Wednesday, November 30, 2011

Liquidity Swaps: Why and Wherefore

David Henry, Jennifer Ablan and Lauren Tara LaCapra explain.

A week or two ago a friend had a moment of panic. He had some money temporarily parked in a money market fund. Would that cash turn trash when the Euro folded? His broker explained that his balance was small enough to be covered by the Federal Deposit Insurance Corp, and hence effectively backed by the US government. People and corporations with more than $200k need to be more concerned though. Money markets had put quite a bit of cash into Euro bonds, or European banks and at least some of that was at risk.

Consequently, those money market funds have been struggling to unload their European assets, and this has produced a (so-far) low intensity run on European banks as everybody grabs for dollars. That's the reason for the swap deals announced today, and the Reuter's article linked above has helful details and explanations.

One short excerpt:

"They're basically responding to the looming failure of the European Summit on December 9," said Cornelius Hurley, director of Boston University's Morin Center for Banking and Financial Law and former assistant general counsel at the Federal Reserve. "They're putting foam on the runway."

More immediately, the signal is that they are ready to provide dollars European banks need. "It is the moral equivalent of breaking an incipient bank run," said Paul McCulley, a former Pacific Investment Management Co executive.

So why would the Dow think that basically bad news was worth 500 points? My uninformed and speculative guess: my friend's first thought at his money market panic was to put the cash into stocks. The swaps deals say that the cash to make those purposes will be there.