In the fall of 2008, the US financial system was severely exposed to the threat of foreign bank defaults in light of frozen global dollar-funding markets. The risks facing US financial institutions were not just troubling; they were also systemic and existential. In particular, the two components of the US financial system most at risk were its major banks and money market funds. After that brief lull in foreign lending by US financial institutions during the 1980s after the international debt crisis early that decade, it picked up again during the 1990s.[1] It exploded during the 2000s. What drove the foreign lending boom among US banks during the 2000s was the growing demand for dollars from foreign banks looking to invest in the lucrative mortgage-backed securities (MBS) market in the United States. In order to invest in these assets, foreign institutions borrowed huge volumes of dollars from wholesale credit markets, a large portion of which came from major US banks via the interbank funding market. Although foreign demand for short-term dollar funding was global, it was most concentrated in Europe where banks were borrowing heavily to invest in MBS.

Besides borrowing directly from US banks in the interbank market, foreign banks wanting to invest in dollar-denominated assets also acquired dollars by issuing what is known as asset-backed commercial paper (ABCP). ABCP is simply another type of short-term debt instrument—an IOU— which firms can issue to raise funds. Typical maturities range from 30 to 180 days. While US banks purchased some ofthe foreign ABCP, the biggest player in the market during these years was US money market funds. Money market funds are those "safe-as-a-savings-account” investments where millions of middle-class US residents stash away their hard-earned cash. Risk associated with money market investments is low. The return, while modest, is typically better than a standard savings account at your corner bank. So, in short, millions of middle-class US residents invested their savings in

Figure 7.5

US Foreign Debt Securities and Bank Claims, 2001-2007

money markets; those funds, in turn, used the money to invest it in shortterm debt securities (ABCP) issued by major domestic and foreign financial firms. Besides ABCP, money market funds also loaned tens of billions of dollars to foreign financial firms via various other instruments, including certificates of deposit (CDs) and corporate notes. One study examines the mid-2008 holdings of the largest 15 prime money markets using data drawn directly from portfolio holdings reports. It finds that these prime funds placed half of their dollar portfolios in foreign banks with a total estimated value of $1 trillion.10 11 When the assets of the Institutional Money Market Fund Association’s European US dollar funds are included—another $180 billion—McGuire and von Peter estimate that prime fund exposure to European banks alone was about $1 trillion.[2] [3] To put this in perspective, this means that European banks alone relied on US money market funds for one-eighth of their total $8 trillion in dollar funding.

Together, US bank and money market lending was the lifeblood of the global, dollar-dependent financial system that expanded dramatically during the decade that preceded the crisis. To illustrate the impressive buildup of foreign assets by US banks and money market funds, Figure 7.5 reports US foreign debt securities and bank claims from 2000 through 2007.[4] In aggregate, US holdings of foreign debt securities nearly tripled from $700 billion in 2000 to just under $2 trillion in 2007. Foreign bank claims grew more than two-fold from roughly $700 billion to nearly $1.7 trillion during that period. Thus, trillions of dollars in foreign, dollar- denominated purchases required to be paid back rather quickly were made with other people’s money. This put foreign banks in a rather precarious position: if credit markets were to freeze and they were no longer able to roll over their loans, a colossal gap in international dollar funding would appear. Of course, it was not just the foreign banks that were vulnerable. The parties that lent to these banks were equally (if not more) exposed. Because foreign banks were borrowing from one short-term source to pay off existing short-term debt as it matured, if wholesale markets jammed, their ability to continue servicing maturing dollar liabilities would come into question. To put it plainly, if foreign banks were cut off from private dollar funding, they would be forced to default on maturing obligations to US banks and money market funds.

How capable were US financial institutions of weathering a broad- based default on the part of major European banks? The amount of capital US banks held in reserve relative to their European lending was quite small. Figure 7.6 presents all US banks’ claims on just the Eurozone and United Kingdom in relation to their Tier 1 capital stock.13 In 2007, US bank claims on the Eurozone and United Kingdom alone were nearly twice the amount (193 percent) of their total capital. The picture was even starker if we focus just on the nine systemically important financial institutions (SIFIs) that in 2007 held claims on Eurozone and UK sources equal to 430 percent of their Tier 1 capital!14 Thus, a broad-based default on the part of major European banks alone was sufficient to render the htm. Debt securities data represent aggregate long-term (maturities greater than one year) and short-term (maturities less than one year) debt securities together and include commercial paper, CDs, and other forms of foreign debt issuances, such as straight debt and zero-coupon debt. Calculations were made by the author with data collected from the US Treasury’s Annual Cross-US Border Portfolio Holdings (ACBPH) report available at The 2002 debt securities data are interpolated because no ACBPH report was released that year.

  • 13. Tier 1 capital, sometimes referred to as core capital, refers to the sum of a financial institution’s common stock and disclosed reserves or retained earnings. In chapters 4, 5, and 6, my references to capital referred to total capital, which also includes additional reserves, subordinated debentures, and other legitimate components of an institution’s capital base. However, beginning largely after the Basel I agreement was reached in 1988, Tier 1 capital became the standard measure of a bank’s core financial strength. I relied on total capital data because the Country Exposure Lending Surveys (CELS) reports only published total capital data until late 1998. Beginning in 1999, CELS began only reporting Tier 1 capital.
  • 14. Totals in the figure were calculated by the author using data from 2007 CELS reports. Unfortunately, due to changes in how foreign bank claims are reported in the CELS reports, I am unable to present a consistent picture of SIFI exposure to Europe from 2000 to 2008.

Figure 7.6

US Banking System's Exposure to Eurozone and United Kingdom, 2000-2008

small number of systemically important US banks (which held nearly all of this foreign debt) insolvent. Similarly, US money market funds were also facing an existential crisis. Although data on capital held by these institutions are unavailable to the public, these institutions hold even less capital in reserve than major banks.[5] To make matters worse, deposits in money markets are at far greater risk to panic runs than traditional bank deposits. Unlike money in a bank, money market investments are not insured by the Federal Deposit Insurance Corporation (FDIC). Consequently, if global credit markets froze, the possibility of a worst- case scenario, depicted in Figure 7.7, would emerge. As a consequence of frozen credit markets, European borrowers would default on their obligations to money market funds. This would in turn generate fears that a prime fund might actually "break the buck,”[6] sparking a run on money market investments among millions of middle-class US investors. A run would complete the vicious cycle by causing money markets to collapse under the panic. This further threatened the US financial system because lending by these funds represented a vital artery of credit (to a tune of $1 trillion) for US financial institutions.[2] Thus, their potential collapse would have resulted in the drying up of a critical source of domestic funding for US financial institutions at a time when banks themselves were also incredibly reluctant to lend. How plausible is this counterfactual story? How real was the threat of foreign bank default? And, even if such a default had occurred, would this really have caused a run on the market?

Figure 7.7

Money Market Fund Worst-Case Scenario

Although it is impossible to answer these questions with complete certainty, there are salient examples from the crisis that offer strong support to the veracity of these counterfactual claims.

First, how real was the threat of foreign bank default? In the summer of 2007, when international dollar scarcity was just beginning to become a real problem, two German banks nearly did just that. Indeed, there is little doubt they would have defaulted on their dollar debt were it not for the multiple government-led bailouts they received. According to estimates, IKB Deutsche Industriebank and Sachsen Landesbank had each provided credit guarantees three times larger than their equity capital as a means of issuing ABCP.[8] Viewed as a low-risk investment, most ABCP was sold to money market funds prior to the crisis through ABCP "conduits”—special entities set up by banks for this purpose. Like many other foreign banks, a majority of the assets IKB and Sachsen conduits used to guarantee the ABCP they issued was the US residential MBS they had accumulated. Table 7.2 is a reconstructed balance sheet of Sachsen Landesbank ABCP conduit Ormand Quay in July 2007.[9] The sheet reveals two important facts that are indicative of the financial structure of conduits at this time. First, nearly 80 percent of Ormand Quay’s assets were of the MBS variety, meaning the conduit was significantly exposed to subprime risk. Second, Ormand relied exclusively on the short-term ABCP market to finance its dollar investments and lending activities.


AssetsGuaranteed by Sachsen Landesbank

LiabilitiesShort-Term Debt,

Maturity < 1 Month

Residential Mortgage-Backed Securities

$6.3 bn

Asset-Backed Commercial Paper

$11.3 bn

Commercial Mortgage-Backed Securities

$2.7 bn

Consumer Loans

$0.5 bn


$1.8 bn


$11.3 bn


$11.3 bn

As information about the increasingly toxic nature of assets linked to US subprime mortgages became available, money markets became very reluctant to extend these short-t erm loans to banks for fear that the counterparty’s MBS might be infected with the subprime virus. As the ABCP market dried up, banks that backed the conduits became their sole provider of capital.20 So long as the banks that backed the entities had sufficient dollars, calamity could be forestalled. Yet, the extent to which European banks could finance the conduits’ losses was in doubt. If the backing bank itself were to run out of dollars, the only recourse for the conduit would be to sell off its assets to pay its debts. Of course, as the subprime crisis unfolded, once valuable AAA-rated MBS now had little appeal to markets. In short, these assets had become effectively illiquid. In July and August 2007, conduits backed by IKB and Sachsen were unable to issue sufficient commercial paper to roll over their short-term debt. The two financial institutions were unable to fund the conduits on their own. In the end, both avoided default (in the short term) only when a consortium of state-owned and private banks as well as the German federal government came to their rescue with nearly €12 billion in emergency loans and guarantees.21

But what would have happened if IKB, Sachsen, or any other European bank had been unable to pay off a maturing debt obligation to a US money market fund? Again, one need not look far in answering this counterfactual.

  • 20. Fitch Ratings 2007, p. 3.
  • 21. Ram 2007. Ultimately, the €3.5 billion in loans and €8 billion in guarantees to IKB were not enough as the bank eventually defaulted on $7 billion in debt and was sold off to a US private equity firm (Schwartz 2009b, xiii). Sachsen was initially given a €17.3 billion credit line but was soon bought out by the German bank LBBW and subsequently merged and dissolved.

During the week of September 15, 2008, shares in the Reserve Primary Fund, one of the oldest and largest money market funds in the world, fell below $1 to $0.97. For only the second time in history, a money market fund "broke the buck.” What led to this nightmare scenario was the fact that the Reserve Fund had a $785 million position in Lehman Brothers’ commercial paper. When Lehman collapsed, those holdings lost all their value. The Reserve Fund would have to "eat” the losses. Investors panicked. In a very short period of time, $300 million was withdrawn from the money markets as people sought to insulate themselves from any further losses.[10] For a time, the whole prime funds system appeared to be on the edge of disaster. An artery that provided $1 trillion credit to the US economy, including the teetering banking system, was frozen. There is little reason to believe that a default on the part of a European or any other foreign institution would have resulted in a different outcome. These two cases provide a window into what very well would have happened had the Federal Reserve not stepped in and acted as an ILLR by providing swap lines of unprecedented size to 14 foreign central banks.

Thus, it is likely that the primary motivation for the Fed’s dramatic provision of liquidity was to prevent just such a worst-case scenario from unfolding where a foreign financial institution defaulted on its obligations to a US money market fund or major bank. Amid the subprime panic, financial institutions all but stopped lending to one another. To address the credit shortage in the domestic market, the Fed introduced a suite of liquidity facilities including the TAF, TSLF, and the CPFF. Yet, as noted above, the Fed permitted foreign banks with affiliates operating within the United States to borrow from these facilities, and, ultimately, these foreign banks gobbled up the majority of the dollars the facilities provided.[11] However, banks and other financial institutions not operating within the United States did not have access to these programs. This left them vulnerable. Since foreign central banks were unable to create the dollars that these institutions needed, it raised the possibility that some might default on their external, dollar-denominated liabilities with calamitous consequences for the US economy. As Figure 7.8 depicts, the Federal Reserve globalized its lender of last resort mechanism when it provided dollars via swap lines to selected partner central banks. Those monetary authorities, in turn, took the dollars and provided them to banks within their jurisdiction. Those banks, then, were able to use the newly acquired dollars to continue servicing their obligations to US banks and money market funds, thereby insulating the US financial system from foreign default.

Figure 7.8

How the Fed’s Swap Lines Protected the US Financial System

Thus, the Fed’s actions were entirely consistent with a classic Bagehot- style effort to stabilize a financial system amid a panic—with one notable exception: Because US financial institutions managed global portfolios, the Fed was forced to act as a global lender of last resort in order to protect the stability of the domestic financial system.

  • [1] See Figure 4.5 in chapter 4.
  • [2] Baba et al. 2009.
  • [3] McGuire and von Peter 2009, p. 67. Baba et al. (2009) say that these 15 prime fundsaccount for about 40 percent of the total prime funds’ assets, meaning that the numberswould increase if the other 60 percent were accounted for.
  • [4] Bank claim data are from the Bank for International Settlements consolidated bankingstatistics, immediate borrower basis available at
  • [5] Norris 2013. This is in part a consequence of lax regulation. For instance, at the time ofthe crisis, money markets were not required to hold any capital in reserve.
  • [6] This is a circumstance when the net asset value of a money market fund drops below $1.
  • [7] Baba et al. 2009.
  • [8] Acharya and Schnabl 2010, p. 3. Commercial paper is a promissory note with a fixedmaturity between one and 270 days. ABCP is a collateralized form, meaning that the issuerprovides another asset to guarantee the debt.
  • [9] Adapted from Acharya and Schnabl 2010.
  • [10] Serchuk 2009.
  • [11] A fact that, as I will discuss, raised concerns among some members of the FOMC.
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