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Dollar, swaps, and European Banking

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  • Dollar, swaps, and European Banking

    I know most people don't remember this but just to refresh your memory.

    The Federal Reserve's Covert Bailout of Europe | Cato Institute
    Former Fed VP Accuses Bernanke Of Bailing Out Europe Via Currency Swaps | Zero Hedge

    Most euro banks are insolvent but they still generate some cash. My guess is that those hundreds of billions of dollars that were lent by the FED were simply transitioned from direct foreign central banks to the subsidiaries of Euro banks in the US, ergo they simply make money arbitraging ECB rates in Europe via USA. Ergo lets say Santander would have gotten a loan from the ECB it then would turn around and recycle that money into its' subsidiary in the US, lent it back to the FED and US bonds getting higher rates and pledged those bonds to get capital back to repay the ECB which repaid the FED except the surplus interest rate differential was ill gotten by the foreign bank at no risk at all.

    Now my guess is all of them think they are pretty clever. Earning interest on imaginary funds recycled through the FED and ECB, there is only a few problems.

    If those funds simply generate imaginary cash flow that never enters the economy to make up holes in your balance sheet which are ever widening, did you really fix the problem? Theoretically all you did is simply create a few entries in the electronic balance sheet which add a zero here or there and carry a one periodically. It did not solve the major problem, the deflationary effect of capital being destroyed (when it was lent years ago). So on paper all is wonderful, but in real life there is simply no velocity, or action by the public or the economy at large. Its' like dressing up a zombie and then saying "see all cured".

    The implications are interesting.

    If they are using dollar cash flows to shore up euro capital (via conversion) they are inflating our money supply but actually decreasing their own. This would explain why the Euro keeps strengthening.

    Imagine you are a big bank and you know all this. It makes it very enticing to actually borrow through a swap in Dollars to repay them later as the Euro strengthens. Now you have customers whom may need swaps as well and you earn money there as well. But what happens when there is a dislocation and the arbitrage in the dollar market stops paying. Unwinding all of this becomes not just painful but severely destructive.

    All this is kind of a self-fulfilling prophecy. IF US rates go to 3%+ while EU remains in the crapper the dollar would have to strengthen severely by implication. Yet all those banks are positioned on the other side of the tide.
    They would have lent at the lower ebb of the rate increases so present value of their bonds would be at a loss even though they would be cash flow positive while their dollar liabilities would increase as the dollar strengthens. But you aren't just locked into the transaction you are actively seeking to profit from the flows by stabilizing flows for others. So in some sense the Euro banks are seeking to have continuous intervention in a currency which they do not control, the only way they could is by liquidating those assets they hold to increase money and yet velocity is going down and rates are rising. So its' a loosing proposition.

    Once we have one or more asset unwindings in Europe this whole point becomes somewhat moot because those dollar assets would go up pretty high relative to imploding Euro. But all of this is just numerical imaginary numbers. It is almost like a self-preservation of purchasing power by Euro banks really. Their failing is that none of those falling U.S. "assets" would be available because the banking system won't allow capital transition from an institution below certain levels. So they would still have 'rich' subsidiaries but insolvent holding companies in their respective countries, and my guess in the end the first company to liquidate their subsidiary makes more money on regaining lending in Europe because their capacity to lend will be constrained.

    Anyway I know none of this is interesting but there are lots of implications.
    For one if inflation increases due to this after a short amount of time the wins on arbitrage these banks have will be overshadowed in loss on purchasing power even if they win on Euro/Dollar conversion. Second they won't have flexibility in actually lending on present value creating assets because the mass of their balance sheet will be deployed in "safe" government or backed securities creating very meager arbitrage percentages. Third it helps eliminate the banking system as a financing source for many companies because they will have to get an alternative venue for their growth.
    Originally from Sochi, Russia.