The Great Recession: The Carry Trade and Asset Bubbles

The classic method of the Fed using monetary policy to stimulate the economy via bank loans that in turn fund spending by consumers and businesses is clearly not working at all.  However, there are new channels of monetary policy that are opening that do have positive effects on spending but do so via the public capital markets rather than commercial banks.

The Repo market is very short term mostly overnight lending that is over collateralized by purchased assets.  The procedure is that at the time the loan is made and the collateral is purchased by the borrower both borrower and lender also agrees to unwind the deal the following day.  The lender of the security hence repurchases the security it sold the previous day.  Hence the risk for the lender is the security as collateral for the loan will take a “Black Swan” dive the next day and the sale proceeds will be insufficient to cover the loan.   The lender hence takes the overnight Black Swan risk and the risk that the borrower will have insufficient capital to cover the Black Swan losses. This is much the story of the creation of highly leveraged assets bubbles in 2006-2007 when institutions including regulated Investment banks were found to have leverage well in excess of what is implied by regulatory capital limits.  Often the leverage was 50 to 1 not the 33 to 1 as implied by a 3% minimum capital ratio. It is also the story of the immediate collapse of the Investment banks and hedge funds when the Black Swan event of the precipitous fall in the price of Residential Mortgage Back Securities occurred and wiped out borrower capital. This transaction is also dubbed the Carry Trade.

In 2009 after the great Investment Bank meltdown of late 2008 security prices came roaring back though the economy had not made significant headway.  In fact many observers believed the financial collapse would carry the economy into Great Depression II.  Yet security prices turned on a dime with first the fixed income market recovering and a few months later the equity markets.

The anatomy of that recovery made logical sense despite the depression potential if one understood the mechanism of the Carry Trade.   As lenders to the carry trade there were conservative institutional investors (pension funds, endowments or insurance companies) who in these risky times preferred an over collateralized very short term loan as an asset class in lieu of holding short term Treasuries or investment grade debt which in a near zero short Treasury yielding market provided virtually no investment income for the institution.  From the borrowers perspective the trade made sense in that the fixed income securities purchased typically had yields of 10 to 20 percent which were funded by loans with a perhaps 25 basis point cost of capital.  Not only were the borrower spreads large but the borrower could leverage up its own capital many times.
If the conservative lender senses economic or financial market problems ahead it seeks to protect itself from that risk by requiring additional collateral being pledged in order to renew the loans the next day.  The capital required by the risk taking entity to over collateralize the loan is called the Repo “haircut.”  That is if there is 10 percent excess collateral to the loan amount meaning total collateral of 110 for a loan of 100, the haircut is 10/110th or approximately 9%.  In this case the borrower own capital supplies about 9% of the total asset purchase.

In an alternative Carry Trade arrangement, the conservative institution might hold a market traded asset that it is not proud of in a risk environment.  The institution might wish to sell the asset but doesn’t care to take a loss and a write off of its capital base if the asset declined in value during its holding period as occurred in 2008.  In this case the institutions asset is sold on an over-night basis by signing a repurchase agreement that the asset will be repurchased the next day. The institution also provides owner financing of the purchase of the asset and the buyer put up some of its own capital which is the Repo haircut hence putting the buyer in the first loss position.  From the selling institution’s point of view, the objectionable asset is off the books of the institution (at least overnight and the agreements are typically renewed daily) safe from the eyes of prying regulators or others performing oversight, and from the risk perspective of the institution, the buyers capital acts as financial insurance as the buyer is in the first loss position if the asset falls in value overnight.  Furthermore since an agreement to repurchase the asset has taken place the accounting write off from the overnight sale is treated less stringently than a straight sale.
In this way, the Repo market provided a market for objectionable risky assets in 2009.  From the perspective of the buyer, the depressed asset offering an exceedingly high yield spread relative to the borrowed funds with an ability to leverage their own capital perhaps 50 times.  On their own capital this could be in excess of 100 percent returns if the asset had reached a depressed but stabilized value and yet more total return if there was sufficient Repo activity to cause the market prices to rise in value.  This is the story of what drove financial markets in 2009.

Starting from the most depressed fixed income levels at the post Lehman times in November 2008, the Carry Trade provided the purchasing power for the borrower with enormous spreads and risk protection for the conservative lenders.  Indeed the volume of Carry Trade activity was estimated by Roubini of NYU to be in excess of $800 billion in 2009.
Not only did the Carry Trade again pump up prices in the US financial markets but much of it also went abroad to the Emerging Market Countries (EMCs) to create even greater returns there.  Indeed, the volume was sufficient to move exchange rates and the EMCs found the capital inflow raised their currency values to uncomfortable heights to interfere with their sought after trade surplus.   Some of these countries intervened in the currency market such as China and others and Brazil instituted a tax on foreign capital inflows to limit the process.  While these countries welcomed the capital inflow, they did not welcome the adverse terms of trade that it caused.

Thus the Carry Trade provided leverage for risk takers and drove financial markets and some say to bubble levels for both fixed income and equities in 2009 from the depressed levels of the post Lehman bust.  It also raised some interesting and important questions because the Carry Trade which is an overnight evacuation of risk caused prices in financial markets to deviate from valuations based on underlying cash flow fundamentals.  Hence, there is a new force in the market that does not rely on the cash flows of the business plan of the fixed income issuer but rather on the risk that the market price of the leveraged assets falls OVERNIGHT.  This is an entirely different risk perspective.  Indeed, it explains much of the market rebound of the last year despite the fundaments of the economy not improving near as much as the financial prices.
Hence the Carry Trade now has a prominent place in driving financial markets and institutions. The overnight Repo loans market allowed hedge funds and Investment banks to accumulate extreme leverage positions and drove financial prices to asset bubble proportions that set the markets to fall in 2008 and the institutions holding the assets to become instantaneously insolvent.

Aside from this fundamental leveraging source and asset bubble prices and financial fallout when pushed to its ultimate level, the Carry Trade does seem to have some redeeming values.  It allows the financial liquidity in the system to be utilized more fully (increase in the velocity of money) and has the other virtue of providing funding to lien of a stagnant bank loan market.  Indeed, the US corporations refinanced much of its balance sheet in 2009 on public capital markets on more favorable terms than it faced going into the Great Recession.  The Repo market allowed firms to not only lengthen maturities at lower rates but also provided some equity to reduce leverage.

Hence, the corporate sector that can reach the public debt market is not an upside down victim of the financial collapse of the Great Recession. In fact, to the extent the Repo market provides funding to firms that reach public capital markets, it has generated real investment in plant and equipment mainly of the sorts that is used to increase firm efficiency.  Hence, the financial resources flowing through the Repo market is an alternative to the moribund commercial banks and is helping to revive the US economy.

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