In spite of spending most of the last week reassuring the public that it would not use its resources to bail out European banks and having decided against engaging on another round of balance sheet expansion, data shows the U.S. Federal Reserve engaged in precisely those two actions that week.
On Tuesday, the top decision-making body of the U.S. Federal Reserve held a monthly meeting in which -- according to a statement released that day -- it ultimately decided against the new round of monetary easing that many market observers had anticipated. On Wednesday, Fed Chairman Ben Bernanke met with Republican lawmakers, telling them behind closed doors that no bailout of Europe was forthcoming.
On Thursday, however, data released by that central banking entity showed that, in spite of public pronouncements and private promises to the contrary, the U.S. central bank tacitly did those very things last week.
A particularly troublesome datapoint further suggests the Fed quietly bailed out a major financial institution midweek, something at least one bank strategist has already surmised.
The Balance Sheet Balloons
According to Federal Reserve statistical release H.4.1, a weekly statement, the Fed's balance sheet grew to $2.946 trillion for the week ended Dec. 14, a jump of $87.2 billion, or 3.05 percent, when compared to the previous week. The weekly upsurge in total assets held was the largest nominal dollar increase since March 2009, when the Federal Reserve was systematically adding to its balance sheet as part of an expansionary monetary policy known as quantitative easing.
The unusual enlargement in assets held came mostly from an increase of $52.03 billion in liquidity swap lines, essentially, dollar-denominated loans offered to foreign central banks, $31.03 billion in mortgage-backed securities and $6.07 billion in "other Federal Reserve assets," a catch-all category for assets denominated in foreign currency.
Even more atypical than the enlargement of the balance sheet, the Fed swung open its primary credit discount window, which had been essentially dormant since the first week of the year, lending $393 million on an average daily basis last week. That amount of lending, at a yearly interest rate of 0.75 percent, was the largest since June 2010. Because of the way the Federal Reserve accounts for discount window lending, the figure could likely mean a financial institution borrowed some $2.35 billion from the emergency loan mechanism sometime last week.
Both the large amount of liquidity swap line lending and the buildup in mortgage-backed security assets were signaled prior to occuring. The Federal Reserve Bank of New York, which engages in open market operations on behalf of the Fed, had previously announced it would ramp up purchasing of mortgage-backed securities by noting "the Desk plans to purchase approximately $30 billion in its operations over the noted monthly period" beginning Dec. 13. However, it is the first time in 18 months the Fed's net holdings for these kind of securities went up.
Dollars Fly to Europe
Taken together, the facts paint the following story: As the Fed was assuring politicians and the public it would not engage in atypical action to aid overseas banks, it lent $52.03 billion to foreign central banks at a rate of 0.59 percent. Foreign central bank then aggressively passed those dollars to commercial banks within their jurisdictions: the European Central Bank, for example, reported Wednesday it made an unusually high amount of dollar loans ($5.12 billion) to European banks in the preceding week.
That explosion in interbank lending meant the U.S. central bank offered up more than 20 times the average weekly amount of dollars that it had been sending foreign governments since the European financial crisis intensified in late August.
The sudden spike in the Fed's discount window lending is perhaps the most out-of-place figure, suggesting a deeply troubled European institution came knocking on the central bank's door hoping to avert bankruptcy. While it is theoretically possible for hundreds of institutions to have taken advantage of the Fed's "no questions asked" lending, the size of the loans and current state of the market suggest it was a European bank. All major U.S. banks are currently exceedingly well-capitalized and profitable, in stark contrast to their European peers, who have seen the amount of capital their Continent-wide regulator is asking them to raise by next summer grow considerably since July.
Requesting funds through the discount window mechanism is widely considered an emergency strategy that can sear the stigma of insolvency on banks that take advantage of it. So widely recognized is the symbolic shame of borrowing from the Fed, U.S. law currently allows the U.S. central bank to withhold information on which financial institutions used the mechanism for two years after the event occurs.
Providing lender of last resort funding to a foreign bank would not be a first for the U.S. central bank. Records released recently to Bloomberg News, which that news organization had to sue the Fed to obtain, show that during the worst of the financial crisis, many of the financial institutions to use the discount window were foreign banks. Even more pointedly, the top four borrowers by loan volume were not U.S. entities.
Besides the lending uptick, the data from the Fed shows the central bank took on over $31.03 billion in mortgage-backed securities, the relatively illiquid assets at the heart of the past decade's financial crisis. The amount of these assets the central bank has suddenly loaded its balance sheet with represents a hike of 3.75 percent over the previous week's holdings, a remarkable break from a pattern whereby the institution had been reducing its cache of these securities since July 2010.
The Markets Notice
The flow of cash from the discount window was noticed by at least one bank analyst, who implied the increase came from lending to a specific bank.
"It is unclear what prompted this pick-up in borrowing from the Fed. There was neither a spike in the fed funds rate nor any disruption in the repo market, so we are a bit puzzled. Of course, under Dodd-Frank, the borrowing bank's name will be released -- after two years," Barclays Capital strategist Joseph Abate wrote on a research note Friday, according to financial blog ZeroHedge.
The fact that a big event involving a Fed transfer likely happened last week was also obvious elsewhere in the markets. After free-falling some 8.15 percent from an intra-day high during the first trading day of the month, the Dow Jones Banks Titans 30 Index, a benchmark index tracking some of the world's largest bank, broke its tailspin decline Thursday. For the last two days of the week, the index was up 0.93 percent to 51.91. This, in spite of the fact that during the relevant period, a top rating agency (Fitch) downgraded some of the safest banks in Europe and some of the largest banks in the world.
The liquidity swap actions by the Fed also reverberated through the markets. Thursday, the short-term euro-dollar swap spread, a foreign exchange derivative that rises in situations where European banks face difficulty obtaining dollars from the direct foreign exchange market, broke its breakneck rise. This suggests European banks were finding it easier to obtain dollar-denominated loans in spite of the elevated rates for interbank lending officially being reported in the Continent.
Not Quiet On The Home Front
Further ripple effects from the Fed action were seen not in the market pits of New York and London but, more subtly, in the vaunted chambers of Washington, as Fed officials seemed to be paving the way for lawmakers to accept its new direction.
While assuaging Congress on Friday it would not bail out Europe directly by buying up its sovereign debt, saying that "the bar to doing that would be extraordinarily high" and that the European debt crisis was "really their problem to solve," Federal Reserve Bank of New York William Dudley stressed the importance of providing the indirect loans to foreign entities through liquidity swaps.
"This is about ensuring the flow of credit to U.S. households and businesses," Dudley told Congress, according to Bloomberg News, adding "it is in the U.S. national interest to make sure that non-US banks that are judged to be sound by their central bank are able to access the U.S. dollar."
Another Fed official who testified during the same hearing, newly-appointed director for international finance Steven Kamin, sold Congress on the safety of those transactions, stating the swaps "present no exchange rate or interest rate risk to the Fed" and noting how the central bank had not suffered losses the last time it backstopped the financial instruments, during the worse of the 2008 financial crisis.
Spokespersons for Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York were unavailable to comment publicly on either the spike in discount window lending or the increase in mortgage-backed securities, respectively.