looked good a few years ago, they always said that it was not sustainable. Now there is big slowdown.

How about Brazil, it Latin America a good place to be now?

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Anonymous
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August 26, 2008 at 7:13 PM ×

It's easy to blame "the currency manipulators". There are so many fingers to point, rating agencies, gses, greenspan, mortgage originators, china... you name it... you can probably make a case for some type of blame. Whatever happened to individual responsibility? The fact that american consumers don't buy into the concept of rainy day... and live significantly beyond their means... Would we have as much subprime debt defaulting if they were a little more careful about their spending habits and things aren't always gravy... Just because you can buy a 300k house because someone will give you a low payment for the first 5yrs.... doesn't mean you should take it. Blame irresponsible people...

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James
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August 26, 2008 at 7:35 PM ×

last time I checked if one country wants to run a major surplus another one has to run a deficit.

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Click Broker
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August 26, 2008 at 8:42 PM ×

I think that the Treasury now regrets its emphasis on moral hazard and the devastation implied moral hazard has had on the GSE stock prices. My feeling is the GSEs should halt common and preferred dividends, and even start deferring unsecured debt interest payments. This would allow recapitalization through earnings and balance sheet reduction, without the need for government capital injections. As for moral hazard on SWF, the government cannot imply protection without the purchasers of the GSE debt expecting it. But common and preferred dividends never had an implied guarantee, only the secured debt did.

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Anonymous
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August 26, 2008 at 8:55 PM ×

sure they have to balance out... So there's a large current account deficit in the U.S. so what? The CNY has strengthened since they went to the NEER system of targeting against a basket since 2005, and it still hasn't changed the balance of payments. American's want cheap goods! and even if you double the currency it'll still be significantly cheaper than if they were made in the U.S. Japan has an artifically low currency too due to their low interest rates... why don't people blame them too?

Are they America's problem? Is that the reason why credit spreads were really tight? No! An extended steep yield curve coupled with some financial alchemy and excessive greed in amplifying leveraged returns is what got us here. Now the fed wants to regulate the excessive greed... good luck. Get people to be a little more responsible about their future then the problems won't be so big...

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Macro Man
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August 26, 2008 at 9:54 PM ×

Bear in mind that I am in now way suggesting that American consumers are not at significant fault for their own consumption and savings patterns.

But also consider that the government backing of GSEs, while widely believed, has also always been implicit, rather than explicit (except for the piddling amounts that are literally guaranteed.)

This has enabled Agency holders to collect a reasonably tasty premium over Treasuries; that premium is surely suggestive that the guarantee is NOT explicit?

I for one can recall seeing marketing docs for CPDOs a few years ago, wherein the prospective purchaser was offered the "safety of a AAA" rating, and yet was also offered a yield of UST + 150 bps. The old bullshit detector didn't have to be set at a very sensitive level to start going off. As it turns out, of course, T + 150 was nowhere near enough premium to compensate investors for the horrors that have subsequently unfolded, but the underlying moral of the story alos applies to Agency debt holders, both private and public sector:

If something seems too good to be true, it probably is.

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Anonymous
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August 26, 2008 at 10:07 PM ×

macro man --- I very much agree with your POTENTIALLY valid argument as to when, (or whether), "the electorate" in the U.S. realize they (for the most part the majority of "working-class Americans") rebel against the "status quo) and move to overturn the arrangements that have basically screwed them to the wall.

Well, here's my view --- for the most part, these are the very same "working class" people who voted for Reagen, Bush 1 and Bush 2 --- NOT BECAUSE OF THEIR ECONOMIC POLICIES (like overseas outsourcing of U.S. jobs), but because Bush et al WERE AGAINST ABORTION, PLUS SIMILAR ISSUES.

I am a realist, and it appears to me as a realist that there is almost no chance of the U.S. electorate changing DC players on the basis of "the breaking of the social contract", although I agree with MM that this would seem to be the logical outcome of the vast "working middle class in America" having's been royally screwed by design --- the design of the folks running DC (Repubs AND Dems).

The oncoming economic situation would have to become
MUCH MUCH worse before the untutored and brain-dead vast American "middle class" even begins to understand what a "social contrat" even means, and where they fit into the scheme of things.

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Anonymous
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August 26, 2008 at 11:30 PM ×

Agreed on the fact that everybody gets too complacent about GSE credit risk... but I think in someways the government wanted people to believe the guarantee as lower financing costs is "always" a good things for broader home ownership aka the american dream.

The rating agencies giving AAA ratings to CPDOs certainly didn't help the already overleveraged financial community. I doubt many people understood that CPDO algorithms just added to the trade if it's losing and hoping that it mean reverts.

What's the point of understanding what you own through credit analysis... when you can just trade credit correlation right??!!!

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mOOm
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August 27, 2008 at 12:16 AM ×

Foreign investors don't pay tax on interest from US investments. They do pay on dividends for some reason. I pay 15% due to the tax treaty with Australia. The default rate is 30% for individual investors.

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James
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August 27, 2008 at 3:01 AM ×

Either the US can start enforcing market rules or we can forget the world as we know it. IB's, bad banks, insurance, GSE's all need to be wound down if they cant survive. It doesnt matter if your an SWF or an asian government. Without market enforcement this whole system is worthless.

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Anonymous
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August 27, 2008 at 8:00 AM ×

"in a democracy the people make the rules"

No, the people who provide the largest campaign contributions make the rules (numerous examples exist of such contributors literally writing Congressional legislation).

"Chinese leadership is still beholden to central planning and the illusion that they can control the future."

They have done a remarkably good job so far, which will only make the (inevitable) future mistake that much more costly.


MM,

Given your love of sports, I offer this piece penned by a sportswriter who seems to have decent economic instincts:

http://washingtonpost.com/wp-dyn/content/article/2008/08/24/AR2008082400603_pf.html

I don't see China's system of regimentation as one that can develop the creativity needed for the knowledge based economy of the future, but we will see what happens as the future unfolds.

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Anonymous
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August 27, 2008 at 4:52 PM ×

anonymous -- you are wrong when you argue that the CNY's moves since 2005 haven't had an impact. since then the CNY has appreciated v the USD and depreciated v the EUR. if you look at the pattern of Chinas trade surplus by region, the surplus with the us has now stabilized in nominal $ terms and may fall this year, while the surplus with europe has increased. that is precisely what one would expect.

the move to NEER targetting was partial at best, the CNY never apprciated enough against the USD to offset the USD's fall against the euro. The biggest uptick in a CNY nominal index v a basket actually has come from the USD's recent rebound, not from the CNY's move v the USD. And all available data suggests a rebalancing of the sources of China's surplus. It is no longer just the (not quite so profligate) US.

macroman -- great post. a pure cost-benefit calculation leaves me with the conclusion that the us had to bailout out central bank creditors of the agencies. yeah, they get a bit of a windfall (so do domestic banks, so it has an aspect of being a covert bailout/ recapitalization). but the US needs them to keep lending, and that gives them leverage. moreover, if the agencies were restrutured and could no longer support the mortgage market, the price of homes would keep fallin and the treasury likely would have to step in more directly to support consumption/ the housing sector/ the bnaks. and central banks would either shift to funding the treasury or would stop financing the US altogether. the risk return isn't worth it, in my view. Especially when most CB holdings of agencies are pretty short-term and the size of the windfall isn't that big.

Moreover, I sort of buy a variant of Delong's argument that the last thing the US wants from a strategic persepective is a domestic chinese narrative that the US government actively undermined China's growth. Delong uses this to argue against pushing too hard on the RMB. I am not on board there. But i don't think the US should risk a narrative that argues the US stole 10% of China's GDP by borrowing funds from China that it didn't repay. sure, the agencies have assets as well as liabilities so the actual losses would be smaller, but i suspect the CCP wouldn't bother explaining the fine print as it tried to deflect attention from the fact that it put so much of China's savings in agency bonds.

i would tho draw the line at the bansk that were recapped by SWFs. I worry that China might view morgan stanley like the agencies -- and try to pressure the US to avoid a bear like outcome if morgan stanley got into really deep trouble. That is unlikely, but if it were too happen, it goes too far for me -- especially when the CIC's investment in Morgan Stanley is effectively rounding error on China's broad currency losses.


bsetser

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Macro Man
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August 27, 2008 at 5:29 PM ×

Brad, I thought you were at the beach!?!?

The "who has the upper hand" question is an interesting one. Ultimately, the answer probably depends on the degree to which you believe that China and the US are partners in the brave new world of the 21st century, and the degree to which you believe they are strategic adversaries fighting an economic war on multiple fronts.

(One could argue that the US takes the former view, and China the latter!)

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Anonymous
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August 27, 2008 at 6:27 PM ×

macroman -- what i can say, your post hit a nerve! and there is internet at this particular beach.

Incidentally, I took Summers' FT oped on Monday as more or less agreeing with your point that China views its accumulation of assets as strategic, as there is no other plausible explanation for its ongoing efforts to repress Chinese consumption ...

bsetser

p.s. if you want to chime in over my blog on the question of whether central bank reserve managers can impact the USD/ EUR -- and how they have played their hands during the recent USD rally -- feel free! it came up after I headed off to the beach

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