September 15, 2011 Dylan Ratigan

Is the U.S. on the Hook for Swap Lines to Europe?

Are we seeing the beginning of the next bailout? According to today’s Wall Street Journal:

Five major central banks have agreed to provide dollar liquidity in a coordinated move to ease dollar-funding constraints among some European banks… The European Central Bank, in conjunction with the U.S. Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank, will conduct three U.S. dollar liquidity-providing operations with a maturity of approximately three months.

The issue at hand is not whether the Federal Reserve is committing American money to stabilize the European financial market — that’s apparent.  The questions are whether the Fed is now providing financially-based political support to protect against the breakup of the European Union, and what amount of financial risk that the U.S. is taking on to do that.

We wanted to know who will end up paying for swap lines in the end, and under what scenarios our taxpayer money could be at risk.  To get answers and for deeper insight into Europe’s sovereign debt crisis and what the U.S. has at stake at this point, we spoke with Josh Rosner and Sean Egan.   Here are transcripts of our conversations with them.

Josh Rosner, Managing Director at Graham Fisher & Co.  Co-author of Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon.

DYLANRATIGAN.COM: Josh, what just happened?
JOSH ROSNER: Europe and the European banks are having seemingly funding issues, suggesting that they are having liquidity issues actually. And as a result several of the global central banks have agreed to provide dollar swap lines so there is an adequate supply of dollars to meet the funding needs of those institutions.

DR.COM: Why did the Fed do this?
JOSH: The Fed did this in the name of bank stability. Obviously Europe is in the midst of a sovereign debt crisis. Many of the European banks have significant sovereign exposures especially risky exposures to Portugal, Italy, Greece, Spain and Ireland. And as a result the Fed, the Bank of Japan, the Swiss National Bank, the ECB, stepped in to make sure that there was an adequate supply of liquidity so that these banks would be able to make their obligations.

DR.COM: Is this legal, and who authorized this?
JOSH: Well, the Fed has embarked on the use of swap lines before. They did so most recently and most significantly in the the crisis, and did it again in the summer of 2010. In terms of the legality, it’s unclear as to whether it’s legal, but given the face that no one in Washington has ever challenged the authority, it almost doesn’t matter.

DR.COM: Could U.S. taxpayers be on the hook for losses?
JOSH: Well, in an extreme case the U.S. taxpayers are on the hook. Now, the way that it works is that Europe’s government enters into agreements with the foreign central bank, in this case the European Central Bank, that we will exchange U.S. dollars for local currency, the Euro, at an agreed-to exchange rate, which is then locked in as of today. The ECB has an obligation to repay those dollars at some point at that exchange rate. So theoretically, the U.S. doesn’t have risk. We’ve gotten rid of the exchange rate risk through that agreement. Even the credit risk, should the collateral that the ECB lends dollars against go bad, then it would be the ECB who would have that credit risk. To that point, no, the Fed doesn’t have any risk. However, given the severity of the crisis in Europe, there remain questions as to whether the European Union might break apart, could see change in membership, and that the ECB could end up in trouble. So if the Euro collapses, the question is, where would we end up getting repaid? And in that extreme example, the U.S. is on the hook it seems.

That’s also an important point to consider, because really, the Fed has thus committed to support the European Union and the Euro through these transactions. And that almost seems to take them out of the role of monetary policy almost into the role of foreign policy. Because it’s now not just a matter of bank stability and international financial market stability, but in fact the Fed inserting itself in support of the stability of the European Union and the Euro itself.

DR.COM: In a podcast a month or so ago, Sean Egan from Egan-Jones told us that recovery on Greek debt in particular is going to be much lower than expected, that European banks do not have the capital to absorb the hit — and the question is how the financial system is going to be rescued in Europe. He goes on to say that the ECB is pretty much tapped out with a capital base of 10 million euros, which sounds like a lot, but it has on it’s balance sheet assets with a face value of 300 billion euros that are probably worth about 80% of that at most. So, is the U.S. even more at risk when you hear those numbers?
JOSH: Yes, the U.S. is at risk — and I find it particularly interesting when I hear that this was not a decision that was coordinated or thought through apparently with Washington. Congress is supposed to have the power of the purse, but yet the Fed has committed the U.S. to this policy where it’s unclear whether those risks have been fully appreciated or considered by those with the power of the purse.

DR.COM: How would the Fed have to sell Americans on bailing out a bankrupt Europe? Or do they even have to sell Americans on it before taking action?
JOSH: It seems at this point — and we don’t know the size of the commitment, or I haven’t seen the size of the commitment that they announced this morning – it seems like they started to commit us, and there has been no discussion in Washington. The other thing that is important — to the defense of the global central bankers — is because of a lack of leadership, legislative or executive in the U.S. or Europe, the Central banks have been forced by default to increasingly take on fiscal policy roles outside of their monetary policy mandate by default.

DR.COM: What are the risks of this action?
JOSH: Unfortunately it’s unclear until we know the size. Frankly, this could have been a very small agreement for the purpose of trying to buy time and increase confidence. But until we actually know the details, we won’t know whether that’s what it is or whether it is a larger swap line.

DR.COM: When would the size of the agreement come out?
JOSH: It will come out — the Fed has put the prior swap line agreements on their website. But we have not seen it yet and it’s unclear when we’d see it.

DR.COM: Will the Fed’s actions today even begin to help Europe’s deep problems?
JOSH: Even with these swap lines, it’s not going to solve Europe’s problems. It may buy them time, but it’s not clear what their solution is. The head of the IMF, Christine Lagarde, has rightly recognized that the problems of Europe at this point are capital problems — just like the U.S. banks during the crisis. They have too many troubled assets on their balance sheets. But most in Europe continue to argue that this is a liquidity problem, failing to recognize that liquidity has been withdrawn by investors based on an understanding of just how deep the capital problems are.

DR.COM: For Greece for example — what should they be doing that they’re not doing?
JOSH: Unfortunately, much of the tension currently is about trying to hold Europe together. And Greece, with the constraints that it faces, the inability to let out further austerity, probably cannot survive in the European Union without likely causing the downgrade of France and further risks to the periphery of Europe.

DR.COM: At this point, is it irresponsible to say that Europe’s problems are liquidity based?
JOSH: I think it is, but it’s the “continue to pretend and extend.” It in fact — the only purpose for swap lines is liquidity. And that in itself suggests that the U.S. Fed is, at least in name, supporting the notion that there is a liquidity problem. But failing to recognize that the liquidity problem is a result of a deep capital problem. So while I’ve never been a fan of the manner of which we instituted our Troubled Asset Relief Program (TARP), there is a real need for the Europeans to embark on a write-down of the troubled assets, and then a recapitalization of certain of their financial institutions.

We also had the chance to catch up with recent Radio Free Dylan guest Sean Egan, founding partner and President of Egan-Jones Ratings Company.  Here is his take:

DYLANRATIGAN.COM: Sean, What’s your take on what just happened?

SEAN: My take is that the Fed recognizes the severity of the problem and is encouraging the European banks to take action.  And as part of that encouragement has offered to participate in the process.

DR.COM: Why did the Fed do this?
SEAN: Because the Fed is the 800 pound gorilla on the face of the globe, that they have been through this as a result of the 2007/2008 crisis, and they recognize the possibility of a banking run when they see it and realize that it’s going affect their market.

DR.COM: Is this legal?  And if so, who authorized it?
SEAN: As of 30 years ago, it would not have been legal.  However, with the changes in the law stemming from the 2008 crisis, the Fed’s powers have significantly broadened, and so they will probably make the argument that this is within their powers.  Does it directly benefit U.S. taxpayers?  Well, some could easily make a cogent argument that it doesn’t and it puts the U.S. taxpayers at risk.  However, it’s likely that the Fed will make the argument that if there are problems in Europe, that it affects the U.S. markets.

DR.COM: But say things do go south, are U.S. taxpayers on the hook for losses?
SEAN: Whenever you run money, you have the potential of losing that money, and that certainly applies here.

DR.COM: Worst case scenario, what could be the risks of the actions taken by the Fed?
SEAN: Well, the most immediate impact might be if a major European bank fails and can’t pay 100% of its obligations, in which case the U.S. taxpayers would have to make up the difference.  Additionally, the Fed’s actions increases the amount of currency outstanding and you have the longer term impact, possible increases in inflation; however, that’s not the most immediately problem.  The most pressing problem is a possible meltdown, a deposit run for European banks, which is actually in the process of happening.  Greek deposits have shrunk significantly over the past six months, as have Portuguese and Irish bank deposits. The world is interconnected and in the event that Europe saw a significant run on one of it’s major banks, it would result in the massive de-risking and would hurt the global economy.

DR.COM: Why are we in this problem in the first place, Sean?
SEAN: The core issue is the lack of adequate checks and balances in our credit system; that dumb mistakes were made in providing credit.  And, as a result, the financial institutions—not only in the U.S., but also in Europe—became overextended and did not have the ability to absorb the losses when – as is becoming more apparent that some of the assets aren’t worth 100% of face.   And in the case of the European banks, they simply don’t have the capital to absorb the hits.  The question that everybody is asking is how are the European banks going to find the capital.  This action addresses liquidity; it doesn’t address solvency and capitalization, and that’s the core underlying problem is how to recapitalize the European banks in an effective manner.  When the governments step in, they will be highly dilutive to the current shareholders of these banks and you’re likely to see a significant continued declined in the bank share prices.  Over the past three months, the European banks have declined between 40% and 75%, which is unprecedented in normal times.

DR.COM: Josh Rosner from Graham Fisher & Co. said that the Fed is, by doing this, basically agreeing that this a liquidity crisis, that swap lines are there to fix liquidity problems — but he said there is no way this is a liquidity problem.  Do you agree with that assessment?
SEAN: Josh is absolutely right.  This is not a liquidity problem; this is a solvency problem.  Liquidity problems aren’t very difficult to address, and this is much, much bigger than a simple liquidity problem.  And by the way, that was exactly what Bear Stearns and Lehman Brothers argued that there’s a lack of liquidity in the market.  It became very obvious that it wasn’t the simple liquidity; it was the valuation in solvency that was at the core of it.

— Megan Robertson is a digital producer for

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