Dollar Shortages and Fed Swap Lines

How (in 2009) The Federal Reserve Bailed Out The World

Tyler Durden on 10/19/2009

When the financial system almost imploded in the fall of 2008, one of the primary responses by the Federal Reserve was the issuance of an unprecedented amount of FX liquidity lines in the form of swaps to foreign Central Banks. The number went from practically zero to a peak of $582 billion on December 10, 2008. …

The Bank of International Settlements just released … “The US dollar shortage in global banking and the international policy response” which (explores how and why the) Fed chief Ben Bernanke in essence bailed out the entire developed world, which was facing an unprecedented dollar shortage crisis due to the sudden implosion of FX swap lines and other mechanisms which until that point were critical in maintaining the dollar funding shortfall for virtually every foreign Central Bank.

The BIS provides …

The funding difficulties (arose from) expansion in banks’ global balance sheets over the past decade. … As banks’ balance sheets grew, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities, (such as) retail and corporate … hedge funds, and holdings of structured finance products based on US mortgages and other underlying assets. During … the crisis (these) became the main source of mark to market losses.

The accumulation of US dollar assets saddled banks with significant funding requirements. … Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. (This) exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over.

How did it happen than in 8 short years virtually every bank would become reliant on the Fed’s wanton printing of dollars for their very survival?

The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks’ international balance sheets. (This) took place during a period of financial innovation, which included the emergence of structured finance, the spread of “universal banking”, which combines commercial and investment banking and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services. …

Swiss banks’ foreign claims jumped … Dutch, French, German and UK banks’ foreign claims expanded … In contrast, Canadian, Japanese and US banks’ foreign claims … did not significantly outpace the growth in domestic or world GDP. … European banking systems’ … estimated US dollar- (and other non-euro-) denominated positions (investments) accounted for more than half of the overall increase in their foreign assets between end-2000 and mid-2007.

Taking a step back: how do countries traditionally express long positions in dollars, and how (did this) get so out of hand.

Consider a bank that seeks to … expand its presence in a specific market abroad. This bank will have to finance a particular portfolio of loans and securities, some of which are denominated in foreign currencies (eg a German bank’s investment in US dollar-denominated structured finance products). The bank can finance these foreign currency positions in several ways:

  1. The bank can borrow domestic currency, and convert it in a straight FX spot transaction to purchase the foreign asset in that currency.
  2. It can also use FX swaps to convert its domestic currency liabilities into foreign currency and purchase the foreign assets.
  3. Alternatively, the bank can borrow foreign currency, either from the interbank market, from non-bank market participants or from central banks.

The first option produces no subsequent foreign currency needs, but exposes the bank to currency risk, as the on-balance sheet mismatch between foreign currency assets and domestic currency liabilities remains unhedged. Our working assumption is that banks employ FX swaps and forwards to hedge any on-balance sheet currency mismatch. … Importantly, the second leg of the swap in option 2 is not that different from funding a position through foreign currency borrowing in the first place (option 3): in both cases, the bank needs to “deliver” foreign currency when the contractual liability comes due.

The key issue is that over the years, banks managed to accumulate a substantial amount of funding risk as a result of positions set to take advantage of the Fed’s dollar destructive generosity:

Funding risk is inherently tied to stresses across the global balance sheet: mismatches between the maturity, currency and counterparty of assets and liabilities. …

One of the key findings of the BIS paper is that the host countries of foreign banks have massive international operations, which traditionally are funded in the reserve currency – the dollar: …

In five countries (BE, CH, DE, JP and UK), banks’ cross-border positions accounted for almost half of that country’s external assets at end-2007, and as much as a quarter in five other countries (CA, ES, FR, IT and NL). The offices of foreign banks alone accounted for nearly 40% of the United Kingdom’s external assets. …

The 6 countries that make up the core of the Eurozone all have foreign dollar denominated claims which are well over 100% of their respective GDPs! These countries took on an amount of Dollar exposure that would take on a country’s entire GDP to fund and then some. …

As for how this funding mismatch manifests itself in practice, the BIS had this insight:

Foreign currency assets often exceed the extent of funding in the same currency. … these cross-currency net positions are a measure of banks’ reliance on FX swaps. … Several European banking systems expanded their long US dollar positions significantly since 2000, and funded them primarily by borrowing in their domestic currency from home country residents. …

UK banks, for example, borrowed (net) in sterling (some $550 billion in mid-2007, both cross-border and from UK residents) in order to finance their corresponding long positions in US dollars, euros and other foreign currencies. (Of that,) their long US dollar positions stood at $200 billion, on an estimated $2 trillion in gross US dollar claims. Similarly, German and Swiss banks’ net US dollar books approached $300 billion … Dutch banks surpassed $150 billion. …

This is consistent with European universal banks using their retail banking arms to fund the expansion of investment banking activities, which have a large dollar component and are concentrated in major financial centres. In aggregate, European banks’ combined long US dollar positions grew to roughly $700 billion by mid-2007 … funded by short positions in sterling, euros and Swiss francs. As banks’ cross-currency funding grew, so did their hedging requirements and FX swap transactions, which are subject to funding risk when these contracts have to be rolled over. …

And here comes the first estimate ever attempted at quantifying the Fed sponsored “Dollar Destructive” moral hazard: the upper bound of the total loss in the case of a major liquidity event occurring with the Fed’s complicit bailout on the table would amount to a staggering $6.5 trillion from a dollar duration funding mismatch alone! This is an astounding, unfathomable and untenable number. Yet it is likely the same now as it was at the onset of the Lehman crisis. …

The major European banks’ US dollar funding gap had reached $1.0–1.2 trillion by mid-2007. Until the onset of the crisis, European banks had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion), and used FX swaps ($315 billion) to convert (primarily) domestic currency funding into dollars. If … these banks’ liabilities to money market funds (roughly $1 trillion) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0–2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion

The Crisis

So what exactly was the chain of events that ended up with the Fed having to singlehandedly bailout the rest of the world? …

Beginning in August 2007, heightened counterparty risk and liquidity concerns compromised short-term interbank funding. (It became more costly) to obtain US dollars via currency swaps (Baba and Packer (2009a)), as European banks’ US dollar funding requirements exceeded other entities’ funding needs in other currencies. (This was) compounded by instability in the non-bank sources of funds as well. Money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks. (Also, central banks in some) in emerging markets reportedly withdrew placements (from commercial banks of US dollar foreign exchange reserves) in support of their own banking systems in need of US dollars. … Market conditions during the crisis … made it difficult for banks to respond … by reducing their US dollar assets. (They couldn’t sell the crap.) Prior to the collapse of Lehman Brothers (up to end-Q2 2008), European banks tapped funds in the United States; (including) their borrowing from Federal Reserve facilities,(which) grew by $329 billion (13%) between Q2 2007 and Q3 2008. …

Short-term sources to sustain the massive dollar funding mismatch disappeared virtually overnight, and CBs were suddenly facing a toxic spiral of selling increasingly more worthless assets merely to satisfy currency funding needs in an environment where all of a sudden nobody was willing to provide FX swap lines. So what happens next…

The Fed Bails Out The World

… Had the Fed not stepped in, the rest of the world … would have simply collapsed as the $6.5 trillion dollar funding gap closed in on itself, causing a indiscriminate selling off of all dollar denominated assets. …

European central banks … could not provide sufficient US dollar liquidity (and) entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (Figure 7). Swap lines with the ECB and the Swiss National Bank were announced as early as December 2007. Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion, (which) were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network (Figure 7). Various central banks also entered regional swap arrangements to distribute their respective currencies across borders.

Whether the Fed was within its rights to bet the American way of life in order to mitigate the stupidity of Europe is a question best left to politicians (how about to the people?). And politicians take note: the Fed’s actions were to the benefit of “banks around the world including those that have no US subsidiaries or insufficient eligible collateral to borrow directly from the Federal Reserve System.”

On 13 October 2008, the swap lines … became unlimited to accommodate any quantity of US dollar funding demanded. … In providing US dollars on a global scale, the Federal Reserve effectively engaged in international lending of last resort. The swap network can be understood as a mechanism (that) extends loans, collateralised by foreign currencies, to other central banks, which in turn make these funds available through US dollar auctions in their respective jurisdictions.This made US dollar liquidity accessible to commercial banks around the world. …

Most of the Federal Reserve’s international provision of US dollars was indeed channelled through central banks in Europe, consistent with the finding that the funding pressures were particularly acute among European banks. Once the swap lines became unlimited, the share provided through the Eurosystem, the Bank of England and the Swiss National Bank combined was 81% (15 October 2008), and it has remained in the range of 50–60% since December 2008.

Concluding observations

(According to) BIS:

In contrast to many previous international financial crises, it was banks’ international exposures to other industrialised countries that deteriorated, and the global interbank and FX swap funding structure which seized up. … What pushed the system to the brink was not cross-currency funding per se, but rather too many large banks employing funding strategies in the same direction, the funding equivalent of a “crowded trade”. Only when examined at the aggregate level can such vulnerabilities be identified … by quantifying the US dollar overhang on non-US banks’ global balance sheets …

Why is this critical? … In one short year since the collapse of Lehman we have gone back to the same dollar funding risk exposure … an unprecedented dollar funding gap, which is likely back to record levels once again? What is obvious is that the Fed’s current policy of a weak dollar, contrary to its repeated lies otherwise, is simply enhancing the dollar funding moral hazard: and the breaking point will come sooner or later with disastrous consequences.

The Fed’s liquidity swaps are now back to almost zero (Until August, 2010). As the DXY continues tumbling ever lower to fresh 2009 lows, the trade de jour is once again the dollar funding one, although unlike before when the Yen was the carry currency of choice, this time it is the dollar itself, positioning banks for the double whammy of not just a dollar funding shock, but one coupled with a potential massive and historic short squeeze. If and when an exogenous event occurs, not even $6.5 trillion in Fed swap lines will be sufficient to bail out the world economy.

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