Questions relating to elements of the Financial Turmoil

Questions relating to elements of the Financial Turmoil:

Recently, I’ve been asked some similar questions having to do with specific topics related to actions taken and elements which existed or still exist, that are part the macro financial picture.  I’ve chosen two of them to mention in this post: 

1. The Federal Reserve ended its currency swap lines in February of this year.  How do these “swaps” relate to the dollar, and could this affect the value of the currency? 

The Fed “Swap Line” is essentially using a different definition of “swap”–which is also used to denote certain classes of  “Over the Counter” ( or unregulated and non exchange traded) options style contracts such as Credit Default,  Foreign Exchange/Currency or Interest Rate Swaps –which make up the vast majority of these unregulated or OTC derivatives. 

This definition (Fed Line) is literally swapping or trading dollars with other central banks.  These are mainly used to settle contracts that are denominated in U.S. dollars when there is a shortage of dollars held by foreign commercial banks–primarily to facilitate international trade or various cross border transactions.  It relates generally to a country’s “current accounts”–which appears in the public press as trade deficits or surpluses, etc.   When the Fed set the swap line up, there was a shortage of dollars available to settle foreign exchange contracts and this line allowed stability in the price of dollars for other countries to be able to settle trade contracts.  The effect of its “ending” could be volatility in the price of dollars if a shortage is perceived.  I’m including a title from the WSJ A Primer on the Fed’ Swap Lines with Europe* about this swap line for your convenience.  

2. There are some 1.4 quadrillion dollars of derivatives floating around.  Interest rate swaps and currency/exchange rate swaps are most worrisome. I haven’t seen a breakdown of these anywhere but I assume a lot of them are valued in dollars. If they were to cascade into a default what effect could this have on the dollar? 

The back story of this question is really tantamount to asking “What happened anyway?”  

It’s really a longer study but briefly: 

The “notional” aggregate amount of Quadrillions, is just that–notional or imaginary–probably better defined as the face amount of the outer limit of all liabilities real and contingent contained within this economic class of instruments.  As assets or rates decline or increase, it forces settlement of these contracts–which could be a small portion of the notional amount or all of it, a moving target which is impossible to accurately quantify.  That is a real problem.  

These “derivatives” are pretty evenly divided between Exchange Traded (regulated with rules, settlement protocols, reserves against future liabilities, margin calls, etc.) by various regulatory bodies such as CFTC, Chicago Mercantile Exchange, etc. and non-exchange traded or Over the Counter (OTC).  There is a lot of regulatory and legislative history related to all this.  The OTC market literally has no “real” rules or regulation (except made up on a sort of ad hoc basis by the dealers in these contracts) which unfortunately are primarily the large money center banks and investment banks.  You’ll recall that the original plan by the U.S. in ‘08 was to purchase the “toxic assets” from banks through the TARP program. The idea was: this plan would un-freeze the capital markets and let the economy re-set and move forward–sort of back to normal.  Why did they suddenly change the plan to “recapitalizing” the banks rather than just purchasing the bad assets–as was done many times in past anomalies–such as the savings and loan crisis in the 1980’s? 

This brings us back to the derivatives.  The banks losses or liabilities were magnified by the OTC derivatives (CDS, Interest Rate and Foreign Exchange) in a parabolic fashion– like a particle accelerator in a nuclear reactor.  The correct action at the time would have been to suspend all trading in these OTC contracts (as the Chinese allowed their private corporations to do) as a matter of National Security and then to create a bad bank to liquidate the assets–have treasury or the fed pay the difference which at the time was only around a trillion dollars, and just move on down the road.  This bad bank had been the usual “workable” solution used in past anomalies–not ideal but at least a better solution. 

So instead, we get a “suspended animation” of real economies–hoping that banking capital will increase sufficiently to be able to then take the “losses” into account and then re-set.  Problem is that this is a slow painful process–the fragility of which cannot handle another major anomaly. 

So, simple answer to the question is that: it’s the erosion of banking capital that is at risk–which would have tangential effects on the value of the dollar, such as continued freezing of credit, more bailout, more fiscal deficits, more loss of confidence, geo-political implications, etc.  

As a note, there could be currency manipulation as well, but at this point, the Fed and Treasury would step in to handle that–so I don’t see it as very deleterious to the overall situation. 

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 Stephen R. Ganns has more than 30 years of real estate experience in acquisition, management, restructure/workout and financing.