By Steven K. Beckner

(MNI) – Unless the European debt crisis and related inter-bank
dollar funding pressures become far worse, it is unlikely the Federal
Reserve will reduce the interest rate it charges on dollar loans to the
European Central Bank under recently renewed reciprocal currency swap
agreements.

The rate terms of the new swaps are no more onerous than those
which prevailed during the depth of the global financial crisis, and so
it would seem to make little sense to make them easier now.

What’s more, the Fed could open itself to further political and
public criticism if it were to make the dollar funding available at
cheaper rates. As it is, the Fed is being viewed, unfairly, in some
quarters as “bailing out” Europe by helping to ease dollar funding
pressures on banks that hold the suspect debt of Greece and other
nations.

Under the U.S. dollar-Euro swap agreement dated May 10, the ECB is
committed to paying the New York Federal Reserve Bank interest at 100
basis points above the overnight indexed swap (OIS) rate, a measure of
average expected overnight rates.

The agreement states: “Interest payable by the ECB on proceeds of
any Swap Transaction (“the Interest Rate”) shall be no less than the
applicable Overnight USD Indexed Swap Rate (OIS) (rounded to 4 digits
after the decimal point) plus a 100 basis point spread. Interest shall
be calculated on a 360-day basis from, and including, the Value Date
to, but excluding, the Maturity Date. On the Maturity Date, such
interest shall be paid by the ECB to FRBNYH in USD (based on the
Exchange Rate applicable to the Swap Transaction), and FRBNY will debit
the ECB Account with said interest amount.”

Under the swap arrangements that expired in February, the
understanding was that the ECB and other foreign central banks would pay
the Fed “an amount of interest on the dollars borrowed that was equal to
the amount the central bank earned on its dollar lending operations,”
according to a report written by New York Fed economists Michael Fleming
and Nicholas Klagge.

At least in the first phase of the swaps from the program’s
inception in December 2007 to the time of the Lehman Brothers collapse
in September 2008, ECB loan rates were tied to the rates at which U.S.
banks were borrowing from the now-defunct Term Auction Facility.

Typically, write Fleming and Klagge, the ECB “executed one-month,
and later three-month, fixed-rate tenders at the ‘stop-out rates,’ or
lowest rates at which bids were accepted, for the most recent TAF
auctions.”

But in terms of the interest rate the Fed earns on dollar swaps,
there is essentially no difference between the current swap rates and
the older ones. Fed spokeswoman Michelle Smith told MNI, “The terms,
structure, and operational mechanics of these swap arrangements closely
parallel the arrangements that expired on February 1, 2010.”

As the financial crisis deepened following the Lehman bankruptcy,
swaps outstanding soared to a peak of $580 billion, helping to swell the
Fed’s balance sheet.

And during this crisis period the interest rate which the Fed
charged on dollar loans to the ECB and other central banks was no lower
than 100 basis points. Not even when the spread between the London
Interbank Offering Rate (LIBOR) and OIS widened to an unheard of 4.8%,
did the Fed lower its own swap lending rate.

Recently, in response to the Greek debt crisis, LIBOR has risen but
comparatively far less — to 0.54% Wednesday.

If the Fed was unwilling to narrow the swap lending rate in the
depths of the mortgage crisis, it seems unlikely to do so now.

That could change if the European debt crisis deteriorates further
and has more far-reaching spillover effects on the U.S. and global
economies, but it does not seem to be in the cards now.

Regardless of the interest rate on Fed swap loans, it is important
to understand that it is up to the ECB, not the Fed, to determine the
rate at which foreign banks can borrow from the ECB. The Fed is lending
to the ECB, not to the banks themselvles.

** Market News International **

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