Committee for the Abolition of Illegitimate Debt

At the onset of the recent volatility that has taken place in the global financial markets, much attention has been focused on the behavior of stock exchanges and the evolution of the debt crisis in Europe. But while the markets are reacting strongly to the signs that the process of restructuring the debt of the countries of the European periphery is only a matter of time, most media specialists are missing a key factor of fragility in the European and global financial system: its dependence on short-term, dollar denominated, bank funding.

To understand the origin of such dependence and the magnitude of it, its necessary to go back in time, to the genesis of the subprime bubble in the United States. As is well known, European banks were among the most eager buyers of Asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). Backed Securities (ABS ABS
Asset backed security A generic term designating a security issued by an intermediate entity (SPV) between a transferor and investors in the context of a securitization operation. This security is a bond. When the assets backing these securities (called underlying assets) are made up of mortgage loans like subprime loans, they are called Mortgage Backed Securities (MBS). MBS are subdivided into Residential Mortgage Backed Securities (RMBS), backed by mortgage loans made to private individuals and Commercial Mortgage Backed Securities (CMBS). The term Collateralized Debt Obligations (CDOs) is used when the underlying assets are bonds issued by companies or banks, and Collateralized Loan Obligations (CLOs) when these assets are bank loans. ), which were being originated in the United States over the last decade. This led to a sharp increase in the positions of European banks held abroad, which went from 16% of global GDP GDP
Gross Domestic Product Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another. in 2000, up to 35% in 2007. Half of this growth occurred in assets denominated in dollars and other currencies different to the euro [1].

Due to the fact that European banks do not have direct access to the dollars required to finance this expansion, they were forced to rely on short-term swaps in currency markets and obtain financing through the so-called Money Market Funds MMF
Money Market Funds Mutual investment funds that invest in securities, including money funds. (MMF) [2]. The use of such short-term mechanisms posed an additional dilemma associated with the maturity mismatch that arose in their balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets. Whereas the dollar denominated assets that were being acquired had a long-term nature, as in the case of packages of subprime mortgages, short-term financing was used for their purchase. This involved a financing strategy in which European banks had to steadily rollover their balance sheet positions denominated in US dollars, through the swap markets and MMF. The strategy was highly profitable as long as two conditions were met. On the one hand there should be a high and positive differential between the costs of short-term financing denominated in US dollars and the yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. of long-term assets being acquired by the banks. On the other hand, banks had had to be able to access in a stable, predictable and regular way the swaps markets and MMF.

This strategy worked without any problems until the implosion of the subprime market and the collapse of Lehman Brothers. After Lehman fell, credit markets froze abruptly due to widespread counter-party risk in the system. One of the first victims of this situation was the Federal Reserve FED
Federal Reserve Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank : http://www.federalreserve.gov/ Fund, the oldest MMF of the U.S. financial system. The announcement that this fund had broken the buck started a generalized run against similar institutions. It was only after the FED declared its intention to insure all the deposits in MMF, which slowly restored calm in the markets.

Nevertheless, European banks were left in an even more desperate situation during this period. Not only the value of their dollar-denominated assets was collapsing, but at the same time they were forced to seek alternative sources to fund those same positions. Faced with the prospect of a fire sale originated by European financial institutions, which would have increased the market upheaval, the Fed agreed to establish direct swaps lines with the major central banks around the world, including the ECB ECB
European Central Bank The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.

https://www.ecb.europa.eu/ecb/html/index.en.html , the BOE and the SNB. Only in the third quarter of 2008, the program distributed more than 450 billions dollars to the aforementioned group of central banks [3]. This new source of funding allowed European central banks to distribute dollars to their member banks, thus staving an even greater financial panic. During this period, the FED became the de facto lender of last resort of the global financial system.

But what is the link between these events and the current instability affecting the European financial system? The fact is that once the initial panic was contained and the conditions in the interbank credit markets began to stabilize, European banks returned to their old ways. Instead of liquidating their dollar holdings in order to reduce vulnerability, they returned to the regular use of swaps and MMF to finance their dollar denominated positions. An important factor behind this behavior was the inability of financial institutions to find a market where to dump the toxic assets Toxic assets An asset that becomes illiquid when its secondary market disappears. Toxic assets cannot be sold, as they are often guaranteed to lose money. The term “toxic asset” was coined in the financial crisis of 2008/09, in regards to mortgage-backed securities, collateralized debt obligations and credit default swaps, all of which could not be sold after they exposed their holders to massive losses. that were in their balance sheets. Due to this circumstance, it is estimated that by the end of 2009 the short-term financing needs of European banks are in the range of 300 billion to 1.8 trillion dollars [4].

What this reveals is that the ability of European banks to access low cost funding denominated in US dollars is critical to the stability of the European and global financial system. This is the dark and little secret of European banks. Another breakdown of the markets for short term funding, similar to the one that took place with Lehman, represents a serious threat to the solvency of European banks. In recent weeks, even though a complete shutdown hasn’t taken place, these banks are finding that the conditions in which they access those markets are gradually deteriorating. The reason behind this situation is the serious threat that the default of one or several countries of the European periphery represents to the solvency of a large number of banks in the old continent.

The logical conclusion of this analysis, it is then that the ECB, SNB, BOE are completely defenseless against a new breakdown in credit markets. For example, while the ECB can agree to purchase bonds from countries like Greece and Portugal, or provide lines of credit in euro to banks in trouble, the ECB cant do anything to help banks that have problems financing their positions in US dollars. It would be possible to say then that in a future episode of financial panic, this group of central banks depend on the willingness of the Fed to extend unlimited swap lines in order to prevent the collapse of major European financial institutions.

The consequences of such an event would be so severe to even consider a scenario where the FED would refuse to extend swap lines as required. It is due to the concern that Europeans banks are increasingly facing problems rolling over their positions, that the NY FED is increasing its surveillance over these banks, in order to step in, in case of problems [5]. However, as a result of the Dodd-Frank Act, the FED would be unable to extend unlimited swap lines with other central banks without getting explicit approval from the Congress of the United States. Given the speed with which a financial panic spreads, this limitation can magnify the impact of a disruption in the markets for short-term financing in dollars. It is for this reason that to properly understand the evolution of the global financial situation, attention should shift from the stock exchange indexes to the evolution of credit markets. And in these markets, the first signs of panic are already visible.