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Brad Setser:
Follow the Money reports about the shadow financial system.
(emphasis mine) [my
comment]
The shadow financial system – as
illustrated in three new papers that cut through the London fog
Posted on Sunday, March 8th, 2009
By bsetser
[…]
[BIS = Bank of International Settlement]
Two papers (one on US money market funds’ role funding
European banksand one on European banks dollar funding needs) in
the BIS quarterly shed some light on the role European financial institutions
played in the rise – and the subsequent fall – of US credit
markets. [I have included extract from these two papers below. If you have an
accounting/financial background, then try looking over the whole articles.
However, be warned that these are academic papers which, while interesting,
are painfully difficult to read.]
[First Paper: one on US money market funds’ role
funding European banks]
The first paper – by Baba, McCauley and Ramaswamy –
explains how US money market funds were a crucial channel for transmitting
the financial stress caused by Lehman’s default to Europe’s banks
(and then back to US credit markets).
It turns out that Lehman (and no doubt other investment banks) and
European banks both borrowed heavily from the US money markets. In
effect, they shared a common creditor – “prime” money
market funds – and when Lehman’s default led the reserve primary
fund to break the buck and massive withdrawals from “prime” money
market funds – European banks lost access to dollar financing.
Baba, McCauley and Ramaswamy write: “the run on US dollar money
market funds after the Lehman failure stressed global interbank markets
because the funds bulked so large as suppliers of US dollars to non-US
banks.”
This isn’t really news. There is a reason why the Fed lent $600
billion to European central banks – the Fed was making up for collapse
of dollar funding from US money market funds. (see graph 6 on p.77)
Baba, McCauley and Ramaswamy highlight the huge growth in the dollar
assets of European banks over the last eight years. Those assets increased
from $2 trillion to around $8 trillion (with Swiss banks accounting for about
½ the total). That growth “outran their retail dollar
deposits,” making Europe’s banks reliant on wholesale dollar
funding in much the same way that the growth in the assets of the US broker
dealers made them reliant on wholesale funding. US money market funds
that weren’t limited to Treasury and Agency paper happily met this need:
“competition to offer investors higher yields, however, led them to buy
the paper of non-US headquartered firms to harvest the Yankee premium.”
The BIS estimates that US money market funds were supplying $1 trillion of
credit to non-US banks in mid-2008 (dollar denominated European money market
funds supplied another $180b ….). That is far more dollar financing
than supplied by the offshore dollar deposits of the world’s central
banks: “by contrast, central banks … provided only $500
billion to European banks at the peak of their holdings in the third quarter
of 2007.”
Still, those looking for a direct (rather than indirect) link between
central bank reserve growth and boom in lending to US households can find a
link here. A fraction of central bank dollar reserves were held in
deposit in European banks – and another fraction was invested in
onshore and offshore dollar-denominated money market funds. European
banks used those sources of dollar “funding’ to buy securities
backed by loans to US households. The growth in their balance sheets
undoubtedly explains the huge increase in cross border flows (outflows from
US money market funds financed the inflows associated with European banks
purchases of US securities) during the boom years – and large corporate
debt purchases through the UK.
[Second Paper: one on European banks dollar funding
needs]
The second BIS paper — by Patrick McGuire and Goetz von Peter on
the “US dollar shortage in global banking” — uses the BIS
banking data (actually, I would say that they tortured the banking data [Agreed,
which didn’t make it easy to read], as the data didn’t yield its
secrets without a tremendous amount of effort) to estimate European banks
need for dollar funding. It is superb.
The results are
interesting, to say the least. They confirm that the losses that money
market funds that held Lehman paper were a key channel of contagion, as
European banks depended on US money market funds to meet their need for
dollar funding.
Among other things, McGuire and von Peter find:
– “European banks experienced the most pronounced growth in
foreign claims relative to underlying measures of economic activity.”
[Translation: European banks lent the US far more than it could ever pay
back.]
– “After 2000, some banking systems took on increasingly large
net on-balance sheet positions in foreign currencies, particularly in US
dollars. While the associated currency exposures were presumably hedged off
balance sheet, the buildup of large net US dollar positions exposed these
banks to funding risk , or the risk that their funding positions could not be
rolled over.”
– “A lower bound estimate of banks’ funding gap …
shows that the major European banks funding needs were substantial ($1.1 to
$1.3 trillion by mid-2007).”
– UK banks, for example, borrowed in pounds sterling [some $800b] in
order to finance their corresponding long positions in US dollar, euros and
other foreign currencies. By mid-2007 their long US dollar positions
surpassed $300b, on an estimated $2 trillion in gross US dollar claims.
Similarly, Germany and Swiss banks net dollar books approached $300b by
mid-2007, while that of Dutch banks surpassed $150b …. ”
Setser note: this created large positions that needed to be hedged, and meant
that if UK banks couldn’t raise a lot of sterling funding to swap into
dollars, they would need to go out into the market and borrow dollars
directly …
– The term structure of the fx swaps Eurpoean banks used to
transform their pound and euro funding into dollars “are even more
short-term on average” than dollars borrowed on the interbank market.
– “these estimates suggest that European banks’ US dollar
investments in non-banks [read holdings of dollar securities and corporate
loans] were subject to considerable funding risk …. The major European
banks US dollar funding gap reached $1.1-1.3 trillion by mid-2007. Until the
onset of the crisis European banks had met this need by tapping the interbank
market ($400 billion) and borrowing from central banks ($380 billion) and
used FX swaps ($800 billion) to convert (primarily) domestic currency funding
into dollars.”
By the way, US banks were net borrowers from the rest of the world –
but most of their borrowing came from a few Caribbean islands – and
those islands borrowed heavily from “non-bank” counterparties in
the US. The BIS doesn’t think this represents a true external flow:
“this could be regarded as an extension of US banks domestic activity
since it does not reflect (direct) funding from non-banks outside the United
States.”
The subprime crisis in August 2007 put these funding arrangements under
stress. And they effectively collapsed after Lehman, leading to a scramble
for dollars – or a “dollar shortage.” In the fourth
quarter, the US government was a net LENDER to the rest of the world [This
isn’t as good as it sounds. The reason the fed lent dollars to the rest
of the world was to prevent foreigners from selling US assets. More on this
at end of article]. Inflows from central banks were dwarfed by the $400 billion
in swap lines the US provided European central banks. That is rather
strange; deficit countries usually aren’t net lenders … but,
well, a lot of institutions really were desperate for dollars.
The main source of stress on European banks came from the withdrawal of
money market funding and the difficulties obtaining currency swaps. But it
seems like European banks also lost another source of dollar funding: the
world’s central banks.
Emerging economies were facing their own liquidity shortage – and
emerging market banks in particular. Their home central bank helped them out.
Countries with lots of dollar reserves though didn’t need to turn to
the Fed for dollars. They could withdraw dollars from European banks
and put them on deposit in their local banking system.
“A portion of the US dollar foreign exchange reserves that central
banks had placed with commercial banks was withdrawn during the course of the
crisis. In particular, some money authorities in emerging markets reportedly
withdrew placements in support of their own banking systems in need of US
dollars. Market conditions made it difficult for banks to respond to
these funding pressures by reducing their dollar assets [the
“Market conditions” which made it difficult for European banks to
reduce their dollar assets was the collapse] …. “
It was long argued that official investors were intrinsically stabilizing
investors – and thus that they would never trigger a funding crisis or
add to market distress. And it is certainly true that central banks
haven’t triggered a dollar crisis. Indeed, they almost certainly
prevented one in 2006 and 2007 when they added crazy sums to their reserves,
preventing the dollar from falling against a host of emerging currencies. At
the same time, central bank reserve managers haven’t been a stabilizing
force in the credit market during this crisis.
– Central bank reserve managers – led by China and Russia - shifted
massively out of Agencies and into Treasuries. And that shift came after a
long period when central banks kept buying Agency bonds even as (in
retrospect) the quality of the Agencies balance sheet was eroding, as they
were lending against collateral inflated by housing bubble.
– Central banks shifted dollars out of European banks short of
dollars to their home countries banking system.
The first flow represents a flight to safety. The second flow represents a
flight from the risk associated with global banks – but putting funds
on deposit in shaky local banks isn’t necessarily the safest of
investment either. It was a flow driven by the banks need to stabilize their
own markets.
In both cases the offsetting flow – the flow that prevented an even
deeper crisis than we have seen to date – came from the US Federal Reserve.
They should get a bit of credit. [They printed money to buy what foreign
central banks and European banks were selling. Printing money is easy. Not
printing money is hard.]
My reaction: This
explains the direct link between central bank reserve growth and boom in
lending to US households:
1) Central bank dollar reserves funded European banks in two ways:
A) A fraction of these reserves were held in deposit in European banks
B) Another fraction was invested in onshore/offshore dollar-denominated money
market funds, which then financed those European banks.
2) European banks used this "funding' to buy AAA rated US debt:
treasuries, agencies (mortgages securitized by Freddie/fannie), securities
backed by loans to US households, etc...
3) Many countries with lots of dollar reserves withdrew dollars from European
banks to support their local banking system’s needs.
4) When Lehman's default led to massive withdrawals from money market funds,
European banks lost access to dollar financing.
5) The Fed lent $600 billion to European central banks (via currency swaps
with EU central banks) to make up for collapse of dollar funding from US
money market funds.
Conclusion:
When foreign central bank and money market withdrawals cut off European banks
from their dollar financing, the fed stepped in to fill the vacuum. To
understand why the fed did this, here are the extracts from two papers in
the BIS quarterly mentioned above:
From one on European banks dollar funding needs:
European
banks’ need for US dollar funding
Non-US banks' overall need for US dollar funding provides a useful
perspective on their reliance on money market funds. European banks increased
their dollar assets sharply in this decade (Graph 1, left-hand panel).
Since this growth outran that of their retail dollar deposits, they bid for
dollars from nonbanks and banks (see McGuire and von Peter in this issue). US
banks’ need for European currencies is much smaller (Graph 1,
right-hand panel) because US banks have leveraged their domestic operations
with foreign assets much less. European banks’ foreign assets in all
currencies topped $30 trillion in early 2008, 10 times the figure for US
banks. (Netting out intra-euro area assets does not alter the
order-of-magnitude difference.)
…
Overall, European banks appear to have relied on money market funds for
about an eighth of their $8 trillion in dollar funding. By contrast, central
banks, which invest 10–15% of US dollar reserves in banks (McCauley
(2007)), provided only $500 billion to European banks at the peak of their
holdings in the third quarter of 2007. Given these patterns, any run
on dollar money market funds was bound to make trouble for European banks.
Whereas the Treasury guarantee provided an incentive not to withdraw
funds, the expansion of the swap lines between the Federal Reserve and
European central banks, inter alia, offset withdrawals that resulted in less
credit to European banks from US money market funds (Graph 6). Even
as money funds and others shifted to safer assets, the Treasury
“overfunded” its immediate cash needs and placed the proceeds in
the Federal Reserve. [Money funds stopped lending to European banks
and bought treasuries. The US government (fed/treasury) then sold treasuries
to these money funds and lent money to those same European banks. That is
what the graphic above is showing in the diagram.] These funds were
the counterpart of the expansion of Federal Reserve funding to European
central banks which in turn funded their banks. In quantity terms, the
accommodation was more than complete in the last two weeks of September.
Redemptions of prime funds amounted to $350 billion in the 11 business days
16 September to 1 October. Given the allocation in Table 1, this implied
an eventual loss of funding for non-US banks of $175 billion. In the two
weeks ending on 1 October, the Federal Reserve’s swaps rose by $225
billion.
From one on US money market funds’ role funding
European banks:
Taken together, Graphs 2 and 3 thus show that several European banking
systems expanded their long US dollar positions significantly after 2000, and
funded them primarily by borrowing in their domestic currency from home
country residents. This is consistent with European universal banks using
their retail banking arms to fund the expansion of investment banking
activities, which have a large dollar component and are concentrated in major
financial centers. In aggregate, European banks’ combined long
US dollar positions grew to more than $800 billion by mid-2007 (Graph 5,
top left-hand panel), funded by short positions in pounds sterling, euros
and Swiss francs.
From the perspective of financial stability, a key metric of interest is
the extent to which banks engage in maturity transformation. [Key point] A
sudden inability to roll over their short-term funding positions will require
that banks "deliver" foreign currency, which may force them to sell
or liquidate assets earlier than anticipated, typically in distressed market
conditions ("distress selling"). [This explains why the fed lent to
those European banks: it was a desperate attempt to delay the liquidation of
US assets by said banks.]
Finally, here is
an article from the Market Oracle which provides the final piece to the
puzzle for understanding all this. The article reports that bankrupt European banks sitting on $23 trillion of
impaired assets.
More
leverage in Europe
Let's begin our journey by pointing out a regulatory 'anomaly' which has
allowed European banks to take on much more leverage than their American
colleagues and which now makes them far more vulnerable. In Europe, unlike in
the US, it is only risk-weighted assets which matter to the regulators, not
the total leverage ratio. European banks can therefore apply a lot
more leverage than their US counterparties, provided they load their balance
sheets with higher rated assets, and that is precisely what they have been
doing.
That is fine as long as you buy what it says on the tin. But AAA is not
always AAA as we have learned over the past 18 months. Asset securitisations
such as CLOs proved very popular amongst European banks, partly because they
offered very attractive returns and partly because Standard & Poors and
Moodys were kind enough to rate many of them AAA despite the questionable
quality of the underlying assets.
Now, as long as the economy chugs along, everything is dandy and the
AAA-rated assets turn out to be precisely that. But we are not in dandy
territory. Many asset securitization programs are in horse manure to their
necks, so don't be at all surprised if European banks have to swallow further
losses once the full effect of the recession is felt across Europe. The two
largest sources of asset securitization programs are corporate loans and
credit cards. Senior secured loans are still marked at or close to par
on many balance sheets despite the fact they trade around 70 in the markets. The
credit card cycle is only beginning to turn now with significant losses
expected later this year and in 2010-11.
My reaction: This
explains the dollar shortage the world is experiencing: European banks need
dollars so they don't have to sell US assets, forcing them to recognize
losses.
1) European banks increased their dollar assets sharply in this decade, with
foreign assets in all currencies topping $30 trillion in early 2008, 10 times
the figure for US banks.
2) European banks' combined long US dollar positions grew to more than $800
billion by mid-2007. This $800 billion was then leveraged into $8 trillion in
US assets.
3) These enormous US holdings were funded by
A) Borrowing in their domestic currency from home country residents (ie:
Short positions in pounds sterling, euros and Swiss francs)
B) Loans from money market funds (1 trillion)
C) Loans from central banks, either directly or via the money markets. ($500
billion)
Since European banks relied on money market funds for about an eighth of
their in dollar funding, a run on dollar money market funds created serious
trouble for European banks.
4) The Federal Reserve expanded its currency swaps with European central
banks to offset US money market withdrawals from European
banks.
5) As long as they buy AAA rated securities, European banks are/were allowed
to apply a lot more leverage than US banks.
In Europe, unlike in the US, it is only risk-weighted assets which matter to
the regulators, not the total leverage ratio. European banks can therefore
apply a lot more leverage than their US counterparties, provided they load
their balance sheets with higher rated assets, and that is precisely what
they have been doing.
6) While much of the AAA rated securities they bought were treasuries and
agencies, some of the senior secured loans on the balance sheet of European
banks are still marked at or close to par despite the fact they trade around
70 in the markets.
7) If European banks aren’t able to roll over the short term debt, they
will have to start selling their 8 trillion dollars of US assets.
A sudden inability to roll over their short-term funding positions will
require that banks "deliver" foreign currency, which may force them
to sell or liquidate assets earlier than anticipated, typically in distressed
market conditions ("distress selling").
--------------------------------------
Summary of key points:
European banks own 8 trillion US assets (treasuries, agencies, consumer loans,
etc…) and they are losing access to their dollar funding. If European
banks are forced to sell their US assets, it will crash the credit markets,
and they will have to recognize enormous losses. Since the fed is desperate
to prevent the collapse of the US financial system, it lent those European
banks 600 billion dollars so that they wouldn’t be forced to sell.
Meanwhile, European banks accepted this 600 billion because they don’t
want to recognize losses on their toxic US securities.
What is going to happen? Well in my last entry, I
highlighted how:
“When the American economy fell into depression, US banks recalled
their loans, causing the German banking system to collapse”
The same thing will happen in 2009, except the roles will be reversed. As
Europe falls into a depression, European banks will recalled their loans and
sell off dollar assets, causing the US banking system to collapse. Once this
foreign liquidation and deleveraging of US assets begins, the current need
for dollar financing will be replaced by desperate panic to escape
America’s collapsing currency. Finally, like with US banks back in the
1930s, European banks will have to recognize enormous losses on their foreign
holdings, making many of them insolvent.
Eric
de Carbonnel
Market Skeptics
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