When the financial system almost imploded in the fall of 2008, one of the primary responses by the Federal Reserve was the issuance of an unprecedented amount of FX liquidity lines in the form of swaps to foreign Central Banks. The number went from practically zero to a peak of $582 billion on December 10, 2008. The number of swaps outstanding was almost directly inversely correlated with the value of the dollar (much more on that shortly). A graphic representation of this can be seen below: The topic of skyrocketing liquidity swaps was in fact the headline feature of one of the numerous grillings of the Chairman by the inimitable Alan Grayson...(You have probably seen Grayson mocking and laughing at Bernanke in a public hearing.) And while Bernanke was not very interested in getting caught up in providing actual explanations, the Bank of International Settlements just released a major paper titled "The US dollar shortage in global banking and the international policy response" which goes on to demonstrate just how it happened that Fed chief Ben Bernanke in essence bailed out the entire developed world, which was facing an unprecedented dollar shortage crisis due to the sudden implosion of FX swap lines and other mechanisms which until that point were critical in maintaining the dollar funding shortfall for virtually every foreign Central Bank. The BIS provides the following big picture perspective: The funding difficulties which arose during the crisis are directly linked to the remarkable expansion in banks' global balance sheets over the past decade. Reflecting in part the rapid pace of financial innovation, banks' (particularly European banks') foreign positions have surged since 2000, even when scaled by measures of underlying economic activity. As banks' balance sheets grew, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities. These assets include retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on US mortgages and other underlying assets. During the build-up, the low perceived risk (high ratings) of these instruments appeared to offer attractive return opportunities; during the crisis they became the main source of mark to market losses. How exactly did this improper perception of funding risk manifest itself? The accumulation of US dollar assets saddled banks with significant funding requirements, which they scrambled to meet during the crisis, particularly in the weeks following the Lehman bankruptcy. To better understand these financing needs, we break down banks' assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another. We find that, since 2000, the Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over. Once again, the specter of everyone (and in this case it really means everyone) doing the same trade: sound familiar? This is eerily similar to what happened to basis traders in late 2008 (nothing pretty) when the balance of the trade was so skewed to one side, that there was nobody willing or able to take the opposing side, leading to massive wipe outs for everyone who participated. It is also comparable to the situation prevalent in equity markets currently. What is now unquestionable, and what will be made clear shortly, is that the dollar trade is precisely what the basis trade, or any other trade, would have ended up being for any and every Central Bank that had a funding mismatch in dollars after the Lehman bankruptcy (all of them), had the Federal Reserve not stepped in and become the lender of last resort to the entire world.
The topic of skyrocketing liquidity swaps was in fact the headline feature of one of the numerous grillings of the Chairman by the inimitable Alan Grayson...(You have probably seen Grayson mocking and laughing at Bernanke in a public hearing.)
And while Bernanke was not very interested in getting caught up in providing actual explanations, the Bank of International Settlements just released a major paper titled "The US dollar shortage in global banking and the international policy response" which goes on to demonstrate just how it happened that Fed chief Ben Bernanke in essence bailed out the entire developed world, which was facing an unprecedented dollar shortage crisis due to the sudden implosion of FX swap lines and other mechanisms which until that point were critical in maintaining the dollar funding shortfall for virtually every foreign Central Bank.
The BIS provides the following big picture perspective:
The funding difficulties which arose during the crisis are directly linked to the remarkable expansion in banks' global balance sheets over the past decade. Reflecting in part the rapid pace of financial innovation, banks' (particularly European banks') foreign positions have surged since 2000, even when scaled by measures of underlying economic activity. As banks' balance sheets grew, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities. These assets include retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on US mortgages and other underlying assets. During the build-up, the low perceived risk (high ratings) of these instruments appeared to offer attractive return opportunities; during the crisis they became the main source of mark to market losses.
How exactly did this improper perception of funding risk manifest itself?
The accumulation of US dollar assets saddled banks with significant funding requirements, which they scrambled to meet during the crisis, particularly in the weeks following the Lehman bankruptcy. To better understand these financing needs, we break down banks' assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another. We find that, since 2000, the Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over.
Once again, the specter of everyone (and in this case it really means everyone) doing the same trade: sound familiar? This is eerily similar to what happened to basis traders in late 2008 (nothing pretty) when the balance of the trade was so skewed to one side, that there was nobody willing or able to take the opposing side, leading to massive wipe outs for everyone who participated. It is also comparable to the situation prevalent in equity markets currently.
What is now unquestionable, and what will be made clear shortly, is that the dollar trade is precisely what the basis trade, or any other trade, would have ended up being for any and every Central Bank that had a funding mismatch in dollars after the Lehman bankruptcy (all of them), had the Federal Reserve not stepped in and become the lender of last resort to the entire world.
Cheap Fed money financed US real estate loans. Wall Street repackaged these and, obligingly, sold them to European banks wanting in on US profit opportunities. First there were mortgage backed securities and matching credit default swaps.
The banks needed US dollars to play, but if they just went and got them, they would be exposed to exchange rate risk on their balance sheets. Tres gauche! A more elegant solution seemed to be to just enter into currency, or FX, swaps and pair the swaps with matching futures options as hedges. This way the bank only needs actual foreign currency when the obligation comes due---normally. And of course AIG was a highly rated supplier of credit default swaps.
Proceeding in this manner, the banking sector in numerous countries could accumulate dollar obligations that were greater than the GDP of the country in which they operated.
The fly in this ointment was the small possibility that everyone would need dollars at the same time, as dollar obligations greatly exceeded available dollars. This, of course, is exactly what happened. But not to worry! Helicopter Ben is here! He will sent in the helicopters with cash. And so he did, to the tune of half a trillion US$. Then some Europeans thought: "Poor US taxpayer! This is not good for their currency" Then they thought: Hey, that is our international reserve currency.
The demand for dollars was most acute in Nov and Dec. '08, and the value of the dollar soared. Then Paulson threw a dollar banquet, called the TARP, for the TBTF banks, and people started looking at all the money the Fed was creating, in conjunction with Treasury, and the US $ began its slide towards its present value. But this is only the background.
Alas alack! I grow too soon old and too late wise! I should have bought precious metals and euros for Christmas '08. As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
Is David Bloom Wrong About the Dollar?
As I have previously noted, HSBC currency chief David Bloom doesn't think that the dollar will rally when the stock market next tanks: The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off]. Is he right? I have argued that the new dollar carry trade could very well unwind during the next crash, which could create an enormous need for dollars. I've also pointed out that many top economists say that the problem with America's banking system was not really a liquidity crisis, but an insolvency crisis. Now, Tyler Durden has written a must-read summary of a new report by BIS which shows that the real liquidity crisis last year was among European banks, which were hugely overexposed to the dollar (in amounts many times greater than their GDPs, in some cases), and so they were desperate to raise dollars last year when the market crashed.
The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off].
Is he right?
I have argued that the new dollar carry trade could very well unwind during the next crash, which could create an enormous need for dollars. I've also pointed out that many top economists say that the problem with America's banking system was not really a liquidity crisis, but an insolvency crisis.
Now, Tyler Durden has written a must-read summary of a new report by BIS which shows that the real liquidity crisis last year was among European banks, which were hugely overexposed to the dollar (in amounts many times greater than their GDPs, in some cases), and so they were desperate to raise dollars last year when the market crashed.
