This week we look closely at two important U.S. economic issues: reforming the mortgage securities market and teacher pensions. Barclays expects the Treasury to suggest government catastrophe insurance for mortgage securities.  Muhlenkamp outlines the options for funding teacher pensions.  On the investment front, in Asia, growth is on track despite inflationary pressures.

 Rajiv Setia and James Ma, Barclays Capital, Market Strategies Americas

The Treasury’s January 31 deadline for releasing a proposal on how to reform Fannie Mae (FNM)/Freddie Mac (FRE) looms. Recall that during the crafting of the Dodd-Frank Act, this measure was created as a response to GOP criticism that the legislation otherwise omitted steps to reform housing finance. Dodd-Frank itself only explicitly requires the Treasury to do the following:

 “Conduct a study of and develop recommendations regarding the options for ending the conservatorship…while minimizing the cost to taxpayers.” The Treasury must consider options including “gradual wind-down and liquidation” and “any other measures the Secretary determines appropriate.”

 Analyze various consequences of housing finance reform, including “the role of the Federal Government in supporting…housing finance” and “how to…ensure that consumers continue to have access to 30-year, fixed-rate, pre-payable mortgages.”

In our view, the absence of any details from the administration suggests that whatever is released may not be dramatic; we expect an evaluation of several possible strategies.

Furthermore, the language of Dodd-Frank does not force the Treasury to take a position explicitly endorsing any particular view on how to conduct GSE reform. Overall we expect housing finance reform to unfold only over a long timeline.

Despite this, we ultimately expect the Treasury to support an enhanced, mixed public-private model in the study, which could resemble one proposed by the MBA and outlined in a New York Fed paper. Democrats in the administration and Congress have consistently supported retaining some government involvement in housing finance, and such a model would do so by having the government provide a form of catastrophe insurance:

Several securitization entities would be established; they would be collectively owned and capitalized by originating banks.

 The banks would sell mortgage loans to the collectives, which would then securitize them.

The resulting MBS sold to investors would bear an explicit guarantee, for which the government would charge a guarantee fee – this cost could be passed along to the originators or ultimately the borrower.

This model’s main advantage is its resemblance to the existing framework: Banks already have precedent for capitalizing a collectively owned mortgage funding entity in the form of the FHLB System. Furthermore, the GSEs already represent the vast majority of mortgage market share, and investors should have few qualms about explicitly guaranteed MBS issued by these entities, as evidenced by demand for GNMAs.

Overcoming partisan positions may prove difficult

While the Treasury’s study will serve to further shape the debate on the future of housing finance, we have long argued that it will be difficult to reconcile the stances of Democrats and Republicans on how best to replace FNM/FRE. Leading Republicans are likely to take issue with features of the present-day GSEs that the enhanced mixed model is likely to retain:

Involving an explicit government guarantee is almost certain to be a sticking point, even with a guarantee fee, given the government’s history of underpricing catastrophe risk – the FDIC is a prime example. Furthermore, this arrangement still passes along considerable liability to the taxpayer if losses on loans exceed the combined down payment, paid-in capital to the collective, and guarantee fees.

In some sense, the enhanced mixed model actually exacerbates the “too big to fail” issue by creating collectively owned securitization entities – these will most likely be dominated by the largest mortgage originators, which are also the largest banks.

More broadly, leading Republican lawmakers have consistently supported an accelerated phase-out of FNM/FRE and replacing them with the private market: This week, Rep. Jeb Hensarling (R, TX-5) reintroduced his earlier bill to wind down FNM/FRE within five years.

Similarly, Rep. Scott Garrett (R, NJ-5), Chairman of the HFSC Subcommittee on Capital Markets and GSEs, has publicly rejected proposals involving government guarantees: “Any of those proposals still conceivably would facilitate a potential bailout…you still could potentially put the taxpayer at risk, and we don’t want to see that.” Rep. Garrett has also repeatedly suggested legal frameworks for covered bonds as a competing source of housing finance.

Proposals with clear common ground

On the bright side, we believe that there are several ideas supported by both sides of the aisle. Foremost among these is a reduction of the government’s role in housing finance. Our own studies suggest that this can be accomplished as long as the transition is managed properly:

Throughout the 1990s and well into the 2000s, private lending held over a 50% market share in mortgage origination. Post-crisis, this market share shrank to <5% as private lenders ceased jumbo origination altogether. In response, the conforming loan limit rose to $729K; we believe that returning this to well below $450K would be healthy, as well as a precondition for GSE market share to reduce enough to allow competition from private lending.

We also expect the Treasury to endorse covered bonds, which have a proven track record overseas, as a way to reinvigorate private lending – we believe both sides of the aisle would receive this idea positively. If covered bonds are limited to 4% of bank liabilities as per previous proposals, we would forecast $250-300bn in funding (Figure 4), contingent on a legal framework and some regulation to prevent competition from the FHLB. However, this will not be enough to replace the $5trn of mortgages financed by the GSEs (Figure 5), given the banking system’s currently $14bn balance sheet.

Finally, note that the Treasury’s study is non-binding, and does not force Congress to vote on the issue. Given the wide ideological gap between left and right on this issue, we expect a lack of consensus to paralyze Congress on FNM/FRE. If control of the Senate shifts to the GOP with the 2012 elections, we would expect a comprehensive Republican proposal at that time. In all, housing finance reform is likely to be a two-decade process, especially in any solution that relies on the banking sector. For banks to organically grow their balance sheets by another $5trn to accommodate the agency mortgage market, at the current savings rate, dozens of years will be needed.

What do we not believe will be in the Treasury’s report?

We do not expect the Treasury to announce a nationalization of FNM/FRE or an explicit guarantee of their obligations in the forthcoming study; this would be unworkable, given how close the Treasury is to the statutory debt limit. In our view, such an event would be more feasible several years from now, when the portfolios have run down (recall that their maximum limits decrease by 10% per annum) and the debt ceiling is less of a concern.

Another obstacle to nationalization, in our view, relates to our previous projections for FHA losses, which will ultimately have to be borne by the taxpayer. We have estimated $100-120bn in losses at the FHA on a guarantee book of $1trn. Were FNM/FRE to be nationalized, these losses could be scaled up four to five times, which would be unacceptable, given the current environment of fiscal tightening.

Jeff Muhlenkamp, Muhlenkamp & Company

In an earlier report, Ron [Muhlenkamp] characterized underfunded pension plans that hold assets largely in stocks and bonds  as “us versus us.” This observation generated questions from a variety of constituents, including a school teacher in Ohio. The teacher submitted that during the November 2010 mid-term elections, she was pitted against those who might disband her union, or limit the pension to which she was entitled—clearly an “us versus them” scenario.

The following essay provides clarification to the meaning of “us versus us.”

In the 1930s, labor unions drew the battle lines between the owners of labor—the workers— and the owners of capital. The unions fought to improve the conditions for the workers at the expense of the owners, shifting a portion of profits from owners to workers. Unlike the ‘30s, today’s union workers ARE the owners—through their pension plans—and they are, in many cases, government employees. These differences are not trivial and can change who bears the cost of improving worker benefits from the “Us versus Them” argument of the 1930s. Let’s use teachers as an example:

The conflict between politicians (school boards, mayors, governors—the owners of the schools) and teachers is coming to the fore for one very simple reason: teacher pension plans are massively underfunded. According to an April 2010 report by the Manhattan Institute for Policy Research, the 59 pension funds that account for most teachers’ pensions in the United States are underfunded by between $332 billion and $933 billion, depending upon the assumptions you make about the appreciation of existing assets. Only five of the 59 are better than 75% funded.

These pension plans receive funds from two sources: teacher contributions and school district contributions, and the contributions are primarily invested in U.S. debt and equity instruments. As a result, the teachers own portions of U.S. companies, and lend money to U.S. companies and U.S. governmental entities. Thus, there are only three ways to make up the shortfall in the pension funding so that the teachers can get the benefits they have contractually been promised when they retire:

    * The returns on the invested assets can improve to make up the difference between pension assets and liabilities.

    * The school districts can contribute more money to the pension.

    * The teachers can contribute more money to the pension.

I’ll discuss these ideas in turn.

Asset appreciation is the least painful way to make up the pension shortfall as no one has to pay any more than they already are; the problem is it is very unlikely to happen. The head of the California State Teachers’ Retirement System has said, “In order to fully fund the [defined-benefit] program in 30 years, investment returns for the next five years would have to exceed 20% per year, a rate of return that is 2½ times the assumed investment return.” (The California pension system is about $100 billion short and is in the worst shape in the country). Returns on investments are limited to what is available in the marketplace: 30-year government bonds are yielding about 4%; equity returns for the last ten years have been approximately flat—and it is an open question what they will do the next ten years. While the Federal Reserve’s efforts to keep interest rates low have benefitted borrowers, those same low rates have hurt lenders like the pension plans. Efforts to raise taxes on corporations to increase government revenue hurt the profitability of these companies and, by extension, their owners—the pension plans—and reduce the possibility of asset appreciation. It seems clear that federal government action going forward will impact the returns available to the pension plans and their beneficiaries, the teachers.

What happens if the school districts increase their pension contributions? Over the last twenty or thirty years school district revenues have generally increased without an increase in tax rates as property values grew—but the last few years have seen a decline in property values, not an increase, and a turn in the housing market does not seem imminent. The easy historical option of allowing rising property values to increase school district revenues is not currently available to decision makers. Now, in order for the school districts to contribute more to the pension plans, they will have to get the money by either reducing costs or raising revenues. (Remember, school district revenues are residents’ property taxes, so raising revenues means raising taxes; without property value increases, it means raising tax rates). Who would benefit and who would pay? The retired or retiring teacher would benefit as the promises made to them about their retirement plan would be kept. Any teacher laid off or not hired as districts reduce costs, any teacher with a greater work load and fewer resources because of budget cuts, and any teacher with her own children in the school would pay the price—as would all the residents of the district as their taxes went up. In the long run, communities may decline as residents move elsewhere looking for lower taxes and higher quality education. At the extreme, this becomes a self-reinforcing process as higher taxes and lower quality education fails to attract new residents or even chases existing residents away, requiring increased taxes to fund the pensions, driving more residents away in a spiral of community decline and decay.

If the teachers contribute more of their salary to their own pension, who benefits and who pays? This is pretty straightforward—the teacher benefits and the teacher pays.  A couple of examples of current payment levels may be useful: Chicago teachers  pay 2% of their salary to their pension while the district contributes 7 percent. In Cleveland, teachers  pay 10% of their salary to their pension and the district contributes 14 percent. A big spread, but it gives you an idea of the numbers.

Debates are now occurring across the country as every state and community tries to figure out how to resolve the difference between what has been promised and the assets available to keep the promises. I suspect there will be a broad spread of solutions in the end.

The key point I’d like to make is that the teacher—the worker—is now also the owner through his/her pension plan. For the teacher to benefit in their role as worker they will pay in their roles as owner, tax payer, and consumer. Hence, the statement that it is no longer “Us versus Them,” but now “Us versus Us.” This reality does not appear to have sunk in yet, and it is noticeably absent from the rhetoric of the parties involved in the discussion. When this reality sinks in to the participants in the debate, I think it will lead to more fruitful discussions and, hopefully, more acceptable solutions. 


Edmund Harriss, Guinness Atkinson Funds

Asia Brief

In the last few months there have been signs of rising inflationary pressure in Asia and China, in particular. Recent spikes in headline inflation are largely attributable to food prices, which we expect to subside in coming months. But this cannot hide the fact that rising commodity prices, rising wages and loose monetary policy in the developed world are feeding through into underlying inflation.

China’s policy response is the most keenly watched with measures to soak up liquidity, measures to dampen speculation in real estate and two increases in interest rates, all of which have been implemented in the last three months. The most recent round of economic data heightened investors concerns, and over the past month Chinese stocks and those in the region that benefit from Chinese growth did not perform as well as the broader market.

It is our view, however, that China has already been active in addressing these issues stemming from the substantial expansion in credit over the past two years, and while tightening measures are likely to remain in place, we think it unlikely that a sharp or aggressive policy response will be needed. We believe that over the medium term inflation in China will run between 3% and 5%, and in the coming year, it will likely be at the top end of that range.

Inflation issues are, of course, not confined to China. Hong Kong is experiencing very loose monetary conditions, imported from the US through the currency board arrangement that ties together the Hong Kong Dollar with the US Dollars and means that Hong Kong cannot pursue an independent monetary policy. The effect has been to push up real estate prices, resulting in the imposition of property transaction taxes as well efforts to increase housing supply.

In Indonesia inflation is likely to remain the highest in the region and climb further from the 6.3% rate recorded in November. This is the result of robust loan growth and money supply growth that has been accelerating over the course of 2010. At current levels, inflation is running at a ‘normal’ rate for Indonesia, but there is a risk that capital flows, attracted by easy monetary conditions and relatively high growth, could present problems.

Our overall view is that, for the moment, inflationary pressures in the region are reasonably well-contained. Most of the inflation that we see is the result of higher food prices, and non-food, or core inflation, remains mostly flat. In those countries where core inflation pressures are evident, such as China and India, steps have already been taken to address these over the last few months. Therefore, we do not expect to see aggressive policy moves that will put stock markets under pressure this year.

The story for 2012 is more uncertain. The impact of Quantitative Easing, or equivalent stimulus efforts, in the US and Europe are likely to have an impact elsewhere in the world. Looking at the US, it is apparent that the Federal Reserve is especially concerned that as the consumer continues to increase savings and pay down debt, growth is failing to take hold and an era of weak growth and falling prices beckons, as has happened in Japan. This is to be avoided at all costs.

The Federal Reserve, we believe, will therefore continue to do whatever it takes to avoid deflation and will continue on the same path until the economy begins to grow at a steadier rate. The impact on the rest of the world is not really the Federal Reserve’s concern. As a result, we expect to see prices of long term assets rise, and we also expect to see money flowing into economies either with less expansionary policies or those offering higher returns, such as Asia.

For Asian recipients of these money flows there are going to be problems. There will likely be pressure on Asian currency exchange rates to rise, which will impair competitiveness. If they choose to intervene in the exchange rate to prevent appreciation, the result will be a rise in domestic liquidity that will increase inflationary pressures at home. It will also be hard to increase interest rates to tackle inflation with US and European interest rates still at historical lows, as this will simply encourage greater capital inflows.

We shall have to watch this year to see how Asia responds to these pressures and whether or not policy discipline and credibility can be maintained.


To some extent, Asia will either be helped or hindered by economic growth in 2011. Food price inflation is likely to abate during the first half of the year, absent further supply shocks. Export growth is also expected to slow in coming months, although it is fair to say that recent trade figures were much stronger than expected. If trade growth does slow, as overseas demand and consumer confidence suggests it might, that would free up capacity and leave economies running below their maximum potential, thus alleviating some price pressures.

Although we expect to see slower economic growth in Asia in 2011, we still expect it to be attractive. We expect economic growth in China to be constrained to around 9% in 2011; the second half of the year will likely be stronger than the first half, and policy will be focused on rebalancing and enhancing the quality of growth. Outside China and Japan we expect to see economies growing between 3% and 6% with India again producing growth akin to China’s of around 8%.

We think that that this year may also see a growing realization that much of Asia’s future growth will be, in fact will have to be, domestically generated within the region. Export manufacturing is not about to disappear, and it is still economically significant. However, the world is changing.

On the one hand, the consumer boom in the US and Europe, fueled by debt and the now-discredited asset-based savings model is giving way to a more sober and prudential approach, which will mean less consumption. On the other hand, the mass industrialization policies pursued by China over the last thirty years, now being imitated by India, Indonesia and Vietnam, have increased household wealth and formed the basis for a new consumer market within Asia itself.

China’s economic plan for the next five years is focused on rebalancing growth away from investment to consumption, from the coastal areas to the poorer Western provinces, while simultaneously seeking to prevent current social and economic imbalances from derailing the process. China’s domestic growth story is critical for Asia’s future, and given the state of the worlds other leading economies – the US, the Euro-zone and Japan – it’s going to be critical for world growth too.

Rahul Bajoria and Jian Chiang, Barclays Capital, Emerging Markets Weekly

Macro Outlook: Emerging Asia

China: Growth on track, but inflation pressures remain

The Chinese economy grew 10.3% in 2010, up from 9.2% in 2009. Real GDP growth was a strong 9.8% y/y in Q4, faster than our above-consensus forecast (BarCap: 9.5%, market: 9.4%), compared with 9.6% y/y in Q3 and 10.3% in Q2. We continue to expect quarterly growth to bottom in Q1 11, partly reflecting the high base and the impact of continuing policy tightening. We see upside risks to our full-year 9.3% GDP growth projection for 2011, which assumes a 50bp increase in benchmark rates in H1.

December CPI inflation moderated to 4.6% y/y from 5.1% in November. CPI food inflation eased to 9.6% y/y from 11.7% in November, while non-food inflation picked up to 2.1% y/y from 1.9%. We think the slowing in food inflation is a reflection of the government's intensive campaign to curb surging food prices, including a package of measures to ensure food supplies, punish food speculation/hoarding and reduce transportation costs.

However, we believe the moderation in the CPI will be temporary and expect CPI inflation to rise above 5% in January, owing to the timing of the Chinese New Year (earlier than last year), unfavourable base effects and adverse weather conditions. Furthermore, weekly data show that food prices (meats and edible oils) have edged up during the past few weeks, and though vegetable prices dropped during the first two weeks of December, they rebounded in the following weeks. PPI inflation continued to move higher, rising to 5.9% y/y in December on the elevated input cost pressures, including higher commodity prices.

We expect the moderate policy tightening cycle to continue, with the PBoC using a combination of tools to normalise monetary conditions and anchor inflation expectations. We believe three more increases in banks' reserve requirement ratio (RRR) are likely in H1 11, depending on liquidity conditions. We maintain our forecast of another 50bp increase in the benchmark rate in 2011, front-loaded, with 25bp in Q1 and 25bp in Q2.

EM Asia: Export momentum is gradually rising

In late Q4 10, Asian export data started to show signs of improvement, consistent with the rebound in global PMI reports in past three months. Export momentum in Korea, Taiwan, Singapore and Thailand has rebounded markedly, after moderating in Q3 10. Indeed, on a 3m/3m saar basis, export growth has turned sharply positive, and we expect it to remain well supported in the coming months.

We believe the outlook for exports will continue to brighten in Q1. In Taiwan, for example, growth in export orders has started to accelerate, with bulk of the gains coming in the electronics and the automotive value chains. For instance, PC makers are likely to have begun shipping notebooks equipped with the initial batches of Intel’s new Sandy Bridge platform in December, and a number of new tablet PC products are slated for launch in Q1 11. According to Gartner, tablet PC shipments are expected to reach 54.8mn in 2011 and displace around 10% of PC units by 2014. This is likely to have spillover effects, as well.

Indeed, industrial production appears to have bottomed in most EM Asia economies and is likely to see further gains in Q1.

The week ahead: Monetary policy in India, Malaysia; Korea Q4 GDP

We expect the Reserve Bank of India to hike the repo and reverse repo rates 25bp at its last credit policy review for FY 10-11. With WPI inflation rising in December, we believe the RBI will try to pre-empt any possibility of being perceived as falling behind the curve. We expect Bank Negara Malaysia to keep rates on hold, but in our view, it may hint at the possibility of raising rates at its March policy meeting. Q4 GDP data from Korea is released next week, and we forecast strong sequential growth on improving export performance and robust domestic demand. Finally, we expect industrial production in Singapore and Taiwan to remain robust, despite fewer working days in December.

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