The Debt Clock in New York City shows the gross national debt, currently less than half in size of private sector debt and still below 100% ratio to GDP. But, 40% of this is intra-government i.e. internal to government. Thus government bond debt sold to US and foreign private sectors and to foreign governments is only about one quarter of US private sector bank debt. A third again of this is held anyway by foreign investors including foreign governments foreign currency reserves. US National debt and budget deficits however are not generated by the Federal Reserve and US Treasury 'bail-outs' of US banks. That is accomplished by swapping Treasury bills for securitized bank assets and subject to fees and large haircuts, and should generate substanial profit for taxpayers over the medium term (3+ years). Hence, the 'crowding out' theory scarcely applies to the US economy - that is the theory that government borrowing deprives the economy of private investment capital.Federal assets and liabilities can go down as well as up. The assets are those pledged, bought, swapped in exchange for treasury bills. Fed assets fell $82bn this week in reductions to term auction credit and central bank swap lines offset by purchases of Treasuries ($14bn), MBS ($5bn) and agency debt ($3bn). That the Fed is able to shrink its balance sheet is an indicator the economy is being weaned from central bank life support and shows that banks have generated substantial internal capital (profit) in the last quarter. The balance sheet will have declines and rises and net rises, including from $800bn of commitments to buy-in MBS, Treasuries, and agency debt, with a steady total purchase target of $1.75t of which about $1tn has been processed. Much of the sharp increase in Fed Assets has occurred following the collapse of Lehman Brothers when medium term interbank lending costs spiked sharply and banks faced problems refinancing their 'funding gaps'.
It is because of the stress pressures in short-term funding that the Federal Reserve System, following the earlier clear example of the Bank of England's SLS and APS schemes and generous liquidity window facilities and the ECB and other central banks with money market facilities variously also, approved a temporary Term Auction Facility ("TAF") program in which the Federal Reserve auctions term funds to credit/depository institutions i.e. regulated banks. TAF is a credit facility that allows banks to bid for an advance from its local Federal Reserve Bank at an interest rate determined by the auction. This lets the Fed inject term funds via a broader range of banks against a broader range of collateral than shorter term 'open market operations', the 'liquidity window', to ensure that liquidity is disseminated efficiently even when 'unsecured' interbank markets (borrowing and lending between high-rated banks) are under stress. TAF auctions term funds of 28-day or 84-day maturity. All banks judged to be in sound financial condition by their local Reserve Bank and expected to remain so over the terms of TAF loans are eligible to participate. All TAF credit is fully collateralized; loans for which the remaining term to maturity is more than 28 days are subject to additional collateralization. Depositories may pledge the broad range of collateral that is accepted for other Federal Reserve lending programs to secure TAF credit. The same collateral values and margins applicable for other Federal Reserve lending programs also apply to TAF. Some commentators characterise TAF and related programs as buying in junk from banks that will only lose money. This is grossly untrue. Current commitments to buy bank assets outright at $700bn of which just over half has processed is actually less than that committed to by the Bank of England and HM Treasury.
To complete the picture, it has to bee xplained how useful a public service all this is to the US and the world economy where more than half of all world trade is denominated in US dollars. Similarly, dollar exposures are a large part of banks global funding markets. Additionally, US banks have foreign currency exposures and liquidity requirements that the Fed supports. It has swap lines agreed with foreign central banks for this but has not actually had to draw on these in recent months. The Federal Reserve coordinates with other central banks to provide liquidity via agreements for reciprocal currency arrangements (central bank liquidity swap lines): dollar liquidity lines and foreign-currency liquidity lines.
These lines are now authorized with the following institutions: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, the Norges Bank, the Monetary Authority of Singapore, the Sveriges Riksbank, and the Swiss National Bank. The FOMC has authorized these lines through October 30, 2009.
When a foreign central bank draws on its swap line with the US Fed, the foreign central bank sells an amount of its currency in exchange for dollars at the market exchange rate. The Federal Reserve holds the foreign currency in an account at the foreign central bank. The dollars that the Federal Reserve provides are deposited in an account that the foreign central bank maintains at the US Fed NY, with a binding agreement to reverse the swap at a future date at the same exchange rate. At the second transaction, the foreign central bank pays interest, at a market-based rate.
Other cenhtral banks operate similar facilities, as does the BIS and INF, each with about $500bn in assets. The foreign central bank lends the dollars to its banks and bears the credit risk associated with that.
The foreign currency that the US Federal acquires is an asset on its balance sheet. The dollar value of the asset swap is not affected by changes in the market exchange rate, and similarly this is also how asset swaps for bills operate with US banks, so there is no mark-to-market credit risk borne by the central bank. The dollar funds deposited in the accounts that foreign central banks maintain at the NY US Fed
are a Federal Reserve liability. However, the foreign central banks generally lend the dollars shortly after drawing on the swap line. At that point, the funds shift to the balance sheet line "deposits of depository institutions."
Dollar liquidity swaps have maturities ranging from overnight to three months. On April 6, 2009, the FOMC announced foreign-currency liquidity swap lines with the Bank of England, the ECB, the BoJ, and the Swiss National Bank to provide the Federal Reserve with lines to offer liquidity to U.S. institutions in foreign currencies should a need arise. If drawn upon, the foreign-currency swap lines would support operations to address financial strains by providing liquidity to US banks of £30bn, €80bn, ¥10 trillion, and CHF 40bn, authorized these through October 30, 2009, but so far, these have not been drawn upon.
One reason for this may be the withdrawel by banks globally from lending to foreign banks, which is quite serious for world trade as it is for banks, especially those in small countries where their assets are exceptionally larger than domestic GDP and their funding gaps financing heavily reliant on foreign borrowing. I suspect this and other aspects of liquiity risk have yet to be brought out in banks stress tests that 19 and 47 leading banks respectively in the US and Europe have been urgently tasked to complete by governments and central banks.
Following the rather insipient factors that FDIC asked US banks to scenario stress-test, liquidity risk (the essence of the credit crunch) appeared missing in action?
Nevertheless, 6 of the US top 19 banks stress tested need to raise additional capital. Two of the six are certainly Citi and BofA. The others may be SunTrust (STI), KeyCorp (KEY) and Regions Financial (RF) (according to a Morgan Stanley) but HSBC (USA), Citizens (RBS), and Wells Fargo and possibly even JPM might be candidates depending on the view of their credit derivatives and ABS and corporate bond exposures.
In the absense of a macro-economic model that reklates the banking sector to the domestic and global economies, the whole exercise still feels like a limp excuse to direct additional support to “systemically important” financials, although the pretext was to determine if any of these banks need to be nationalized.
There was a hope that stress tests may guide an 'over-the-cycle' analysis an basis for 'cleaning up' troubled banks balance sheets. The tests should also define solvency more concisely than hitherto, and uncover which banks need more capital with the aim of maintaining all US banks total reserve capital at about $1tn and then force them to raise new capital optimally over time against some reasonably realistic forecasts of the arrival rates of losses and writedowns net of internally generated capiutal. So far, we could say that a false economy was instituted by the banks when they balked at the lower net interest income of paying temporary higher rates for medium term financing only for this to result in many times this cost being wiped out in shareholder capital and being forced to sell assets at firesale prices. One solution now being canvassed as an alternative to straight capital raising which dilutes shareholders even further is that of executing debt for equity swaps to reduce liabilities and rebuild equity, but actually also diluting shareholders yet gain! 'Growing Shareholder value' as a creditable mantra of banks will not recover for many years, notwithstanding the large gains in bank shares from their postage stamp levels so far this year; the markets remain volatile and nervous.
But were the Basel II style scenario stress-tests ever a serious exercise?The “scenarios” to stres-test banks balance sheets are far too imprecise in being precise about actual months, quarters and years looking forward, and too benign or rosy. Already property prices are falling faster, unemployment going higher, and growth falling more steeply than the Fed, FDIC and Treasury offered up as scenario macro-factors.
Properly stressing the big banks’ balance sheets would demonstrate the liquidity risk issues and should encompass the full gamut of factors specified by Basel II Pillar II.
Critics say that no-one buys the argument that government off-balance sheet finance and guarantees to buy time for the banks will solve their problem. As far as I can see that is the only thing that can solve their problems. The UK, US and others governments are sensitive to the general cyncicism and disbelief and are now saying that taxpayers aren’t supposed to provide further capital support, not now, or little more this year; banks should go to private markets first and/or convert preferred shares to common voting stock etc. WShat governments are loath to admit to is that bail-outs are facilitated by everything except taxpayers money! That is too hard to explain and politically deemed a minefield. More like intellectual cowardice, a dangerous misdirection.
Private capital markets believe they know that banks are insolvent and should therefore be backed into hard corners and broken up and sold off, so they aren’t going to provide additional capital except on the severest of terms that might allow private equity funds and hedge funds at last to buy the banking market they have long craved to own believing they could transfer their carpet-bagging strategies to the central arteries of whole economies cash-flows. Only government and regulators can apply and enforce public service standards, ethics, and prudential risk management and it is on this basis that they know that the solvency of systemically important banks must be judged. Private sector vulture funds waiting to pounce see only the large short term profits to ne made from realising banks book values that are currently several times their market equity value. The deleveraging this would bring about is certain to guarantee long run Depression!
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