I read two fascinating articles this week that shed a little light on the opaque workings of our global financial system. One used recently declassified documents to show that foreign banks were the greatest beneficiaries of the Federal Reserve's efforts to quell the financial crisis. The second elucidated a recent BIS report (pdf) that revealed the relative exposure of U.S. versus European financial institutions to a PIIGS default. The former article posited that the data provides the grounds for Ben Bernanke's impeachment. The latter offers some information on why that might not necessarily be the case - at least not for one of the reasons given.
Where Did All the QE2 Money Go? The first article comes to us via Zero Hedge: "The Fed's $600 Billion Stealth Bailout Of Foreign Banks Continues At The Expense Of The Domestic Economy." It shows how a greater portion of the reserves created by the Fed through quantitative easing ended up at the U.S. branches of foreign banks, only to be funneled back to their European home branches. According to Zero Hedge, "one can argue that the whole point of QE2 was . . . to rescue European banks!" They also point out several important implications of this phenomenon:
- Foreign Aid: Foreign banks with primary dealer status at the New York Fed used reserves provided by QE2 to support branches outside the U.S. and plug some of the capital holes created by PIIGS exposure - exposure to the debt of troubled sovereigns like Portugal, Ireland, Italy, Greece and Spain.
- Impeachment: Fed Chairman Ben Bernanke will be impeached for helping foreign banks at the expense of domestic ones: "the data . . . proves beyond a reasonable doubt why there has been no excess lending by US banks to US borrowers: none of the cash ever even made it to US banks! This also resolves the mystery of the broken money multiplier and why the velocity of money has imploded."
- Euro Boost: The influx of reserves into the European banking system has artificially boosted the Euro over the U.S. dollar. The Fed "was willing to sacrifice European economic output in order to plug European bank undercapitalization."
- Less Demand for Treasuries: Primary dealers will not be unwinding their excess reserves by lending money or buying Treasuries because those reserves are long gone. Zero Hedge speculates that this validates Bill Gross' question about who will buy Treasuries after QE2.
- "QE3 is a certainty." The Fed will need to release $500 billion to $1 trillion in reserves in the coming months as systemic risk flares again.
While point #2 makes the case for the impeachment of Mr. Bernanke specifically on the grounds of effectively rescuing European banks at the expense of American ones, Zero Hedge goes on to broaden its indictment suggesting this data provides "definitive proof of the Fed abdicating any and all of its mandates, and merely playing the role of globofunder explicitly at the expense of US consumers and borrowers, not to mention lackey for the banking syndicate." While I think you can make a pretty good case for the wider accusation, I'm not sure the specific European favouritism charge will hold water. The next article explains why. PIIGS Defaults: U.S. and European Exposure. Like Zero Hedge, John Mauldin thinks it's "Time to Get Outraged" by the banks. His article looks at the summary of a Bank of International Settlements report provided by Kash Mansori. Mr. Mansori's analysis differentiates between direct and indirect exposure to a default by one of the PIIGS countries. Financial institutions with direct exposure hold the bonds issued by these countries. Those with indirect exposure sold default insurance to creditors of these countries, mainly in the form of credit default swaps (CDS).
Mr. Mansori makes 3 key observations with respect to the BIS data:
- Default Insurance Matters: 30% of exposure to PIIGS debt is covered by CDS, meaning that bondholders will absorb 70% of the losses in case of default, while CDS issuers will take a hit on 30% of the losses.
- Direct Exposure in Europe, Indirect in the U.S.: In terms of exposure to PIIGS debt, it seems European banks loaded up on the bonds whereas U.S. institutions sold CDS.
- Overall Exposures in U.S. and Europe about Equal: While European institutions would take more direct losses through the bonds they own if one of the PIIGS defaulted, U.S. banks apparently have just as much to lose via the CDS they wrote on those bonds. Oops, they did it again.
"When, not if, Greece defaults, US banks are going to have to dip into capital to pay those commitments. Capital that should be available for loans to businesses but will have to be paid to European banks instead." Mauldin thinks it's outrageous that these too-big-to-fail banks have put taxpayers and the global economy at risk again. He thinks the 1998 repeal of Glass-Steagall was our undoing and that we need to reinstate it, separating commercial and investment banking once and for all. So it seems that QE2 reserves did benefit European banks as it allowed them to plug some of the capital holes created by their exposure to PIIGS debt. But if the BIS data is correct, saving the bondholders (mostly European banks) also served to save the financial institutions who wrote CDS on those bonds (mostly U.S. banks and insurance companies). Financial institutions on both sides of the Atlantic seem to have been the main beneficiaries of recent Fed policy initiatives.
Did Ben Bernanke (and Alan Greenspan for that matter) inflate asset bubbles? Sure. Did they punish savers and reward speculators by keeping interest rates excessively low for far too long? You bet. Did they favour financial institutions over taxpayers? The data presented above makes that pretty clear.
There are a lot of reasons to find fault with Mr. Bernanke and his policies, and maybe he should be impeached. If he is censured at all however, I have a hard time believing it will be because he favoured foreign banks over domestic institutions. If anything, he and his accomplices should be indicted for fostering a too-big-to-fail financial system that flouts free market capitalism in favour of financial oligarchy.