Are we seeing a Fannie & Freddie bail out unfold - in China?
First, some background and context.
Back in September 2008, 9 days before the collapse of Lehman Brothers, Henry Paulson the then Secretary of the US Treasury agreed to something never attempted before.
Grab tax payer money to bail out two Government sponsored residential mortgage acceptance corporations - subject to those corporations coming under the 'conservatorship' of the Federal Housing Finance Agency.
This was motivated by questions over solvency and other issues during the so-called 'housing correction,' a political label that played down the reality of the debt fuelled property lending and securitisation binge.
Some US$200 Billion of taxpayer's hard-earned was used - let's call it ~US234 Billion in today's dollars. Another US$500 Billion was used to bail out Wall Street Banks.
The Freddie and Fannie deals were done by issuing the US Treasury with 10% preference shares, plus (almost) free warrants (call them options) over just under 80% of the common share capital.
Those mortgage corporations still exist and are still paying dividends to the Treasury. Their names are Fannie Mae and Freddie Mac.
The housing correction I am referring to, along with the unravelling of the underlying debt (and derivatives thereof, called collateralised debt obligations, or CDOs for short) is now referred to as the US sub-prime mortgage crisis, but you know it as the global financial crisis, or the GFC.
Remember AIG? That was the insurer, American International Group, that insured CDOs and had to be bailed out 10 days after the Freddie and Fannie takeover, but this time by way of the US Federal Reserve lending it US$85 Billion in a secured loan in exchange for 80% of AIG's equity - another debt for equity swap.
So what?
These interventions and debt monetisation events (i.e., swap the debt for ownership) caused a global contagion which eventually led to ~$10 Trillion in money printing across the Balance Sheets of the US Fed Reserve, Bank of Japan and the European Central Bank - you know it as QE, or quantitative easing.
QE and its long-coming tapering and balance sheet run-off (so far only in the US, with the European Central Bank only recently announcing an end, we think, to bond buying this year) has and remains the main source of rocket fuel for global equities.
In other words, the industrial fundamentals of equities have been replaced with the monetary fundamentals of the global economy. This is because politicians judged bail outs to be necessary in the face of insolvent organisations that were 'too big to fail'.
All of these events in one way or another have shaped our lives for the past (nearly) 10 years, i.e., half a generation.
That said, it's easy to forget these events and their drivers because we get used to cold water once it starts to get warmer, and all of a sudden there is a new normal.
However, the longer this goes the more people will relax in their baths and slowly get cooked as it becomes harder to adjust to the effects of balance sheet and interest rate normalisation.
Are similar events starting to unfold in China?
So, it's with equals measures of hindsight and forethought (and the fear of being complacent) that I contemplate what's behind China's recent moves in its banking sector.
There are two key components to the unfolding bail out.
Two days ago in a surprise move, the People's Bank of China (i.e., the Central Government owned Central Bank) or PBC, lent 502 Billion yuan to financial institutions via its one year lending facility.
This equates to around US$72 Billion, with the objective being to stimulate lending to small businesses.
What's interesting and a tad worrying is that it comes very shortly after the Central Bank's ~700 Billion yuan commitment to bail out troubled banks. Call it US$103 Billion so far, and about 45% of the initial Freddie and Fannie bail-out funds, in today's dollars.
This will be in the form of a reduction in the required reserve ratio, which is code for slackening the balance sheet safety buffer. 500 Billion of the release will effect China’s largest state-owned banks, plus the large joint-stock commercial lenders. The remaining 'release' is to be allocated to smaller lenders, according to the Central Bank.
However, the 500 Billion in released liquidity is subject to lawful, debt for equity swaps.
In other words, social contract inspired Government ownership for fear of failure and contagion, in exchange for bail out accommodation - sound familiar?
At the same time, China has encouraged banks to use this 'liberated liquidity' to lend more to small and micro businesses.
Part of this might be to take the strain off the rising cost of inter-bank lending, which should be a positive for credit agencies but only in relation to the top 17 or so banks.
I also recall the US Federal Reserve encouraging banks to lend the free and easy money to stimulate the economy - but the fact that the Fed still offered an interest rate on money parked up with the Fed meant a lot of free money recipients reinvested instead of lent. Whereas, the European Central Bank took a different approach by creating negative interest rates after charging Banks for parking money with it.
However, with the US ready to double down and slap tariffs on a further US$500 Billion of Chinese goods, China seems to be juggling several watermelon size items at the minute.
So, is this China's version of a Freddie, Fannie conservatorship mixed in with an AIG debt for equity swap?
It does look that way. But it's not as though these are the first bail-outs, as I estimate this round of bail-outs to be enhancements to the bail outs which started in 2016.
And we have often said that as a Communist platform with a 'visible hand', China is able to wallpaper over events that would otherwise cripple a free economy, but I'm not so sure what that looks like in the context of a full blown trade war.
Still, it's likely that the yuan will continue to be 'managed down' if these bail outs get bigger, and that will help Beijing hedge some trade war downside as its exports become relatively less expensive.
I don't think its any coincidence that these liquidity measures have come just as the trade war has started to heat up. Think currency war.
US Response?
Competition from a weaker yuan (and other competitor/foe currencies) is also likely to be behind President Trump's recent comments about wanting to keep interest rates low.
Some of that's about mums and dads with mortgages (good fodder for social media), but most is about rebuilding US industry through fiscal tariffs, plus keeping US exports price competitive (and the equities markets up) through trying to jawbone monetary levers.
But interest rate moves are in the hands of the US Fed, and we will have to wait to see if Chair Jerome Powell is his own man in the weeks and months ahead.
Meanwhile, the President is risking internal retaliation from industries that will now have to buy more expensive steel and aluminium products, and as a result of certain companies that will simply move manufacturing to China.
The EU?
Germany, France, Italy and other EU exporters of machinery, aircraft, luxury cars, scooters, etc., will be looking for a weaker Euro and that will be occupying the thoughts of Mario Draghi and the European Central Bank (ECB).
That is code for opaque guidance and interest rates that will likely stay at low levels for some time.
The Tariff impact on European cars, aircraft and machinery would not be a great outcome for the EU when seen in isolation - and as part of a global trade war it becomes even murkier due to political and military alliances.
Was last night's truce between President Trump and EC President Jean-Claude Juncker (where they agreed to work toward lower tariffs and other trade barriers, subject to the EU buying billions of dollars US soybeans and natural gas) a real preliminary agreement, or a fake détente as per the US/China lull that flipped into the 301 tariffs?
Japan
While Japan has high debt levels, most of it is domestically held with lenders (including its ageing population) happy to earn very low rates of interest on their holdings, plus it has a trade surplus.
This contributes to the ‘safe haven’ nature of the yen.
To protect this and jobs, Prime Minister Shinzo Abe is seeking to convince the US not to slap tariffs on its motor vehicle exports to the US, saying that they do not pose any threat to the National Security of the US.
President Trump has often spoken of his wish to boycott German and Japanese vehicles. That said, many millions of units are manufactured in the US by Japanese car companies in particular, and that means employment.
And it's not as though the President doesn't acknowledge the ugly side of tariffs, given his calls for US$12 Billion to be set aside to help farmers withstand the retaliatory effects of tariffs.
But how many industries can he expect to cover using these blunt instruments? Not a sustainable strategy.
What gives Down under?
As price takers, Aussie based USD exporters of raw and value-added natural and food resources, and in turn their service industries are not immune to the trade and currency effects of the above.
In this regard, the health of China (importers of Australian iron ore, coal and LNG) along with Japan and South Korea (iron ore and LNG) is critical for Australia's economic health, and the WA/QLD job markets in particular.
Careful navigation and de-risking is still required, particularly in light of the lag in Australia's monetary normalisation (due to very high household debt and the requirement to leave rates low for longer).
At the same time here out West, more investment in alternative industries to broaden our economic base is essential.
Mike
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