The Fed’s Recent Action on Swaps

What the Fed recently announced regarding its swap agreements should be helpful in forestalling a liquidity crisis in Europe, but it is not a “bailout” of anyone, and it does not increase any risk or cost to the U.S. taxpayer. It will help prevent a freeze up of European banks needing “dollar” liquidity. The swap agreements were already in place. What was announced was a maturity extension of the arrangements and a reduction in the interest rate charged. As long as the rate is positive, it will be a positive for the U.S. taxpayer; a zero rate would not be negative.

In a “swap” agreement, the Fed, for example, offers the European Central Bank (ECB) a given amount of dollar credit for an equivalent amount of Euro credit with an agreement that the swap will be reversed on the same terms at a point in the future with a modest interest payment. The ECB will then have dollars that it can lend to Euro-banks needing dollar liquidity, presumably with collateral receiving a haircut.

The Fed’s counterparty is the ECB, not the banks the ECB may lend the dollars to. The ECB’s risk is minimized because of the discounted collateral. This helps with banks’ liquidity, not solvency. However, that is not to minimize its importance since banks require a liquid money market to roll over their liabilities daily. What happens in a banking crisis is that banks become distrustful of each other and therefore reluctant to do business with each other. Each wants to wait to get paid before paying. Interbank credit “dries up.” The Fed’s action helps keep this from happening, at least as it pertains to the dollar market. Read more.....