Hold Your Schadenfreude

Although the crisis in the international credit markets today is not yet as severe as it was in 2007 and 2008, there are mounting signs that Europe’s debt troubles are producing another global credit crunch. A top U.S. Federal Reserve official has already felt compelled to warn of dangers facing the American economy, and President Obama has said that he’s monitoring the situation closely.

But what, exactly, does Europe’s mess have to do with U.S. credit markets? Understanding that link is ultimately going to be the key to deciding what to do about it.

The root of the problem is the fact that Europe’s banks desperately need American dollars. It’s a dependency that traces back to the early 2000s, when, in the pursuit of big profits, European banks threw caution to the winds in greatly increasing their holdings of dollar-denominated assets. The total value of those investments went from $10 trillion in 2000 to $34 trillion by the end of 2007.

But those assets could only be purchased through borrowing: While American banks can fund dollar-asset purchases using bank account deposits from ordinary Americans, European banks have most of their deposits in euros or other domestic currency. So they need to find greenbacks from external sources to fill this "dollar funding gap" and fuel their dollar-denominated investments.

There are several places foreign banks go to borrow dollars, but among the primary providers of dollar funding are U.S. money-market funds, those "safe-as-savings-account" investments where millions of Americans have stashed their hard-earned cash. Prior to the subprime crisis that began three years back, money markets had lent roughly $1 trillion to European banks.

Money-market funds typically offer very short-term loans to borrowers, expecting their money back (plus interest) in 30 days or less. That might have posed a problem for European banks, since they were mostly dealing in medium- to long-term dollar assets, but the Europeans got accustomed to simply "rolling over" their loans. Essentially, they borrowed to make the initial investment — and then borrowed more to pay off the first debt when it came due, doing the same for each successive debt thereafter. Once the original investment matured, or so the theory went, the bank would cash out, pay off its last dollar debt to the money-market fund or whomever, and do with its profit what it wished.

European banks have spent the past two years reducing their stock of dollar-denominated investments, but they’re still holding huge dollar assets that haven’t yet matured. That’s why they still rely on rolling over short-term dollar loans.

So long as credit markets are functioning normally, the "roll over" strategy is a great plan. But, if money-market funds and other dollar-funding sources become unwilling to lend, then European banks have bills due that they can’t pay. That is precisely where the global financial system found itself three years ago and, unfortunately, it’s where it appears to be heading today.

Beginning in the summer of 2007 and peaking in the fall of 2008, money-market funds became reluctant and then unwilling to lend to banks because they didn’t know which ones might collapse under subprime losses. Today, their reluctance has nothing to do with bad mortgages, but rather a general belief that the $1 trillion European bailout package announced on May 9 will not solve the problem of bank exposure to government debt markets. But the basic logic is the same: European banks have invested heavily in toxic assets that one day may not be worth the paper they are written on. The money-market folks understandably fear they may never get their dollars back if they lend to one of these exposed banks.

This renewed sense of risk has led to a feeling of déjà vu for money-market funds over the past several weeks. The amount of dollars the funds are lending has fallen to levels not seen in more than a decade. And, when they are willing to lend, they want their money back much sooner than normal. These developments are making dollar funding harder and harder to come by, particularly for European banks.

But why should the U.S. care if European banks can’t get dollars? Isn’t that just a European problem? Not really.

Despite efforts to reduce their exposure to Europe’s debt problems, U.S. money-market funds are still owed hundreds of billions of dollars from banks across the Atlantic. All it would take is one bank default to throw the entire U.S. money market system into panic. Sound far-fetched? It’s not.

A very similar scenario played out less than two years ago. During the week of September 15, 2008, Lehman Brothers infamously collapsed. At that time, Lehman owed $785 million to the Reserve Primary Fund, one of the oldest and largest money-market funds in the world. The Reserve Fund, now sitting on a massive loss, suffered the unthinkable: it "broke the buck", meaning the value of a share fell below 1 dollar to 97 cents.

Millions of average investors panicked, facing losses on investments believed to be as safe as a savings account and withdrawing $300 million from the U.S. money-market system. Even worse, other funds were so spooked they stopped lending dollars to banks altogether, both domestic and foreign, depriving the global economy of a vital source of credit. For a moment, the whole system appeared to be on the edge of disaster, until the U.S. Treasury and Federal Reserve stepped in to save the day through a barrage of emergency policies that guaranteed investments and increased global dollar liquidity.

So what are the chances of a Lehman-style collapse in Europe today? No one knows exactly, but global credit market skittishness is indicative of a belief that such an event is definitely possible. If Greece (or another heavily debt-ridden European country, such as Spain) defaults on its debt, money-market lending could seize up entirely — when European banks came back to the funds to try and roll over their loans, they would be rebuffed. Without access to dollar-funding markets, these banks wouldn’t be able to pay back what they owe when it came due. And, as the Lehman case showed, if one money-market fund absorbs a massive loss from a defaulting European bank, investors in all such funds will run for the exits, threatening to bring down the whole system.

That’s the bad news. But there’s also some good news. The Fed has already taken some steps to make sure the scenario portrayed above doesn’t occur. How? By doing the same thing it did back in 2007 and 2008, when the global credit system faced the same problem: It opened "currency swaps," or swap lines, with major foreign central banks three weeks ago.

The swap lines essentially provide dollars directly to foreign central banks, who can then deliver the currency to domestic banks that are having difficulty acquiring dollars from fearful market participants, like money-market funds. In essence, the Fed is indirectly providing credit to European banks to protect U.S. money-market funds and banks that are owed money from beleaguered European financial institutions. Recent research suggests that the swap program was quite effective at reducing strains in credit markets the last time around, so there is reason for optimism.

So far, the swap lines have seen nowhere near the use they did at the height of the subprime crisis, which is also encouraging. Nonetheless, most analysts expect the situation in dollar-funding markets to get worse over the coming weeks, so their popularity may rise. If strains in credit markets spread outside of Europe, the Fed may expand the program to other economies facing difficulty.

It appears indeed that history might just repeat itself, as the saying goes. And while the prospect of facing Global Credit Crunch 2.0 only a year after the last version is no doubt an unpalatable scenario, at least we’ll know what we’re getting into.