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Fed says it takes no risk in lending dollars for Europe

November 30, 2011 |  7:22 pm

Fedeccles
Stocks soared Wednesday as global markets lauded central banks’ decision to funnel more money into the financial system, a move mainly aimed at assisting struggling European banks.

But the agreement to expand so-called currency liquidity swap arrangements among the Federal Reserve, the European Central Bank and four other central banks could be viewed another way: an act of desperation.

“It suggests that policymakers’ concerns about the outlook are significant and have increased substantially,” economists at Nomura Securities International wrote in a report.

For its part, the Fed insisted that it's taking no real risk under the program.

Europe is the epicenter of global financial worries, of course. Soaring market interest rates on government bonds across the continent over the last month have further weakened European banks. That’s because their bond holdings have dropped in value with each rise in rates.

In shades of 2008, fear of a new round of bank failures has made lenders worldwide increasingly reluctant to do business with European banks. That has made it more difficult for some banks to get the dollars they need to repay their own debts -- for example, when a U.S. money market fund calls in a loan it previously made to a European bank.

To avert a new global credit squeeze, the Fed agreed to make more dollars available to the ECB and other central banks, and to cut the interest rate for such loans. That, in turn, will allow the ECB to lower the cost of dollars it lends to individual commercial banks.

The Fed noted on its website that it lends only to other central banks under these arrangements, and that the borrowing central bank “therefore bears the credit risk associated with the loans.”

In other words, the Fed isn’t on the hook if the ECB’s dollar loans to individual banks go bust.

The Fed also said it doesn’t bear any risk of currency loss on the loans, if for example the euro’s value were to fall against the dollar. (The euro rose Wednesday, gaining 1% to $1.345.)

The swap program doesn’t attack the most pressing problem in Europe, which is the surge in government bond yields. The central banks aren’t directly funneling money to cash-strapped European governments.

“These actions do not address solvency issues in European sovereigns,” analysts at Keefe Bruyette & Woods wrote in a note to clients.

Still, bond yields fell across most of Europe on Wednesday. The yield on two-year French bonds slid to 1.29% from 1.58% on Tuesday. Italian two-year bond yields eased to 6.93% from 7.10%, the third straight drop after reaching a euro-era high of 7.66% on Friday.

Despite the Fed’s assurances, one of the central bank’s harshest critics -- Rep. Ron Paul (R-Texas) --  attacked the swap agreements.

“Rather than calming markets, these arrangements should indicate just how frightened governments around the world are about the European financial crisis,” Paul said in a statement.

“The Fed is behaving much as it did during the 2008 financial crisis, only this time instead of bailing out politically well-connected too-big-to-fail firms it is bailing out profligate government spending” in Europe,  Paul said.

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Americans feel more confident, but should they?

-- Tom Petruno

Photo: The Federal Reserve building in Washington. Credit: Andrew Harrer / Bloomberg News

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