Discussion on the Hill
Dollar Crisis Averted, But at What Cost?
The Cost of Global Dollar Reliance
A Year After TARP -- Was It Necessary?
Attaboy Jack!

In this letter, we are going to spend some time digging into the recent volatility of the U.S. dollar.  In case you haven't noticed, the U.S. dollar roared back in 2008 only to resume its free fall in 2009.  There are advantages and disadvantages to having a strong/weak dollar and some passionate arguments for/against various dollar policies.  Historically, every great power in history has used a weak dollar to inflate their way out of paying off large amounts of debt.   

Below is a recent discussion between Chairman Bernanke and Congress on the use of currency swaps as an apparent tool of the Fed to manipulate the currency market.  It appears that the recent financial crisis and the fact that the U.S. dollar is the reserve currency of the world, gave the Fed a perfect opportunity to have its cake and eat it too.  The recent drop and increased volatility in the U.S. dollar may mean that the Fed got more than it bargained for. 

Question?
If you are invested in the S&P 500 in 2009 and it goes up 15% in value and at the same time the U.S. Dollar drops 16% in value, has your global net worth increased?

"Swap" Discussion on the Hill

A hearing in Congress on July 21, 2009 provided a unique insight into the Federal Reserve's actions at the beginning of the credit crisis. Here is a noteworthy exchange between Congressman Alan Grayson (D - Florida) and Fed Chair Ben Bernanke.

Grayson:
"Chairman Bernanke, I'm looking at the report you handed out this morning... There's a table on page 26 [of your report] that consists of [the Federal Reserve] balance sheet and one of your entries called central bank liquidity [currency] swaps shows an increase from 2007 from $24 billion to $553 billion ...by the end of 2008. What's that?"

Bernanke:
"Those are swaps (derivatives) done with foreign central banks, many [of which] are short dollars and [that would have had to] come into our markets looking for dollars, drive up interest rates and create volatility in our markets. What we have done... [is to] swap dollars for currencies [of 14 central banks']; they take the dollars and lend it out to banks to bring down interest rates in those jurisdictions." (What he didn't say was that such action also helped keep US interest rates down.)

Grayson:
"We looked at one of the arrangements, [one of which was] $9 billion for New Zealand, which works out to $3,000 per person [New Zealand resident]. Wouldn't it have been better to extend that kind of credit to Americans?"

Bernanke:
"...we are extending that kind of credit to Americans."

Grayson:
"...look at the next page which shows... a 20% increase in the nominal USD exchange rate at exactly the same time that you were handing out a half a trillion dollars to foreigners. Do you think that is a coincidence?" 

Bernanke:
"... [Pause]...Yes."

It's an interesting question, despite how Bernanke answered it. Action contradicts his answer but in his defense, strengthening the dollar was probably not the goal of the Federal Reserve in taking this action - it was an unintended consequence.

Dollar Crisis Averted, But at What Cost?

In August, September and October, the US Dollar Index (USDX) appreciated 21% after falling 24% from late 2005 into early 2008. But if taming volatility was a motivator for the Federal Open Market Committee to sell swaps as Mr. Bernanke claimed, the strategy failed abysmally. The dollar shot up from 72 in early August 2008, before peaking at 90 in March 2009, after which it then lost 16%.

And the aftermath isn't pretty. The dollar is still falling and recently broke key support at 75, and there is little on the horizon to indicate that this trend will change anytime soon, especially given the moves by foreign central banks to shift away from the dollar (see articles in Related Reading below). Can anyone blame them? Current Federal Reserve and government policies and responses have been anything but dollar positive.

This month, the Bank of International Settlement (BIS) published a paper that attempted to answer this and other questions surrounding central bank actions entitled "The US Dollar Shortage in Global Banking and the International [read: Federal Reserve] Policy Response."

The paper wasted no time in getting down to brass tacks and asked some probing questions of its own.

The  global  financial  crisis  has  shown  just  how  unstable  banks'  sources  of  funding  can become. Throughout the crisis, but particularly following the collapse of Lehman Brothers in September 2008, many banks faced severe difficulties securing short-term US dollar funding. In  response,  central  banks  around  the  world  adopted  extraordinary  policy  measures, including international swap arrangements with the US Federal Reserve, to enable them to provide  US  dollars  to  commercial  banks  in  their  respective  jurisdictions.  What caused this global shortage of US dollars? Which banking systems have been most affected? How could a shortage develop so quickly after dollar liquidity had been viewed as plentiful?

In a nutshell, when the crisis hit the dollar a shortage was the result caused from a trend that had become popular with foreign banks of taking increasingly larger US dollar positions, thereby creating significant short dollar positions among foreign banks. In Europe's case, "[the] banks' need for short-term US dollar funding was substantial at the onset of the [credit] crisis, at least $1.0 -$1.2 trillion by mid-2007."

And that was just Europe.

The Cost of Global Dollar Reliance

The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks' international balance sheets. The outstanding stock of banks' foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity (Figure 1, left panel). The year-on-year growth in  foreign  claims  approached  30%  by  mid-2007,  up  from  around  10%  in  2001.  This acceleration took place during a period of financial innovation, which included the emergence of  structured  finance,  the  spread  of  "universal  banking",  which  combines  commercial  and investment  banking  and  proprietary  trading  activities,  and  significant  growth  in  the  hedge fund industry to which banks offer prime brokerage and other services.  

So how big was the risk of the credit crisis on these foreign dollar positions?

Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion.

Many of these dollar short positions held by foreign banks was the result of participation in complex derivatives in a market that had grown to around $600 trillion. This short-term funding liability was little more than one percent of the derivative total.

Figure 1

And it is this amount and potentially more that the Federal Reserve was attempting to cover in the action taken by the FOMC. In other words, the Federal Reserve became the buyer of last resort in an effort to avert further crises with the taxpayer, ultimately being on the hook for the tab!

The BIS paper highlighted just how little was known about the structure and complexities of international bank balance sheets and their dependence on one another thanks to financial globalization. It also exposed the risks that grew from this trend and growing use of foreign exchange swaps and other derivatives.

When the credit crisis hit and Lehman Brothers collapsed, short-term currency funding sources were seriously compromised, which many believe required that a buyer of last resort step into the fray. These problems became most acute in smaller countries like Iceland, that had become heavily reliant on complex derivatives and foreign banks to provide a funding backstop in case something went wrong. And in 2008, that is exactly what happened.   

But what happens when the next crisis strikes? Will the Federal Reserve be ready and able to again act as buyer of last resort and provide necessary liquidity? And who assumes the risks of this action? As we have learned in the past year, it will be the US taxpayer.

This was just one event in a series of events that were part of a larger global crisis that some experts would have us believe threatened our financial system.

A Year After TARP - Was It Necessary?

Another quickly improvised solution to the 2008 crisis was the $700 billion Troubled Asset Relief Program (TARP), introduced by Secretary Treasurer Hank Paulson in September 2008. Without it, we were told, the financial fabric of our country would have been irrevocably torn with untold consequences. Given this supposed threat, Congress quickly approved TARP on October 3, 2008.

A year after TARP, what has it accomplished? A paper by Florida State University Professor Randall Holcombe published recently sought to address this question.

Figure 2 - Chart from the Federal Reserve showing the effect of TARP, a reduction in commercial and industrial bank lending by commercial banks, which is the opposite of the intention (we were told at the time) of the program.  Based on the amount of money spent to date, this chart should make you sick to your stomach.

So what risks did the credit crisis pose based on these foreign dollar positions?

In his opinion, TARP was neither necessary nor has it worked (see Figure 2).

To look at the first question, consider what TARP was designed to do. Secretary Paulson said interbank lending had dried up because banks had toxic assets (mortgage-backed securities) clogging their portfolios. Because nobody knew what they were worth, banks were uncertain of the financial security of other banks. This uncertainty caused a reluctance to lend and prompted the financial markets to lock up.

The solution, Paulson argued, was to approve TARP and use $700 billion to buy the toxic assets. Replacing the assets with Treasury securities would fortify bank balance sheets and interbank lending would resume.

Dr. Holcombe pulls no punches in his synopsis.

It is easy to say the program wasn't necessary, despite Paulson's arguments, because the TARP money wasn't used to buy toxic assets. TARP money was instead used to buy preferred stock in banks, shoring up their balance sheets by giving the federal government part ownership of the banks.

Nine of the largest banks were forced to issue stock to the Treasury, paid for with TARP money, even though several of the banks tried to opt out. Secretary Paulson said that if some of the big banks participated and others didn't, it would identify their varying levels of weakness, which Paulson believed was undesirable.

Instead of buying up toxic assets, the TARP money was used to partially nationalize the banking industry. It was also used for a federal takeover of AIG (after it was initially rescued by the Fed) and the bailout of Chrysler and General Motors.

He admits that without this sizable taxpayer infusion some banks would have failed, but he believes that wouldn't have been so bad.

When firms take risks, they must balance the potential profits from success against the potential losses from failure, and the TARP support removes the last part of that balancing act. There may have been some dislocations in the short run from bank failures, but in the long run allowing them to go under preserves the incentive structure that fuels a market economy. Banks are financial intermediaries that match up borrowers and lenders. When a bank goes under, it does not reduce the amount of money available to borrowers, or prevent savers from providing money that can be lent. Other financial intermediaries are available to borrowers and lenders to replace the activities that failed banks would have performed.

We contacted Professor Holcombe this week to discuss his article with him. His comments provide an excellent TARP overview and epilog.

As to the stimulus package and bailouts, they are both counterproductive.  As the economy now enters a recovery, the "stimulus" spending will divert resources from the private sector into government spending, which will slow the recovery. 

In hindsight we can see the folly of the auto industry bailout.  The justification was to give them a source of temporary funding so they could avoid bankruptcy, but they went into bankruptcy anyway.  Now, GM is 61% owned by the federal government, which will make it harder for the company to survive long-term than if it had just gone through a regular bankruptcy proceeding last December rather than getting its first distribution of bailout money.

His comment that stimulus spending "will divert resources from the private sector (and real jobs creator) into government spending, which will slow recovery" is significant. That is exactly what happened during the Great Depression with FDR's New Deal (and other programs). It has also proven to be true as a result of the official response from the Japanese government following the breaking of its asset bubble in 1990 over the last two decades in Japan.

The huge difference in the economies of the U.S. in the 1930s and Japan in the 1990s is that complex derivative ticking time-bombs did not exist at the time, which will make the next crisis far more "interesting."

Definitions

Currency Swap
A currency swap is a financial derivative and an arrangement in which two parties exchange specific amounts of different currencies initially and a series of interest payments on the initial cash flows are exchanged. Often, one party will pay a fixed interest rate, while another will pay a floating exchange rate (though there may also be fixed-fixed and floating-floating arrangements). At the maturity of the swap, the principal amounts are exchanged back. Unlike an interest rate swap, the principal and interest are both exchanged in full in a currency swap. http://www.investorwords.com/1244/currency_swap.html

Derivatives
Warren Buffett describes them as "financial weapons of mass destruction" for good reason. A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity/equity prices.  Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

Related Stories and Links:

Alan Grayson and Ben Bernanke Video
http://www.youtube.com/watch?v=n0NYBTkE1yQ

US Dollar Shortage in Global Banking and the International Policy Response
http://www.bis.org/publ/work291.pdf?noframes=1

How the Federal Reserve Bailed Out the World
http://www.zerohedge.com/article/how-federal-reserve-bailed-out-world

A Year After TARP: $700 Billion Down the Drain - Holcombe
http://blog.mises.org/archives/010873.asp

Economist - Down with the Dollar, Why the Dollar Is Falling
http://ow.ly/15W3ht

Dollar to Hit 50 Yen, Cease as Reserve
http://ow.ly/v6hS

Russia Ready to Abandon Dollar in Oil, Gas Trade with China
http://ow.ly/v5Ru

Iran Joins List of Nations in Moving Away from the Dollar...
http://ow.ly/v5QZ

Attaboy Jack!

I put my dad on a plane back to Tennessee on Monday after enjoying another successful bird hunting trip with him.  We had great weather, which made for incredible hunting.  We recapped the entire experience with friends and family, while enjoying incredible southern cuisine.  My new hunting dog Jack made it all possible by exceeding my wildest expectations and performing like an experienced dog well beyond his years.  I owe a special thanks to my good friend Brian King for helping me plan a special pheasant and chukkar hunt for us on his ranch. 

On our last day, I took my oldest daughter Sarah so she could share this special time with her Papaw.  Below is a picture of Sarah and me as we stop for a rest. 

I don't think I could have wiped that smile off her face. 

My dad and I have been going on this hunt for 12 years and it seems like I enjoy each hunt more than the last.   My father turns 70 in March and I know our bird hunting days are numbered, so I am blessed to spend this special time with my dad.  For next year, I am in the planning stages of a two-week hunt across Idaho, Montana, North and South Dakota.  If you are a bird hunter and can help me plan some stops along the way, I would welcome your call. 


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.


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