from Follow the Money

Give the Fed a bit of credit ...

October 2, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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For holding things together. Barely. Bad as things are, they could be worse. Really.

By my count, the Fed is now providing about $1.25 trillion in liquidity support to the global financial system.

The Fed’s latest balance sheet data shows: $80b of repos; $150b of term auction credit, $410b in other loans, $30b in portfolio investment with "Maiden Lane" (the Bear Stearns vehicle), $320b in "other assets," and $260b in securities lent to dealers.

Do the math. It is a huge number. Or look at my CFR colleague Paul Swartz’s updated chart. I wouldn’t believe these numbers could possibly be true if I hadn’t been watching the data for a while. Frankly the TARP is now starting to look small relative to the Fed’s balance sheet.

The $1.25 trillion total likely includes the swap lines that have allowed other central banks to provide dollar liquidity to their financial institutions.** (This sentence has been edited after my initial post: see the note below, it is important)

I have long thought that sovereign funds, which provided equity capital to support banks’ existing management in the early stages of this crisis, have gotten too much credit for helping to stabilize the financial system and the Fed and other central banks have gotten too little, in part because there isn’t as obvious a set of beneficiaries.

The latest data release should settle the question; absent enormous liquidity support from the Fed, a much broader set of financial institutions -- including some that received equity investments from sovereign wealth funds -- would have failed.

What are sovereign investors from the emerging world doing? We don’t know much about what sovereign wealth funds are doing -- and in any case, the set of sovereign funds and big state firms from the emerging world is sufficiently diverse that it makes little sense to try to paint a single picture. But we do know a little bit about what the world’s central banks are doing from the New York Fed’s custodial data.

That data suggests an overwhelming flight away from any kind of risk. Or at least any kind of risk other than the currency risk that they have to take. Central banks are petrified of losing money. This is one reason why I have long thought that sovereign investors could be destablizing; they aren’t necessarily leveraged -- but they are very loss-adverse.

From August 27 to October 1, the world’s central banks added $72.6b to their custodial holdings of Treasuries, and $0.9b to their custodial holdings of Agencies. Annualized, that works out to a $872b annual growth for Treasuries -- a sum well in excess of the US current account deficit.

Between July 30 and October 1, they added $118.5b to their Treasury holdings (a $710b annual pace) while reducing their Agency holdings by $12.5b.

The enormous growth in central bank custodial holdings of Treasuries has helped to support the dollar -- and that is stabilizing. The United States credit crisis has not turned into a currency crisis. But the flight out of risk has destablized other key markets, and that hasn’t been stabilizing. I suspect that central banks and sovereign funds are pulling out of money market funds, for example. The growth in the Fed’s custodial holdings in September almost certainly exceeded the growth in central banks’ reserves (we will have data on this next week) -- a fact that suggests that central banks have sold other, slightly more risky assets and used the proceeds to buy Treasuries.

The basic story that emerges from the Fed’s balance sheet over the past few months is simple: the emerging world’s central banks have fled from any asset with a hint of credit risk, and while the Fed (and other G-10 central banks) have been lending ever large sums to the financial system. In the process they have taken on a lot more credit risk -- and offset the broad flight away from risk by private investors and emerging market central banks alike.

Absent the Fed’s liquidity support, things would be worse. Much worse.

** I initially wrote that the $1.25 trillion in liquidity support to private financial institutions that shows up on the Fed’s balance sheet data likely did not capture the swap lines with foreign central banks, and thus understates the Fed’s true activity. The comments have led me to revise this view -- as it seems that "other federal reserve assets" captures the fed’s foreign assets, including the collateral posted against swap lines that have been used, and thus $1.25 trillion likely represents the global total for dollar credit extended by all central banks to all financial institutions globally. JKH was the first to suggest this, and Murph’s comments lent support to JKH’s point. I hope to get full clarity on this on Friday; if anyone knows, please email me at bsetser at cfr dot org or just contribute to the comments. It is important.

UPDATE: I have confirmed that the foreign exchange posted as collateral in dollar swap line appears in "other federal reserve assets."

UPDATE 2: I initially wrote "the credit crisis has turned into a currency crisis" (after describing how central bank dollar purchases had been stabilizing); I meant to write "the credit crisis has NOT turned into a currency crisis." The post has been updated.

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