Crashed

by Adam Tooze

  I

  The wholesale funding stop had hit the European banks already in August 2007. It was no coincidence, therefore, that it was the ECB that led the way in providing 95 billion euros in liquidity to overnight interbank markets on August 9.1 Trichet was not the central banker to take such dramatic action without due cause.2 By the autumn of 2008 both the ECB and the Bank of England were pumping liquidity on a huge scale. This did not involve parliamentary votes or unusual long-term capital investments. These were not bailouts but money market transactions, of the type that central banks routinely conduct to tighten and ease financial conditions, but now on a scale never seen before. As they lent cash or cash equivalents against collateral—good and bad—the balance sheets of all the major central banks began to expand. Potentially, at least, this could be done without limit within a closed national economy, or a large currency zone like that of the euro or the dollar. But what such operations could not conjure up was liquidity in foreign currencies. The Bank of England supplied sterling, the ECB euros. This domestic currency constraint was a crucial limit on the power of central bank operations and particularly so in 2008, because what the European banks desperately needed were dollars. It was into this breach that the Fed stepped with a program of liquidity provision that matched the global reach of the offshore dollar banking system.

  Starting from a conventional trade-based view of international economics, it is not easy to see how a shortage of dollars could have been so threatening to Europe. In September 2008 the eurozone as a whole was running a trade surplus with the United States. Germany, in particular, was a champion exporter. Surely, if European banks needed dollars they could buy or borrow them from global exporters like Audi, VW and Mercedes-Benz. But this is where the disparity between the trade-based view of the economy and global financialization becomes starkly evident. In 2007 Germany’s exporters earned a trade surplus with the United States of roughly $5 billion per month. According to calculations by economists at the Bank of International Settlements, what the European banks needed was not $5 billion, or even $10 billion. Prior to the crisis they had funded their dollar operations with c. $1 trillion in commitments from US money market funds. On top of that they had borrowed $432 billion in the interbank market, $315 billion on the foreign exchange swap markets and $386 billion in short-term funding from those monetary authorities that were managing dollar cash pools. In total this added to more than $2 trillion.3 The precise figure depended on how much of Europe’s gigantic bank balance sheet needed to be refinanced and how quickly.

  What the 2008 crisis exposed was a dangerous imbalance in the business model of the European banks. As the American money markets shut down, all the European banks were scrambling for dollar funding. They tried to borrow from one another, which led to a painful surge in short-term funding costs as measured by the so-called Libor-OIS spread.4 At the same time, the market for currency swaps was becoming dangerously congested, with Europeans bidding for dollar credits and ever fewer counterparties willing to take the other side of the trade. The cross-currency basis swap spread, which measures the interest rate spread that European banks were willing to pay to transfer euro or sterling funding into dollars, became strongly negative, indicating that it was extremely difficult to access dollar funding directly. When markets are functioning normally, this premium should be close to zero. In September 2008 it exceeded 200 basis points. When the FOMC met on September 16, the day after Lehman’s bankruptcy, with AIG teetering on the brink, its first item of business was the funding difficulties not of American but of European banks. As Bill Dudley of the New York Fed put it, “The big thing, where there has probably been the most severe stress in the market, is in dollar liquidity for foreign banks.”5

  Demand for Dollar Funding in the European Central Bank’s One-Month Auctions, December 17, 2007, to September 9, 2008

  Source: Michael J. Fleming and Nicholas J. Klagge, “The Federal Reserve’s Foreign Exchange Swap Lines,” Current Issues in Economics and Finance 16, no. 4 (2010): 1.

  Where could more dollar funding come from? One might think of central banks as a possible source of foreign exchange. But the dollar reserves of the European central banks were, by themselves, nowhere near large enough to meet the funding needs of the banks.6 As the crisis worsened in the autumn of 2008 and the City of London convulsed, the Bank of England had as little as $10 billion on hand.7 Throughout July, in the dollar auctions held regularly by the ECB, the bids exceeded the allotted sums by a factor of four. Little wonder that as the crisis deepened, the dollar was not falling in value, as standard macroeconomic models had predicted, but rising.

  Lesser countries in this kind of predicament would be directed to the IMF. And in the fall of 2008, in close dialogue with the US Treasury and the Fed, the Fund was scrambling to devise a new genre of short-term liquidity facility to offer support for countries under acute funding pressure, which did not require a full IMF adjustment program.8 But for the ECB or the Bank of England to have resorted to the IMF would in 2008 have been a disaster of historic proportions. In any case, the Fund was still defined by the basic rationale of the 1944 moment in which it was born and had the proportions to match. The IMF financed trade deficits and handled public debt crises. It was not in the business of filling gigantic private sector funding gaps. Its programs were denominated in tens of billions of dollars. It was not conceived for an age of trillion-dollar transnational banking.

  In the autumn of 2008 the stark truth could no longer be escaped. As Tim Geithner of the New York Fed told the FOMC, the Europeans “ran a banking system that was allowed to get very, very big relative to GDP with huge currency mismatches and with no plans to meet the liquidity needs of their banks in dollars in the event that we face a storm like this.”9 As Bernanke remarked with typical understatement, the dollar funding needs of Europe’s banking system were “a novel aspect of the current situation.”10 It was a novel aspect with potentially drastic implications for the United States. If the Fed did not act, what threatened was a transatlantic balance sheet avalanche, with the Europeans running down their lending in the United States and selling off their dollar portfolios in a dangerous fire sale. It was to hold those portfolios of dollar-denominated assets in place that from the end of 2007 the Fed began to provide dollar liquidity in unprecedented abundance not only to the American but to the entire global financial system, and above all to Europe. In 2008 that flow of dollars grew to such proportions that it rendered any effort to write a separate history of the American and European crises anachronistic and profoundly misleading.11

  II

  The Fed labeled its liquidity facilities in a bamboozling array of acronyms—among insiders the programs were known collectively as the “hobbits.” But when broken down by function, they mapped directly onto each of the key elements of the shadow banking system: the asset-backed commercial paper market, repo lending, the market for the mortgage-backed securities, currency swaps. As Fed economists observed, this was no longer conventional monetary policy in which the Fed manipulated interest rates to affect market behavior. Instead, the “Federal Reserve’s balance sheet expansion” was an “emergency replacement of lost private sector balance sheet capacity by the public sector.”12 The Fed was inserting itself into the very mechanisms of the market-based banking model. The relationship between the state, as represented by the central bank, and the financial markets was nakedly revealed. The Fed was not just any branch of government. It was the bankers’ bank, and as the crisis intensified, the money market reorganized itself accordingly, taking on the shape of spokes with the Fed as the hub.

  The scale of the Fed’s liquidity actions was so large and varied that it poses problems of accounting. How should one measure the Fed’s huge programs? As a stock at the point of maximum exposure? As a rate of flow over a given period during the crisis? Or should one simply compile the sum total of all lending from the beginning to the end of the crisis? The first
measure will tend to minimize the image of intervention. The last measure will yield the largest figure. Each measure has its uses.13 Thanks to records extracted from the Fed by legal action, we can compile all three numbers.14

  The point where distressed banks normally accessed central bank assistance was the discount window. At the discount window, the central bank bought and sold securities for cash. As a classic sign of stress, it was generally reserved for banks in dire need of emergency liquidity. The list of the largest customers at the discount window in 2008 included all the most prominent American casualties of the crisis—AIG, Lehman, Countrywide, Merrill Lynch, Citigroup. If anything, the stigma of using the discount window was less severe for non-American banks. So alongside the American strugglers, the Fed’s accounts also prominently featured two of the European basket cases: Franco-Belgian bank Dexia and the ill-fated Irish branch of Hypo Real Estate, Depfa.15

  As the ABCP market shut down in the autumn of 2007, the Fed realized that it needed to add new facilities. The first was the Term Auction Facility (TAF), which provided banks with access to short-term funds they could no longer acquire on the ABCP markets. Avoiding stigma was a key concern. A wide range of collateral, including ABS and CDO, were accepted, and the more banks participated, the more popular TAF became. Between December 2007 and March 2010 TAF expanded on a gigantic scale. The maximum outstanding balance in the spring of 2009 was almost $500 billion. If TAF loans of varying duration are converted to a common twenty-eight-day basis, the total sum loaned came to a staggering $6.18 trillion in twenty-eight-day loans. Hundreds of smaller American banks took advantage of TAF, but the biggest beneficiaries were the giant American and European banks with Bank of America, Barclays, Wells Fargo and the Bank of Scotland heading the list. Among the large borrowers the foreign share was well over 50 percent.16

  Following the Bear Stearns crisis, it was not just ABCP but the collateralized repo markets that shut down. In the summer of 2008 the Fed, therefore, stepped into the breach, setting itself up as a repo dealer of last resort, offering twenty-eight-day repo against prime collateral (single-tranche open market operations, or ST OMO). A total of $855 billion were lent by December 2008, of which over 70 percent was taken by foreign banks, with five European banks dominating the entire program. Just one bank, the Swiss giant Credit Suisse, was the recipient of 30 percent of the liquidity the Fed provided.

  Because the collateral that was preferred by triparty repo markets was Treasurys, in the spring of 2008 the Fed instituted another program, the Term Securities Lending Facility, under which it lent out top-rated US Treasurys on twenty-eight-day terms in exchange for a variety of mortgage-backed securities, including private label. In total through this mechanism, $2 trillion in superior collateral was flushed into the system, with the program reaching its peak in the wake of Lehman in September and October 2008. Of the collateral provided by the Term Securities Lending Facility, 51 percent was lent to non-American banks, with RBS, Deutsche and Credit Suisse alone taking up more than $800 billion.

  The largest backstop for the repo market that the Fed operated during the crisis was the Primary Dealer Credit Facility (PDCF).17 It was introduced after the run on Bear Stearns under the emergency 13(3) powers of the Fed. The PDCF offered the key operators in the repo market discreet and unlimited access to overnight Fed liquidity in exchange for a wide range of collateral. Not surprisingly, the dealers took ample advantage. Total lending under PDCF came to $8.951 trillion. This was a huge amount, but the loans were made overnight and they should be seen in relation to the daily collateral posting in repo markets that peaked at $4.5 trillion in March 2008. The maximum amount outstanding on the PDCF was on September 26, 2008, at $146.57 billion. PDCF had the distinction of being the only large Fed liquidity program to have supported predominantly American banks. Merrill Lynch, Citigroup, Morgan Stanley and Bank of America were the heaviest users. But appearances were to a degree deceiving because the Fed allowed the London-based subsidiaries of Goldman Sachs, Morgan Stanley, Merrill Lynch and Citigroup to take advantage of the program. The Fed was thus remotely backstopping the City of London repo market.

  When the crisis in the money market funds knocked the last remaining support out from under the commercial paper market, the Fed took the unprecedented decision not just to backstop banks and the mutual funds but to enter the lending business directly. It established its own SPV, the Commercial Paper Funding Facility, to buy top-quality short-term commercial paper. In total it provided $737 billion in funding through this facility, with a peak outstanding in January 2009 of $348 billion. The largest user of the system was the troubled Swiss giant UBS, which soaked up 10 percent of the Fed’s funds. Another 7.3 percent went into Dexia, and 5 percent each into Fortis and RBS. Some of the most severely stressed European banks received 27 percent of the entire program. In total, the European share cannot have been much less than 40 percent.

  Alongside the mortgage market, the broader market for asset-backed securities had frozen up. To reenergize lending, on November 25, 2008, the Fed introduced the Term Asset-Backed Securities Loan Facility, which became the vehicle for the most mixed bag of lending sponsored by the Fed and the Treasury. It offered five-year nonrecourse loans to a select group of borrowers collateralized through the purchase of highly rated securitizations of consumer credit, such as auto loans, student loans, credit card loans and lending to small businesses for equipment and building construction. It was never the Fed’s largest program. Total lending came to $71.09 billion. But the program accommodated some of the most adventurous support actions undertaken by the Fed. The firms taking advantage were exclusively American, with Morgan Stanley, PIMCO and CalPERS in the lead.

  Finally, in early 2009, the Fed began to move from emergency liquidity provision to what would subsequently become known as QE1—the buying up and holding on the Fed balance sheet of large quantities of mortgage-backed securities. For a central bank, buying securities was a conventional mechanism of monetary policy. But it would now be done on a far larger scale than ever before and with a wider array of assets. On top of the conventional purchase of Treasury securities, the Fed bought $1.85 trillion in GSE-backed mortgage-backed securities by July 2010. The busiest week of purchases was the third week of April 2009, and holdings (net of sales) peaked in June 2010 at $1.129 trillion. Crucially, what the Fed was doing was not just pumping liquidity into the system. It was also absorbing onto its balance sheet the maturity mismatch, which had done such damage in markets like ABCP. The Fed took the long-term asset in exchange for immediate liquidity.

  Quantitative easing, or QE, is generally thought of as the quintessential “American” policy, the symbol of the Fed’s adventurousness. It would earn Bernanke regular scolding by conservative policy makers in Europe. But after what we have already said, it will come as no surprise that 52 percent of the mortgage-backed securities sold to the Fed under QE were sold by foreign banks, with Europeans far in the lead. Deutsche Bank and Credit Suisse were the two largest sellers, outdoing all their American rivals by a healthy margin. Barclays, UBS and Paribas came in eighth, ninth and tenth. Having kept open the basic institutions of transatlantic shadow banking during the most acute phase of the crisis in 2008, the Fed now worked hand in glove with the European megabanks to unwind the transatlantic balance sheet.

  III

  Not everyone in the network of Atlantic finance could take advantage of the facilities that the Fed offered to the top tier of international banks in New York. Nor did everyone have the kind of collateral the Fed demanded. To have lent to the most fragile European banks without adequate collateral would have exposed the Fed to serious risk. But to deny the weakest banks liquidity assistance was to court disaster. So from 2007 the Fed repurposed an instrument that was first developed in the age of Bretton Woods. To manage the fixed currency system in the 1960s the central banks had developed a system of so-called currency swap lines that allowed the Fed to lend dollars to the Bank of
England against a reverse deposit of sterling in the accounts of the Fed.18 Having gone out of use in the 1970s, the swap lines had been briefly revived in 2001 to deal with the aftermath of 9/11. In 2007 faced with the implosion of the transatlantic banking system, they were repurposed and expanded on a gigantic scale to meet the funding needs not of sovereign states but of Europe’s megabanks. As Geithner explained to his Fed colleagues: