ECB dollar swap lines: solidarity and precaution

The illuminated euro sign is seen between the European Central Bank's (ECB) headquarter (R) and the sky scrapers of main business banks Commerzbank (2nd R) and Dresdner Bank (L and C) in Frankfurt, November 28, 2005.

LONDON (Reuters) - European central banks' decision to rejoin the U.S. Federal Reserve in its latest financial system fix on Tuesday was a show of solidarity in crisis management but also an acknowledgement of several more months of pressure.

Precaution rather than reaction was likely to have been the reason behind reopening dollar taps into Europe, analysts said.

As the Fed detailed its second $200 billion market stabilization plan in a week on Tuesday, the European Central Bank and Swiss National Bank said they would this month auction up to $21 billion of one-month dollar funds for domestic banks.

A reprise of the dollar swap lines set up between the Fed and ECB and SNB in December, the move marked a reversal of the ECB's decision on Feb 1 to close the December swap windows as money markets calmed over yearend and through January.

Yet while the December foray was clearly prompted by an extreme shortage of dollar funding in Europe, bankers said there was no obvious signal of a equivalent squeeze this month.

Most reckon reopening the so-called Term Auction Facilities into Europe was more likely intended to signal common concern about wider credit market malfunctioning -- which also engulfed non-German euro zone government bond markets among others this month -- than addressing a new dollar funding shortage per se.

"They clearly want to instill some confidence that all the world's central banks are aware of the problem and making a concerted effort," said Pavan Wadhwa, interest rate strategist at JP Morgan in London, adding that more policymaker solidarity will be needed as the crisis intensifies.

The move, likely discussed by top central bankers meeting in Basel at the weekend, does not necessarily mean the dollars will be drawn down. The Fed opened $90 billion of similar swap lines with foreign central banks after the September 11, 2001 attacks on the United States but only $20 billion was taken up.

With the epicenter of the crisis elsewhere, this sort of action is aimed at increasing options if things get worse.

"The big problem of bank balance sheets still remains," said Wadhwa. "This might solve some liquidity problems in the short run but broker/dealers are not going to resume lending to hedge fund clients just because they are getting cheaper money from the Fed. Hedge fund deleveraging is the real problem right now."

The latest and third big wave of the seven-month old credit crisis emerged last month as cash-strapped banks and brokers, suffering multi-billion dollar hits to the balance sheets, started to cut back lending to hedge fund clients as they sought to protect capital ratios for end-quarter accounting.

U.S. broker/dealers' first quarter ended in February while U.S. and European banks' first-quarter reporting extends to March 31. Japan's financial year also ends this month.

And the first quarter is not expected to be pretty for banks. On Monday, Citigroup (C.N) forecast another $9 billion of writedowns at U.S. investment banks alone.

The Fed's latest package helps by giving U.S. banks low risk Treasuries instead of heavily marked down mortgage securities over that accounting period -- a move some say amounts to an injection of capital to the banks. Either way it gives banks a period of high-quality collateral with which to raise cash.

But what of European banks?

DECEMBER REPRISE

The European Central Bank has been prompt in providing hundreds of billions of euro funding for euro zone banks and brokers since August, but demand for U.S. dollars in Europe has been intense at various stages of the crisis.

European banks who bought U.S. dollar mortgage debt typically funded those holdings with short-term dollar loans, loans that need to be continually rolled over until the assets they financed are either sold or mature.

More specifically, European banks were heavily exposed to affiliated structured investment vehicles that used these assets for funding on commercial paper markets -- which then shut them out over doubts about the value of some of those mortgages.

The banks were forced to take the SIVs back on their balance sheets, but still have to raise dollars to keep funding those assets for the remainder of the estimated 18-24 months of average maturities.

The most recent Bank for International Settlements report, for example, showed net borrowing by European banks from other banks, including uncollateralized loans and repos, soared to $800 billion in September 2007 from near zero in 1997.

At the same time, German banks' U.S. dollar net claims on non-banks grew from $50 billion in 2000 to $463 billion in 2007.

The BIS report said this sort of exposure and need for such frequent rollovers of short-term funding in stressed markets contributed to the problems in dollar interbank markets in Europe last year and the establishment of the TAFs in December.

DIFFERENT NOW?

Back then, that scramble for dollars in Europe sent premia on U.S. dollar London interbank offered rates over Fed funding rates and currency swap rates for dollars soaring in December. But the same pressure was not as obvious in recent weeks.

The premium on three-month dollar Libor over expected official Fed rates, while still wide at about 60 basis points, is almost half December levels prior to the first TAF swaps.

Reopening dollar swap lines now into the quarter end may well be simply an admission by the ECB and others that the crisis is far from over and they need to be prepared.

"What the European central banks were trying to signal last month was some return of normality -- but it looks to have been very premature," said Nick Parsons, chief market strategist at nabCapital, stressing coordinating action was a positive move.

(Reporting by Mike Dolan)