Thursday, August 9, 2012

Bubbling Up...8/9/12

1) Pettis: The Chinese rebound will be short by Houses and Holes

If we assume that China will have no problem sailing through its economic rebalancing, the European crisis, and everything else, then clearly we don’t need to worry about anything. But if China’s rebalancing is accompanied by a sharp slowdown in economic growth, or if it occurs during a worsening of the European crisis – both very likely scenarios – then we need to think about what the debt burden will be under those conditions.
So, for example, will commodity prices drop? I think they will, perhaps by as much as 50% over the next three years, and to the extent that there is still a lot of outstanding debt in China collateralized by copper and other metals (and there is), our debt count should include estimates for uncollateralized debt in the event of a sharp fall in metal prices. Will slower growth increase bankruptcies, or put further pressure on the loan guarantee companies? They almost certainly will, so we will need again to increase our estimates for non-performing loans.
Will capital outflows increase if growth slows sharply? Probably, and of course this puts additional pressure on liquidity and the banking system, and with refinancing becoming harder, otherwise-solvent borrowers will become insolvent.  Will rebalancing require higher real interest rates, a currency revaluation, or higher wages? Since rebalancing cannot occur without an increase in the household income share of GDP, and since these are the biggest implicit “taxes” on household income, there must be a net increase in the combination of these three variables, in which case the impact on net indebtedness can be quite significant depending on which of these variables move most.  Since I think rising real interest rates are a key component of rebalancing, clearly I would want to estimate the debt impact of a rise in real rates.

2) Guest Contribution: ‘The Making of America’s Imbalances’ by Paul Wachtel and Moritz Schularick
Last but not least, in the paper we point to a potentially important distinction that was lost in previous analyses of household savings behavior. When we delve deeper into the role of capital gains for savings and borrowing decisions, we uncover a close statistical relationship between gains in equity (but not housing) wealth and active savings decisions (i.e., acquisition of financial assets) by American households. Borrowing behavior, by contrast, depends much more closely on fluctuations in housing wealth, both directly because of higher values of the housing stock and indirectly through mortgage equity withdrawals. We think that this result challenges the (conventional) wisdom that non-leveraged equity market bubbles pose a lesser problem for macroeconomic balance than credit-fueled housing bubbles. Our results indicate that equity market bubbles too trigger substantial changes in the financial behavior of households. The economic and financial repercussions of those could be costly to reverse at a later stage.

3) Is the Fed Eyeing a New Kind of Twist? by David Schawel
An astute Credit Suisse analyst pointed out this week that the Fed could perform a “MBS Twist” operation in which they sell up in coupon premium MBS pools and buy lower coupon MBS which could have the affect of lowering mortgage rates to borrowers.  In their own words:
“…this policy will specifically target the near par secondary MBS rate, the key driver of the primary rate that is offered to the consumer.  Consumers spend “permanent income”, not temporary tax rebates…Operation MBS twist will reduce mortgage payments and redirect consumer cash to increase M-velocity and bump up inflation.”
To put this in perspective, the Fed owns ~$530bil of Fannie 4.5-5.5% pools (purchased during QE1) in which they have an unrealized gain of ~$32bil.  30yr 3.5’s (borrower rates of 4%) still comprise the lions share of origination volume, but 30yr 3.0’s are in production now as well.  Pushing down on 3’s and 3.5’s by buying almost all new production could, as CS points out, help compress the primary-secondary spread.
Woj’s Thoughts - Very interesting policy idea here. In essence this is a reverse Operation Twist, although the maturities are equivalent. My three initial concerns are the following: Will the increase in interest income from higher coupon pools exceed the reduction in net interest margin from new pools (i.e. will it help or hurt bank capital)? Do the higher coupon pools represent borrowers unable to refinance (due to credit worthiness or underwater mortgages), suggesting credit risk is shifting back to the private sector? Will markets perceive the policy as a “risk-off” since it reduces the incentive to shift outwards on the risk/yield curve?

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