Thursday, February 27, 2014

Fed to Cut Off Europe to Support U.S. Borrowing

February 27, 2014

Fed to Cut Off Europe to Support U.S. Borrowing

By Chriss Street

Janet Yellen, newly confirmed Federal Reserve (Fed), announced on February 19th that America’s central bank is moving to cut off the massive financial lifeline that has been subsidizing the European banking system since the beginning of the global financial crisis in March of 2008.  By delaying foreign bank compliance with the stringent capital and borrowing requirements of section 165 of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) imposed on American banks, the Fed was engaging in the moral hazard of allowing Europe to borrow at virtually zero interest from the Fed to fund their bloated social welfare states.  Chair Yellen’s actions mean the Fed is cutting off Europe and providing greater support for U.S. borrowing.      

 

People around the world often complain about the “exorbitant privilege” America enjoys by sponsoring the U.S. dollar as the world’s reserve currency.  Of the $1.25 trillion of dollars in circulation, about $700 billion is held outside the United States.  Foreign holdings of the dollar essentially act as a perpetual interest-free loan to the U.S. government and force foreign businesses to lose money exchanging their foreign currency into dollars.  The privilege also reduces the interest costs the American government pays on the $5.8 trillion of U.S. Treasury debt held by foreigners by one half percent.  This privilege adds more than $120 billion to U.S. consumption each year.  

 

But with the privilege of sponsoring the dollar as the world’s reserve currency, America also bears “extraordinary risk” in times of financial crisis, because the Fed is morally expected to provide liquidity at virtually zero interest rates to foreign banks as the lender-of-last-resort.  According to Fed data, at the peak of the financial meltdown on Oct. 29, 2008 almost half of the $111 billion in central bank emergency “discount window” loans went to the U.S. subsidiaries of French/Belgium based Dexia Bank and German based Depfa Bank.  Although the parent banks of both of these institutions were grossly insolvent, money borrowed from America’s Fed was quickly wired offshore to prevent imminent bankruptcy filings of the institutions’ European parent banks.

The 2008-2009 financial meltdown was caused by what economists refer to as “moral hazard,” a situation where one party takes undue risks if they know the potential costs of the risk will be borne by others.  U.S. and European banks knew the moral hazard of using risky valuation models to profit from mortgage securitization was inappropriate, but they expected the America’s Fed would bail them out of potential losses. 

But during Fed Chairman Alan Greenspan's 1987-2006 tenure, whenever a crisis arose and stocks fell by more than 20%, the Fed lowered the Fed Funds Rate to add liquidity to avert further deterioration.  Greenspan’s Fed bailed-out banks during the 1987 stock market crash, savings and loan crisis, Gulf War, Mexican debt crisis, Asian debt crisis, collapse of Long Term Capital Management, Dot-Com Bubble, and 9/11 terrorist attacks. 

In March of 2008, recently appointed Fed Chair Ben Bernanke bailed out thousands of hedge funds with $30 billion in cash subsidies to bail out of Bear Stearns.  Hedge funds knew Bear Stearns was outrageously leveraged by 35 times equity, but deposited their money in the firm’s Prime Broker accounts as unsecured creditors, because Bearn Stearns allowed hedge funds to also engage extremely leverage investments. 

The moral hazard of the Fed bailing out Bear Stearns actually encouraged speculators to take much more risk based on the confidence the Fed would bail them out of any future problem.  Increased speculative investing drove up inflation and interest rates in the summer of 2008.  When the Fed refused in September to bail out Lehmann Brothers, securities markets crashed and a worldwide financial panic erupted.  The Fed was then forced to organize and lead the largest financial bail-out in history.

From November 2008 through January 2014 the Fed flooded the world with liquidity by engaging in three rounds of “quantitative easing” to buy $2.8 trillion in bank debt, mortgage-backed securities, and Treasury notes.  During the same period, the European Central Bank and the Bank of England also engaged in another $1.4 trillion of quantitative easing. 

Almost none of this liquidity was loaned to U.S. operating businesses, as private non-residential investment in America fell by 80% as a percentage of the total GDP of the U.S. between 2007 and 2009.  Although capital spending has somewhat recovered, American business investment is still at its lowest level as a share of GDP since 1947. 

Most of the Fed’s cash appears to have gone to European Union (EU) banks to cover loan losses and buy sovereign debt of EU countries.  Bank balance sheets in the EU are still leveraged at 25 to 35 times equity.  Despite the GDP of the EU nations since 2008 falling by .4%; their debt outstanding rose by 34%, from $10.3 trillion to $14.5 trillion.

Congress and financial regulators sought to avoid future moral hazard by passing Dodd-Frank’s Section 165 “Stress Testing” requirements in 2012 to impose strict leverage limits on U.S. financial institutions with “consolidated assets of more than $10 billion.”  Large banks, brokers and insurance companies were forced to raise $450 billion in capital and their leverage was cut from 18 times to less than 9 times, a 50% reduction. 

Just 16 day after her confirmation, Chairman Yellen seems determined to root out the expectation that the U.S. Federal Reserve will continue the moral hazard of allowing excess risk taking in the expectation the Fed will provide bail-outs as the sponsor of the dollar.  President Teddy Roosevelt said: “Speak softly and carry a big stick; you will go far.”  New Federal Reserve Chairman Janet Yellen on February 18th picked up her big stick and softly announced the Fed is about to cut off its massive cash lifeline keeping Europe afloat and will now concentrate on support the credit needs of Americans. 


Page Printed from: http://www.americanthinker.com/2014/02/fed_to_cut_off_europe_to_support_us_borrowing.html at February 27, 2014 - 12:55:25 PM CST

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