Over the past few weeks, a troubling trend is reemerging in global credit markets: as the debt crisis across the Atlantic drags on, it is getting more difficult for European banks to borrow dollars. In short, yet another international credit crunch appears to be developing. On the face of it, this may sound like another “European problem”; but the reality is the rising cost of borrowing dollars in the interbank market not only puts U.S. financial institutions at risk, but also the American homeowner. Moreover, it could make China all the more central to global economic recovery. It’s a complicated story, but one worth understanding.
It all starts more than a decade ago when European banks, in search of high profits, grew their holdings of dollar-denominated assets. The total value of those assets grew by more than $20 trillion between the year 2000 and 2007. Of course, because Euro banks don’t have large dollar deposits, they had to borrow dollars from U.S. banks and money market funds in order to invest in said assets. Typically, loans in the interbank market are short-term; ranging from fewer than 30 days to three months before repayment, plus interest, is required. That means European banks must continually “roll-over” these short-term loans in order to continue financing their dollar-denominated investments.
So long as the interbank market is working properly, this works great. Of course, back in 2008, the world learned in a very scary way what happens when credit markets seize. Then, U.S. banks and money markets were fearful of European banks’ exposure to toxic U.S. mortgage backed securities (MBSs). They worried a European bank might collapse just like Lehman Brothers. So, they started charging more for loans and eventually stopped altogether.
Fast-forward to today. The bad debt U.S. financial institutions are concerned about is no longer MBSs, but rather bad sovereign European debt. In Europe, unlike in the United States, the vast majority of public debt is held by domestic banks. That means if a European government is in danger of defaulting, their own commercial banks would face huge losses. So, as markets continue to be fearful about the fiscal health of Greece, Spain, Italy, and other European sovereigns, they are naturally fearful of the health of commercial European banks.
That is why, over the past few weeks, U.S. banks and money market funds have started charging more for loans in dollars as a way to hedge against this increased risk. As a result, the three-month dollar Libor index has risen to its highest level in six-months. What is Libor? It literally stands for “London Interbank Offered Rate” which, when translated, means the average interest rate banks are charging one another to borrow in dollars.
So, how does all this impact the U.S. homeowner? Remember, it’s complicated.
The second half of the story begins in the early 1990s. At that time, it became popular to index a wide variety of financial products to Libor. One such financial product was U.S. adjustable rate mortgages (ARMs). While other indices were also popular—including U.S. Treasury rates—Libor became the index of choice by the 2000s, especially for “hybrid” ARMs—those that start with a fixed rate, but then reset to adjustable. In 2008, 60 percent of “prime” hybrids and essentially all of subprime hybrids were tied to Libor. And, while ARMs declined in popularity after the initial bursting of the American housing bubble, recent reports reveal that more buyers are wading back into the alluring arms of, well, ARMs.
All this means that when Libor rises, U.S. homeowners whose mortgage rates are linked to that index will be met with higher monthly payments. Another troubling aspect is that the Libor rate is largely out of the control of the U.S. monetary authority. It does not matter that the Fed has promised to keep interest rates at zero for two years; Libor’s rise reflects strains in interbank lending. And while a low federal funds rate may ease things a bit, 2008 proved the effect of this is limited when fears reach a fever pitch.
Back then, when Libor was rising at an unprecedented rate, the U.S. mortgage industry became seriously concerned about its impact on already rising delinquencies. An internal Citibank study from the fall of 2008 warned that Libor’s upswing was increasing the monthly financial burden on many homeowners and was threatening to cause defaults to jump by 10 percent.
Currently, Libor is nowhere near 2008 or 2009 levels; still, policymakers should be keeping an eye on its steady rise. If this continues into the fall, it would be concerning both because it would signal worsening concerns about Europe’s debt crisis and because of the potential danger it would pose to the American housing market. This is especially true as more bad news about U.S. housing spills onto the news pages, including recent reports that delinquencies are once again on the rise even as new existing home sales are falling.
So how does all of this impact China? Given that most economists agree that a recovery in housing is a necessary condition for any sustained American recovery, all this is trending in precisely the opposite direction of what the U.S. and global economy needs. The longer U.S. housing struggles, the longer growth rates in the U.S. will hover close to zero keeping tax revenues low and making it more difficult it will be for the country to dig its way out of debt. This would, of course, irk Beijing which has already gone on record saying it wants to see serious deficit reduction out of Washington.
Continued strains in European banks and a sustained U.S. housing downturn would also likely lead the rest of the world to continue looking East toward China for leadership and hopeful economic news. As the advanced economies of the West continue to be mired in financial gloom already three years old, Chinese economic growth will become more and more central the global recovery. If U.S. housing continues to struggle or even worsens, once voracious American consumers will continue to keep their belts tight, generating increased urgency for greater Chinese consumption of foreign goods.
In short, stagnation in the West presents opportunities as well as challenges for a Beijing still adapting to its new, much higher-profile leadership role in the world economy.
If there is a bright side to all of this, it is that the Federal Reserve has already stepped in to provide dollars to European banks who are having trouble getting them in normal credit markets. For instance, the European Central Bank and Swiss Central Bank just borrowed a combined $700 million from the Fed which they can loan out to dollar-hungry banks in their jurisdictions. Measures like this should keep Libor under control; that is, unless something catastrophic—a la Lehman Brothers—happens to a debt-laden European government. In that event, even Fed Chairman “Big Ben” Bernanke will find that his normally mighty influence has become significantly impoverished.
Lest anyone think the European debt crisis is just “their problem”, there are fewer degrees of separation between struggling European governments and the American homeowner than most realize. And, even though the relationship may be a complicated one, it is no less real. Meanwhile, China and the rest of the world will be watching.
Daniel McDowell is a Bankard Fund for Political Economy Pre-Doctoral Fellow at the University of Virginia and has written for Foreign Policy magazine, The Washington Times, and is a regular contributor to World Politics Review.