The Real Reason Behind the Central Bank Scramble

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    On Tuesday evening, Standard & Poor's downgraded the long-term debt ratings of some of the largest banks in the world.

    By Wednesday morning, the Federal Reserve, the European Central Bank and central banks from Canada, England, Japan and Switzerland announced coordinated action to support liquidity in financial markets that mirrors the 2008 financial crisis.

    Mere coincidence? Likely not.

    Once banks saw their ratings downgraded, it raised the specter that they would have to post billions in additional collateral on trades just as market pressures make it hard for them to replace the funds through a stock or bond offering.

    Without the funds to trade banks could further pull back in lending to each other, causing borrowing rates like the London Interbank Offered Rate to rise. A precipitous rise could be costly to banks, corporations and even consumers who rely on trillions in variable borrowing.

    Today's intervention by the Fed and other central banks tries to the alleviate those problems which already began to spiral out of control.

    Earlier in November, the cost for European banks to borrow overnight in dollars touched on levels not seen since the crisis, while the overnight bank borrowing of dollars was closing on post crisis highs. Wednesday, when Eurozone leaders couldn't agree on an effort to increase the ESSF, or the European bailout fund, the price paid by European banks to borrow dollars rose to three year highs.

    At the same time, ratings agencies S&P, Moody's and Fitch were all in the process of downgrading major banks like Bank of America(BAC), causing shares to touch on 2011 lows.

    Bloomberg reported on Tuesday that in regulatory filings, Bank of America said that with ratings downgrades it could post nearly $5 billion in additional collateral, while Morgan Stanley(MS) would need to post $1.29 billion and JPMorgan Chase(JPM) would need to post $1.5 billion.

    The liquidity support announced by central banks today is a move to lower the price for banks to borrow overnight borrowings, easing pressure on their capital. The so- called dollar liquidity swap arrangements will lower the price that central banks offer short term funds to the U.S. dollar overnight index swap rate plus 50 basis points. It means that even if banks don't lend to each other, they can get overnight funds from central banks for rates that aren't crippling to their capital base.

    Many of Wednesday's moves closely resemble actions first taken in 2007 as ratings agencies downgraded thousands of sub-prime mortgage bonds, which precipitated funding shortages -- and exposed cracks in the health of banks.

    Calling the move a program to "support the global financial system," the Federal Reserve indicated that the real issue was banks borrowing dollars. As a result, it opened up currency swap lines to offer foreign central banks dollars through February 2013. The move, and a statement from the Fed signaled that the real pressure arose abroad. "At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar," the Fed said in a statement.

    Similar swap arrangements were opened in May 2010 at the outset of the European sovereign debt crisis and in 2007, as the sub-prime mortgage crisis worsened. In all instances, the swap lines help banks fund foreign currency denominated debt, primarily in dollars.

    In a statement the Federal Reserve said that further details will be forthcoming and that "were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses."

    -- Written by Antoine Gara in New York


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