Stock markets soared on Wednesday after coordinated announcements from the Federal Reserve, European Central Bank and four other government central banks about "temporary U.S. dollar liquidity swap arrangements."
Here's a primer to what the swaps are and why the step was so important:
Q. Why did the central banks act?
A. The banks said it was "to ease strains in the financial markets" that threaten access to loans for individuals and companies. Outside experts offered more urgent descriptions, ranging from stemming a run on European banks by their money market lenders, to bolstering the markets in case of a collapse of the euro, to, possibly, heading off damage from an imminent failure of a major bank.
"They're basically responding to the looming failure of the European Summit on December 9," said Cornelius Hurley, director of Boston University's Morin Center for Banking and Financial Law and former assistant general counsel at the Federal Reserve. "They're putting foam on the runway."
More immediately, the signal is that they are ready to provide dollars European banks need. "It is the moral equivalent of breaking an incipient bank run," said Paul McCulley, a former Pacific Investment Management Co executive.
This run, slightly different from individual depositors rushing to get their money back, has been building in the form of U.S. money market funds and U.S. banks taking back short-term loans of dollars to European banks. The dollar lenders have retreated out of fear that some banks could be insolvent because they own too much bad debt from countries including Greece, Italy, Portugal and Spain.
To repay the dollars they owe, the European banks could be forced to sell, or call in for repayment, loans they have made in dollars to businesses, including companies in the United States.
"It could lead to fire sales of assets, which would have further spiraling effects on other firms in the economy," said Viral Acharya, a professor at New York University's Stern School of Business. "This is an aggressive move to meet the dollar shortages of the European banks," he said. "It is a signal that the situation is getting pretty tight for the banks."
Q. What did the central banks actually do?
A. They made it easier and less costly for banks to get U.S. dollars. The central banks already had in place agreements -- going back to December 2007 and emergency actions they took in the early days of the global financial crisis -- to swap local currencies with the Federal Reserve for dollars for, typically, up to three months. On Wednesday, they reduced the charge for doing that and extended the size and timing of the swap lines.
The lower price should encourage European commercial banks to go to the European Central Bank to borrow, through repurchase trades, the dollars that came from the swaps. The ECB also announced that it was reducing the amount of margin the banks have to post on those deals.
The steps are "designed to both remove the stigma and costs associated with the use of cross border swap lines," according to a report from bank analysts at Keefe, Bruyette & Woods.
Q. Did you say the central banks have done this before?
A. Yes, and how. In December 2007, the swap arrangements were put in place as financial markets worldwide were cracking from a chain of defaults starting with U.S. subprime home mortgages and extending to short-term money market instruments and held around the world.
Demand began to build a few months later and then, as Lehman Brothers and other banks collapsed and funding markets froze up, soared to $583 billion in December 2008. Use of the swaps then trailed off in 2009 as banks raised new capital and the situation steadied. Only $2 billion of the swaps were outstanding as of November 23, according to Federal Reserve data.
"It started to smell like 2007 again. That's the easiest way for me to describe it," said Peter Vinella, a director at consultancy Berkeley Research Group who previously held senior trading and management roles on Wall Street. "They're trying to do things to keep banks liquid enough so there's not a big failure."
Q. Will this solve the European financial crisis?
A. No, though it buys time in which lasting solutions might be put in place. Providing liquidity is "no substitute for other actions that Europe must take to solve its current woes," Anthony Crescenzi, a strategist and portfolio manager at Pacific Investment Management Co said in an email.
European banks still need to be convincingly solvent, said Acharya of New York University. To do that, they need new capital and dependable values for the loans they have made to problem areas of Europe.
Shoring up the loans will likely require new promises from European governments. "If buying time is important to get recapitalization and a political solution in Europe, this is probably a useful tool," said Acharya.
(Reporting by David Henry, Jennifer Ablan, Lauren Tara LaCapra and Matthew Goldstein in New York; editing by Edward Tobin and Chizu Nomiyama)