By Warren Mosler, a fund manager, co-founder and Distinguished Research Associate of The Center for Full Employment And Price Stability at the University of Missouri in Kansas City, and creator of the modern euro swap futures contract.
Gillian Tett of the Financial Times wrote today about stress in the dollar funding markets, which she regards as a “curious” spillover from Eurozone market fears. Space constraints or concerns about unduly complicating her article appear to have prevented Tett from shedding useful light into how the Fed is using indirect, and in my opinion, confused methods to intervene in the dollar funding market.
Let’s start with Tett:
Last week, European leaders unveiled an aid package worth €750bn that was designed to remove market fears about weak eurozone countries….and – by extension – lessen any funding pressures on eurozone banks.
But something curious has been happening in the dollar funding markets. This week, the average cost banks in Europe need to pay to borrow dollars for three months has gone on rising: it was running at 46 basis points on Tuesday, up from 30 basis points earlier this month.
Meanwhile, the spread between the three-month dollar Libor and the “risk-free” Overnight Indexed Swap rate has risen to about 24bp….worse than anything seen for almost a year. And unsurprisingly, that worries central bankers.
The issue appears to relate to an estimated $500bn-odd funding gap haunting European banks. Until three years ago, central bankers and investors did not usually take notice of the currency in which banks funded themselves, because it was assumed modern financial markets had become so sophisticated banks would always be able to raise money anywhere.
But in 2007, it became painfully clear such faith was misplaced: when panic erupted, European banks suddenly found it very hard to get dollars, because their counterparts did not trust them and they could not borrow from the US Federal Reserve.
To cope with this, the Fed and European Central Bank eventually agreed to implement a temporary currency swap.
The issue is actually larger that the one Tett describes. This is not just that Eurobanks might have trouble funding their dollar exposures. The problem is that US domestic contracts are often indexed to Libor.
Libor is set in London when the British Bankers Association collects rates paid by the largest banks to borrow dollars that day, and posts the average rate paid according to its formula to determine that “average” rate.
So when the Eurobanks are faced with higher costs of borrowing dollars, those higher dollar interest rates can cause the dollar Libor settings to rise. That in turn causes a variety of US domestic interest rates to increase including the rates paid on home mortgages and other wholesale and consumer lending indexed to Libor, directly or indirectly.
In other words, Eurobanks paying higher rates of interest on dollar loans causes interest rates to rise in the US.
The Fed’s response was to fund those troubled banks at lower interest rates, thereby lowering the Libor settings. The Fed did this through dollar swap lines which are functionally nothing more than unsecured dollar loans to foreign central banks, who then pass through the rate set by the Fed to their member banks.
That of course begs the question as to why the Fed would not push to ban the US banking system from entering into Libor-based contracts in the first place, in which case they would not care if some foreign banks had to pay more for dollar funding.
Back to Tett:
And behind the scenes, European banks have recently been urging eurozone banks to curb use of dollar funds.
This appears to have had some success….banks have unwound SIVs and sold dodgy US mortgage bonds.
However, $500bn is still a very big number, and as tensions have recently risen across the eurozone, the dollar Libor market has once again become a flashpoint. More interesting still, a divide is now seen between strong and weak banks. Late last week, for example, HSBC was reporting Libor rates well below those of West LB, apparently because there is more concern about German entities.
To combat this problem, the ECB and Fed agreed last week to implement another dollar-euro swap.
As we noted above, the strategy is to get the Libor setting down by lending to weaker credits at lower rates. Back to the article:
However, when the ECB offered short-term dollar funds last week, only $9bn was taken up – a relatively paltry sum.
Some officials suspect this is because the ECB has been supplying the wrong type of dollars: though it offered short-term funds last week, what European banks really need is medium and long-term dollar funds.
If the goal is to keep the 3 month Libor settings down, the authorities need only to supply cheap 3 month dollar loans. If the goal is to keep longer-term rates down, they need to supply cheap dollars for longer time periods. Let’s return to Tett:
Other financial officials, however, blame the rising Libor rate on a generalised sense of market fear…This fear is thought to be hurting weak banks because investors find it tough to work out whether to trust banks that rely on government support, if they do not know how strong the government is…
Meanwhile, the ECB is preparing to offer some medium-term dollar funds. But in the next few days, plenty of central bank eyes will be watching that Libor dial with considerable unease.
In my humble opinion, providing low rate loans to troubled banks for the purpose of lowering the Libor settings is a very confused strategy.
Some will argue that these objections are misplaced, that there is “no risk” in the Fed’s exposure to the ECB. But that is inaccurate. While the risk is low, “low risk” is not the same as “no risk”, particularly given the concerns about the future of the Eurozone.
The risk is the ECB might not pay the loan back, and if they don’t, functionally the Fed has no recourse, as for all practical purposes the loan is unsecured. The ECB borrows the dollars from the Fed and lends them to its member banks who post collateral with the ECB (not with the Fed) so the ECB appears reasonably well secured. Except for two things- the collateral is denominated in euro so in a Euro collapse the collateral loses value, and it accepts relatively low quality collateral, including unsecured bank debt which banks can generate at will and could also prove worthless in a Euro collapse.
The risk is more than miniscule. If the Eurozone breaks up, the ECB probably goes away as well, and the Fed is left with no counterparty. The national governments in the Eurozone do not guarantee the ECB, and the Fed’s ‘collateral,’ a Euro deposit held at the ECB in its name, will either be gone and/or worth less, and in any case only usable by giving the ECB instructions as to what to do with hit, hoping they will honor those instructions. And it may not even be possible at that point. (Now there is a scenario in which the weaker nations leave the Eurozone, leaving Germany, the Benelux countries, and France in, which would result in a stronger Euro. But that is one of many possible endgames).
The ECB’s only asset of value is a claim on a percentage of the gold of the member nations. But again, in a breakup, it would be doubtful that would be useful as a means of paying off the Fed.
I’ve also noticed with the new swap language that looks like the ECB can roll over the dollar loans in perpetuity. This makes payback strictly voluntary, and renders the transactions fiscal transfers rather than loans, adding to the argument that these should originate from the Treasury rather than the Fed.
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‘The risk is the ECB might not pay the loan back, and if they don’t, functionally the Fed has no recourse, as for all practical purposes the loan is unsecured.’
The idea that this is all fiction hasn’t entered the discussion, has it? After all, 15% of Americans are apparently not paying off their mortgages, and those loans tend to also be no recourse, and yet, we all keep on going our merry way.
Until we don’t, of course.
No recourse is not the same as unsecured. No recourse means that after seizing the collateral (foreclosing on the house) there is no further recourse. Unsecured means there is no collateral at all.
With so many mortgages underwater the property itself may not be great collateral, but it’s a hell of a lot better than nothing at all.
Hence Obama’s passionate intervention to save the euro and push through austerity measures in Spain……..
The scenario is probable but a very unlikely one at best.However raises the interesting point that the Fed is making such huge unsecured loans without the approval from the legislature part of the government.It almost seems that the Fed has become an independent arm separate from government oversight
“It almost seems that the Fed has become an independent arm separate from government oversight.”
Almost?
I was pondering what should be the right “risk-free” interest rate, how inflation and the Fed is involved,and wrote the following post on my blog:
http://squashpractice.wordpress.com/2010/05/14/inflation-and-the-risk-free-interest-rate/
Great breakdown of what is going on.
This is also good-
http://brucekrasting.blogspot.com/2010/05/swiss-did-it.html
Right now it is in Germany’s interest, as the largest banker and exporter in the euro area, to completely trash the currency, while demanding austerity from Southern European nations.
Put another way, Germany is not going to leave the Euro when threatening to leave the euro achieves so much more for them.
Do you think this will be an important issue if we reach a situation where the ECB cannot repay these loans? IMHO we will have much bigger issues to deal with in that eventuality.
Agreed, but I think the point here is a bit different.
One is the main issue, that the currency swaps are backwards way to deal with the widespread use in the US of an index that does not reflect US banking system risk.
The second point, re ECB counterparty risk, is more political. It is treated as if the risk is zero, when it isn’t.
To the extent that there are dollar funding difficulties in Europe, it is limited to unsecured lending. If you look at the (private) repo market with good collateral (i.e. Treasuries), rates have barely ticked up.
I would look for the ECB to reintroduce 1yr LTRO together with EUR/USD swaps, like they did in late ’08.
You are right that LiborOIS is widening as LIBOR is rising faster than Fed funds. But are you so sure that LIBOR is reliable indicator of borrowing rates? I’m not. While 26bp is a far cry from the “normal” 10bp, it is nothing like the 100 or so during the death spams of BSC, to say nothing of the expiration of LEH.
“In other words, Eurobanks paying higher rates of interest on dollar loans causes interest rates to rise in the US.”
Hello Congress?..Hello?…Anybody home?
Like I said, the Fed needs to reserve some pages in its ledger following the Red Roof Inn portfolio. These pages can be titled “Eurozone Longterm Stability Investments” (laughing up my sleeve).
On the other hand, the Fed seems to be being well compensated for the minimal credit risk that the ECB represents. The ECB pays the dollar OIS rate (which I guess is more representative of an unsecured rate anyway than euro OIS) plus 100bps, while the Fed pays no interest on its euros. I am therefore not surprised that the ECB has not been making much use of the facility (at least based on the announcements so far).
I don’t know why the Congress wasted their time proposing and voting for no bailout of Europe. It’s already happening, courtesy Fed swaps and Fed exchange rate management, and Americans haven’t even noticed…
But, that’s democracy in action…
What laughter they must have over aperitifs during Happy Hour at the FED…
Again, situations that have a low likelihood of happening are being elevated to being/becoming probable, that is, Euro blowing up.
Also, no mention of why European banks need Dollars. Well, in addition to genuine FX needs of clients and FX trading on their own behalf, it is cheaper for the European banks to engage in stock market speculation on the Wall Street and to loan $s to the Europe based hedge funds. The Fed is not going to lose, rest assured.
I realize that this a little off topic so my apologies.
But, can any economist help me out there? Could you point me to a “free” source of labor statistics by industry out there?
I am trying to do my own analysis of the direction of the U.S. economy. While not an economist, I can’t help but feel that simply reporting unemployment as a % of population fails to tell the full story of health of the American economy. For example, if someone loses a job paying 35.00 per hr with paid insurance, and takes a job paying 11.00 per hour without benefits, does the BLS consider the labor market as having lost a job and created a new job? I’m especially interested in what is happening in the private sector.
I think a better measure would be year-by-year, industry aggregated gross payroll in cpi adjusted dollars. I will adjust for size of workforce myself.
It seems getting a fix on trends provided by such analysis would be useful in determining the future health of the economy. At least more so than a simple unemployed %. No?
SIC Gross Wages Wh
Industry Year Paid Tax
——– —– ———- —–
670099 1982 100 20
.
.
2009
I’ve tried the BLS site, and if such simple tables and analysis exists I can’t find them.
Sorry the html formatting for the table layout was corrupted in the postback. Simplified, I am looking for:
Sic year wages w/h tax
A few comments:
“The Fed’s response was to fund those troubled banks at lower interest rates, thereby lowering the Libor settings. The Fed did this through dollar swap lines which are functionally nothing more than unsecured dollar loans to foreign central banks, who then pass through the rate set by the Fed to their member banks.”
First, it was not the FEDs response to the increase in OIS-Libor, it was on request of the banks to the ECB in a friday meeting for them to be reinstalled.
Second, the FED is not funding anyone, the FED is exchanging USD for EUR at a pre-agreed rate with the ECB. Hardly any risk there as the EUR equivalent is now owned by the FED and the EUR printer, the ECB, is the counterparty.
Third, this did not result in Libor going down or in cheaper funding for the banks, as the rate was set at OIS + 100, ie 1.22 or 1.24 depending on the period. This is about 70 to 80 basispoints above current libor and therefore very expensive. It was clearly only meant for those banks that cannot get any funding anywhere.
Discussing the European banks you cannot ignore the fact that the USD market is the deepest and offers the most liquidity, therefore it is very hard to ignore or stay out of as a bank. Next to that many European banks have either branches or large operations in the US. Moreover, although Libor is set in London, there are some significant American banks (JP Morgan Chase for instance) that take part in setting Libor, and they are not that significant different from the European banks.
Last but not least, in the mean time the 84 days USD TAF has taken place. Guess what, nothing was taken. It is just to expensive. That means there is no risk at all for the FED. That was the day before you published this post.
A few comments:
“The Fed’s response was to fund those troubled banks at lower interest rates, thereby lowering the Libor settings. The Fed did this through dollar swap lines which are functionally nothing more than unsecured dollar loans to foreign central banks, who then pass through the rate set by the Fed to their member banks.”
First, it was not the FEDs response to the increase in OIS-Libor, it was on request of the banks to the ECB in a friday meeting for them to be reinstalled.
Second, the FED is not funding anyone, the FED is exchanging USD for EUR at a pre-agreed rate with the ECB. Hardly any risk there as the EUR equivalent is now owned by the FED and the EUR printer, the ECB, is the counterparty.
Third, this did not result in Libor going down or in cheaper funding for the banks, as the rate was set at OIS + 100, ie 1.22 or 1.24 depending on the period. This is about 70 to 80 basispoints above current libor and therefore very expensive. It was clearly only meant for those banks that cannot get any funding anywhere.
Discussing the European banks you cannot ignore the fact that the USD market is the deepest and offers the most liquidity, therefore it is very hard to ignore or stay out of as a bank. Next to that many European banks have either branches or large operations in the US. Moreover, although Libor is set in London, there are some significant American banks (JP Morgan Chase for instance) that take part in setting Libor, and they are not that significant different from the European banks.
Last but not least, in the mean time the 84 days USD TAF has taken place. Guess what, nothing was taken. It is just to expensive. That means there is no risk at all for the FED. That was the day before you published this post.
“The Fed’s response was to fund those troubled banks at lower interest rates, thereby lowering the Libor settings. The Fed did this through dollar swap lines which are functionally nothing more than unsecured dollar loans to foreign central banks, who then pass through the rate set by the Fed to their member banks.”
First, it was not the FEDs response to the increase in OIS-Libor, it was on request of the banks to the ECB in a friday meeting for them to be reinstalled.
Yes, they were facing rising costs of dollar loans and were afraid it might get out of hand without the Fed umbrella of dollar lending.
Second, the FED is not funding anyone, the FED is exchanging USD for EUR at a pre-agreed rate with the ECB. Hardly any risk there as the EUR equivalent is now owned by the FED and the EUR printer, the ECB, is the counterparty.
Yes, but think about it. The Fed has euro as collateral at the ECB to protect it against default by the ECB. And the only way the Fed can use that collateral is to give the ECB instructions as to what to do with those euro. See what I’m getting at?
The collateral is held and controlled by the borrower. I call that functionally unsecured.
Third, this did not result in Libor going down or in cheaper funding for the banks, as the rate was set at OIS + 100, ie 1.22 or 1.24 depending on the period. This is about 70 to 80 basispoints above current libor and therefore very expensive. It was clearly only meant for those banks that cannot get any funding anywhere.
Yes, to date it has only set a lid on LIBOR. In the last go round the swap lines served to lower LIBOR
Discussing the European banks you cannot ignore the fact that the USD market is the deepest and offers the most liquidity, therefore it is very hard to ignore or stay out of as a bank. Next to that many European banks have either branches or large operations in the US. Moreover, although Libor is set in London, there are some significant American banks (JP Morgan Chase for instance) that take part in setting Libor, and they are not that significant different from the European banks.
True, and to my point, why should the Fed allow its member banks to contract in a rate outside of the Fed’s control and risk rate rises outside of its control?
Last but not least, in the mean time the 84 days USD TAF has taken place. Guess what, nothing was taken. It is just to expensive. That means there is no risk at all for the FED. That was the day before you published this post.
Agreed that if the Fed offers dollars on a functionally unsecured basis, and, in this case with unlimited rollover provisions, and no one takes them, we dodged a bullet, thankfully!
“Yes, to date it has only set a lid on LIBOR. In the last go round the swap lines served to lower LIBOR”
“True, and to my point, why should the Fed allow its member banks to contract in a rate outside of the Fed’s control and risk rate rises outside of its control?”
My point is, the Swaplines were not meant to lower Libor, they were meant to stem the panic. The FED, through the ECB, now works as a lender of last resort. You claim the FED actioned the swaplines in order to manage LIBOR, which is not the case.
Then, the FED has only one rate under control, which is the overnight Fed Funds rate. Therefore there is no replacement rate for Libor, would the FED want to disallow using Libor. Efforts to get one in place, a rate set in New York time, have not gone well. And, with American banks having a major say in the setting of Libor, why would they not use it?
Lastly, the main reason that the Libor rates are going up has nothing to do with Europe, but with the changing rules in the United States themselves. A lot of short term funding for all banks comes from moneymarket funds. Governed by newly tightened 2a7 rules, the money funds are severely limited in their ability to place cash with longer maturity with the banks. This means it is harder for banks to raise term cash and they need to pay more to get it.
Combine this with the upcoming new Basel rules, where stricter liquidity guidelines will be published, and you see why Libor is going up. Banks need more term funding, and one of their major suppliers is forced by the new rules to stop lending term funds.
Conclusion: the US themselves is a major factor in driving up short term rates like libor. The panic in Europe did not help, mistrust between the banks is also a major force.
comments to M in CAPS:
My point is, the Swaplines were not meant to lower Libor, they were meant to stem the panic. The FED, through the ECB, now works as a lender of last resort. You claim the FED actioned the swaplines in order to manage LIBOR, which is not the case.
I’D SAY WE ARE SAYING THE SAME THING. THIS TIME THE FED PUT THE LINES IN PLACE PRE EMPTIVELY TO KEEP A LID ON LIBOR. I CALL KEEPING LIBOR FROM RISING MANAGING LIBOR.
THE FED ACTED TO KEEP LIBOR LOWER THAN IT OTHERWISE MIGHT HAVE BEEN. IT ACTED NOT TO LEND PER SE, BUT OUT OF CONCERN THAT ONCE AGAIN HIGHER LIBOR FROM SETTINGS FROM LONDON DUE TO PROBLEMS WITH NON US BANKS WOULD DRIVE UP US RATES TIED TO LIBOR.
Then, the FED has only one rate under control, which is the overnight Fed Funds rate.
GENERALLY THE FED ELECTS TO CONTROL ONLY ONE DOLLAR RATE, TARGETING THE FED FUNDS RATE AS YOU STATE. HOWEVER, IT HAS THE ENTIRE TERM STRUCTURE OF ‘RISK FREE’ RATES UNDER ITS CONTROL THOUGH IT IS ONLY BEGINNING TO UNDERSTAND THAT.
Therefore there is no replacement rate for Libor, would the FED want to disallow using Libor. Efforts to get one in place, a rate set in New York time, have not gone well.
THEY COULD DISALLOW THE USE OF LIBOR, WITH CONGRESSIONAL SUPPORT, BY DECREE, SIMPLY ADDING THE REGULATION THAT US BANKS ARE NO LONGER ALLOWED TO CONTRACT IN LIBOR, AND THAT ALL DOMESTIC RATE CONTRACTS CAN ONLY BE INDEXED TO ANY RATE THE REGULATORS ALLOW. THERE COULD BE A DOMESTIC VERSION OF LIBOR CALLED SOMETHING ELSE THAT INCLUDES ONLY US MEMBER BANKS, SET IN NYC, FOR EXAMPLE. US BANKS ARE PUBLIC PRIVATE PARTNERSHIPS THAT EXIST FOR FURTHER PUBLIC PURPOSE.
And, with American banks having a major say in the setting of Libor, why would they not use it?
BECAUSE OF WHAT HAPPENED BEFORE- PROBLEMS WITH FOREIGN BANKS CAUSED LIBOR TO RISE WHEN THE FED WANTED RATES CHARGED BY ITS BANKS TO BE LOWER. THE FED IS THE US ENTITY RESPONSIBLE FOR CONTROLING THE INTEREST RATES AND COST OF FUNDS FOR ITS MEMBER BANKS. AS MONOPOLY SUPPLIER OF CLEARING BALANCES (RESERVES) FOR ITS MEMBER BANKS, THE GOVT. IS NECESSARILY ‘PRICE SETTER’ AND ONE WAY OR ANOTHER MUST SETS THE TERM STRUCTURE OF RISK FREE RATES. IT USES THE FED TO DO THIS.
Lastly, the main reason that the Libor rates are going up has nothing to do with Europe, but with the changing rules in the United States themselves. A lot of short term funding for all banks comes from moneymarket funds. Governed by newly tightened 2a7 rules, the money funds are severely limited in their ability to place cash with longer maturity with the banks. This means it is harder for banks to raise term cash and they need to pay more to get it.
YES THAT WOULD TEND TO RAISE TERM RATES, HOWEVER THE FED CAN READILY SET THE BANK’S TERM COST OF FUNDS BY OFFERING TERM FUNDING. AND NOTE THAT THOSE TYPES OF OPERATIONS DON’T ALTER THE TOTAL FUNDS BORROWED FROM THE FED BY THE BANKING SYSTEM.
ALSO, THE FED WOULD NOT REOPEN THE SWAP LINES DUE TO DOMESTIC REASONS FOR THE UPWARD PRESSURES ON LIBOR.
Combine this with the upcoming new Basel rules, where stricter liquidity guidelines will be published, and you see why Libor is going up. Banks need more term funding, and one of their major suppliers is forced by the new rules to stop lending term funds.
THERE IS NO REASON I CAN SEE FOR THE US TO PARTICIPATE IN BASEL OR ANY OTHER INTERNATION SETTING OF BANKING STANDARDS. SEEMS TO ME WE SHOULD TAKE CARE OF OUR OWN DOMESTIC BANKING REGULATIONS AND NOT CARE WHAT THE REST OF THE WORLD DOES WITH ITS BANKS.
Conclusion: the US themselves is a major factor in driving up short term rates like libor. The panic in Europe did not help, mistrust between the banks is also a major force.
I AGREE, AS ABOVE, THANKS.