SAFE in danger over agency debt holdings
As investors bail out of Asian bank stocks, worried they may be sitting on debt issued by ailing United States mortgage guarantors Fannie Mae and Freddie Mac, spare a thought for the poor reserve managers at the State Administration of Foreign Exchange in Beijing.
If bank investors are frightened, SAFE's portfolio managers must be downright panic-stricken. They are by far the world's largest owners of US government agency debt, holding as much as half a trillion US dollars worth of the stuff many in financial markets now regard as close to toxic waste.
In the old days, foreign reserve managers never used to buy agency debt. Instead they used to stick to the safest securities they could find: US Treasury bonds backed by 'the full faith and credit of the Federal Government'.
That made them an easy target for investment bankers, who in the early years of this decade took to flying Asian central bank reserve managers to exotic hotels, frequently located on the top of the Swiss Alps. There the investment bankers made forceful sales pitches which went something like this:
'Why risk your job by sticking to boring old treasuries with their dismal returns when you can invest in agency debt issued by the likes of Fannie Mae and Freddie Mac? Their bonds are issued with an implicit US government guarantee, so they are just as safe as treasuries, but they carry a higher yield - typically 1 percentage point higher. Just think, 1 percentage point more return for no extra risk. Buy these and you will be a hero to your bosses. Your career will take off like a rocket.'
No one bought into the pitch quite as eagerly as SAFE.
As the first chart below shows, China's holdings of US agency debt soared from next to nothing in the mid-1990s to hit US$387 billion in mid-2007, according to the US Treasury.
There are no more recent figures, but even if China reduced the proportion of agency debt it holds following the outbreak of the subprime crisis last year, given the massive growth of the country's foreign assets since, Chinese investors are still likely to hold close to US$500 billion of the stuff.
Sure, commercial banks own some of that amount - brokerage house CLSA estimates Bank of China holds US$20 billion - but the vast majority consists of official foreign reserves managed by SAFE.
The trouble is that over time all that buying pushed agency prices up and yields down, to just 0.3 percentage points above treasuries at the beginning of last year, so SAFE's managers never did earn the extra yield they were after.
They did, however, discover that agency debt is not quite as risk-free as they hoped. With the outbreak of the subprime crisis prices fell, with spreads to treasuries briefly hitting 1 percentage point in March when Bear Stearns collapsed (second chart).
Happily, in the last few days, spreads have remained relatively stable, reflecting investors' continued faith that the US government will honour that implicit guarantee, even though US law makes clear Washington has no obligation to.
In the event, however, it is inconceivable that the government would walk away from Fannie Mae and Freddie Mac. Nevertheless, there must be some very scared reserve managers at SAFE right now.