Posted on Saturday, October 18th, 2008
By bsetser
Some emerging market central banks have noticed that they – unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank – don’t have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.
Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:
Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. “In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility” says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.
Think of Korea. There is “a shortage of dollars in the Korean banking system” – and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.
For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7’s importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks – dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.
Banks in emerging market countries have no such luck.
Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn’t part of the G-7 (or G-10) and doesn’t have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves – and its government’s capacity to borrow dollars in the market – to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.
The old global architecture for responding to financial crises had, in my view, two essential components:
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Posted in Systemic Risk, central bank reserves, emerging economies | 73 Comments »
Posted on Thursday, October 16th, 2008
By bsetser
Sometimes a picture is worth a thousand words.
Over the last 52 weeks, foreign central banks have added $321b to their Treasury holdings at the New York Fed (and no doubt more to other accounts) and $147b to their Agency holdings — for a total of $468b. And there clearly has been a big shift towards Treasuries recently. The rise in Treasury holdings over the last two weeks, annualized, tops $1 trillion. The fall in Agency holdings over that period (after the bailout of the Agencies), annualized, also tops $1 trillion.
Stunning? Yes. Stabilizing? Not really. There isn’t a shortage of demand for Treasuries right now. But there is a shortage of willing lenders of dollars to European banks and — to a degree, s shortage of buyers for the debt issued by the US Agencies (Freddie, Fannie and the like). And remember that the Agencies are the main current source of credit for American households looking to buy a home — without their lending, home prices would fall much much further.*
The Fed’s balance sheet by contrast is moving in the opposite direction — out of Treasuries. The Fed has been selling off its Treasury holdings for a while now. But there are limits to how many loans to banks and broker dealers and European central banks the Fed can finance through the sale of its existing stock of Treasuries. The recent increase in Federal Reserve lending has been financed by both the $500b in cash raised by the Treasury and deposited at the Fed through the supplementary financing facility — and a big rise in bank deposits at the Fed. Those two sources combined to provide the Fed with about $750b in financing.
The scale of the expansion of the Fed’s balance sheet is equally stunning. The Fed is currently provided at least $950b in dollar liquidity to the US financial system through various term facilities and its direct lending, and another $450b of dollar liquidity to European central banks — liquidity that is then lent to European financial institutions that are facing a shortage of dollars. Let there be no doubt that this is a systemic crisis.
The falling purple line is the Fed’s total holdings of long-term Treasuries (really holdings of Treasuries that have not been lent out to the dealers); the falling red line is the Fed’s holdings of Treasury bills; the rising green line is the financing from the Treasury supplementary financing account and the rise in bank reserve balances at the Fed; the rising blue line is the financing the Fed is providing to the global financial system. Tim Geithner has been a very busy man this year.
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Posted in Systemic Risk, central bank reserves | 92 Comments »
Posted on Monday, October 13th, 2008
By bsetser
Over the weekend, the countries of the G-7 indicated that they would do “whatever it takes” to prevent another Lehman-style bankruptcy. They pledged to “use all available tools to support systemically important financial institutions and prevent their failure. ”
Many European banks need access to short-term dollar financing to support their dollar assets, as we discovered after Lehman default’s led to a run on money market funds. Today, the Fed and the major European central banks made sure that any European bank that needs dollars will get dollars:
“The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.”
Emphasis added.
Any word, when over-used, loses its impact — but this really is unprecedented.
The US and the major European central banks have effectively agreed to lend without limit to make good on their pledge to avoid a systemic bank failure. All major financial institutions in the G-10 ultimately now have access — through their national central bank — to the Fed. This isn’t quite a global lender of last resort (in dollars) but it is close. Banks are different than countries, so the analogy is imprecise — but back when emerging economies had trouble rolling over their short-term dollar debts during the crises of 97-98, the G-7 never pledged to lend “any amount” needed.
Lending to countries through institutions like the IMF isn’t collateralized — but it also was never unconditional. The G-7’s guarantee of liquidity doesn’t seem to be linked to steps the banks could take to help themselves — like suspending dividend payments on their common stock.
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Posted in Systemic Risk | 111 Comments »
Posted on Sunday, October 12th, 2008
By bsetser
Words no Managing Director of the International Monetary Fund ever wants to utter:
“Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”
(source: FT)
Lehman’s default – and the resulting $400 billion run on money market and “prime” funds – precipitated the current, intense crisis. Van Duyn, Brewster and Tett of the FT report:
As word of the Reserve Fund’s predicament spread, investors fled. By that weekend, more than $200bn had been pulled from money market funds, by both retail and institutional investors. When other short-term funds, such as prime funds, are included, the amount that was taken out of short-term investments quickly reached $400bn. That shift brought the funds under heavy pressure to sell into an illiquid market, simply to ensure they had enough cash to pay investors withdrawing their money. For banks, heavily reliant on these investors for their funding needs, it created a spiral of liquidity crises. “It was the straw that broke the camel’s back,” says Joe Lynagh, a portfolio manager at T. Rowe Price, an investment company. …
The run on money markets created problems for a host of institutions that relied on the money markets rather than deposits for dollar financing. Think European banks – and the large former investment banks. It turns out that American money market funds were financing the large European purchases of US corporate debt. That explains why less risk was dispersed than the regulators thought – and why Europe was providing less financing to the US than the TIC data indicated. Van Duyn, Brewster and Tett:
The impact of the investor pullback is borne most heavily by banks that are predominantly reliant on wholesale funding, a group that includes many European banks,” says Alex Roever, analyst at JPMorgan. “This investor pullback from the secured dollar bank commercial paper market is a contributing factor in the recent wave of liquidity issues at European banks.”
Lehman’s default clearly triggered the run. But the ultimate cause of the crisis is more troubling: a large number of large commercial and investment banks seem to have been borrowing not on the strength of their own balance sheets but rather on the expectation that they were too big and too systematically important to fail.
“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”
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Posted in Systemic Risk | 33 Comments »
Posted on Friday, October 10th, 2008
By bsetser
Central banks with lots of reserves have not been running away from the dollar. But they do seem to be running away from any dollar asset with a hint of risk. Right now, it is hard not to focus on the relentless slide of the stock market (the FT is calling this week a global crash), the enormous daily moves in the foreign exchange market or oil’s sharp slide. But New York Fed’s latest custodial data is stunning in its own way.
Since September 10, central banks have added close to $100 billion to their custodial holdings of Treasuries. Custodial holdings of Treasuries reached $1537.6b on Wednesday — up from $1513.1b last Wednesday, and up from $1438.1b on September 10.
Some of the increase in Treasury holdings is explained by a slight fall in Agency holdings — which fell from $956.6b on September 10 to $944.8b on October 8. But the roughly $8b fall in Agency holdings cannot explain the huge increase in Treasury holdings.
Solid data on global reserve growth in September doesn’t yet exist - China and Saudi Arabia matter, and they don’t release data quickly. But the reserves of nearly every country that reports data quickly fell in September. I have no doubt that the Fed’s custodial holdings are increasing far more rapidly than global reserves.
That either means that:
a) Central banks are shifting from euros to the dollar, adding to their dollar holdings;
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Posted in Systemic Risk, central bank reserves | 59 Comments »
Posted on Tuesday, October 7th, 2008
By bsetser
A few years ago, analysts looking at the same data that Dr. Krugman highlighted started to call the US a hedge fund. It borrowed short-term in dollars, providing the world wit a safe liquid asset (or it was said) and used the proceeds to buy risky assets abroad — collecting a risk premium in the process.
That kind of hedge fund is has had a bad run recently. The US — viewed as a hedge fund — is structurally “short” the dollar and “long” global equities, as it borrows in dollars to buy assets abroad. It consequently did well when the dollar fell and global equity markets rose, and correspondingly did poorly when the dollar rises and global equities fall. Unless something changes, the United States net international investment position will deteriorate quite sharply this year.
The US as hedge fund metaphor actually never quite worked for the US — as the US was borrowing as much to finance a current account deficit (current consumption) as to finance the purchases of assets abroad. It actually was a better description of Europe (which also is having a bad week) in general and the Eurozone in particular. The Eurozone attracted large inflows and used the resulting inflows to finance equally large outflows, not a large current account deficit.
But no national resembled a high-living hedge fund quite as much as Iceland. Its big banks and big firms had enormous international liabilities and enormous international assets — at least in relation to Iceland’s small economy. And for a while, Iceland used the profits from its intermediation to live very well, running a large current account deficit. In that sense, it also resembled the US.
Suffice to say it is a very troubled hedge fund.
And it has apparently turned to Russia — yep, Russia — for emergency financial support. Iceland’s prime minister claimed to have no choice. Iceland’s friends, he claimed, all turned Iceland down (maybe they were too busy rescuing their own banks). The FT reports
Geir Haarde, Iceland’s prime minister, said on Tuesday that the country’s “friends” had not offered financial assistance to his country, forcing it to seek a capital injection from Russia.
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Posted in Sovereign Wealth Funds, Systemic Risk | 61 Comments »
Posted on Monday, October 6th, 2008
By bsetser
I think it is fair to say that we have reached, for all intents and purposes, step 12 of Nouriel Roubini’s 12 steps to financial disaster — i.e. “a cascading and mounting cycle of losses and further credit contraction.”
Macro-man, speaking of the currency market, says crash.
John Jansen is a bit more verbose:
“The movements in the FX market are incredible. One friend just read me something which he has received from an fx trader which said that the only things that anyone desires to own are the US dollar,the Japanese Yen, gold, bottled water and bullets”
If 1998 is any guide, these kind of dislocations in currency markets won’t do wonders for the aggregate returns of the hedge fund industry. A host of high carry currencies (i.e. the currencies of countries with high interest rates) have sold off sharply. Look at the euro and Australian dollar v the yen, the Brazilian Real against the dollar and the Icelandic krona against pretty much anything. To facilitate comparison, I set all these currencies at 100 at the end of 2005.
Looking back to 2003 paints only a slightly less ugly picture.
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Posted in Exchange Rate, Systemic Risk | 46 Comments »
Posted on Thursday, October 2nd, 2008
By bsetser
For holding things together. Barely. Bad as things are, they could be worse. Really.
By my count, the Fed is now providing about $1.25 trillion in liquidity support to the global financial system.
The Fed’s latest balance sheet data shows: $80b of repos; $150b of term auction credit, $410b in other loans, $30b in portfolio investment with “Maiden Lane” (the Bear Stearns vehicle), $320b in “other assets,” and $260b in securities lent to dealers.
Do the math. It is a huge number. Or look at my CFR colleague Paul Swartz’s updated chart. I wouldn’t believe these numbers could possibly be true if I hadn’t been watching the data for a while. Frankly the TARP is now starting to look small relative to the Fed’s balance sheet.
The $1.25 trillion total likely includes the swap lines that have allowed other central banks to provide dollar liquidity to their financial institutions.** (This sentence has been edited after my initial post: see the note below, it is important)
I have long thought that sovereign funds, which provided equity capital to support banks’ existing management in the early stages of this crisis, have gotten too much credit for helping to stabilize the financial system and the Fed and other central banks have gotten too little, in part because there isn’t as obvious a set of beneficiaries.
The latest data release should settle the question; absent enormous liquidity support from the Fed, a much broader set of financial institutions — including some that received equity investments from sovereign wealth funds — would have failed.
What are sovereign investors from the emerging world doing? We don’t know much about what sovereign wealth funds are doing — and in any case, the set of sovereign funds and big state firms from the emerging world is sufficiently diverse that it makes little sense to try to paint a single picture. But we do know a little bit about what the world’s central banks are doing from the New York Fed’s custodial data.
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Posted in Systemic Risk | 73 Comments »
Posted on Thursday, October 2nd, 2008
By bsetser
A systemic financial crisis is one that affects the “system” — not a single institution. In my view, the US — and perhaps the US and Europe — are now facing one.
Systemic crises aren’t new. Many emerging economies experienced a systemic crisis when their currencies crashed in the 1990s, as most of their financial institutions either than foreign currency denominated debts and domestic loans or had lent in foreign currency to domestic borrowers who had no foreign currency revenue. Nor are foreign currency denominated debts the only cause of systemic crises: Japan experienced a systemic crisis in the 1990s because its banks had lent heavily against domestic real estate.
American financial institutions recently lent too much money to American households on the assumption that real estate only went up. The also assumed that macroeconomic and financial volatility had been vanquished, which meant that higher level of financial leverage made sense. The result is now obvious.
Systemic crises are particularly hard to resolve because most large institutions, by definition, have the same underlying financial exposure. If a host of large institutions all have the same problem and all want to get rid of the same bad bet, the overall result is that there are structurally far more sellers than buyers. If most leveraged institutions made the same bet, the problem is compounded: leverage magnifies the downside as well as the upside. The result is something not far from the “great unwind” — though the trigger for the unwind is a bit different than the one Staiman and Kips initially identified. A host of leveraged institutions all want to cut back on their leverage and sell their risky assets — something that is hard so long as everyone is trying to sell at the same time. Warren Buffet (hat tip Steve Hsu of Information Processing) puts it well:
all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.
That doesn’t necessarily imply the only possible policy response is buying bad assets; equity injections could play a role too. There are plenty of ideas out there — including this proposal by Morris Goldstein. It does though imply that the government has to play a role in resolving the crisis.
Anna Gelpern* has noted that the dynamics of a systemic crisis also apply to over-stretched households. Normal processes break down when too many households are in the same position — namely underwater on their mortgage. She writes:
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Posted in Systemic Risk | 58 Comments »
Posted on Tuesday, September 30th, 2008
By bsetser
A Merrill Lynch strategist seems to have come up with a new reason to buy stocks: The US isn’t far from adopting the “Swedish” approach to managing a financial crisis – and that didn’t turn out to be bad for the Swedish market. Forbes reports:
“The failure of TARP legislation worsens the short-term credit situation. But in so doing it increases the likelihood of a Swedish-style recapitalisation of the banking sector in the U.S,’ says Merrill Lynch emerging equities strategist Michael Hartnett. The Swedish government in Sept 1992 decided to guarantee the whole banking system and transfer bad debt to state ownership. ‘This chemotherapeutic event marked the beginning of a multi-year bull market in Swedish equities,’ Hartnett says.”
This crisis has produced a lot of surprises.
I never thought I would see the Wall Street that pitched privatization as the solution to most of the emerging world’s problems in the 1990s enthusiastically welcome (partial) state ownership through sovereign wealth funds. That though may have reflected my own naivete. Fees talk; many large fund managers have been close to the big sovereign funds for some time.
I never thought David Brooks would channel Dani Rodrik and warn of the danger of too much capital sloshing around – and imply that financial liberalization had gone too far. That concern presumably extends to too much Chinese central bank money sloshing around; China after all was the ultimate source of a lot of the money sloshing through the US housing market.
But you really know there is a true crisis when parts of the Street are arguing in favor of the (temporary) nationalization of the financial sector.
Who knows, if this continues the Street may soon be arguing for taxing carried interest as income and suggesting that the US might be able to reduce the cost of health care by looking closely at the French model …
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Posted in Systemic Risk | 27 Comments »
