In a brief news article, tucked neatly towards the bottom was one sentence with incredible global implications:

“The big drop in China’s holdings meant that it lost the top spot in terms of foreign ownership of U.S. Treasuries, dropping to second place behind Japan”

Chin ahas long been the largest holder of US Treasuries.  They are (were) our go-to group when we (the US) needed to raise some cash.  If the demand for our Treasuries from China drops off, that could lead to the US paying higher interest rates and a double dip recession for our economy.

It now appears that they are in fact reducing their holdings.  In fact, China has been reducing its exposure to US Treasuries for some time now.  While they are not out in the market selling them (that we know), they are trending towards purchasing shorter  duration notes.  This gives them a quicker “out” when the time comes.

When will that time be?  Well, that’s the $64,000 question.  If they were to dump their holdings onto the market at once, they would devalue the holdings they are trying to sell and do more harm to themselves than they care to.  If they become gradual sellers, they would damage the US economy and potentially we would not be able to buy as many Chinese made goods – again hurting their economy.

What China is doing is making every effort to create a burgeoning middle class that can replace the US as the consumer of their manufactured goods.  With 2 billion people to work with, that shouldn’t take too long to replace the 300 million or so US consumers.  Once that middle class is in place, China has much more freedom in their financial policy because they are not as tied to the US consumer.

This is one that will definitely take some time to play out, but it will play out and it will have dramatic consequences for our economy.

It seems like the worst may yet be over.  The Congressional Oversight Panel recently released its February Oversight Report entitled, “Commercial Real Estate Losses and the Risk to Financial Stability”.  You can read the full report HERE.  While the initial wave of destabilization came from the larger institutions (think AIG, Lehman Brothers, Etc.), this looming round could come from the nations’ small to mid-sized banks.

The report estimates that in the next 4 years over $1.4 trillion (with a “T”) of commercial loans will come due and need to be retired or refinanced.  In one half of those cases, the value of the underlying asset is now worth less than the amount owed on the loan.  They are “underwater” and they are a problem.  Losses to the lending institutions could total over $300 billion.  That’s not the amount that will default.  That’s the loss realized after foreclosing on the property, finding a buyer and selling it for whatever can be achieved.

But wait, we ran the Stress Test and our banks have the capital reserves to weather this storm.  Unfortunately, the Stress Test only looked through 2010.  The vast majority of these loans will become a problem for the banks in 2011-2014.  Plus, the Stress Test was only run on the larger banks.  The small and mid-sized banks were never subjected to the Stress Test.

On the plus side, there has been an insane amount of equity raised to acquire these troubled assets.  Once the banks have foreclosed on the assets and they are brought to market, there should be a willing pool of buyers.  The question then becomes, will there be so many buyers that the value get bid up to a point where the “distressed buyers” are no longer interested.  My best guess is that you see an initial round of sales at very attractive pricing.  As buyers flock to this sector, the demand and valuations will go up and the transaction volume will go down.

The worst may not be over yet for the US Municipal Bond market.  That’s according to a recent report from the ratings agency Moody’s Investors Service.  The report shows that in 2009, the agency downgraded 279 state and local government tax-backed bonds.  That is up 244% from 2008 when Moody’s downgraded only 81 such entities.  Overall, the ratings fell for 300 revenue debt issuers, up from 133 in 2008.

While the struggles that state and local governments are facing to balance their budgets is nothing new, we are beginning to see the hardship take a toll on their credit ratings.  Those lower credit ratings will make it much more difficult and costly to issue bonds, exacerbating the problems they are facing.