Bernanke And The U.S. Taxpayer: Europe's Unsung Heroes

Includes: DIA, EU, QQQ, SPY, VGK
by: Colin Lokey

Is it fair to say that a story is "late" if the general investing public is still largely in the dark regarding the topic under consideration? I'll leave that for readers to judge once they have taken the time to review the following piece.

On December 28, 2011, an article appeared in the Wall Street Journal entitled "The Federal Reserve's Covert Bailout Of Europe." The piece was written by Gerald P. O'Driscoll a former vice president at the Dallas Fed and it represented a rare moment of candor emanating from one of the world's most mainstream sources of financial news. The point of the article was to describe how the Fed, via dollar swap liquidity lines, was actively engaged in a backdoor bailout of struggling European financial institutions.

Dollar swaps are conducted between the Fed and foreign central banks and the mechanics of the transactions are actually quite simple. The participating foreign central bank simply trades the currency it prints for dollars at the prevailing exchange rate and agrees to return the dollars to the Fed at a later date (generally between one day and three months later) at the same exchange rate, plus interest. Because the exchange rate remains the same on both the opening and closing leg of the transaction, the Fed incurs no exchange rate risk.

According to the Fed, the swap lines are in place because "strains in dollar funding markets overseas can disrupt financial conditions in the United States." The swap lines are an attempt "to address [these] severe strains in global short-term dollar funding markets [by allowing] foreign central banks [to] draw on those lines to provide dollar liquidity to institutions in their jurisdictions." On December 12, 2007, the Fed authorized the opening of these swap lines with 14 central banks around the world. This authorization expired in February of 2010, but was promptly renewed in May of that year due to "the re-emergence of strains in short-term dollar funding markets abroad" -- the swap lines are now authorized through 2014.

The "nice" thing about these operations is that they are not booked as loans by the Fed because,

...the foreign central bank is obligated to return the dollars to the Federal Reserve under the terms of the agreement [and as such] the Federal Reserve is not a counterparty to the loan extended by the foreign central bank to depository institutions.

In other words, the swap lines are a way for the Fed to loan dollars to struggling foreign banks without carrying those loans on its book. This deserves a bit of clarification. The swap activity is disclosed on the New York Fed's website (see here). However, the data merely shows which central banks have tapped the facility and for how much. For example, consider the following table which shows dollar liquidity swap operations for the week ending March 6:

Click to enlarge

Source: NYFed

Notice that what isn't clear from the above is which foreign depository institutions are the final recipients of the loaned dollars. This absence of transparency was the subject of a Bloomberg piece published in late 2011 entitled "No One Is Telling Who Took $586 Billion In Swaps." In it, Scott Lanman and Bradley Keoun noted that

...the lack of openness may leave the U.S. government and public in the dark on the beneficiaries and potential risks from one of the Fed's largest crisis-loan programs.

During the financial crisis, foreign central banks' use of the facility exceeded half a trillion dollars.

The continuation of this program past its original expiration in 2010 has incensed some politicians including Texas Republican Randy Neugebauer and the always outspoken Ron Paul who had the following to say about the swaps last March:

Essentially... the Fed provided U.S. dollars to the European Central Bank in exchange for Euro. The ECB then funneled those dollars to European banks to prevent... bank insolvencies. Since the currency swap was not technically a loan, the Fed did not have to embarrass itself by openly showing foreign bank debt on its balance sheet. The ECB meanwhile did not have to print new Euros and expose the true fragility of big European banks. The entire purpose of this unholy arrangement was to obscure the truth: namely that the Fed was bailing out Europe with U.S. dollars. But why is it the business of the Federal Reserve to bail out European banks that find themselves short of dollars to pay their dollar-denominated contracts? Let private banks, European or otherwise, take their own risks. Let foreign central banks inflate their own currencies and suffer the consequences. (emphasis mine)

The issue so angered Judicial Watch Inc. that the non-profit, education foundation filed suit against the Fed in July of 2012 and demanded the disclosure of

...any and all records identifying, describing, or setting forth the identity of any bank or financial institution and the collateral offered by the bank or financial institution.

The following chart shows the extent to which the ECB (and other central banks) have used the swap facility over the past several years:

(click to enlarge)Click to enlargeSource: ZeroHedge, NYFed

There are two important points to make here. First, note the very obvious spike in ECB dollar borrowing that occurred between October of 2011 and February of 2012. That is what has caused the uproar, as the Fed was effectively loaning hundreds of billion of dollars to insolvent European financial institutions with the ECB acting as the guarantor. Second, the red arrow points to the fact that ECB dollar swap line usage spiked last week, something which has some commentators worried. As intriguing as all of this is, the Fed has in fact conducted a second, complimentary bailout of Europe alongside the extension of dollar swap liquidity that has gone largely unnoticed outside of conspiracy theory circles, a sad state of affairs given the rather convincing body of available evidence.

Readers will recall that the European debt crisis began in earnest in 2010 when Greece lost market access and was forced to request a troika-backed bailout. In November of that same year, Ireland was forced to take a bailout as well. Consider the following charts which show Spanish and Italian 10-year yields with the spikes which occurred in November of 2010 highlighted for illustration purposes:

(click to enlarge)Click to enlarge(click to enlarge)Click to enlargeSource: Bloomberg

One can see from the above that the risk of contagion from Greece and Ireland began to cause enormous stress in the sovereign debt market for periphery bonds beginning in November of 2010.

Those who have closely followed the Fed's action over the past five years are probably well aware that November 2010 also marked the beginning of QE2. Given what was going on in Europe at the time, one might have been able to predict which banks would receive the majority of the newly created cash coming out of the Fed. As ZeroHedge noted at the time and as the following graphic shows, every penny created under QE2 went to foreign banks with U.S. operations:

Click to enlarge

Source: ZeroHedge, Fed H.8

If that graphic isn't enough to convince you, have a look at the next chart which shows cash balances at foreign and domestic banks plotted with excess reserve balances at the Fed (dark black line) -- note that the excess reserve balance begins tracking the cash balance at foreign banks almost precisely beginning in November of 2010 while the cash balances at domestic banks remains largely the same over the same period:

(click to enlarge)Click to enlargeSource: ZeroHegde, Fed H.8

In case it isn't clear what the implication is here, allow me to elaborate. In the same way U.S. banks can use their QE dollars in anyway they see fit (contrary to popular opinion which holds that these very fungible reserves are never used to boost risk assets), foreign banks can also use their Fed money for whatever they choose and as one might imagine, there is no better time to have $600 billion delivered to your doorstep than on the eve of an epic debt crisis.

Thus, whatever portion of that $600 billion was not used by the dealer desks of the foreign banks to purchase U.S. equities was simply

...repatriated and used by domestic branches of foreign banks to fill undercapitalization voids left by exposure to insolvent European PIIGS and for all other bankruptcy-related capital needs.

In other words, the Fed printed $600 billion, handed it to foreign financial institutions who then turned around and used it to stabilize the European banking sector and to suppress yields on periphery sovereign debt. Have a look again at the Spanish and Italian yield charts above and note how yields stabilized as QE2 was being implemented and began to rise again just as the program was winding down.

Unfortunately, this is still going on today. Many an inquisitive commentator has wondered aloud at the miracle that was the ECB's OMT program. The simple fact is, the ECB hasn't bought a single, solitary periphery bond and yet somehow, Spanish and Italian yields have fallen markedly since the OMT was announced in early September of last year. The announcement of the program undoubtedly had a chilling effect on periphery bond bears for a month or two and the Greek debt buyback also helped to calm markets over the same period.

However, what is unclear is how periphery bonds have remained remarkably resilient for more than a half a year in the face of a continually deteriorating economic situation in the eurozone, an extraordinarily unstable political environment in Italy, and exactly zero bond purchases from the ECB. The answer may well be that just as the OMT rally was fading, the Fed began injecting cash into European financial institutions via foreign banks' U.S. operations.

The Fed has bought somewhere in the neighborhood of $210 billion in assets since December. Keep that in mind and have a look at the following table from the Fed's most recent H.8 release. The portion of the table shown is from the "Assets and Liabilities of Foreign Institutions" section and the arrows point to both those institutions' aggregate cash balance as of December, 2012 and their cash balance as of February 27 of this year:

Click to enlarge

Source: Fed

As you can see, these institutions' "cash assets" which, for clarification purposes, comprise vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks, have risen by nearly $182 billion over the same period that the Fed has bought $210 billion in assets. Just to drive the point across, consider one final chart which shows the cash increase at foreign banks in the U.S. for the week ending February 27:

(click to enlarge)Click to enlargeSource: Fed H.8

If you follow the political situation in Europe it should be abundantly clear why the Fed would inject $99.3 billion into foreign banks in the last week of February -- it was the week during which the contentious Italian elections took place. Finally -- and perhaps this is the best way to convey what is taking place -- note that since the fall of 2009, total cash held by U.S. commercial banks has barely increased at all while total cash held by foreign banks with U.S. operations has more than doubled.

What the above suggests is that the Federal Reserve -- and by extension, the U.S. taxpayer -- has been bailing out struggling European financial institutions and indebted periphery governments for the past four years via two complimentary liquidity operations. This is disconcerting for a whole host of reasons but for our purposes, note that this is just further evidence that aside from the Fed's propensity to print (and loan) endless amounts of dollars, there is very little in the way of support not only for U.S. stocks (NYSEARCA:SPY) but for European equities, periphery sovereign debt, and indeed for the eurozone financial system as a whole. When the music finally stops, not only will investors be at risk of losing money on their holdings, they will be at risk of losing out as a taxpayer who has unwittingly propped up the eurozone for over half a decade.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.