How did we get here? A "map" of the Fed's balance sheet's history

Some in the mass media continue to be confused about the historical trajectory of the Fed's balance sheet. People have trouble distinguishing between the liquidity facilities provided by the central bank and the various monetary expansion activities. Here is a historical "map" to show how we got here.

Fed's balance sheet (Source: FRB; click to expand)

1. The Fed launches the Term Auction Facility (TAF) to replace term interbank funding and commercial paper for banks who started having trouble rolling short-term debt. The Central Bank Liquidity Swap Facility was also launched at the time to provide dollars to other central banks.

2. Increase in TAF demand (it's no longer taboo to use the facility) and increase in the Central Bank Liquidity Swap Facility as foreign banks start having trouble raising dollars to fund their dollar assets.

3. The Fed provides Bear Stearns (Maiden Lane) funding to support the purchase of Bear by JPMorgan.

4. All hell breaks loose as the Fed is forced to ramp up TAF and the Central Bank Liquidity Swap Facility (as foreign banks desperately need dollars). The Fed also launches the Commercial Paper Funding Facility (CPFF). Among other reasons, CPFF was meant to help corporations like GE Capital, who relied heavily on commercial paper funding and were beginning to have trouble rolling debt.

5. Around the same time as #4, AIG failed. The Fed responded with Maiden Lane II (see post), Maiden Lane III (see post), as well as direct funding for AIG. This was the one move by the central bank that made Bernanke especially angry.

6. QE1 (treasuries and agency MBS). Shortly after, the TALF program was launched (relatively small impact to the balance sheet).

7. QE2 (treasuries).

8. Central Bank Liquidity Swap Facility facility picks up again as the various Eurozone banks lose their ability to roll dollar commercial paper (US money market funds cut exposure) - see posts here and here.

9. QE3 (treasuries and agency MBS).

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Capital flight out of Eurozone seen in foreign deposits at the ECB

When a non-Eurozone central bank holds euros, it tends to deposit those euros with the ECB. So when the Fed executed its liquidity swap, it received euros as collateral and deposited  them in its account at the ECB. That deposit by the Fed created a "non-Eurozone resident" liability at the ECB.

But the Fed's liquidity swap is now a fraction of what it was at its peak. The ECB returned the dollars and the Fed returned the euros.

Fed Liquidity Swap

That means the ECB's liability to non-Eurozone residents should have declined. And it has, until recently. But now we have a new spike in non-resident liability at the ECB. So who outside the Eurozone is depositing a massive amount of euros? The Swiss National Bank (SNB) of course. As as the SNB defends the Swiss Franc from strengthening (trying to keep the peg at 1.2), it buys a great deal of euros and of course promptly deposits them at the ECB, increasing the non-resident liability .

Therefore this second spike is created by flight of capital our of the Eurozone (the ECB provides this data on a weekly  basis allowing one to monitor the trend closely - ht Kostas Kalevras). Note, these euros are still held within the Eurozone (the amount of euros is always fixed unless the ECB chooses to change it), but they no longer belong to Eurozone residents. These Eurozone residents have swapped their euros for Swiss Francs.

ECB balance sheet

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Eurozone's banks cutting dollar businesses

As predicted back in February, European banks are beginning to exit their dollar businesses. They've reduced dollar denominated loans and sold dollar assets.

MarketWatch/Business Wire: This reduced appetite for MMF funding has likely contributed to a significant dip in Eurozone bank lending to project and trade finance, sectors that historically have largely been USD-denominated.

That in turn has led to a reduced need for the Fed's dollar swap facility, which has fallen off sharply.

Fed Liquidity Swap Facility

It is important to note that the decline in the Fed's Liquidity Swap Facility does not necessarily mean an improvement in the strength of Eurozone's financial institutions. It is simply an indication that European banks will never again rely on US money market funds to this extent to finance their dollar operations. Neither does it point to Eurozone's banks obtaining alternative dollar funding sources such as unsecured bonds. Trying to issue unsecured dollar paper may be a difficult task indeed for these firms for years to come.

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The Fed Liquidity Swap term extended to replace the CP markets

The Fed's Central Bank Liquidity Swap program is continuing to grow in order to meet the demand for dollar funding in the Eurozone. But in order to replace the funding provided by the dollar commercial paper markets, the Fed has pushed out the average maturity of the facility. Unlike the past couple of months, almost the entire program is now between 2 weeks and 3 months in maturity (as opposed to under 2 weeks), roughly matching the typical term of the CP market. This is meant to complement the ECB's LTRO program to stabilize bank funding.

Fed Central Bank Liquidity Swap

The increased, longer-term Liquidity Swap facility is taking pressure off the currency basis swap markets used to convert euro loans into dollar loans (see description of basis swaps). With term dollars available directly from the ECB (via the Fed), for many banks it is no longer necessary to borrow euros and swap into dollars just to fund their dollar assets and dollar businesses. As the chart below shows, the 3m EUR/USD basis swap spread has come in significantly since the worst levels reached in November.

3m EUR/USD basis swap spread (Bloomberg)

Again, over time, Eurozone banks are expected to exit their dollar businesses because they can no longer rely on money market funds lending them dollars via the commercial paper markets. This will continue presenting opportunities for US banks who can gain market share by having access to sustainable dollar funding.

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The squeeze on dollar funding in the Eurozone continues

The latest data on US money market funds is continuing to show reduction in holdings of Eurozone banks' commercial paper (CP). Again, money funds do not sell their CP, they just let it mature without rolling into new paper from the same banks.  Instead money market funds are buying Australian, Canadian, Japanese, and some UK bank paper (in addition to their holdings of US CP).

Non US holdings by US money market funds (Source: Fitch)

These Eurozone banks in turn are replacing their dollar funding with dollar loans from the ECB via the Fed's liquidity swap.

Fed Liquidity Swap

The impact of this transition will be a substantial reduction of dollar assets and even whole dollar businesses at European institutions. US corporations, real estate firms, US energy projects (where some European banks used to be active), etc. should not expect to see substantial new lending from  Eurozone banks going forward.  Dollar lending business will now be dominated by US banks who have easy access to dollar funding.   

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Severe dollar funding constraints will push EU banks out of US markets

The tightness in dollar funding continues to be a major problem for a number of EU banks. Much of it is driven by US money market funds not rolling their commercial paper (CP) holdings issued by eurozone banks. As CP matures, European banks have to find alternate sources, which is proving to be difficult.

Yahoo Finance: "It is utter madness ... When we see big names paying 300 basis points over overnight rates for dollars you know something is wrong," said the head of money markets at a bank in London, who asked not to be named.

The non-US financial institutions' commercial paper outstanding continues to dwindle:

This demand for term dollar funding keeps putting upward pressure on interbank lending rates as banks want to charge increasingly more to part with dollars for longer than overnight:

3M USD LIBOR

The ECB has responded by tapping the Fed Liquidity Swap Facility this week in the amount not seen since 2009 in order to provide dollars to numerous eurozone banks.

Many European banks will be forced to change their business models.  This inability to raise dollars will severely constrain their activities in the US, making it increasingly difficult for them to lend to US corporations or buy illiquid US assets.  Even if the situation in the eurozone improves, these banks will be loathe to add dollar assets to their balance sheets because of potential funding risks in the future.

In many instances they will also be constrained from lending in Asia and the Middle East, where dollars are often preferred to euros because of trade with the US.  Without access to dollar funding, European banks will shift their focus to Europe, creating new opportunities for US (and in some instances UK) and Asian banks. Banks like JPMorgan and HSBC will be clear winners and increase market share because of their access to dollars.

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Busting the myths behind gold lease rates

Myths continue to surround gold lease rates, with notions such as market manipulation and government intervention rampant in the blogosphere. This may upset a number of people but the recent dynamics in gold leasing are actually fairly easy to explain. Here are the two key questions:

1. Why have gold lease rates been negative in recent months?

Recently as the usual sources for dollar funding (US money market funds) in Europe have been dried up, banks are resorting to some nontraditional approaches to fund their dollar based assets. Some borrow from the ECB via the Fed liquidity swap, others resort to borrowing euros from the ECB and swapping these euros into dollars for a short period of time via a currency basis swap.

A number of European banks hold gold as part of their asset portfolio. They haven’t been eager to sell it as they continue to be concerned about the stability of major currencies, particularly the euro.  They also enjoy the price appreciation gold experienced in recent years. However, they desperately need short-term dollars, so they lease out their gold. In a lease transaction typically a bank turns the gold over to a counterparty for say 3 months and receives gold “lease rate”. The counterparty in turn places dollars with the bank as collateral on which the bank pays “LIBOR-like” rate. Now the bank has access to dollars it needs. The demand for dollars has become so great, that banks are willing to accept negative lease rate, just to obtain term (1-12 months) dollars. Therefore negative lease rates is not a surprise.

2. Why have gold lease rates spiked recently?

As banks and other investors realized that gold prices can indeed drop significantly, many decided to hedge their positions by putting on gold forwards to lock in the price. A gold forward involves a future sale of gold at a fixed price. Whoever sold them the forward becomes long gold for future delivery. The forward provider will hedge her position by borrowing gold (via a lease) and selling it into the spot market. Now the forward provider will receive gold in the future on the forward contract and can deliver it against her lease, and is therefore fully hedged. Some market participants also entered into “naked” forwards to short gold as a speculative trade. All these forward transactions generated incremental demand to borrow gold, creating a spike in lease rates (though still negative.)

3m gold lease rates (Bloomberg)

One of the stories circulating on the web is that this spike in lease rates forecasts an impending improvement in gold price.  In fact the spike is saying that investors are nervous and are hedging or shorting gold.  With the precious metal down another 1% today, there is no evidence for this relationship between the two. And for those who are still looking for manipulation conspiracy theories in gold lease market, just remember your Occam's razor. Simple explanations must be exhausted first.

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The Fed's Liquidity Swap and the latest Hype Award

Riding on the coattails of the recent court ruling on disclosure from the Fed, Bloomberg reporters are now focused on the Fed Liquidity Swap Facility (FLSF).

Bloomberg: As part of a currency-swap plan active from 2007 to 2010 and revived to fight the European debt crisis, the Fed lends dollars to other central banks, which auction them to local commercial banks. Lending peaked at $586 billion in December 2008. While the transactions with other central banks are all disclosed, the Fed doesn’t track where the dollars ultimately end up, and European officials don’t share borrowers’ identities outside the continent.

They are trying to make the case that the Fed is not aware of who are the ultimate users of what Bloomberg calls "loans". Not to defend the Fed, but the popularity of pounding on that institution for the sake of getting attention has become the latest pastime and represents the best of media hype. Most would expect Bloomberg to rise above that. Here are some facts that may help ease the minds of our zealous journalist friends:

1. FLSF outstanding currently is barely visible in comparison to what was in place in 2008 or even in 2010.

Did our friends at Bloomberg just notice it?

2. FLSF is not a loan. It is in fact a currency swap. The Fed is in effect both lending dollars and borrowing euros at the same time. The impact of actual net financing provided is zero.

3. The swap is with the ECB, not the European banks. The credit risk of transacting with the ECB is similar to that of transacting with the Fed - nonexistent. That's because the ECB can always "print" enough euros to return the dollars, just as the Fed can always "print" enough dollars to return the euros.

4. If the Fed needed to do the swap to provide euros to US institutions, it would not be obligated to tell the ECB to whom it is providing the currency. The same holds true for the ECB.  Just as a bank transacting with another bank is not obligated to disclose what the funds are used for, neither are the central banks.

5. Instead of focusing on this phantom FLSF risk, the reporters should look at the IMF exposure and the US administration's ability to provide additional funds without going to Congress. That's because the funding has already been approved:

The White House: ... It also expands the resources available to the International Monetary Fund (IMF) by allowing it to boost its lending ability. Many developing countries are experiencing severe economic decline and a massive withdrawal of capital, and the IMF needs to make sure it has the resources necessary to effectively respond to the current financial crisis

So congratulations go to Scott Lanman and Bradley Keoun of Bloomberg.  They get the Sober Look Hype Award.

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The not so "secret" ECB lending efforts

With the all the hoopla about the "secret" loans to US banks during the 08 crisis, there doesn't seem to be the same level of scrutiny on the ECB's current support for European banks. In dollar terms the amount outstanding to European institutions is over 3/4 of a trillion and growing. This shows increasing dependence of European institutions on the central bank for short-term funding. The ECB is also considering easing collateral requirements (as banks run out of eligible collateral) as well as adding 2-year loans to allow banks to lock in term funding.

ECB lending to Euro-area banks in Billion EUR (Bloomberg)

There are other forms of support from the ECB.  To add liquidity to the systems the ECB continues to purchase covered bonds as part of their second "mini-QE" program.  The idea behind covered  bonds is to supposedly avoid taking on sovereign risk directly.

 ECB Covered Bond Purchase Program # 2 (source: ECB)

To address European banks' continuing need for dollars the ECB keeps tapping the Fed's Liquidity Swap Facility (chart below).

These efforts from the central banks, combined with the Fed's move to cut dollar borrowing costs on this facility, has reduced the EUR/USD Currency Basis Swap spread quite dramatically.

3-month EUR/USD Basis Swap Spread (Bloomberg)

But tightness in term dollar interbank funding continues to persist with USD LIBOR grinding higher.  This is particularly noticeable in the 3-month TED spread (LIBOR to T-bills):

3m TED Spread (Bloomberg)

Based on this, one should fully expect to see the ECB do more (not so "secret") lending and continuing to come up with innovative ways to keep the euro-zone banking system afloat.

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A Discount Rate cut? It just doesn’t matter

The rate on the Fed Liquidity Swap has been changed today to the OIS rate + 50 down from (OIS +100).

The Fed: The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

The liquidity swap represents the Fed providing dollar funds to the ECB and other central banks while taking euros or other currency as collateral. The all-in rate should be around 60 bp. If the US chartered banks want to borrow from the Fed, they have to pay 75 bp – the so-called Discount Rate. Some have speculated that it makes no sense for the Fed to offer lower rates to foreigners than it would to the US banks and therefore the Fed intends to lower the Discount Rate.

MarketWatch: “It is now cheaper for foreign banks to borrow dollars from their local banks than it is for U.S. banks to borrow dollars from the Fed, so we could see a 25 basis point cut in the discount window in the coming days to level the playing field,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.

First of all that is unlikely because the Fed clearly stated at the last meeting that they want to raise not lower the discount rate:

FOMC Oct 3d Minutes: As another step toward restoring a pre-crisis discount rate structure, some directors supported increasing the primary credit rate by 25 basis points (to 1 percent) at this time. Such an action would result in a 75-basis-point spread between the primary credit rate and the upper end of the Federal Open Market Committee's target range for the federal funds rate. These directors favored a move toward normalization of the primary credit rate in light of current and anticipated economic conditions.

Second of all US banks are NOT borrowing from the Fed these days – they have no reason to. In fact they are lending via excess reserves.  The rate that is important is the “Fed Funds Effective Rate”, the rate at which banks lend dollars to each other overnight. And that’s sitting around 8-9 basis points.

 Fed Funds Effective (FEDL01 Bloomberg)

The need for dollars directly from the Fed comes from the European banks (via the ECB) because US banks and US money markets are limiting their lending to them. Thus lowering the Discount Rate simply won’t make any difference.

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The European bank failure hype from Forbes

Nigam Arora, a contributor to Forbes Online, wrote the following today: 

Forbes: It appears that a big European bank got close to failure last night. European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs.

"It appears" Mr. Arora?  This certainly started a buzz in the market.  Arora continues: "The cavalry was called in and has come to the successful rescue."

And where exactly are you hearing about this supposed bank failure?  Maybe you can tell us how a 50 bp reduction in dollar borrowing rate would have averted a European bank failure?

Just because you are an engineer and a nuclear physicist, are we supposed to take your word for it? Absolutely no evidence of such an event has been provided in the article.  So congratulations Mr. Arora.  You get the Sober Look Hype Award.

We are doing well with the Hype Awards - two already this week, and that doesn't even count the La Stampa fiasco.

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Two central bank actions light up the equity markets

Big move in the market this morning, with S&P futures up over 2.5%. We had two major moves by central banks: China reduces reserve ratio and the Fed lowers the rate on its liquidity swap to the ECB (and other central banks).

It's a 50bp swap rate reduction and term extension to ease demand for dollars in Europe. The implication on dollar liquidity however is expected to be muted.  The euro basis swap spread improved only slightly.

The markets are looking for reasons to rally and two reasons were given.  The overall impact on the euro-zone crisis is still uncertain.  Italian and Spanish bond yields have not budged.

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Fed Swap on the Rise

The Fed is continuing to extend dollars to the ECB via the liquidity swap facility (taking euros in as collateral). As dollar money markets refuse to buy/roll European (non-UK) commercial paper, banks in Europe are increasingly turning to the ECB for dollar funding.

The levels are a fraction of what was extended in 08-09 but are still an indication of a continuing stress in the dollar funding markets.

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