Europe's Growing Crisis Puts the Fed at Risk
By JACK WILLOUGHBY
European central banks are at risk of defaulting on their currency swaps
with the U.S. Federal Reserve, unless major banks on the Continent can find
some way to stabilize their deteriorating balance sheets.


TO AID THEIR AILING COMMERCIAL banks, central banks in Europe have relied on
huge currency swaps, borrowing nearly $400 billion from the U.S. Federal
Reserve. But as European commercial banks and European currencies
deteriorate, repaying all that money to the Fed is becoming ever more
difficult.

Some believe the Fed's swaps to prop up Europe's banks are a foolish bet.

"[Fed Chairman Ben] Bernanke's assurances aside, I don't see how they can
easily be repaid," warns Gerald O'Driscoll, senior fellow with the Cato
Institute and formerly with Citigroup and the Dallas Fed.

Here is how the swaps work. The Fed and, say, the European Central Bank
agree to exchange a set amount of each other's currencies at a certain
exchange rate for six months, with a provision to renew the terms at
maturity. The ECB uses the money to help aid bank-bailout packages for
countries like Belgium, Finland, Hungary and Ireland that have troubled
dollar-based assets. (Asian central banks are also part of the program, but
haven't utilized it nearly as heavily.) The Fed gets a promise from the ECB
to repay the debt in six months.

A big hitch: Europe's commercial banks have more exposure to wounded
emerging markets than U.S. counterparts. By one estimate, European banks
provided three-quarters of the $4.7 trillion in cross-border loans to the
Baltic countries, Eastern Europe, Latin America and emerging Asia. Their
emerging-markets exposure exceeds that of U.S. lenders to Alt-A and subprime
loans.

THE SWAPS MAY MERELY delay the inevitable major shake-up of Europe's banking
system, O'Driscoll fears, and move the U.S. Fed beyond its original
operating brief. Adds Neil Mellor, currency strategist at Bank of New York
Mellon: "The aftershocks of the current global credit crisis are continuing
to induce huge turbulence in the foreign-exchange markets, which is only now
being more keenly felt in the eurozone and Britain."

You can debate the merits, but not the size of the swaps program. It is big.
The Fed's currency swaps have expanded from zero a year ago to $506 billion.
Of the 14 central banks involved, the ECB by far has been the biggest
counterparty to date, drawing down $264 billion (versus Mexico's $33 billion
drawdown via a similar program at the height of the 1995 peso crisis).
Skeptics contend that the swaps are thinly disguised spending that was
carried out without Congressional approval.
[swapmeet]

"A case can obviously be made for [swaps] in the current global crisis,"
says Al Broaddus, a former president of the Federal Reserve Bank of
Richmond. "But these swaps always struck me as uncomfortably close to the
Fed making fiscal policy. That is why, whenever they came up for
authorization, I voted against them." Last week, current Richmond Fed
President Jeffrey Lacker voted against the Fed's targeted-credit programs.
It is rare for a Fed official to openly oppose the Federal Reserve Board.

Traditionalists would prefer that the Fed stick to guiding interest rates
and controlling the money supply. Fiscal policy, by contrast, forces the
bank to decide who gets what, which can become a political calculation.

In a Jan. 13 speech at the London School of Economics, Bernanke said the
joint actions of the Fed and foreign central bankers "prevented a global
financial meltdown in the fall." Were these loans not made, he said, there
would have been a much greater risk of crossborder financial collapses that
would have left the global economy in even worse shape.

The swap lines, Bernanke continued, were necessary and will be
self-liquidating, running off the Fed's book like some of its
commercial-paper programs already have. "Liquidity provision by the central
bank reduces systemic risk by assuring market participants that, should
short-term investors begin to lose confidence, financial institutions will
be able to meet the resulting demands for cash without resorting to
potentially destabilizing fire sales of assets," Bernanke said.

Yet in recent weeks, the situation seems to have worsened for European banks
and their home countries alike. The Dow Jones Euro Stoxx Banks Index is off
66% since Bernanke spoke. The Royal Bank of Scotland (ticker: RBS) is now a
government property, as is Belgium's Fortis (FORB.Belgium).

"I would say that most of the big banks in Europe are insolvent," says Dory
Wiley, president of Commerce Street Capital, a money-management firm that
invests in banking stocks. "That is what made them great -- but
unpredictable -- shorts. They represent major components in those country
funds everyone buys." The danger is that governments, being the prime
backstops for their commercial banks, will be forced into default or be
downgraded. One hedge-fund manager advises retail investors to simply steer
clear of Europe.

Particularly vulnerable to further decline seem to be: Switzerland's Credit
Suisse (CS) and UBS (UBS), as well as Britain's Barclays (BCS), Austria's
Erste Bank (EBS.Austria), Sweden's Nordea (NDA.Sweden), the Netherlands' ING
(ING), Belgium's Fortis and Spain's Banco Santander (STD). These highly
leveraged banks have huge emerging-market exposure, and reside in European
countries whose financial resources are small relative to the assets of the
giant banks they host.

Little wonder that countries have had a difficult time selling their own
debt to investors worried about both general economic conditions and the
possibility that the banks' problems may overwhelm their governments'
ability to cope with them. Moody's Investors Service recently downgraded the
credit ratings of Latvia, and commented on Greece; the agency cited, in
part, bank problems in both countries. Ireland was just put on credit watch
with a view to downgrade by Moody's because of its banking crisis.

How can the governments raise the cash to repay the Fed? The possibilities
include printing more currency, thus undermining the euro's value and
increasing inflation; selling more sovereign debt; or raising taxes. None is
a pleasing prospect.

The Bottom Line:
European banks face a new round of challenges. Most vulnerable: Credit
Suisse, UBS, Barclays, Erste Bank, Nordea, ING, Fortis and Banco Santander.

A further complication: Countries such as Ireland must go along with
whatever currency policy the European Central Bank chooses, even if it isn't
necessarily the right one for the nation. Those outside the ECB currency
regime -- like Switzerland -- can custom-tailor their monetary response.
Ireland has gone so far as to threaten to leave the monetary union unless it
gets more help.

RECENTLY LATVIA, WHOSE central bank has bailed out the country's banking
system, was the scene of demonstrations and populist rhetoric aimed at
granting borrowers relief on loans from Swedish banks -- which have a big
presence in the Baltic nation. If the Latvian government grants this relief,
it would seriously hurt Swedish lenders, whose central bank has borrowed $25
billion from the Fed in these currency-swap lines.

"This is the kind of fiscal pressure that can easily rip the European Union
apart, and cause the kind of civic upset that leads to revolution," says
Sean Egan, co-founder of Egan-Jones, a credit-rating firm in Pennsylvania.

And some of the most stable countries are involved. Switzerland, whose
banking system has assets valued at eight times the nation's annual economic
output, is in hock to the Federal Reserve to the tune of $20 billion, a
massive amount for a small country. Britain, with its highly leveraged
financial system, has had to bail out its banks three times so far, yet must
repay the Fed $54 billion.

These pressures are starting to affect sovereign borrowing, too: Germany
recently auctioned 10-year government bonds -- but the government was left
holding 32% of the offer, in what analysts regarded as a failed deal.

Economists Carmen Reinhart of the University of Maryland and Ken Rogoff of
Harvard have studied sovereign defaults going back to the 14th century, and
found that mass sovereign defaults tend to run in waves when currencies
begin to melt down. Says Reinhart, "We've found that global banking crises
cause the kind of turbulence that leads to sovereign defaults. It's just
beginning."

Lee Hoskins, former president of the Cleveland Fed, in the early '90s led a
move to stop the U.S. central bank from using swap agreements to warehouse
foreign currencies to help the Treasury implement its foreign-exchange
policy. Hoskins views the Fed as pursuing a policy of credit allocation
rather than targeting monetary aggregates or interest rates. Hoskins
believes the Fed should let some of the banks here and abroad go under.
"Unless we stop the forbearance and dispose of the insolvent banks, the
problems are only going to get worse," says Hoskins.

Meanwhile, Bernanke says he isn't so much managing the money supply on a
quantitative basis, but rather pursuing "credit easing," focusing on a mix
of loans and securities affecting household- and business-credit conditions.
Emergency loans and swap lines made to central banks will essentially be
repaid once things return to normal for the big banks.

Walker Todd, a former lawyer for the New York Fed, would prefer that
Congress review these swap lines and the agreements behind them -- to make
sure they were made with the proper authority.

Bernanke concedes that the banking sector is far from saved at this point:
Worsening growth prospects, continued credit losses and markdowns will keep
pressure on the capital and balance sheets of financial institutions.

"More capital injections and guarantees may become necessary to ensure
stability and the normalization of credit markets," says the Fed chief.

But shouldn't Congress have a say in how much more the Fed lends to Europe?

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