The Initiation of the Swap Lines and the TAF, August 2007-December 2007

While the Fed’s swap program did not fully mature until the fall of 2008, its origins can be traced back to more than a year before Lehman’s collapse. In mid-August 2007, billions of dollars in short-term dollar-denominated borrowing by European banks were days from coming due. Meanwhile, money market funds and US banks had significantly retrenched lending to European institutions.[1] This raised the prospect that foreign banks, on a widespread basis, would face difficulty rolling over their short-term dollar debt. The tightening became clear in the interbank credit market, evidenced by spikes in the TED spread.[2] For a decade, the TED spread averaged about 40 basis points; in August 2007, it reached 220 basis points.[3] Around this time the Fed began expressing serious concerns about strains in money markets. Indeed, as early as mid-August, it is clear the Fed was aware of the severity of the risks facing US money market funds. In an August 16 FOMC conference call, members were briefed by William C. Dudley (manager of the FOMC’s System Open Market Account). Dudley noted that strains in credit markets raised the risk that "money market mutual funds could suffer losses on certain asset-backed commercial paper programs that have weak backstops. This could conceivably cause some funds to ‘break the buck.’[4]

Also in August 2007, the Federal Reserve first began considering the prospect of opening up swap lines with the ECB and, potentially, other central banks. According to David Wessel, it was actually the Fed that first approached the ECB about the plan.[5] However, Wessel says that the ECB refused the idea at the time in large part because it wanted to "pin the Great Panic” on the United States. Accepting the credit line was akin to accepting a portion of the blame for troubling circumstances developing in the markets.[6] Bernanke first proposed the possibility of opening up a temporary swap line with the ECB and SNB to the entire FOMC in the group’s September 18 meeting. By that time, conditions had improved since August, and so the chairman admitted that it was "a relatively close call as to whether such a facility is needed at this juncture.”[7] Ultimately, after minimal discussion, the swap proposals were not put to a vote during the meeting.[8]

By December, sentiments in Europe had apparently changed. In a December 6 conference call with the committee, Bernanke once again raised the prospect of opening up a $20 billion swap line with the ECB and possibly a smaller one with the SNB as well.[9] The chairman noted that the "problem” with dollar funding in Europe was once again reverberating in the US economy. The unusually elevated demand for dollars was, as Bernanke put it, creating "problems for our monetary policy implementation,” as it tended to push the federal funds rate to open higher in the United States. The swap lines would allow the ECB and SNB to provide dollars to financial institutions in their jurisdiction through credit auctions and, thus, would ease growing strains in the market. In addition to the direct benefit the Fed’s provision of liquidity would have on markets, Bernanke also hoped they would have an important psychological impact, adding, "I think it will send a good signal, and particularly I think the international cooperation aspect of this would be well received.”48 Support for the measure was not unanimous, however. Governor William Poole raised doubts about the necessity of the lines, pointing out that the ECB held a considerable sum of dollar reserves. "What does a swap give them,” Poole asked, "that they don’t already have on deposit at the [Federal Reserve Bank of New York] or their holdings of Treasuries?” Poole wanted to know why the ECB could not simply self-finance the dollar shortage rather than relying on the United States. 49 In response, a Fed economist (tapped to answer the question by Bernanke) acknowledged the ECB’s roughly $200 billion in reserves but added that "pursuing some sort of a cooperative arrangement with the ECB would provide us with more advance information about what the ECB is planning to do ... . So we see some advantages arising from cooperation and coordination as opposed to their injecting the reserves just on their own.”50 Thus, at least initially the swap lines appear to have been motivated not only by a desire to reduce spillovers from European dollar-funding strains but also as a means to foster coordination and information sharing between the United States and European central banks. In his memoir of the crisis, Bernanke explained that the ECB swap line’s "purpose would be to help insulate US markets from financial turbulence in Europe.”51 The FOMC approved both swap lines with a 9-1 vote with Poole being the lone dissenter in each case.

At this same meeting, the TAF was established to provide liquidity to banks in the domestic US market, which were also facing difficulties

line. The Swiss, however, had not yet made a formal request, although Bernanke noted it was possible they would soon follow suit (FOMC 2007c, pp. 13-14).

  • 48. FOMC 2007c, p. 14.
  • 49. McGuire and von Peter estimate that in mid-2007 the euro area, SNB, and BOE had a combined total of $294 billion in reserves, a total far smaller than their lower-bound estimate of the dollar funding gap (p. 20). In these cases, there were ultimately not enough dollars to go around.
  • 50. FOMC 2007c, p. 18.
  • 51. Bernanke 2015, p. 157.

finding the credit they needed.[10] The facility was designed to address funding pressures in the United States at the same time the swaps would address funding pressures in Europe. Eligible borrowers were depository institutions determined to be in "generally sound financial condition,” which included foreign-owned banks with branches operating in the United States.[11] As it became evident that the majority of the TAF’s credit was going to US branches of foreign banks, concern and confusion were expressed at FOMC meetings. One Federal Reserve Bank (FRB) president inquired about the benefits of lending to European banks via the TAF as opposed to allowing the ECB and SNB to provide dollars from the swap lines at their own auctions.[12] At another meeting a different FRB president expressed concerns about the "optics” of a liquidity facility that was lending primarily to foreign institutions, noting he was concerned about "political vulnerability” and "worried about a backlash.”[13]

However, William Dudley, manager of the Fed’s System Open Market Account, explained that giving foreign banks access to the TAF was a condition the ECB imposed on the Fed in exchange for accepting the swap line.[14] The reason for this condition, according to Dudley, had to do with the ECB’s "sense of what their responsibility [was] in terms of providing dollar liquidity to their institutions ... . They were less willing to do something in which they were taking responsibility for the problem and saying that they were going to get the dollars and supply them to those banks.”[15] In other words, the ECB felt that becoming the sole provider of dollars to European banks would equate to taking responsibility for the crisis. So the decision to provide credit to foreign banks via the TAF as well as the swap lines appears to have been the results of a preference for blame sharing at the ECB.[16]

  • [1] As both the interbank market and money markets seized, foreign banks in need of dollars first turned to the foreign exchange swap market. Yet, as Baba et al. (2008) show, thisshift in demand drove up the cost of borrowing on the FX swap market.
  • [2] As discussed above, this index measures the difference between Libor rates and shortterm US Treasury rates.
  • [3] Schwartz 2009a, p. 202.
  • [4] FOMC 2007a, p. 4. Emphasis added.
  • [5] This is interesting in its own right since it contrasts with how ESF credits were made.According to officials I spoke with at Treasury, that institution was never the first mover.Rather, countries in need of financing came to ask for the Treasury’s help. This does notappear to have been the case with the Fed’s swap lines in 2007.
  • [6] Wessel 2009, p. 141.
  • [7] FOMC 2007b, p. 44.
  • [8] The decision to hold off was likely not just a function of improving conditions but alsobecause the ECB and SNB were still lukewarm on the idea at this time.
  • [9] According to Bernanke’s comments during the meeting, the ECB (which had met thesame day) had informed the Fed on December 6 that they were now interested in the swap
  • [10] The FOMC did not vote to approve the TAF as it was established by the FederalReserve Board under the authority granted by Regulation A ("Extensions of Credit byFederal Reserve Banks”).
  • [11] FOMC 2007c, p. 8.
  • [12] FOMC 2008a, p. 14.
  • [13] FOMC 2008d, p. 21.
  • [14] Dudley explained, "Regarding the foreign institutions issue—the choice betweendollar balances from us versus dollar balances from foreign central banks—I think it was alittle more complicated than that because, if I remember how we got to the foreign exchangeswaps, they were essentially more or less conditional on our doing the TAF. They were willing to do the swaps if they could get the auctions in tandem with our term auction facilities.So my judgment would be that we probably didn’t really have a choice of getting dollars tothose foreign banks through the ECB if we hadn’t done the [TAF]” (FOMC 2008a, p. 14).
  • [15] FOMC 2008a, p. 15.
  • [16] This echoes Wessel’s (2009) account of the ECB’s initial rejection of the swap lines inthe summer of 2007.
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