Dollar Swaps & the Financial Crisis: A Short Overview of the Dollar Shortage of 2008

8/14/2019 Dollar Swaps & the Financial Crisis: A Short Overview of the Dollar Shortage of 2008

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Dollar Swaps & The

Financial CrisisA Brief Overview of the Dollar Shortage of 2008Kristjan Velbri

1.01.2010

This aim of this short report is to give some insight to the dollar liquidity swaps initiated bythe Federal Reserve Bank of the United States and the market conditions that precipitatedthe need for such arrangement.


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Dollar Swaps & The Financial Crisis: A Brief Overview of the Dollar Shortage of 2008

2 | P a g e 2 0 1 0 Kristjan Velbri www.kristjanvelbri.com

Introduction

This aim of this short report is to give some insight to the dollar liquidity swaps initiated by

the Federal Reserve Bank of the United States and the market conditions that precipitated

the need for such arrangement. This report is not an official document and was put

together by a non-professional. The facts used and claims made in this report are known to

be true as far as the author comprehends the issue at hand. Although the report goes into

some detail in regard to financial innovation and derivatives, the author acknowledges that

his understanding of financial instruments is limited at best. Furthermore, it is not the aim

of this report to give a comprehensive overview of derivatives. Readers are welcome to

point out factual, conceptual and other errors and suggestions to the author by e-mail:

[email protected]

The report is divided into three parts: the first part takes a look at what led to thevulnerabilities that precipitated the need for dollar swaps, the second part examines

financial innovation and the last part sheds light on the dollars swaps.

Kristjan Velbri, author

January 2010


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banks had met this need by tapping the interbank market ($432 billion) and byborrowing from central banks ($386 billion), and used FX swaps ($315 billion) toconvert (primarily) domestic currency funding into dollars.22 If we assume thatthese banks liabilities to money market funds (roughly $1 trillion, Baba et al(2009)) are also short-term liabilities, then the estimate of their US dollar funding

gap in mid-2007 would be $2.02.2 trillion. Were all liabilities to non-bankstreated as short-term funding, the upper-bound estimate would be $6.5trillion.5

5The US dollar shortage in global banking and the international policy response, BIS Working Papers (No 291),

Patrick McGuire and Gtz von Peter, October 2009, p. 15

Figure 1 European banks' balancesheet positions (BIS 291, p. 16)

3. US dollar positions vis--vis US

residents booked by banks offices in

the United States (LCLC and LLLC).6. The net position vis--vis non-banks

is estimated as the sum of net

international positions vis--vis non-

banks and net local US positions (vis--

vis all sectors).

8. Lower bound estimate plus estimated

US dollar liabilities to money market

funds.

9. Consolidated gross claims on non-

banks.10. Consolidated gross claims (ultimate

risk basis) on the US public sector.


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Figure 1.1 Gross foreign assets and liabilities (BIS 291, p.11)


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Financial Innovation the Story of Financial Magic

During previous periods of instability in the real estate market, mortgage loan companiesaccrued the first losses. Hedge funds, commercial and investment banks only took losses ifthe fall in the real estate market was large enough to influence financial markets and slow

down the whole economy. However, ever since the first mortgage backed security was soldin the 1970s by Ginnie Mae6, new ways of investing in the real estate market had beendeveloped by Wall Street. These securities were supposed to replicate bonds.

A mortgage-backed security (MBS) is a securitized interest in a pool of mortgages.It is a bond. Instead of paying investors fixed coupons and principal, it pays out thecash flows from the pool of mortgages. The simplest form of mortgage-backedsecurity is a mortgage pass-through. With this structure, all principal and interestpayments (less a servicing fee) from the pool of mortgages are passed directly toinvestors each month.7

Some of these securities were sold to investors, but some of them were pooled intocollateralized debt obligations (CDOs) by banks. The securities were packaged together toinclude prime, near prime and subprime mortgages, but the riskiest of all CDOs had onlysubprime assets backing them. CDOs comprised not only of mortgage debt in the form ofmortgage backed securities, but also car loans, student loans, credit card receivables andother assets in the form of asset backed securities (ABS).

Collateralized debt obligations are securitized interests in pools ofgenerally non-mortgageassets. Assetscalled collateralusually comprise loans or debtinstruments. A CDO may be called a collateralized loan obligation (CLO) orcollateralized bond obligation (CBO) if it holds only loans or bonds, respectively.Investors bear the credit risk of the collateral. Multiple tranches of securities areissued by the CDO, offering investors various maturity and credit risk

6http://www.riskglossary.com/link/mortgage_backed_security.htm

7Ibid

Investor/CDOMBS

Structure

Homeowners

Homeowners

FLOW OF FUNDS (PRINCIPAL+INTEREST)


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characteristics. Tranches are categorized as senior, mezzanine, andsubordinated/equity, according to their degree of credit risk. If there are defaults orthe CDO's collateral otherwise underperforms, scheduled payments to seniortranches take precedence over those of mezzanine tranches, and scheduledpayments to mezzanine tranches take precedence over those to

subordinated/equity tranches. Senior and mezzanine tranches are typically rated,with the former receiving ratings of A to AAA and the latter receiving ratings of B toBBB. The ratings reflect both the credit quality of underlying collateral as well ashow much protection a given tranche is afforded by tranches that are subordinate toit.8

These CDOs were divided into different portions, or tranches, to manage risk. Lower

tranches are riskier, but offer higher returns. Lower tranches also absorb the first losses

based on a waterfall structure (money flows from higher tranches to lower tranches, but it

cannot flow to the lower tranches if it has not filled the upper tranches 100%. 9 Supposing

that a mortgage backed security was divided into ten tranches, the lowest tranche would

take the 100% of the first 10% of losses, the second lowest tranche would take the second

10% and so on until the highest tranche. Tranching allows to give a higher rating to the

highest tranches because they are deemed safer due to the waterfall structure of CDOs.

Even subprime debt could be divided into tranches and the highest tranches be given an

AAA rating, because the highest tranches were unlikely to absorb any losses.

In order to sell all the securitized debt, the banks that packaged these instruments needed

to have access to large investors pension funds, large banks and local governments. A

symbiotic relationship developed between the originators of securitized debt and the credit

8http://www.riskglossary.com/link/collateralized_debt_obligation.htm

9http://en.wikipedia.org/wiki/Tranche

3rd tranche2nd tranche1st trancheCDOMBS/ABS

MBS/ABS

FLOW OF FUNDS (PRINCIPAL+INTEREST)

INTEREST

RISK


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rating agencies, the latter giving securitized debt ratings as high as for US government debt

(AAA), something that should have served as a warning signal for the auditors of credit

rating agencies. It is now widely recognized that rating agencies should have been more

conservative when rating CDOs. The difficulty in determining the risk posed to investors

comes from the nature of the derivatives market. Derivatives are not traded on an

exchange like stocks are, they are bought and sold from originator to buyer. They are also

highly specific (not standardized), which makes comparing credit risk very complicated. It

is relatively easy to compare bonds that have a different originator but the same maturity,

because they are all essentially the same thing, only the risks are different. Comparing

derivatives is not as easy as comparing potential returns and figuring default risk because

the derivatives market has not been standardized, which means that banks have everything

to gain from making derivatives as complicated as possible to hide the risks so the rating

agencies will not be able to figure out the real risks involved.


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The Perfect Financial Storm

The real estate boom resulted in people using their homes as ATMs, drawing out fundseach time the value of the house had gone up. Some of these funds were used to speculateon the financial markets and some of it was used to acquire second homes, either as holiday

retreats or for investment purposes. As the value of houses kept going up, home equity wasincreasingly being used to finance consumption. In some districts, home prices went up somuch that homeowners took out as many as three mortgages.

In 2005, 40 percent of existing mortgages were refinanced. The Flow of Funds dataimply that mortgage equity withdrawals between 1997 and 2006 totaled more than$9 trillion, an amount equal to more than 90 percent of disposable personal incomein 2006.10

And then, the real estate bubble popped. At first, the banks and more importantly, thechairman of the Federal Reserve, thought the risks were contained. In July 2007, testifying

before Congress, chairman Bernanke said the following

The pace of home sales seems likely to remain sluggish for a time, partly as a resultof some tightening in lending standards, and the recent increase in mortgageinterest rates. Sales should ultimately be supported by growth in income andemployment, as well as by mortgage rates that, despite the recent increase, remainfairly low relative to historical norms. However, even if demand stabilizes as weexpect, the pace of construction will probably fall somewhat further, as builderswork down the stocks of unsold new homes. Thus, declines in residentialconstruction will likely continue to weigh on economic growth in coming quarters,although the magnitude of the drag on growth should diminish over time.11

In 2007 signs of distress in the subprime market began to show. In February 2007,Bernanke said the following:

Our assessment is that there's not much indication at this point that subprimemortgage issues have spread into the broader mortgage market, which still seems tobe healthy. And the lending side of that still seems to be healthy.12

Bernanke was right in saying that the subprime mortgage issue had not spread into thebroader mortgage market. Yet. But he should have added that it was a very likely scenario,given the nature of the subprime market, especially the implicit dangers of securitization.Whether he left that out because he was not aware of it or because he was trying to avoidthe blame for ultralow interest rates and zero regulation is irrelevant because it was a badcall any way you look at it.

10Housing, Housing Finance, and Monetary Policy, Martin Feldstein, p. 6

11http://www.youtube.com/watch?v=HQ79Pt2GNJo, transcript available at http://mises.org/story/3588

12Ibid


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When mortgage rates were reset to a higher level due to expiring teaser rates,delinquencies soared to a level that most subprime lenders had not been prepared for.Many of those mortgage loans were given out to people who never should have taken out ahome mortgage loan. These were people with low credit scores, low or no income and inmost cases, did not have sufficient income to pay the higher interest rates once the teaser

rate had expired. But it would be misleading to say that only poor people got subprimemortgages. People who were relatively well off were also lured into getting a subprimemortgage with a low teaser rate.

The effects of this were felt worldwide as securitization and the internationalization of USmortgage debt had spread risk across the globe. As delinquencies and foreclosures surged,the price of mortgage debt began to plunge. The asset depreciation was not limited tomortgages, however. Auto and credit card debt began to fall in value as the US consumerwas no longer able to pay off consumer debt with home equity loans.

But it would be unfair to claim the write-offs were due to delinquencies only. Mark to

market accounting rules were one of the prime reasons for write-offs. According to mark tomarket rules, banks have to mark the value of their assets according to what the market isor would be willing to pay for them. Consider the example of a 3.5% mortgage loan. If theinterest rate goes up and new loans are given with a minimum 5% interest, the value of theprevious loan will be marked down regardless of its performance. If the market considers5% interest enough to satisfy the risk of default, 3.5% will surely not be enough. Mark tomarket accounting rules mean the loan has to be marked down on the balance sheet, whichmakes for an operating loss. If the market is in turmoil as it was during the height of thecrisis, the market value of those loans might plummet to levels that wipe out the wholebalance sheet of a bank. In order to stay in business, banks have to have adequate capitalreserves. If the reserves reach critical levels, banks start to sell off assets to stay in business

and that is exactly what happened. They used the proceeds to buy US dollars.

As the value of banks dollar assets plummeted, their dollar claims started eating awaytheir dollar reserves, hence the banks needed additional dollar deposits to back theirdeclining dollar assets. The massive dollar funding needs of foreign banks led to a rapiddeteriorating of available funding due to perceived counterparty risk, a perception that wasbecoming a reality as banks were forced to write down losses due to mark to marketaccounting, which has now been suspended.

Over the years that preceded the crisis, leverage helped boost profits. Now leveragebecame the ultimate tool of destruction.

In the summer of 2007, European financial institutions started to increase activityto secure dollar funding to support troubled US conduits to which they hadcommitted backup liquidity facilities, and at the same time interbank fundingliquidity deteriorated in line with increased concerns about the creditworthiness ofbanks. Under these circumstances, an increasing number of European institutions


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moved to convert European currencies into dollars via FX swaps, resulting in one-sided order flow, and a severe impairment of liquidity in the FX swap markets.13

TED spread had shot up in 2007. The Libor-OIS spread14 had also widened, both of them

indicating investors increasing unwillingness to hold their assets in money market funds,

thereby depriving banks of funding.

Interbank markets seized up, and dislocations in FX swap markets made it even

more expensive to obtain US dollars via swaps. Banks funding pressures were

compounded by instability in non-bank sources of funds as well, notably dollar

money market funds and dollar-holding central banks. The market stress meant

that the effective maturity of banks US dollar funding shortened just as that of

their US dollar assets lengthened, since many assets became difficult to sell in

illiquid markets. This endogenous rise in maturity mismatch, difficult to hedge ex

ante, generated the global US dollar shortage.15

The funding difficulties faced by international banks were so severe that it threatened to

seize global financial markets. London interbank overnight rates, along with TED spread

went up significantly, reflecting counterparty risk on the market. The funding difficulties

could only be eased by increasing the availability of dollars, but due to counterparty credit

concerns, the opposite happened.

This prompted the central bank of the United States, the Federal Reserve, to arrange FX

swap lines16 with major central banks around the world. The first swap lines were

arranged on December 11th 2007 with the European Central Bank (ECB) and the Swiss

National Bank (SNB). The ECB could swap up to $20 billion for euros and the SNB could

13From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers, by

Naohiko Baba and Frank Packer, BIS Working Papers (No 285), July 2009, p. 414

The difference between Libor, which is an average rate based on a daily survey of 16 banks by the British

Bankers' Association, and the OIS rate indirectly measures the availability of funds in the money market. Overnight

indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange

for the average of a floating central-bank rate over the life of the swap. , source:

http://www.bloomberg.com/apps/news?pid=20601085&sid=a6Ygig7G0bvA&refer=europe15

The US dollar shortage in global banking and the international policy response, BIS Working Papers (No 291),

Patrick McGuire and Gtz von Peter, October 2009, p. 216

An FX swap is a short-term contract in which one party borrows a currency from, and lends another

simultaneously to the same party. Unfortunately, the mainstream media and some members of Congress often

misleadingly put the bailouts and Federal Reserve dollar swap lines in the same category as if FX swaps were free

money. FX swap lines were arranged with foreign central banks in exchange for foreign currency as opposed to

bailouts, where the receiving parties do not post any collateral nor do they have the obligation to pay the money

back. Moreover, FX swap lines with foreign central banks are virtually guaranteed to be paid back. It is not often

that a central bank goes bust. If a central bank had gone bust during that period, getting the money back from FX

swap lines would be the least of their problems as such failures have significant ramifications for financial markets.


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swap up to $4 billion for Swiss francs, both swap lines were designed to expire in June

2008.17

In 2008, the subprime market went into a terminal decline. In March, the Federal Reserve

Bank of New York orchestrated the sale of Bear Stearns, a New York bank that had

significant exposure to the subprime market, to JP Morgan Chase. In March, the Federal

Reserve increased the swap lines with the ECB for up to $30 billion and the SNB for up to

$6 billion. The Federal Reserve continued increasing the total amount of swaps with central

banks all the way through spring and summer.

For the owners of US dollar claims, things could not have gone worse. The simultaneous

decline of asset values and a surge in borrowing costs put the banks under huge financial

pressure. Whereas the surging interbank rates are something completely opaque to the

average investor, pressure on the banks was made evident by the action of the banks share

prices which quite literally went into a tailspin reflecting write-offs and a huge sale ofassets at fire sale prices. A few examples of this are available on the following pages, chart

courtesy of stockcharts.com.




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Figure 2 Libor in black, TED spread in red

Figure 3 Libor-OIS spread


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Figure 4 Bank index (US stocks) in black, S&P 500 in red. Note that bank stocks are still muchsignificantly weaker than the broader market.

Figure 5 Bank of America in black, Citigroup in red


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Figure 6 JP Morgan Chase in black, Goldman Sachs in red. These two banks were relatively isolatedfrom the subprime market, but they too had funding difficulties.

Figure 7 Freddie Mac in black, Fannie Mae in red. These two government sponsored entities were

heavily involved in the subprime market, noticeably in the last years of the housing bubble.


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Federal Reserve Becomes the Global Lender of Last Resort

The dollar assets on their balance sheets were adequately funded up until the crisis hit.

When it did, funding costs went up significantly due to a fear of counterparty risk. The

failure of Lehman Brothers on September 15th

was a day no trader caught on the long sideof the market would want to live through again. The loss of confidence or what was left of it

before September 15th was enough to push the global financial markets over the edge. The

Dow Jones Industrial Average lost 4.4% that day. Libor and TED spread shot up while

commodities and stocks plunged.

Non-performing assets and asset write-offs were putting a huge pressure on banks, hedge

funds and other market participants. The owners of the bottom tranches of CDOs were in a

particularly bad position, especially if they were leveraged to start with. The non-

performing assets, interest rate swaps and credit default swaps that blew up in the faces of

banks required them to put up more capital in the form of US dollars. This created a hugedollar shortage. To meet these requirements, banks started selling their most liquid assets

US stocks (foreign stocks followed suit), bonds and futures contracts. This drove down

the price of everything that could be sold. It is part of the reason that oil fell so much so fast.

Gold, a de facto safe haven, as opposed to currencies, fell along all other asset classes as

futures contacts got hammered. This was turning into a real problem. All the while banks

were selling their most liquid assets to come up with new dollars, they were also buying

dollars on the FX swap market.

European financial institutions moved to actively convert euros into dollars

through FX swaps, creating a one-sided market as US counterparts became more

cautious about lending dollars.18

The three-month FX swap-implied dollar rate using euro as a funding currency

moved together quite closely with dollar Libor prior to mid-August 2007.19

after the bankruptcy of Lehman Brothers, the turmoil in many markets becamemuch more pronounced. In FX and money markets, what had principally been adollar liquidity problem for European financial institutions deepened into aphenomenon of global dollar shortage. The empirical results spanning the failure ofLehman are consistent with this globalization of the dollar shortage problem. USfinancial institutions after the failure faced difficulty raising US dollar fundingpossibly as much as European institutions, and in striking contrast to the pre-Lehman period of turmoil, declining credit worthiness of US institutions provided an



Ibid


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independent source of imbalances in the FX swap markets to the decline increditworthiness ofEuropean institutions.20

The basic laws of economics state that price is a function of supply and demand. Whenever

demand goes up and supply goes down, prices are bound to rise. That is just what

happened with the dollar. The funding difficulties of (mostly) European banks grew solarge that they not only drove up the interbank rates, but they had a very strong effect on

the dollar exchange rate. Since European banks used euros, Swiss francs and Japanese yen

to purchase dollars, all these currencies plunged relative to the dollar. Research indicates

that even some US banks used foreign currency to buy dollars. This crowded trade 21

pushed the US dollar up very quickly, as can be seen from figure 8.

All of this was on the news, of course, but it took on a distorted form. I attribute much of

this to the incompetent financial news media who claimed that this was a flight to safety. I

cannot overemphasize the invalidity of this argument. This was possibly the most acute

dollar shortage ever and the news media played the story as if investors were buying

dollars because they deemed the dollar to be safe. It was the European banks exceedingly

large dollar claims positions that pushed the market up, not their risk aversion tactics.

The failure of Lehman Brother prompted the Federal Reserve to respond and it did. It

announced new swap lines but to little effect22. Counterparty risk had become a major

issue and overnight markets froze up. Money market funds werent able to provide funds

either as talk of Lehman causing a money market fund to break the buck gave investors

every reason to pull their funds. The banks that were able to buy or swap dollars could only

do it at a high cost.

Concerns over the health of the financial sectorand related counterparty risks

increased sharply after the bankruptcy of the investment bank Lehman Brothers on

September 15. The sharp rise in counterparty credit concernswhich were also

damaged by the Federal Reserves announcement of a bailout package for AIG the

next dayled to even more intense pressures in global funding markets. Greater

demand for funding coinciding with heightened precautionary hoarding by

many institutions hit both secured and unsecured term lending markets. Many



A crowded trade describes a situation where many or all the market participants are in or moving into one

particular asset or asset class. Crowded trades have a tendency to have ripple through effects on the prices of

other assets. The situation is similar to people suddenly all moving to one side of the boat.22

An FX swap is a short-term contract in which one party borrows a currency from, and lends another

simultaneously to the same party.


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financial institutions increasingly funded themselves at very short maturities,

raising rollover risks (FRBNY, 2008).23

To avert a major meltdown of the market, the Federal Reserve announced new increases in

the swap lines to the ECB and SNB to the tune of $110 billion and $27 billion, effectively

more than doubling the amount of funds available. New swap lines were opened with theBank of Japan ($60 billion), the Bank of England ($40 billion) and Bank of Canada ($10

billion).

Alarmingly, this was not enough to stabilize the markets. In response, on September 26, the

Federal Reserve increased swap lines with the ECB and SNB to $120 and $30 billion,

respectively. The swap lines were increased again on September 29. On October 13, the

Federal Reserve announced unlimited swap lines with the ECB, SNB and BoE. The

announcement of unlimited swaps with the BoJ was made on October 14. The Federal

Reserve had truly become the lender of last resort. The global lender of last resort.

The Feds actions did much to calm the markets credit remained tight but Libor rates and

TED spreads started to decline to relatively normal levels. However, the markets were still

unstable up until mark to market accounting was suspended in the spring of 2009. The

dollars from the Fed were used to buffer the balance sheets of foreign banks. Although the

dollar swaps were arranged between the Fed and foreign central banks, the foreign banks

then distributed those funds according to their own better judgment. The FX swaps were

not bailouts as some ignorant journalists might claim. The term swap indicates that

something is given in return in this particular case, a foreign central bank would swap

their respective currency for dollars. As the swap lines mature, the Fed and the foreign

central banks will once again swap currencies, reversing the first swaps.




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Figure 8 Dollar liquidity swaps24 and the US dollar index25.

24Factors Affecting Reserve Balances (H.4.1),

http://www.federalreserve.gov/datadownload/Format.aspx?rel=H41&series=eaf166e97bbd7680b16e4d56755119

78&lastObs=&from=12/20/2008&to=01/30/2010&filetype=spreadsheetml&label=include&layout=seriescolumn25

Weekly USDX values from Deutsche Bank

70

72

74

76

78

80

82

84

86

88

90

0

100

200

300

400

500

600

Mar2

6,2008

Apr1

6,2008

May

7,2008

May2

8,2008

Jun1

8,2008

Jul

9,2008

Jul3

0,2008

Aug2

0,2008

Sep1

0,2008

Oct

1,2008

Oct2

2,2008

Nov1

2,2008

Dec

3,2008

Dec2

4,2008

Jan1

4,2009

Feb

4,2009

Feb2

5,2009

Mar1

8,2009

Apr

8,2009

Apr2

9,2009

May2

0,2009

Jun1

0,2009

Jul

1,2009

Jul2

2,2009

Aug1

2,2009

Sep

2,2009

Sep2

3,2009

Oct1

4,2009

Nov

4,2009

Nov2

5,2009

Dec1

6,2009

Jan

6,2010

Jan2

7,2010

dollar swaps in billions of $, lhs US dollar index, rhs

Original chart from

The Economic Reality

Blog:

www.kristjanvelbri.com


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Documents

Dollar Swaps & the Financial Crisis: A Short Overview of the Dollar Shortage of 2008