I'm trying to interpret all the stories floating around about foreign investors starting to demand that US agency paper be converted to an explicit full-faith-and-credit guarantee.
Between Fannie and Freddie, we're talking about $5 trillion in assets. Since the nationalization of the GSEs in September, their periodic debt auctions haven't gone all that badly, all things considered. The spread between agency paper and Treasuries is now in the 70-basis point range across parts of the curve. Far more than what it was pre-crisis, but far tighter than a few months ago.
And yet, foreigners are noting US officials' pointedly stopping short of calling the Federal guarantee of agency debt "explicit." (FHFA Administrator James Lockhart calls the guarantee an "effective" one.)
That's turning out not to be good enough for seriously risk-averse foreign investors, who appear to have shifted at least $100 billion from agencies to straight Treasury paper in the second half of 2008.
In effect, what they're trying to do is to exit their exposure to US housing finance, and change it to exposure to the US dollar itself. In a way, this converts credit risk to market risk.
But is it really that simple?
Between Fannie and Freddie, we're talking about $5 trillion in assets. Since the nationalization of the GSEs in September, their periodic debt auctions haven't gone all that badly, all things considered. The spread between agency paper and Treasuries is now in the 70-basis point range across parts of the curve. Far more than what it was pre-crisis, but far tighter than a few months ago.
And yet, foreigners are noting US officials' pointedly stopping short of calling the Federal guarantee of agency debt "explicit." (FHFA Administrator James Lockhart calls the guarantee an "effective" one.)
That's turning out not to be good enough for seriously risk-averse foreign investors, who appear to have shifted at least $100 billion from agencies to straight Treasury paper in the second half of 2008.
In effect, what they're trying to do is to exit their exposure to US housing finance, and change it to exposure to the US dollar itself. In a way, this converts credit risk to market risk.
But is it really that simple?
At the end of the day, if the Treasury explicitly guarantees debt
backed by US mortgages, then the Treasury will need to fund any losses
in those portfolios. And at the scales we're talking about, this would
be seriously inflationary. And the whole problem get vastly worse if we
follow through on a rewrite of 9 million mortgages or so, as the
Administration suggests.
As I've written elsewhere, you don't get inflation from too many dollars. You get it from too many dollars chasing too few goods. We could be setting ourselves up for an extraordinary pulse of inflation once the economy starts to recover.
But with so much exposure to dollars held in foreign hands, the market will impose a strict discipline of its own. If it should appear to foreigners that the mortgage-credit risk they thought they shed is going to reappear in the form of currency risk, they'll sharply raise our interest rates.
The risk of a meltdown appears because of the enormous current bid for US Treasuries as a safe haven. Treasury debt is nearly the only asset class in the world with robust demand underneath it. If that demand dissipates before the global economy is ready to substitute something for it... well, it could be very rough.
As I've written elsewhere, you don't get inflation from too many dollars. You get it from too many dollars chasing too few goods. We could be setting ourselves up for an extraordinary pulse of inflation once the economy starts to recover.
But with so much exposure to dollars held in foreign hands, the market will impose a strict discipline of its own. If it should appear to foreigners that the mortgage-credit risk they thought they shed is going to reappear in the form of currency risk, they'll sharply raise our interest rates.
The risk of a meltdown appears because of the enormous current bid for US Treasuries as a safe haven. Treasury debt is nearly the only asset class in the world with robust demand underneath it. If that demand dissipates before the global economy is ready to substitute something for it... well, it could be very rough.
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