The Fed as Savior: How the Latest Program Works

Countries are no different than big companies in many respects. For one thing, they both need to borrow money on a daily basis to cover the costs of the services they provide.

If they can’t borrow that money -- either because lenders are too afraid to make loans or because the cost of borrowing becomes too expensive -- then companies and countries alike are forced to shut down.

The ability to borrow is referred to as liquidity, and liquidity was drying up in late 2008 when credit markets froze at the outset of the recent financial crisis. Now it’s happening again in Europe.

Think of liquidity as the oil that keeps the engine running. Without liquidity, the engine seizes.


In a broad and concerted effort to inject liquidity back into European financial markets, the U.S. Federal Reserve on Wednesday joined with other major central banks to make it cheaper and easier for European countries to borrow U.S. dollars. A similar effort, virtually unprecedented at the time, helped ward off a collapse of global financial markets in 2008.

Stock markets cheered the announcement. The Dow Jones Industrial average soared 420 points on optimism that the global lending program will help relieve the long-running European debt crisis and perhaps ward off another European recession.

“It’s having access to credit, that’s the key,” said Peter Cardillo, chief market economist at Rockwell Global Capital. “This coordinated move, it signals that central banks are getting pretty worried” about liquidity drying up in Europe.

“The key factor is that with massive liquidity hitting the financial system in Europe, the fears of a severe recession in Europe lessen and the fears of global recession dissipate,” Cardillo explained.

As Europe’s debt crisis has deepened, investors have dumped the sovereign debt of troubled nations such as Italy and Spain. In turn, borrowing costs for those countries have soared, with yields on their government bonds jumping well above 7%. To put that into context, at the same 7% yield level Greece, Ireland and Portugal required bailouts.

The details of the revised program are complicated, but the overarching premise is simple: the world’s biggest central banks essentially cut their lending costs in half to make it easier for European banks and countries to borrow the money they need to stay afloat.

Here’s how it works: the program reduces by about half the cost of an existing program that allows banks in foreign countries to borrow U.S. dollars from their national central banks. Those central banks borrow the money directly from the U.S. Fed.

Specifically, this revised program applies to the European Central Bank, which can now borrow U.S. dollars at a cheaper cost and then loan that money out again to needy European countries and banks.

“The basic premise (of the new program) is that foreign banks have more ability to raise money in their home countries or through their own central banks at times of stress.  As they get shut out of borrowing directly in dollars they rely more and more on funding in their domestic market.     U.S. banks may be scared to lend to French banks, but French institutions and individuals are far less likely to be as concerned,” said Peter Tchir, founder of TF Market Advisors in Connecticut. The new program, referred to as a dollar line swap because it makes it easier to convert foreign currencies (in this case euros) into more stable U.S. dollars, extends an existing one to February 2013. It was supposed to end next August.

Also on board are the central banks of Japan, Canada, Switzerland and England, although Europe isn’t likely to tap those currencies for help. Still, the broad participation is intended to show a united front against a further deepening of the European debt crisis.

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity,” the banks said in a statement.

European banks like to borrow U.S. dollars because interest rates are so low in the U.S. They then loan these dollars out to other European banks and businesses. But U.S. banks have become reluctant to loan money to banks in Europe because of the latter’s potential exposure to troubled nations such as Greece, Italy, Spain and Portugal.

The fear among U.S. banks is that if those debt-ridden countries can’t pay their debts to the European banks from which they borrowed money, those same European banks won’t be able to repay their debts to the U.S. banks.

In other words, lending and borrowing flows in a circle and if the circle is broken no one gets paid. The program announced Wednesday and led by the U.S. Fed is intended to keep the circle of lending and borrowing intact.