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This gets more ridiculous by the hour.
The dependence on China already was zero.

And, as in my previous post, the high savings rate of the non government sector
comes dollar for dollar from the deficit and is not necessarily indicative of
low spending.

If it were, that would imply there is no inflation risk to deficit spending on the grounds that it all gets added to savings.

So once again one of our opinion leaders is making a statement that supports the opposite of what he thinks it supports.

Federal deficit spending is clearly adding to incomes, savings, and spending.

As it always does.

Surging U.S. Savings Rate Reduces Dependence on China

by Rich Miller and Alison Sider

June 26th (Bloomberg) — Saks Fifth Avenue is cutting orders 20 percent after postinglosses in the last four quarters. Kia Harris says some customers at the Washington shoe store where she works are buying one pair rather than three.

Incomes and spending were up in yesterday’s report.

In the recession following a borrowing binge that sent consumer debt to the highest level ever, Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.

Non government savings and income is ‘funded’ by federal deficit spending — to the penny

While the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment,

Dependence on Chinese investment remains at zero where it’s always been.

it may also restrain economic growth in 2010 and beyond,

No, in fact the higher income and savings added by the federal deficit tends to expand aggregate demand and real economic growth.

said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and a former Federal Reserve governor.

Who would have thought???…

“There’s been a fundamental change in people’s behavior,” he said. “It will affect the economy for years.”

Government data today showed that the household savings rate rose to 6.9 percent in May, the highest since December 1993, as personal spending increased less than incomes. The rate in April 2008 was zero.

1993 was also a year of very high federal deficit spending.

This stuff is not that hard…

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Wonder if they’ve used it?

In my humble opinion lending them $30 billion unsecured is a high risk proposition.

U.S. Federal Reserve Extends Swap Line With Brazil Central Bank

June 25 (Bloomberg) — Brazil’s central bank said today it
has extended an agreement to access up to $30 billion from the
U.S. Federal Reserve as part of a coordinated international
effort to shore up shaky financial markets.

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Looks like they are moving towards higher levels of domestic consumption to sustain output and employment.

(must be reading my blog…)

China’s Central Bank Pledges to Keep Money Flowing

China to Start Trial Rural Pension System to Boost Consumption

China’s Central Bank Pledges to Keep Money Flowing

June 25 (Bloomberg) — China’s central bank pledged to keep
pumping money into the financial system to support a recovery in
the world’s third-biggest economy.

The economy is in a “critical” stage and the central bank
will maintain a “moderately loose” monetary policy, the
People’s Bank of China reiterated in a statement on its Web site
today after a quarterly meeting.

The central bank triggered an explosion in credit by
scrapping quotas on lending in November to back the government’s
4 trillion yuan ($585 billion) stimulus plan. Record lending is
stoking concern that a recovery may come at the expense of asset
bubbles, bad debts for banks and inflation in the long term.

Banks are set to lend more in June than in May, the same
newspaper reported June 22, citing unidentified sources. Last
month, new loans more than doubled from a year earlier.

China to Start Trial Rural Pension System to Boost Consumption

June 25 (Bloomberg) —China, home to 700 million rural
residents, approved a pilot pension program as the government
tries to encourage farmers to spend more to help revive economic
growth.

The new system, which aims to cover 10 percent of rural
counties this year, will help narrow a wealth gap with cities
and spur domestic demand, according to a statement today from
the State Council, China’s cabinet.

China has expanded its social safety net to reduce
precautionary saving by citizens planning for ill health and old
age. Premier Wen Jiabao has pledged to boost domestic
consumption to help the world’s third-biggest economy recover
from its deepest slump in a decade and lessen dependence on
exports and investment.

“The rural pension system has been almost non-existent,”
said Kevin Lai, an economist with Daiwa Institute of Research in
Hong Kong. “Once you build a stronger social safety net, people
will be more inclined to spend without having to worry about the
future.”

The government in late January also announced it would
spend 850 billion yuan ($124 billion) over three years to ensure
that at least 90 percent of its 1.3 billion citizens have basic
health insurance by 2011.

China’s economy grew 6.1 percent in the first quarter, the
slowest pace in almost a decade.

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So how about recommending a suspension VAT for a bit???

King Says U.K. Recovery May Be ‘Long, Hard Slog’

by Robert Schmidt

June 24 (Bloomberg) — “There has to be a risk that it will be a long, hard slog” because of the problems in the banking system, King told lawmakers in London today. “I feel more uncertain now than ever. This is not the pattern of a recession coming into recovery that we’ve seen since the 1930s. Having an open mind and not pretending to foresee the future when it’s so uncertain is important.”

King said that there’s “not much evidence to change our view” since the bank released forecasts in May showing that the economy won’t return to growth on an annual basis until the second half of next year.

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Please send this on to Eugenio Aleman at Wells Fargo

Thinking The Unthinkable: The Treasury Black Swan, And The LIBOR-UST Inversion

Posted by Tyler Durden

>   The below piece is a good analysis of a hypothetical Treasury/Dollar black swan
>   event, courtesy of Eugenio Aleman from, surprisngly, Wells Fargo. Eugenio does
>   the classic Taleb thought experiment: what happens if the unthinkable become
>    not just thinkable, but reality. Agree or disagree, now that we have gotten to
>   a point where 6 sigma events are a daily ocurrence, it might be prudent to
>   consider all the alternatives.

In previous reports, I have touched upon the concerns I have regarding the overstretching of the federal government as well as of monetary policy while the Federal Reserve tries to maintain its independence and its ability, or willingness, to dry the U.S. economy of the current excess liquidity.

Excess reserves are functionally one day Treasury securities.
It’s a non issue.

Furthermore, we heard this week the Fed Chairman’s congressional testimony on the perils of excessive fiscal deficits and the effects these deficits are having on interest rates at a time when the Federal Reserve is intervening in the economy to try to keep interest rates low.

His thinking is still on the gold standard in too many ways.

Now, what I call “thinking the unthinkable” is what if, because of all these issues, individuals across the world start dumping U.S. dollar notes, i.e., U.S. dollar bills?

The dollar would go down for a while.
Prices of imports would go up.
Exports would go up for a while

All assuming the other nations would let their currencies appreciate and let their exporters lose their hard won US market shares, which is certainly possible, though far from a sure thing.

Why? Because one of the advantages the U.S. Federal Reserve has over almost all of the rest of the world’s central banks is that there seems to be an almost infinite demand for U.S. dollars in the world, which has made the Federal Reserve’s job a lot easier than that of other central banks, even those from developed countries.

In what way? They set rates, that’s all. It’s no harder or easier for the Fed than any other central bank.

if there is a massive run against the U.S. dollar across the world then the Federal Reserve will have to sell U.S. Treasuries to exchange for those U.S. dollars being returned to the country, which means that the U.S. Federal debt and interest payments on that debt will increase further.

Not true. First, they have a zero rate policy anyway so they can just sit as excess reserves should anyone deposit them in a bank account, and earn 0. Or they can hold the cash and earn 0.

This means that we will go from paying nothing on our “currency” loans to having to pay interest on those U.S. Treasuries that will be used to sterilize the massive influx of U.S. dollar bills into the U.S. economy, putting further pressure on interest rates.

No treasuries have to sold to sterilize anything.
A little knowledge about monetary operations would go a long way towards not letting this nonsense be published in respectable forums.

If we add the nervousness from Chinese officials regarding U.S. debt issues, then we understand the reason why we had Treasury secretary Timothy Geithner in China last week “calming” Chinese officials concerned with the massive U.S. fiscal deficits. I remember similar trips from the Bush administration’s Treasury officials pleading with Chinese officials for them to continue to buy GSEs (Freddie Mac and Freddie Mae) paper just before the financial markets imploded.

Yes, they have it wrong, and it’s making the administration negotiate from a perceived position of weakness while the Chinese and others take us for fools.

But the situation today is even more delicate because of the impressive amounts of U.S. Treasuries s we will have to issue during the next several years in order to pay for all the programs we have put together to minimize the fallout from this crisis.

Issuing Treasuries does not pay for anything. Spending pays for things, and spending is not operationally constrained by revenues.

The Treasuries issued support interest rates. They don’t ‘provide’ funds.

Furthermore, if China and other countries do not keep buying U.S. Treasuries, then interest rates are going to skyrocket.

There’s some hard scientific analysis. They go to the next highest bidder. The funds to pay for the securities come from government spending/Fed lending, so by definition the funds are always there and the term structure of rates is a matter of indifference levels predicated on future fed rate decisions.

This is one of the reasons why Bernanke was so adamant against fiscal deficits in his latest congressional appearance.

And because on a gold standard deficits can be deadly and cause default. He’s still largely in that paradigm that’s long gone.

Of course, the U.S. government knows that the Chinese are in a very difficult position: if they don’t buy U.S. Treasuries, then the Chinese currency is going to appreciate against the U.S. dollar and thus Chinese exports to the U.S., and consequently, Chinese economic growth will falter.

Yes, as I indicated above.

The U.S. and China are like Siamese twins joined at the chest and sharing one heart. This is something that will probably keep Chinese demand for Treasuries elevated during the next several years. However, this is not a guarantee, especially if the Chinese recovery is temporary and they have to keep on spending resources on more fiscal stimulus rather than on buying U.S. Treasuries.

Again, this shows no understanding of monetary operations and reserve accounting. The last two are not operationally or logically connected.

Thus, my perspective for the U.S. dollar is not very good. And now comes the caveat. Having said this, what is the next best thing? Hugo Chavez’s Venezuelan peso? Putin’s Russian rubble? The Iranian rial? The Chinese renminbi? Kirchner’s Argentine peso? Lula da Silva’s Brazilian real? That is, the U.S. dollar is still second to none!

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Power Point I did for a conference discussion.

Financial Architecture Fundamentals

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The right tools have yet to be deployed:

1. Lending to member banks on an unsecured basis (demanding collateral is redundant).
    
2. Providing banks with term financing at rates set by the FOMC (mortgage rates, etc. can be directly set as desired).
    
3. Prohibiting bank sales of financial assets (buy and hold only and no interbank markets).
    

Instead we have the results of a government that doesn’t understand its own monetary arrangements and has implemented policy that for the most part has made a difficult situation all the more difficult.

Feel free to distribute for comment!

Bernanke Says Fed to ‘Deploy All Tools’ for Economic Revival

by Steve Matthews

March 7 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke said the central bank will “forcefully” use every resource to restore financial-market stability and revive U.S. economic growth.

“We will continue to forcefully deploy all the tools at our disposal as long as necessary to support the restoration of financial stability and the resumption of healthy economic growth,” Bernanke said in prepared remarks for an event today in Dillon, South Carolina. The Fed chief returned to his hometown to attend a ceremony naming a highway interchange after him.

Bernanke didn’t comment on specific Fed policies in his remarks. He said he was aware Dillon now “faces challenges” with the economy in a recession.

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(email exchange)

>   
>   On Fri, Dec 19, 2008 at 9:25 AM, Scott wrote:
>   
>   ECB says to discontinue US dollar swap OPS from end Jan.
>   
>   I guess they don’t want euro to strengthen!
>   

Exactly!

This is the new century version of ‘competitive devaluations.’

Paulson moved first by talking foreign CB’s out of buying USD reserves.

Bernanke thought he was helping with rate cuts.

China said ‘no mas’ a while back started ‘letting’ the yuan depreciate, probably via USD purchases.

Japan recently announced ‘no mas’ and that they were prepared to resume USD buying to abort yen appreciation.

If the ECB in fact cuts off its banks ‘cold turkey’ from the Fed’s $ the shock can be enormous.

Ramifications:

Upward pressure on USD LIBOR.

Downward pressure on the euro.

Upward pressure on eurozone credit default premiums.

Falling US equities.

Etc.

ECB to Discontinue Dollar Swap Tenders From the End of January

By Jana Randow

Dec. 19 (Bloomberg) — The European Central Bank said it will discontinue its euro-dollar foreign exchange swap tenders at the end of January due to “limited demand.”

Right! Only $300 billion outstanding.

The ECB will continue to loan banks in Europe as many dollars as they need for terms of 7, 28 and 84 days in exchange for eligible collateral, the Frankfurt-based central bank said in a statement today. Dollar swaps “could be started again in the future, if needed in view of prevailing market circumstances,” the ECB added.

Those circumstances being the strong euro?

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ECB cuts to 2.5pc and mulls “printing money”

By Ambrose Evans-Pritchard

The Maastricht Treaty prohibits the ECB from injecting stimulus by purchasing the government debt of the eurozone’s fifteen states debt — a method known as “monetizing the deficit” or, more crudely, as “printing money.”

But it can achieve the same effect

not quite

by mopping up sovereign debt, mortgage securities, or even company debt on the open market, as the Fed has already begun to do. At the moment the ECB accepts some of these assets as collateral in exchange for loans, but it has not yet hit the atomic button by buying them outright with its own freshly-minted fiat money.

When the ECB accepts collateral for loans, it doesn’t offer non recourse funding. The owner of the securities remains liable in the case of default.

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Interesting how Europe feels its fate is in the hands of the US.

The Euro was supposed to change all that.

Yes, the national governments know they are constrained fiscally by their self imposed 3% deficit limits. And they also suspect that they are further limited by market forces that may decide not to buy the national government securities and cut off their ability to borrow to spend. The national governments are in that respect similar to the US states which are currently pro-cyclically cutting spending due to funding constraints due to lack of income.

Unlike the US and the UK, in the Eurozone the national governments are providing the deposit insurance for their banks.

It can all come apart very quickly.

They can blame the US, but the fault lies with their failure to be able to sustain domestic demand, which they built into the treaty 10 years or so ago.

Good chance market forces will ultimately force modifications to the treaty.

My highlights in yellow below:

Trichet Says U.S. Must Pass Plan to Rescue `Global Finance’

by Andreas Scholz and Gabi Thesing
Oct. 1 (Bloomberg) European Central Bank President Jean-Claude Trichet said U.S. lawmakers must pass a $700 billion rescue package for banks to shore up confidence in the global financial system.

“It has to go, for the sake of the U.S. and for the sake of global finance,” Trichet said in an interview in Frankfurt with Bloomberg Television late yesterday. “I am confident, but of course it is the decision of the U.S. Congress.”

President George W. Bush and Senate leaders yesterday vowed to revive a plan aimed at buying distressed assets from banks that was rejected by Congress a day earlier. The vote roiled markets already struggling to cope with the collapse of Lehman Brothers Holdings Inc. European governments have helped rescue at least five banks since Sept. 28, with Trichet taking part in talks to save Belgium’s Fortis over the weekend.

Trichet said a pan-European approach to the banking crisis was unlikely, saying “we are not a fully-fledged federation with a federal budget.”

“Each country has to mobilize its own efforts,” said Trichet. “But of course there is a European spirit and that is the spirit of the single market.”

Trichet declined to answer questions about ECB monetary policy before tomorrow’s interest-rate decision. All 58 economists surveyed by Bloomberg News expect the central bank to
keep its benchmark rate at 4.25 percent.

European leaders are trying to better coordinate their response to the financial crisis. Luxembourg Finance Minister Jean-Claude Juncker said yesterday he expects to meet with Trichet and French President Nicolas Sarkozy on Oct. 4 to discuss “a more systematic approach.”

Trichet’s ECB has so far chosen not to follow the Federal Reserve in slashing interest rates since credit markets seized up 13 months ago, injecting cash into their markets instead, while keeping monetary policy focused on inflation.

Price Stability
“What’s needed is for us to continue to tell our fellow citizens that we will ensure price stability,” Trichet said in an interview broadcast yesterday on the France 2 television channel.

Belgium, the Netherlands and Luxembourg on Sept. 28 agreed to inject 11.2 billion euros ($16 billion) into Fortis, the largest Belgian financial-services company.

Governments and other authorities have also taken steps to protect the U.K.’s Bradford & Bingley Plc, Brussels and Paris-based Dexia SA, Iceland’s Glitnir Bank hf and Germany’s Hypo Real Estate Holding AG. Ireland yesterday guaranteed the deposits and borrowings of six lenders.

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Euro equities and banks are now under attack, and the ECB is effectively borrowing hundreds of billions USD from the Fed via swap lines. The eurozone deposit insurance is by the national governments, not the ECN, which are credit constrained.

National government euro bonds have been supported by various CB/monetary authority allocations that are slowing with slowing net exports.

A major bank failure becomes infinitely more problematic in the eurozone than in the US, Japan, or UK, all who have deposit insurance at the ‘federal’ level.

The risk in the eurozone is the payments system completely shuts down, and re opens only when the ECB is allowed to conduct what amounts to fiscal transfers.

In a crunch, USD borrowings will need to be serviced from selling euros to buy USD and result in a sharply falling euro.

Yields on the national government bonds will move sharply higher due to credit concerns, as will credit default premiums in general.

For 10 years the euro ’system’ has functioned reasonably well on the way up.

The systemic risk is only on the way down. And once in motion, it will unwind very quickly.

Protect yourself by not having any euro deposits, buying out of the money puts on the national government bonds and out of the money puts on the euro.

And then hope you lose those bets!

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This may actually help bring LIBOR down as the US banks don’t need USD funds from China while the rest of the world does.

China Halts Interbank Lending With U.S., Morning Post Says

By Joost Akkermans

Sept. 25 (Bloomberg) China’s banking regulator told domestic banks to halt lending to U.S. financial institutions in the interbank market to help prevent possible losses, the South China Morning Post reported, citing people it didn’t identify.

The ban imposed by the China Banking Regulatory Commission is for interbank lending of all currencies to U.S. banks, though not to banks from other countries, the English-language Hong Kong newspaper said today.

The decree came after the regulator obtained data about the risk of local banks to bonds issued by Lehman Brothers Holdings Inc., according to the newspaper. The CBRC wasn’t available for comment yesterday, the Morning Post reported.

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This is an extension of credit to those CBs which functionally allows them to borrow (and thereby also get ’short’) USD, presumably to fund their local USD needs for their institutions short USD, and presumably to cover losses on their USD financial assets and to finance the remaining balances.

The ECB has no USD to fund its member banks, and is not inclined to sell euros and buy USD as, at a minimum, a matter of ideology.

This is not a good sign for the eurozone banking system solvency, though the size is modest, at least for now.

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The Fed has a major strategic advantage over private sector buyers.

With the Fed making the loan, credit spreads in general should narrow.

This will add value to AIG’s short credit position which is where most of the mark to market losses are.

So the Fed’s actions to reduce systemic risk also increase the value of AIG once they take them over.

It’s good to be the Fed!

(not that it matters to the Fed itself financially one way or the other, but they probably don’t know that)

Fed Close to Deal to Give A.I.G. $85 Billion Loan

by Michael J. de la Merced and Eric Dash

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said.

The Fed’s action was disclosed after Treasury Secretary Henry M. Paulson and Ben S. Bernanke, president of the Federal Reserve, went to Capitol Hill on Tuesday evening to meet with House and Senate leaders. Mr. Paulson called the Senate majority leader, Harry Reid, Democrat of Nevada, about 5 p.m. and asked for a meeting in the Senate leader’s office, which began about 6:30 p.m.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for A.I.G. to stave off the financial crisis caused by complex debt securities and credit default swaps . The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Without the help, A.I.G. was expected to be forced to file for bankruptcy protection.

The need for the loans became necessary after the major credit ratings agencies downgraded A.I.G. late Monday, a move that likely to have forced the company to turn over billions of dollars in collateral to its derivatives trading partners worsening its financial health.

Until this week, it would have been unthinkable for the Federal Reserve to bail out an insurance company, and A.I.G.’s request for help from the Fed of just a few days ago was rebuffed.

But with the prospect of a giant bankruptcy looming - one with unpredictable consequences for the world financial system - the Fed abandoned precedent and agreed to let the money flow.

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(an email exchange)

>   
>   On Tue, Sep 16, 2008 at 10:24 AM, Tom wrote:
>   
>   Hi Coach,
>   
>   While financial markets are in a meltdown not unlike the post 9/11
>   experience,
>   

yes, major deleveraging going on

>   
>   the good news is that central banks around the world are providing
>   coordinated liquidity injections along with other positive actions that may
>   create a new basis for global financial rescues.
>   

yes, but all that does is set the fed funds rate and term fed funds rate. it’s about price, not quantity

>   
>   The creation of the League of Nations was an example of how the world
>   responded to WWI.
>   
>   Tom
>   
>   P.S. But it is still not time to buy stock.
>   

agreed!

watch for fiscal policy to do the heavy lifting to support GDP and employment.

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I’ve been recommending the following for the Fed for quite a while (see Proposals for the Fed):

1. Lower the discount rate the Fed Funds rate and:
   1. Accept a pledge of any bank legal collateral from any member bank.
   2. Impose no restriction on quantity borrowed.
   3. Impose no restriction on the duration of any member bank borrowing.

2. Likewise, remove collateral restrictions on the TAF operations.
   1. Set the maturity and interest rate for each TAF operation.
   2. Leave demand open-ended, rather than the current policy of limiting quantity.

Failure to implement the above shows a failure to understand fundamental monetary operations.

These policy changes would alleviate critical liquidity issues, and not, per se, alter net bank reserve demand (not that the size of the bank reserve ‘matters’).

Part of the current crisis is due to the failure to implement the above changes that would have:

1. Normalized bank liquidity.
2. Prevented the forced sales of investment grade, unimpaired, bank legal assets.
3. Allowed banks to finance bank legal assets for third parties.
4. Allowed markets to function to deleverage impaired assets.

The Fed is slowly moving in that direction, but, unfortunately, not proactively to ‘fix’ a flawed institutional structure, but reactively as things fall apart in no small part due to lack of action:

Federal Reserve lowers standards for collateral from primary dealers

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

Also, Schedule 2 TSLF auctions will be conducted each week; previously, Schedule 2 auctions had been conducted every two weeks. In addition, the amounts offered under Schedule 2 auctions will be increased to a total of $150 billion, from a total of $125 billion. Amounts offered in Schedule 1 auctions will remain at a total of $50 billion. Thus, the total amount offered in the TSLF program will rise to $200 billion from $175 billion.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.

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It comes down to public purpose.

The agencies were set up to provide low cost funding for moderate income home buyers.

They have done that reasonably well.

However, for probably 20 years I’ve been saying the agencies should fund themselves directly with the Treasury or Fed financing bank (same as Treasury). This both lowers their cost of funds, which would get passed through to the home mortgages they originate, and eliminates the possibility of a liquidity crisis.

Market discipline should not be on the liability side. It subjects them to risk of a ‘liquidity crisis’ where those funding you can decide to go play golf one day and cut you off for no reason and put you out of business. (And any entity subject to private sector funding to continue operations is subject to this kind of liquidity risk.) Regulation should focus instead on the asset side with assets and capital fully regulated.

This was done for the most part, and this is the same as the general banking model which works reasonably well. Yes, it blows up now and then as banks find flaws in the regulations, but the losses are taken, regulations adjusted, and life goes on.

The agencies made some loans to lower income borrowers as that went bad.

Even with this, most calculations show that at today’s rates of mortgage default they still have adequate capital to squeak by - the cash flow from the remaining mortgages and their capital is pretty much adequate to pay off their lenders (those who hold their securities).

But if defaults increase their ‘cash flow net worth’ could turn negative; hence, it would currently not be prudent for the private sector to fund them.

Paulson has now moved funding to the Treasury where it should have been in the first place.

This removes the possibility of a liquidity crisis and allows the agencies to continue to meet their congressional charge of providing home mortgages for moderate and lower income borrowers at low rates.

There was no operational reason for Paulson to do more than that, only political reasons.

The agencies could then have continued to function as charged by Congress.

If there were any long-term cash flow deficiencies, they would be ‘absorbed’ by the Treasury as that would have meant some of the funding for new loans was in fact a Treasury expense as it transferred some funds to borrowers who defaulted.

Congress has always been free to change underwriting standards.

In fact, the program was all about easier underwriting for targeted borrowers.

If there were any ultimate losses, that was the cost of serving those borrowers.

To date there have been only profits, and the program has ‘cost’ the government nothing.

With Treasury funding and a review of underwriting standards the program could have continued as before, which it might still do.

The entire episode was a panic over a possible liquidity crisis due to the possibility of the Treasury not doing what it did, and what should have been done at inception.

I don’t think the Treasury getting 79.1% of the equity after making sure it took no losses and got a premium on any ‘investment’ it made served any non-political purpose.

There was no reason current equity holders could not have gotten the ‘leftovers’ after the government got its funds and a premium also determined by the government.

Equity IS the leftovers and could have been left alone. (It wouldn’t surprise me if some of the shareholders challenge this aspect of the move.)

Yes, holders of direct agency securities were ‘rescued’, but they were taking a below market rate to buy those securities due to the implied government backing and lines of credit to the government.

I don’t see it as a case of ‘market failure’ but instead poorly designed institutional structure with a major flaw that forced a change of structure.

It’s a failure of government to do it right the first time, probably due to politics, and much like the flaw in the eurozone financial architecture (no credible deposit insurance - another form of allowing the liability side of the banking system to be subject to market discipline), also due to politics.

As for compensation, that too was ultimately under the control of Congress, directly or indirectly.

Lastly, in the early 1970s, with only 215 million people, housing starts peaked at 2.6 million per year.

Today, with over 300 million people we consider 2 million starts ‘gangbusters’ and a ’speculative boom’.

And in the early 1970s, all there were was bunch of passive S&Ls making home loans - no secondary markets, no agencies, etc.

Point is, we don’t need any of this ‘financial innovation’ to further the real economy.

Rather, the financial sector preys on they real sectors, in both financial terms and real terms via the massive brain drain from the real sectors to the financial sector.

At the macro level, we’d be better off without 90% or more of the financial sector.

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Main Bank of China Is in Need of Capital

by Keith Bradsher

HONG KONG — China’s central bank is in a bind.

It has been on a buying binge in the United States over the last seven years, snapping up roughly $1 trillion worth of Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac.

This was part of a ‘weak yen’ policy designed to support exports by keeping real domestic wages in check.

Those investments have been declining sharply in value when converted from dollars into the strong yuan,

Why should they care?

What matters from an investment point of view is what the USD can buy now, what the yuan can buy.

casting a spotlight on the central bank’s tiny capital base. The bank’s capital, just $3.2 billion, has not grown during the buying spree, despite private warnings from the International Monetary Fund.

Doesn’t matter what currency the bank’s capital is denominated in because he doesn’t know it matters.

The government has infinite yuan to spend without operational constraint; so, stated yuan capital doesn’t matter.

Now the central bank needs an infusion of capital.

Why? That’s a self-imposed constraint. Operationally central banks don’t need a local currency capital.

Central banks can, of course, print more money, but that would stoke inflation.

Operationally, this makes no sense. There is no such thing as ‘printing money’ apart from actually printing a pile of bills and leaving them on a shelf, which does nothing.

If they spend those bills, that’s government deficit spending with the same effect as any other government deficit spending.

‘Printing money’ has nothing to do with anything.

Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

Yes, there are self-imposed constraints imposed on various agencies of the government.

There are no operational constraints.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts.

The way they keep a strong currency down is by buying more USD.

A weak currency goes down on its own.

To make a weak currency rise, you have to see your USD.

This could heighten trade tensions with the United States.

Yes.

The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

Yes, but if the yuan has turned fundamentally weak, the way for the US to keep it from falling is for the US Treasury to buy yuan.

The central bank has been the main advocate within China for a stronger yuan.

They want to fight inflation by keeping nominal input costs down.

But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan.

Right, they want to support exports by keeping real wages down.

As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

The two bureaucracies have been ferocious rivals. Accepting an injection of capital from the finance ministry could reduce the independence of the central bank, said Eswar S. Prasad, the former division chief for China at the International Monetary Fund.

“Central banks hate doing that because it puts them more under the thumb of the finance ministry,” he said.

True.

This matters for foreign exchange policy. In the US, Japan, and others, the Treasury makes the foreign exchange decisions, not the Central Bank. And this if far more potent than interest rate policy.

Mr. Prasad said that during his trips to Beijing on behalf of the I.M.F., he had repeatedly cautioned China over the enormous scale of its holdings of American bonds, emphasizing that it left China vulnerable to losses from either a strengthening of the yuan or from a rise in American interest rates. When interest rates rise, the prices of bonds fall.

Those are not risks, as above.

Officials at the central bank declined to comment, while finance ministry officials did not respond to calls or questions via fax seeking comment. Data in a study by the Bank of International Settlements based in Basel, Switzerland, sometimes called the central bank for central banks, shows that many central banks had small capital bases relative to foreign reserves at the end of 2002,

They don’t need any capital base relative to foreign exchange holdings.

Foreign exchange holding are themselves capital.

though few were as low as the People’s Bank of China.

Given the poor performance of foreign bonds, the Chinese government could decide to shift some of its foreign exchange reserves into global stock markets.

If they shift to financial assets denominated in other currencies, this serves to shift the value of the yuan vs those currencies.

Stocks vs bonds is an investment decision only.

The central bank started making modest purchases of foreign stocks last winter, but has kept almost all of its reserves in bonds, like other central banks.

The finance ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corporation, which had been bankrolled by the central bank. That corporation’s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value.

The central bank’s difficulties do not, by themselves, pose a threat to the economy, economists agree. The government has ample resources and is running a budget surplus. Most likely, the finance ministry would simply transfer bonds of other Chinese government agencies to the bank to increase its capital. But even in a country that strongly discourages criticism of its economic policies, hints of dissatisfaction are appearing over China’s foreign investments.

For instance, a Chinese blogger complained last month, “It is as if China has made a gift to the United States Navy of 200 brand new aircraft carriers.”

Bankers estimate that $1 trillion of China’s total foreign exchange reserves of $1.8 trillion are in American securities. With aircraft carriers costing up to $5 billion apiece, $1 trillion would, in theory, buy 200 of them.

By buying United States bonds, the Chinese government has been investing a large chunk of the country’s savings in assets earning just 3 percent annually in dollars. And those low returns turn into real declines of about 10 percent a year after factoring in inflation and the yuan’s appreciation against the dollar.

The yuan has risen 21 percent against the dollar since China stopped pegging its currency to the dollar in July 2005.

The actual declines in value of the central bank’s various investments are a carefully guarded state secret.

Still China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar.

China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year. Chinese officials have suggested in recent comments that they are increasingly interested in stopping the yuan’s rise, and thus are willing to continue buying foreign securities to support the dollar. In fact, the yuan weakened slightly against the dollar last month after 26 consecutive months of gains.

Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & Poor’s estimates China’s holdings at $340 billion.

Some bond traders suspect that the central bank has scaled back its purchases of these securities, as have China’s commercial banks. But the central bank trades this debt through many third parties in many countries, making its activity opaque to outside analysts.

The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, China’s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.

To keep the banks strong when they were getting such little interest on their reserves, the central bank has kept deposit rates low. The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese.

The central bank is now under considerable pressure to reduce the commercial banks’ reserve requirements to encourage growth as the Chinese economy shows signs of slowing.

Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People’s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution’s losses.

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

“A lot of policy makers in China, at least midlevel policy makers, believe this,” Mr. Shih said.

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Recap:

1. If I’m reading it right, the agencies will fund directly through the Treasury. I’ve been suggesting this for many years. This lowers the cost of funds for housing, the point of the entire program, by removing a premium that’s been paid by the lack of an explicit guarantee.

2. Agency portfolios being phased out, to be replaced by direct purchasing of the MBS (mortgage-backed securities) by the Treasury. This has no real implications for the non government sectors, just accounting on ‘their’ side of the ledger. But it does mean lending can continue and funds will be available for all eligible borrowers.

3. Some kind of government preferred stock coming between profits and the remaining shareholders of various classes. This should leave stocks with some value depending on actual portfolio losses, unless I’m missing something.

 
I’d guess most markets have been pricing in worse outcomes than this.

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(a casual email exchange)

>   
>   On 8/24/08, Russell wrote:
>   
>   I found this an interesting read. Roach argues that economies and the US
>   economy has generally been built on a consumption binge.
>   

Right, consumption is the whole point of working.

Some of the output is consumed, some ‘invested’ for future consumption to be greater than otherwise, but it’s all consumption based. There’s no other point.

>   
>   And the reason why it happened was that the consumption was not based on
>   income, but instead since 1999 is has been based on appreciating asset values
>   and easy access to credit.
>   

The budget surpluses of the late 1990s removed that much income and financial equity (net financial assets) from the non govt sectors.

The only way the economy could continue was accelerating non govt debt. Private sector domestic credit expansion was around 7% of gdp by 2000 before it collapsed due to lack of income and financial equity to support that kind of credit structure.

1% interest rates didn’t turn it around. It was the tax cuts/spending increases/larger govt. deficit that turned it in 03. And as that tail wind was allowed to blow out it all slowed down right up to today. There was a small burst due to the private sector deficit spending due to the sub prime fraud, where lender’s equity fraudulently got spent on houses.

And, again, it was the fiscal package that supported gdp in q2 and q3, along with exports, which resulted from foreign cb’s cutting their accumulation of $US financial assets.

>   
>   Sees a slower global commodity market in the next couple of years as ASIA GDP
>   slows as a result of a slowdown in US consumption.
>   

Consumption will slowdown if agg demand isn’t supported by govts as they all implement demand draining tax advantaged savings incentives (pension funds, ira’s, ins reserves, etc.) that require deficit spending for some other entities sustain demand.

And govt deficits are the only ones that are independently sustainable. Non govt entities have limits they hit periodically.

>   
>   
>   
>    The key question going forward is whether an adaptive and
>   
>    increasingly interrelated global system learns the tough lessons
>   
>    of this macro upheaval. At the heart of this self-appraisal must
>   
>    be a greater awareness of the consequences of striving for
>   
>    open-ended economic growth. The US couldn’t hit its growth
>   
>    target the old fashioned way by relying on internal income
>   
>    generation, so it turned to a new asset- and debt-dependent
>   
>    growth model. Export dependent Developing Asia took its
>   
>    saving-led growth model to excess: Unwilling or unable to
>   
>    stimulate internal private consumption, surplus capital was
>   
>    recycled into infrastructure and dollar-based assets – in effect,
>   
>    forcing super-competitive currencies and exports to become
>   
>    the sustenance of a new development recipe.
>   
>   

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