Who benefits from Mr Paulson's Lost Weekend ?

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities. (see table at bottom of post) For detail on China see Holdings of U.S. Securities: Implications for the U.S. Economy - Updated May 19, 2008 latest figure = US$1 Trillion - note that Hong Kong + Macao also own US$200Bn of US securities

FreedomWorks President Matt Kibbe commented (11/7/08), "The prospectus for every GSE bond clearly states that it is not backed by the United States government. That's why investors holding agency bonds already receive a significant risk premium over Treasuries.

"A bailout at this stage would be the worst possible outcome for American taxpayers and mortgage holders, who have been paying a risk premium to these foreign investors. It would change the rules of the game retroactively and would directly subsidize the risks taken by sophisticated foreign investors."

"A bailout of GSE bondholders would be perhaps the greatest taxpayer rip-off in American history. It is bad economics and you can be sure it is terrible politics."

Mike Steinhardt at (Desperately) Seeking Alpha points out a warning he made last July...

The Bush Administration via US Housing and Urban Development Secretary Alphonso Jackson is trying to get China to buy more government-backed mortgage bonds - specifically more Ginnie Mae offerings.

Bloomberg Josephine Lau - U.S. Urges China to Buy Mortgage-Backed Securities In an article that started "The Bush administration is urging China's central bank to buy more government-backed mortgage bonds in an effort to sustain financing for U.S. home loans." she pointed out that ...

"China held $107.5 billion in U.S. mortgage-backed securities as of June 2006, up from $3 billion three years earlier, according to HUD's Web site. The figures include securities offered by Ginnie Mae, Fannie Mae and Freddie Mac, HUD said, without detailing the holdings in each agency. "

U.S. Department of Housing and Urban Development Secretary Alphonso Jackson was in Beijing to meet central bank Governor Zhou Xiaochuan and Minister of Construction Wang Guangtao in Peking apparently to "tap China's $1.33 trillion of foreign-currency reserves, the world's largest, after surging defaults on subprime mortgages caused the near-collapse last month of two hedge funds run by Bear Stearns Cos. "

On the back of this he advised folks (as does Lord Patel ) to read his comments on 3rd June 2008 at hedgefolios on what he calls The Ultimate Counterparty

It is copied here because it puts the finger on the spot. Now that Lord Patel's crack team of tea leaf and chicken entrail gazers finally unwound what the credit default swaps market is - basically a version of musical chairs paid with IOU's totalling US$45 trillion dollars in which he trick is to leave the game having milked the " false belief that the risks of default in the subprime tranche were compensated by the higher cash flows and the supposed certainty and smoothing provided by the Alt-A and prime tranches" just long enough to leave someone else holding the last IOU - who now the US public is discovering , very, very late in the game ,is the US taxpayer , who is rescuing, amongst many others, the Chinese Government from ill judged (?)investments in GSE bonds. (For a slightly more elaborate view (with pictures and graphs)of the irgins and growth of the CDS market see The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!

It must have been evident that the decline in the value of the dollar is , as Mike Steinhardt says..." reflects investor confidence in our government and that it will be able to make good on its promises when needed."

Here is the piece to read and ruminate upon. Don't write and complain.Get in touch with your Congressman.

For far too long, Counterparty risk was ignored throughout the world’s fixed income and structured credit instruments. The markets expanded on this underlying concept of insurance where there were no limits to what could be created (or how much of it) so long as we could say that risk was mitigated. The CDO market could expand exponentially because of the false belief that the risks of default in the subprime tranche were compensated by the higher cash flows and the supposed certainty and smoothing provided by the Alt-A and prime tranches. And even if they were wrong, the bigger failsafe was said to be the monoline insurance that would make good on any payment disruptions in the underlying CDO. After all, the monoline had AAA ratings that would all but crush any hint of counterparty risk. We are paying the price for that ignorance now.

But that is not the only example. Just consider the counterparty effects on the municipal bond market. Additionally, there are elements of counterparty risk in the Asset Backed Commercial Paper market when the assumption that liquidity from investors would continue forever and that the big banks providing backup commercial paper lines of credit would soak up the volume if it ever would be needed. In a sense, those banks and their AAA ratings and backup facility were providing the role of counterparty that kept yields low and volume high. Can ABCP issuers still count on them being there? Can ABCP investors feel confident that they will be there to cover the rollover risk?

The biggest example that is still being ignored is the entire Credit Default Swap market. Every once in a while we see hints of the losses that will eventually hit, but they are always downplayed. Never mind that it is the embodiment of counterparty risk and has a notional amount of approximately $45 trillion. Somehow the lovers of CDS feel it is immune to loss simply because it is designed to counter counterparty risk. Eventually we will suffer from that ignorance.

There are multiple tiers where moral hazard meets counterparty ignorance. The higher it goes, the bigger the consequences. The ultimate counterparty? The United States Government.

Look at our currency. To me, the decline in the dollar reflects investor confidence in our government and that it will be able to make good on its promises when needed. More and more, our government is either called upon or volunteers to provide the ultimate insurance. When it comes to banks needing liquidity, the Fed makes sure they get as much as they need. Is there any reason to believe they will not continue to do so? After all, it is the lender of last resort. And if a bank fails? The FDIC supposedly insures that depositors will get their money back. Is there any reason to believe they won’t? If mortgages fail and foreclosures mount, we now have the Dems putting together a proposal for the government to create a new HOLC and provide the ultimate backstop. There may be no limit to what a government can do to prop up an economy but there are consequences for it.

When I see the problems with GSE debt now getting publicity, it really rests on the Ultimate Counterparty. If investors are losing their appetite for agency debt and need an assurance that they have the full faith and credit of our government before they will hold them, we are facing the Ultimate Counterparty risk.

Readers are advised, if they wish to pursue this further to read the notes "What If China Reduces its Holdings of U.S. Securities?" pages 12-16 this gives a flavour - and evidence that someone, somewhere in Washington has thought about this ....

"A potentially serious short-term problem would emerge if China decided to suddenly reduce their liquid U.S. financial assets significantly. The effect could be compounded if this action triggered a more general financial reaction (or panic), in which all foreigners responded by reducing their holdings of U.S. assets. The initial effect could be a sudden and large depreciation in the value of the dollar, as the supply of dollars on the foreign exchange market increased, and a sudden and large increase in U.S. interest rates, as an important funding source for investment and the budget deficit was withdrawn from the financial markets. The dollar depreciation would not cause a recession since it would ultimately lead to a trade surplus (or smaller deficit), which expands aggregate demand.(Empirical evidence suggests that the full effects of a change in the exchange rate on traded goods takes time, so the dollar may have to “overshoot” its eventual depreciation level in order to achieve a significant adjustment in trade flows in the short run.) However, a sudden increase in interest rates could swamp the trade effects and cause a recession. Large increases in interest rates could cause problems for the U.S. economy, as these increases reduce the market value of debt securities, cause prices on the stock market to fall, undermine efficient financial intermediation, and jeopardize the solvency of various debtors and creditors. Resources may not be able to shift quickly enough from interest-sensitive sectors to export sectors to make this transition fluid. The Federal Reserve could mitigate the interest rate spike by reducing short-term interest rates, although this reduction would influence long-term rates only indirectly, and could worsen the dollar depreciation and increase inflation."

Don't worry however(Page 17)they have an answer .... "In January 2007, Secretary of Treasury Henry Paulson was asked at a Senate Banking Committee hearing *** whether or not he was concerned over China’s large ownership of U.S. debt. Paulson stated that the daily volume of trade in Treasury securities was larger than China’s total Treasury securities holdings and concluded: “given the size of our debt outstanding and the way it trades and the diversity and so on, that’s not at the top of the list.”

*** Congressional Transcripts, Congressional Hearings, Senate Banking, Housing and Urban
Affairs Committee, Hearing on U.S.-China Strategic Economic Dialogue, January 31, 2007.

PS : at market close US$ 1 = 1.5909 Euros