BACKGROUND: “A NOVEL ASPECT” OF THE GREAT PANIC OF 2008

The global dollar shortage that suddenly began in the summer of 2007 and led to the Fed’s decision to open up swap lines with more than a dozen foreign central banks had its roots in a near decade-l ong development. Since 2000, banks around the world—especially European and Japanese institutions—had dramatically increased the stock of foreign currency assets on their balance sheets. According to one study, the outstanding volume of banks’ foreign assets grew from $10 trillion at the beginning of the decade to $34 trillion by the end of 2007.[1] The primary form these investments took was in US dollar-denominated claims on nonbank entities, including loans to corporations and hedge funds as well as holdings of US mortgage-backed securities and other structured finance products. These assets typically represented medium- to long-term investments.

Of course, banks funding asset purchases in a foreign currency have to acquire the currency from somewhere. While US banks have significant dollar deposits to draw on, European and other foreign banks do not. Consequently, as these institutions expanded their holdings of dollar claims, they had to find dollar funding from external sources to fill the "dollar gap.” Broadly speaking, banks have three methods of obtaining foreign exchange on wholesale markets in order to purchase an asset denominated in that currency. First, they can directly convert domestic currency into a foreign currency through a foreign exchange spot transaction. Second, they can utilize foreign exchange swaps. These work just like the central bank swaps being investigated here except they involve nonofficial participants (i.e., corporations or banks are the parties "swapping” monies). Finally, banks can borrow the foreign currency directly from other banks in the interbank market, from central banks, or from nonbank entities such as money market funds. Prior to the crisis, foreign banks could—and did—employ each of these methods to finance their voracious appetite for dollar-denominated asset purchases.

It is important to note that in most cases, these types of dollar funding are short-term in nature. Yet, as discussed above, most of the banks’ dollar claims were medium- to long-term. This created a maturities mismatch between foreign banks’ assets and liabilities. Foreign banks regularly rolled over their debts, borrowing from one short-term source to pay off other short-term loans as they matured. That is, they borrowed to make the initial investment—and then borrowed more to pay off the first debt when it came due, doing the same for each successive debt thereafter. Meanwhile, their own dollar claims matured at a much slower pace. Initially, this was not a problem because debts could simply be rolled over. Once the original investment matured, or so the theory went, the bank would cash out, pay off its last dollar debt once and for all, and do with its profit what it wished. In sum, they were borrowing short while lending/investing long in a foreign currency.

Filling the dollar-funding gap through borrowing short on the wholesale market works fine so long as the wholesale market is well lubricated. However, if the funding markets were ever to seize up, filling the gap would become a problem. Like the fictitious Bedford Falls savings and loan discussed in the introductory chapter, foreign banks’ dollar-denominated assets were tied up for many months or years in mortgage investments. But their liabilities were much shorter-term. If enough lenders (depositors) demanded repayment at once, and banks could not liquidate their assets, they would be forced to default. In other words, conditions were ripe for a liquidity crisis. Illiquidity became a very real problem beginning in 2007 when the US subprime crisis erupted. In August 2007, markets began to seize up based on the fear that counterparties might soon become insolvent due to their ownership of collateralized debt obligations (CDOs) that were contaminated by subprime mortgages increasingly likely to go into default.[2] As market participants grew more and more reluctant to lend to one another, it became more costly and difficult for foreign banks to acquire the dollar funding they needed in wholesale markets to roll over their debts.[3] A scarcity of dollar-denominated credit in the international financial system—what Fed Chairman Ben Bernanke understatedly referred to as "a novel aspect of the current situation”—was developing.[4] This raised the very real possibility that a foreign bank (or banks) could be forced to default on their obligations to a US financial institution.

As the crisis unfolded, it became clear that resource insufficiency severely constrained the IMF’s ability to stabilize the global economy. Fund quotas had not been increased since the Eleventh General Quota Review in 1998. Meanwhile the size of the global financial system, measured in cross-border capital flows—had nearly tripled in the decade that passed. Between 2000 and 2007, US banks’ foreign claims and US residents’ holdings of foreign debt securities had doubled. Simply put, the Fund was incapable of providing the emergency liquidity the global financial system needed. Similarly, the Treasury’s ESF, which had become the primary US ILLR mechanism in the 1980s and 1990s, did not have the financial capacity to respond to global needs. The Fed was the only actor capable of responding to the crisis by virtue of its ability to act quickly, to make decisions independently—and most important—to create dollars. At its full development, the twenty-first-century version of the Fed’s swap network included lines ranging in size from $15 billion up to four unlimited lines. At the peak of their use, the swap lines alone provided nearly $600 billion in liquidity to foreign central banks in need. Alongside the swap lines, US-based dollar auction facilities contributed additional liquidity to foreign banks into the hundreds of billions of dollars. By comparison, the IMF possessed roughly $250 billion in lendable resources in 2008—roughly one-third of the liquidity global financial markets needed at the peak of the crisis. Also problematic was that the epicenter of the 2008 crisis was located in the advanced industrial economies. For reasons of appearance, these countries would have been reluctant to approach the Fund for help even if it was a capable ILLR. Resolution of the situation required US involvement as a global financial crisis manager.

It was in this context that the US central bank, uniquely positioned to act as an ILLR, given the dollar’s international role and its monopoly on issuing the currency, extended an emergency $20 billion swap line to the European Central Bank (ECB) and a $4 billion line to the Swiss National Bank (SNB) in December 2007. The two initial swaps were summarily expanded. New lines were eventually extended to eight other central banks in advanced economies. The Fed’s extraordinary actions culminated in two sequential moves in October 2008, just weeks after the collapse of the major US investment bank Lehman Brothers further jammed already sticky credit markets. First, it announced that swap lines with the ECB, SNB, Bank of England (BOE), and Bank of Japan (BOJ) would be unlimited in size. Second, it extended $30 billion swap lines to four emerging market economies: Brazil, Mexico, South Korea, and Singapore. This brought the total number of participating beneficiaries to 14. Alongside these actions, the Fed also initiated a suite of domestic liquidity facilities in the United States, which collectively provided hundreds of billions of dollars to foreign (primarily European) banks with US branches. Indeed, the majority of emergency credit provided to financial institutions via the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Commercial Paper Funding Facility (CPFF) went to foreign institutions.[5]

Table 7.1 presents a timeline that identifies (1) the size of the swap line [in billions USD; ^ = unlimited line, exp = swap allowed to expire], (2) when new swap arrangements were opened [bold], (3) when existing swap arrangements were increased [italics], and (4) when swap agreement expiration dates were extended [gray box]. Each column is representative of the date at the top; each row is representative of a different central bank partner (see the key below the table). Figure 7.1 reports aggregate drawings on the swap lines by participating foreign central banks from their inception until their expiration. It also reports the total number of participating central banks. As the figure shows, drawings peaked in December 2008 at nearly $600 billion. Figure 7.2 disaggregates the data by reporting the share of outstanding swap drawings by partner central bank at the end of each quarter.[6] Figures 7.3 and 7.4 present total monthly lending by two of the Fed’s domestic liquidity facilities: the TAF and TSLF, respectively.[7]

Table 7.1 US FEDERAL RESERVE SWAP TIMELINE, 2007-2010 (TOTALS IN BILLIONS USD)

12.12

3.11

5.2

6.30

9.18

9.24

9.26

9.29

10.13

10.14

10.28

10.29

2.3

6.25

2.1

2007

2008

2008

2008

2008

2008

2008

2008

2008

2008

2008

2008

2009

2009

2010

ECB

20

30

50

55

110

110

120

240

TO

TO

TO

TO

TO

TO

exp

SNB

4

6

12

12

27

27

30

60

TO

TO

TO

TO

TO

TO

exp

BOJ

60

60

60

120

120

TO

TO

TO

TO

TO

exp

BOE

40

40

40

80

TO

TO

TO

TO

TO

TO

exp

BOC

10

10

10

30

30

30

30

30

30

30

exp

RBA

10

10

30

30

30

30

30

30

30

exp

SR

10

10

30

30

30

30

30

30

30

exp

DN

5

5

15

15

15

15

15

15

15

exp

NB

5

5

15

15

15

15

15

15

15

exp

RBNZ

15

15

15

15

exp

BCB

30

30

30

exp

BDM

30

30

30

exp

BOK

30

30

30

exp

MAS

30

30

30

exp

Key: ECB = European Central Bank, SNB = Swiss National Bank, BOJ = Bank ofJapan, BOE = Bank of England, BOC = Bank of Canada, RBA = Reserve Bank ofAustralia, SR = Sveriges Riksbank, DN = Danmarks Nationalbank, NB = Norges Bank, RBNZ = Reserve Bank of New Zealand, BCB = Banco Central do Brasil, BDM = Banco de Mexico, BOK = Bank of Korea, MAS = Monetary Authority of Singapore.

Figure 7.4

TSLF Lending by Month, 2008-2009

the ESF’s largest foreign bailouts look tiny by comparison. What motivated the Fed to act in such an unprecedented way? In the following section, I argue that the Fed was compelled to act as an ILLR during the crisis in order to protect systemically important US banks and money market funds from the threat of foreign defaults. Indeed, I show that the foreign central banks most likely to receive Fed swap lines operated in jurisdictions where US financial institutions were most exposed. In short, swap lines were provided to jurisdictions that posed the greatest risk to the stability of the US financial system. Moreover, I will show that these risks were systemic in nature. Thus, as was the case with ESF rescues during the 1980s and 1990s, the Fed was acting not simply to protect the financial interests of the private financial institutions, but also to protect the stability of the broader US financial system—the broader public interest.

  • [1] McGuire and von Peter 2009, p. 9.
  • [2] Schwartz 2009a, p. 191.
  • [3] Baba and Packer 2009; Coffey, Hrung, Nguyen, and Sarkar 2009; Goldberg, Kennedyand Miu 2010; McGuire and von Peter 2009; Taylor and Williams 2008.
  • [4] Wessel 2009, p. 140.
  • [5] The TAF was launched in December 2007 alongside the central bank swap lines. It provided 28- to 84-day loans to commercial banks (depository institutions) in the domestic market that were having difficulty borrowing in wholesale markets. The TSLF was introduced inMarch 2008, and it was designed to meet the needs of financial institutions (“primary dealers”) that did not qualify for credit under the TAF including investment banks (nondepository institutions). In normal times, these institutions raised funding by offering securities,including mortgage-backed securities, as collateral. When markets for these securities collapsed, the Fed allowed primary dealers to swap toxic securities for US Treasury securities,which they could then use as collateral to obtain funding in wholesale financial markets.The CPFF was introduced in October 2008 as the market for commercial paper (discussedbelow) dried up. In short, the Fed, via the CPFF, made loans through the purchase of commercial paper issued by financial and nonfinancial firms. At one meeting, Bernanke humorously referred to these, and other primarily domestic liquidity facilities, as “the various creditfacilities for which even I do not know all the acronyms anymore.” See FOMC 2008j, 26.
  • [6] As the figure reveals, only 10 of the 14 central banks actually used the swap lines andthe ECB alone accounted for at least half of their use during the program’s entire existence.
  • [7] TAF and TSLF data are publicly available on the Federal Reserve’s website at http://www.federalreserve.gov/newsevents/reform_taf.htm#data and at http://www.federalreserve.gov/newsevents/re form_tslf.htm. The author and an assistant first coded the institutions’
 
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