The Fed’s Recent Action on Swaps

What the Fed recently announced regarding its swap agreements should be helpful in forestalling a liquidity crisis in Europe, but it is not a “bailout” of anyone, and it does not increase any risk or cost to the U.S. taxpayer. It will help prevent a freeze up of European banks needing “dollar” liquidity. The swap agreements were already in place. What was announced was a maturity extension of the arrangements and a reduction in the interest rate charged. As long as the rate is positive, it will be a positive for the U.S. taxpayer; a zero rate would not be negative.

In a “swap” agreement, the Fed, for example, offers the European Central Bank (ECB) a given amount of dollar credit for an equivalent amount of Euro credit with an agreement that the swap will be reversed on the same terms at a point in the future with a modest interest payment. The ECB will then have dollars that it can lend to Euro-banks needing dollar liquidity, presumably with collateral receiving a haircut.

The Fed’s counterparty is the ECB, not the banks the ECB may lend the dollars to. The ECB’s risk is minimized because of the discounted collateral. This helps with banks’ liquidity, not solvency. However, that is not to minimize its importance since banks require a liquid money market to roll over their liabilities daily. What happens in a banking crisis is that banks become distrustful of each other and therefore reluctant to do business with each other. Each wants to wait to get paid before paying. Interbank credit “dries up.”  The Fed’s action helps keep this from happening, at least as it pertains to the dollar market.

The swap arrangements already existed. The recent action was to extend their maturity (to February 1, 2013) and lower the rate from the U.S. dollar OIS (overnight index swap) rate plus one percent to plus one-half percent. Frankly, I doubt that the duration and rate were major issues, but they provided an opportunity to have a positive announcement effect to show that major central banks were supportive of the European situation. The other participates were the central banks of Canada, England, Japan, and Switzerland. It is doubtful that these central banks would need additional dollar resources, but including them gave the impression of international solidarity. Including those other than the Fed and the ECB was, in my opinion, window dressing.

This was a liquidity action, helpful in preventing a seize-up of financial markets and possible bank failures due to lack of liquidity, which comes with a financial crisis. Other than help buy time, it does not reduce the sovereign debt burden of European countries nor improve the balance sheets of banks that hold significant amounts of that debt—mostly European banks. As I understand it, U.S. bank exposure to Europe is small. Hopefully, that is also true of U.S. money market funds.

Bottom line: This is not a reckless action on the part of the Fed, and it does not create liability for U.S. taxpayers. It may be marginally helpful for European banks and policymakers.

 

 

Comments (7)

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  1. Erosen says:

    Thank you for doing what you do that nobody else does, explaining complex things in plain English.

    Some questions:
    1. What if tipping point theory is relevant and is reached within an extended maturity date? What do they pay us back in if nobody wants Euros? Won’t there be political pressure for us to take a haircut too?
    2. Is Bernanke too naive to trust the accounting all around here? Isn’t that his persistent psychological pattern? Can you see Putin negotiating with Bernanke?
    3. Psychology counts in terms of “window dressing”. You seem on target with the reality and the intent, Obama multinationalism at its worst. It will backfire badly when people figure it out, and they will. It is an idea so stupid and complex, that only a genius could conceive it and sell it. Again, Nixon’s prediction comes to mind…

    Thank you for educating us, please tell me my concern is off the mark. And have a good weekend.

  2. Steve Jordan says:

    This is no risk as long as the Euro stays strong and the EU contines to exist. If they renounce the Euro, the USA is left holding the bag and it’s empty.

  3. Frank Timmins says:

    Bob, Steve Jordan seems to raise a valid question. The talk is of the Euro becoming extinct. What happens to the “dollar swap” in that event?

  4. Jonathan L. Gal says:

    Thanks for the rational analysis. Your comments are always straightforward and clear, removing some of the confusion and misunderstanding that often accompanies the Federal Reserve.

    From what I understand as a non-economist, you and Milton Friedman are also the only prominent economist who shares my views about the proper US Government role in the economy. More specifically, I support Federal Reserve intervention in the capital markets, through measured purchases (and later sales) of US Treasury bonds, in order to prevent a deflationary and recessionary scenario. Yet, I am opposed to increases in the total outstanding debt of the U.S. Treasury and also to increases in taxes and government spending.

    Although my formal education in economics is limited only to the basic undergraduate level economics courses, I believe that this combination of views is more widely known as “Monetarism” and is attributed primarily to Milton Friedman.

    As a prominent Texas economist, you bring the added weight of first hand experience with the Texas economy in the past 20 years, which has produced a faster rate of job growth than most other states. So, perhaps a new term is needed to distinguish your views from plain vanilla Monetarism … how about “McTeerism” to describe “Fair Tax Monetarism”, which my own independent analysis and personal experience reveals to be the most effective combination of monetary and fiscal policy.

    Thanks again for the crystal clear clarification of this recent Fed action.

    And, a question for you … Would U.S. Federal Reserve purchases of U.S. Treasuries (QE3) help the European situation much?

  5. Jonathan L. Gal says:

    Thanks for the rational analysis. Your comments are always straightforward and clear, removing some of the confusion and misunderstanding that often accompanies the Federal Reserve.

    From what I understand as a non-economist, you and Milton Friedman are also the only prominent economist who shares my views about the proper US Government role in the economy. More specifically, I support Federal Reserve intervention in the capital markets, through measured purchases (and later sales) of US Treasury bonds, in order to prevent a deflationary and recessionary scenario. Yet, I am opposed to increases in the total outstanding debt of the U.S. Treasury and also to increases in taxes and government spending.

    Although my formal education in economics is limited to only the basic undergraduate level economics courses, I believe that this combination of views is more widely known as “Monetarism” and is attributed primarily to Milton Friedman.

    As a prominent Texas economist, you bring the added weight of first hand experience with the Texas economy in the past 20 years, which has provided a real world example of Monetarism in practice and produced a faster rate of job growth than most other states.

    So, perhaps a new term is needed to distinguish your views from plain vanilla Monetarism … how about “McTeerism” or “Fair Tax Monetarism”, which my own independent analysis and personal experience reveals to be the most effective combination of monetary and fiscal policy.

    Thanks again for the crystal clear clarification of this recent Fed action.

    And, some question for you … Would U.S. Federal Reserve purchases of U.S. Treasuries (QE3) help the European situation much? Are the Germans over-sensitive to inflation risks? In a previous post, you recommended Unsterilized ECB Bond purchases. So, I presume that you are not overly concerned about the threat of inflation in Europe.

  6. Jonathan L. Gal says:

    Nice, heavy rain today in North Texas!

    As a Massachusetts transplant, I have a new appreciation for rainfall, after the summer of 2011 here in Texas.

  7. Ehrosen says:

    Zero hedge today. Please clarify:
    First it was Zero Hedge. Then Ron Paul joined in. Now it is the turn of a former Dallas Fed Vice President, Gerald ODriscoll, to outright accuse the Fed of bailing out Europe courtesy of “incomprehensible” currency swaps, and implicitly accusing Bernanke of lying that he would not bail out Europe even as he has done precisely that. And not only that: by cutting the USD swap spread from OIS+100 to OIS+50, the Fed has made sure it gets paid less than ever for extended Europe the courtesy of bailing it out all over again. Incidentally, O’Driscoll says, “America’s central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.” One thing we can say proudly – it has been noticed loud and clear here…