Here’s an analysis of how the swap lines were set up:
Understanding the Fed’s swap line
Nov 22, 2008 5:47PM
In a speech last week on “Policy Coordination Among Central Banks”, Ben Bernanke, US Federal Reserve chairman, drew attention to the way that the Fed’s swap line with other central banks has been used to facilitate lender of last resort funding for dollar-denominated assets held outside the US.
We should be thinking here about mortgage-backed securities (and their collateralised debt obligation derivatives) that are now on the balance sheets of European banks as a consequence of the collapse of the off-balance sheet structured investment vehicles where they were originally held.
Recall that the SIVs originally financed themselves in the international dollar money market by issuing asset-backed commercial paper, largely to institutional holders or to money-market mutual funds.
The current “policy coordination among central banks” should be understood as a consequence of the collapse of that money market funding.
What Ben Bernanke is talking about is the movement of a substantial chunk of the international money market onto the balance sheet of the central banks.
These lending facilities involve substantial credit risk for the central bank, even when they are collateralized, since eligible collateral now includes any investment grade security whatsoever.
The $592bn is a substantial underestimate of the scale of the operation, since it does not include the first stage of the lending operation which was financed by liquidation of the Fed’s holding of Treasury securities.
How much money are we talking about? Observers of the Fed balance sheet have watched over the last few weeks as its swap facility (which shows up on the balance sheet as “other Federal Reserve Assets”) has swelled to $615bn. What does this sum mean in terms of exposure of the US government and taxpayer?
The economics of such a currency swap are, in principle, quite simple. Domestic and foreign central banks in effect open deposit accounts with one another, each one writing an IOU in its own currency.
The Fed stepped in to take over AIG, the ailing insurer, on September 16. The next day the Treasury announced what it called its “Supplementary Financing Program” and the day after that the Fed announced the establishment of currency swap lines with other central banks. I think these latter two announcements are related.
Instead of booking its dollar creation to the credit of the ECB, the Fed is booking it to the credit of the Treasury. And instead of booking the ECB’s euro creation as an explicit asset, the Fed is including it in the catchall “other Federal Reserve assets”.
For lack of a world central bank, this is the form that international lender of last resort intervention is taking. The world money market is moving onto the balance sheets of the world central banks.
Here are excerpts from another more general analysis of the swap line issue:
TO AID THEIR AILING COMMERCIAL banks, central banks in Europe have relied on huge currency swaps, borrowing nearly $400 billion from the U.S. Federal Reserve. But as European commercial banks and European currencies deteriorate, repaying all that money to the Fed is becoming ever more difficult.
“[Fed Chairman Ben] Bernanke’s assurances aside, I don’t see how they can easily be repaid,” warns Gerald O’Driscoll, senior fellow with the Cato Institute and formerly with Citigroup and the Dallas Fed.
Here is how the swaps work. The Fed and, say, the European Central Bank agree to exchange a set amount of each other’s currencies at a certain exchange rate for six months, with a provision to renew the terms at maturity. The ECB uses the money to help aid bank-bailout packages for countries like Belgium, Finland, Hungary and Ireland that have troubled dollar-based assets. (Asian central banks are also part of the program, but haven’t utilized it nearly as heavily.) The Fed gets a promise from the ECB to repay the debt in six months.
A big hitch: Europe’s commercial banks have more exposure to wounded emerging markets than U.S. counterparts. By one estimate, European banks provided three-quarters of the $4.7 trillion in cross-border loans to the Baltic countries, Eastern Europe, Latin America and emerging Asia. Their emerging-markets exposure exceeds that of U.S. lenders to Alt-A and subprime loans.
You can debate the merits, but not the size of the swaps program. It is big. The Fed’s currency swaps have expanded from zero a year ago to $506 billion. Of the 14 central banks involved, the ECB by far has been the biggest counterparty to date, drawing down $264 billion (versus Mexico’s $33 billion drawdown via a similar program at the height of the 1995 peso crisis).
“A case can obviously be made for [swaps] in the current global crisis,” says Al Broaddus, a former president of the Federal Reserve Bank of Richmond. “But these swaps always struck me as uncomfortably close to the Fed making fiscal policy. That is why, whenever they came up for authorization, I voted against them.” Last week, current Richmond Fed President Jeffrey Lacker voted against the Fed’s targeted-credit programs. It is rare for a Fed official to openly oppose the Federal Reserve Board.
“I would say that most of the big banks in Europe are insolvent,” says Dory Wiley, president of Commerce Street Capital, a money-management firm that invests in banking stocks. “That is what made them great — but unpredictable — shorts. They represent major components in those country funds everyone buys.” The danger is that governments, being the prime backstops for their commercial banks, will be forced into default or be downgraded.
How can the governments raise the cash to repay the Fed? The possibilities include printing more currency, thus undermining the euro’s value and increasing inflation; selling more sovereign debt; or raising taxes.
And finally the connection to AIG and why these swap lines are so important:
the AIG case shows the importance of another link across financial markets, namely massive regulatory arbitrage. The K-10 annex of AIG’s last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is: “…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”. AIG thus helped to organise regulatory arbitrage on a gigantic scale. A formal default of AIG would have had a devastating impact on banks in Europe. This explains why AIG’s problems had sent shock waves through the share prices of European banks. For the time being the US Treasury has saved, inter alia, the European banking system, but given that AIG is to be liquidated European banks now have to scramble to find other ways of obtaining the ‘regulatory capital relief’ they appear to need urgently.
Get all that? It’s less well known than it should be, but Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered — at triple-A, no less — while carrying less cash than required.
To sum up, the Federal Reserve Bank has lent hundreds of billions to foreign central banks to cover AIG’s commitments, which will likely only be paid back through printing currency, increased taxation, or increased borrowing…by those foreign countries.