Felix Salmon commented on an intriguing and colorful post by Steve Waldman that argues that it’s in China’s best interest to buy a few CDOs and save the Street and the hedge fund industry from a meltdown and possible jail time.
Here is the meat of Waldman’s argument:
Here’s where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States’ current account deficits were unsustainable, that developing countries like China would not be able to fund America’s huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China’s central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China’s Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.
Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are “orderly”, I think China will find it in its interest to be a “bagholder of last resort”, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That’s not really true, but we’ll let it go here.) China won’t buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.
Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let’s put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.
Salmon considers this scenario plausible, and I can’t disagree. However, I wouldn’t call it likely. The reason is that China’s purchases of US financial assets have almost entirely been US Treasuries. (I see the Blackstone investment as a brilliant stroke of political theater). To be blunt, they are way way behind the US in terms of sophistication (which is why they fought hard to keep the current restrictions on foreign firm entry in place. They want to give their domestic players the time to build skills so China will not cede control of its financial markets to foreign players).
The only time I can recall foreign firms coming to the rescue of the US was in a not-very-widely recognized chapter of the 1987 crash. The crash had two immediate triggers: an unexpectedly bad merchandise trade deficit which led to a sharp fall in Treasury prices, and a proposal to tax highly leveraged transactions (meaning LBOs) at higher rates, which led to a collapse of stocks of a number of takeover candidates.
The Dow fell 150 points on Friday October 16 and on Monday the 19th, 508 points (nearly 23% of market value). I was in Japan at the time. Other global equity markets fell, but not close to the same degree. In Japan, it felt like you were watching someone else’s house burn. However, just the way traffic on both sides of a highway slows down in a car wreck because everyone has to have a look, so too trading of all sorts ground to a halt, including Treasury trading.
The powers that be in the US began to see signs of a crash-precipitated liquidity crisis. Early the week after the crash (the week of October 26), the Fed called the Japanese central bank, which in turn called Japanese banks and told them to start buying Treasuries aggressively. They did, recognizing that their house might catch on fire if they failed to act. The rally in the Treasury market led to a resumption of normal bond and money market activity.
Now Waldman argues that the Chinese have more at stake here than the Japanese did in the 1980s, which should lead them to intervene. True enough, but that presupposes that the Chinese recognize the degree of danger and know what to do. Even now, the flow of information between economies is much worse than one might think. I have a Japanese colleague who oversees a nearly $100 billion portfolio in Japan and we have dinner a couple of times a year. He will without fail tell me of things that are widely known in Japan that I haven’t seen in the US press or the Financial Times. I have to assume the ignorance is mutual, and would apply to China as much as it does Japan.
Thus, if the Chinese knew what was afoot, it wouldn’t take much in the way of buying at all (a mere couple of hundred million might do) to legitimate higher CDO values. Remember, in the absence of margin calls, that stuff trades by appointment. But I doubt anyone is clued in, except perhaps a few middle level people (and educating senior people who aren’t savvy is a considerable and time-consuming undertaking).
Per the 1987 crash case, the Fed will reach out only if a liquidity crisis is in play. A CDO meltdown could set that in motion, but it would take more damage, and more sectors of the financial markets seizing up, before it would constitute a liquidity crunch.
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We are already at a point where the dominant players in currencies and fixed income are governments and nowthe PBOC should fix the CDO market? We are creepy towards a system of central planning.
Mind you, I’m not advocating having the Chinese step in, but we are already relying on the Chinese, Saudis, and Japanese to finance our trade deficits.
Perhaps the better way to see this idea is that if we have a full blown financial crisis, there will be government intervention regardless. So the idea of having the Chinese step in (as one of the parties that has a lot to lose) is that an ounce of prevention (a few CDO purchases) is worth a pound of cure.
But as I indicated, the likelihood of this as pretty low. It would be far outside the pale of how central banks operate (after all, the same logic applies to the Fed, and I can’t imagine the Fed buying CDOs either).
“So the idea of having the Chinese step in (as one of the parties that has a lot to lose) is that an ounce of prevention (a few CDO purchases) is worth a pound of cure.”—In the short term…yes, but the fact is that in the medium to long term such actions dramatically increase the odds of a fat, fat tailed event. The intervention of insensitive economic actors prevents the market to clear in accord with the reality of the real economy. Market participants are mis-led and thus fail to recalibrate their risk tolerance, generating larger imbalances.
If real profit motivated actors are not allowed to discover price b/c of the ‘stability’ seeking actors(with bottomless pockets of capital), how efficent of a market can we have?
rj
Let me reiterate the start of my earlier comment, I”m not advocating having the Chinese step in. I am clarifying Waldman’s argument, at least as I understand it.
If you haven’t seen them already, I suggest you read these posts:
http://www.nakedcapitalism.com/2007/06/bear-stearns-and-vagaries-of-models.html
http://www.nakedcapitalism.com/2007/06/more-on-rating-agencies-and-risk-in.html
The mess with CDOs results from the fact that this stuff simply doesn’t trade. This market was never an efficient market. It’s full of chumps who bought paper, bucket loads of it, at unrealistic prices, as well as some sharpies (hedge funds) who think they can (and maybe have) outfoxed the chumps.
If the issue was merely fools getting taken, everyone could take their lumps and go home. But the problem is that prime brokerage operations of investment banks have been lending against this stuff once issued (and their is often leverage in the CDO vehicle itself too). If value of CDOs falls, investment banks make margin calls, as they did with Bear. Holders have to sell the CDOs to raise cash to meet the margin call. Much more of this is suddenly for sale than anyone wants. Prices plummet, forcing more margin calls and more selling. Hedge funds collapse, unable to pay their debts.
The investment banks are left with huge losses. Since their capital bases are now shrunken, they have to carry much smaller inventories (assuming they survive). Suddenly the capital markets aren’t functioning because the intermediaries are too damaged to do their job on the same scale as before. That’s what the concern is about. That’s what the powers that be are worried about when they say “systemic failure.” There is no obvious way to put Humpty Dumpty back together if the scenario above unfolds.
It used to be the banks that were too big to fail. Investment banks have now become so crucial, via their role as liquidity providers in the world capital markets, that the biggest cannot be permitted to fail either. That’s why the Fed forced the bailout of LTCM in 1998. A collapse could have brought down the capital markets by taking out an investment bank or two. So what people are looking for is an orderly fall in value, rather than a panic and collapse.
The need to avoid panics that start to feed on themselves is widely accepted, since fear feeds on itself and produces irrational action. That’s why, in the wake of the 1987 crash, the NYSE implemented circuit breakers, which are forced trading halts, when prices drop too fast, so the participants can catch their breath and think rather than dump out of fear. Because the debt markets are all over the counter (hence the importance of the investment banks), no such mechanism can exist.
I did not mean to imply that you agreed with the Waldmen argument, was just adding an observation about the potential consequences of excacerbating the ineffciencies that you rightly note already preside.
And I agree with your analysis about an ‘orderly’ unwind, as a dramatic fall in price and rating of the CDO market would probably act as one big margin call due to the expontential growth in the amount of capital that has to be held against these instruments as one walks down the rating ladder.
I just think that the powers that be operate with so much fear of an disorderly unwind that they tend to, in the long term, excerbate problems more than they smooth. Sometimes some markets want and need to unwind in a dramatic fashion, to sing and burn enough fingers so that they can move forward in a more effcient and profitable manner.
I think you’re running a first class blog, fine writing and fine analysis.
Cheers,
RJ
Thanks for your kind words! And I do agree with your point. We’ve gotten in this mess because the Fed has been too accommodative (I imagine you’ve heard the expression “the Greenspan put”). Rather than risk an excessive credit tightening that might turn into a credit crunch, the Fed has been too eager to provide liquidity at the first sign of stress. I hope the Bear mess has led to a bit more caution among investors, but it’s way too early to tell.