Reverse Carry Trade Borrowing Proves Deadly 10 comments
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By now, you are familiar with the carry trade, where one borrows in one's own currency in order to invest in higher yielding foreign assets, often times with significant leverage. The Japanese were famous for making this trade in Australian dollars, U.S. dollars, you name it.
What a lot of people don't realize that everyone and his brother was doing the reverse carry trade as well. This is a trade where one borrows abroad in a currency where interest rate are low and then invests that money at home.
Both trades can make one a lot of money, especially using leverage. And indeed, for quite some time, many have made a killing simply by performing this trade. However, both trades carry some risks. The normal carry trade carries currency risk -- i.e. the currency in which you invest your funds falls more than you collect in excess returns before you can repatriate your funds. The reverse carry trade is a problem if your credit comes due and you are unable to rollover this foreign currency debt -- i.e. you essentially default because no one will lend to you in the foreign currency.
Of the two trades I find the reverse currency trade much riskier than the carry trade. Let me give you a few examples why.
First, there's Iceland. This small country of 300,0000 turned itself into a financial services powerhouse, leading to unsustainable spending growth. In order to get there, its banks needed to g abroad to increase their asset base. However, along the way, these companies started to do the reverse carry trade. When Iceland, the country, and its banks ran into difficulties, no one wanted to lend to the Icelandic banks. As a result, result, Kaupthing became the first European issuer to default on Japanese yen denominated bonds.
From Bloomberg ("Iceland Kaupthing Defaults on Samurai Bonds as Yields Hit 450%"): Kaupthing Bank hf today became the first European borrower to default in Japan's samurai bond market after the state-controlled bank missed its last chance to make a 450 million yen ($4.8 million) coupon payment.
Two investors in the Reykjavik-based bank's 50 billion yen in 1.8 percent notes, who declined to be identified, said they hadn't received funds that were originally due on Oct. 20. Kaupthing had a one-week grace period to make its payment, according to the terms of the sale prospectus.
Yields on the bonds have risen as high as 45,000 basis points over the one-year yen swap rate to nearly 451 percent as investors hurried to unload the securities in recent days.
A basis point is 0.01 percentage point.
Then, there are the stories behind the Fed's need to extend swap lines to every Tom, Dick, and Harry central bank around the world. You were probably wondering where all the money Alan Greenspan printed went. Well, some of it went to our own mortgage bubble in the good ol' U.S. A. But, some of it also went to foreign banks that proceeded to finance their own speculative binges abroad. Houston, we have a problem -- these banks can't roll over their dollar-denominated. The credit markets have come unstuck and everyone is in a panic. What to do?
Enter the Fed. Basically, the Fed is acting as a global lender of last resort by offering virtually unlimited dollars to the ECB, the Swiss central bank, the BoE, the South Korean central bank, as well as the Mexican and Brazilian central banks. Needles to say, this is not good for the U.S. dollar's value over the long-term. But, who else is going to step in here?
All of these central banks need the money for their domestic financial institutions. So rather than leave these banks at the mercy of the global credit markets, Ben Bernanke and company have stepped in and given the money to the local central banks who then help these companies by loaning them the dollars to roll over their debt or by helping them get out of dollars and into their own currency. Again, swapping out of dollars means less demand for the Greenback and a lower U.S. dollar.
Finally, there's this little story I caught at Bloomberg Friday ("`Panic' Strikes East Europe Borrowers as Banks Cut Franc Loans"): Imre Apostagi says the hospital upgrade he's overseeing has stalled because his employer in Budapest can't get a foreign-currency loan.
The company borrows in foreign currencies to avoid domestic interest rates as much as double those linked to dollars, euros and Swiss francs. Now banks are curtailing the loans as investors pull money out of eastern Europe's developing markets and local currencies plunge.
"There's no money out there,'' said Apostagi, a project manager who asked that the medical-equipment seller he works for not be identified to avoid alarming international backers. ``We won't collapse, but everything's slowing to a crawl. The whole world is scared and everyone's going a bit mad.''
Foreign-denominated loans helped fuel eastern European economies including Poland, Romania and Ukraine, funding home purchases and entrepreneurship after the region emerged from communism. The elimination of such lending is magnifying the global credit crunch and threatening to stall the expansion of some of Europe's fastest-growing economies.
``What has been a factor of strength in recent years has now become a social weakness,'' said Tom Fallon, emerging-markets head in Paris at La Francaise des Placements, which manages $11 billion.
It makes you want to cry -- this is a hospital for Pete's sake. And they are getting caught up in this global currency and credit crisis. But, that's the carry trade for you.
From where I am sitting, a lot of the recent turmoil in emerging markets is a direct result of the reverse currency trade -- borrowing at low rates in foreign currency in order to invest at home. Argentina, Brazil and half of Asia blew up less than 10 years ago for just these reasons.
When will they learn? Do people have that short a memory.
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- The carry trade unwinds and it's not pretty
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This article has 10 comments:
In a world that has enjoyed interest rates of much less than 5% for most of the past decade, most businesses are marginal. It's very easy to load up on debt that costs nothing and eke out a modest ROE, no matter how bad the business model or how poor the management. Now that money is being repriced toward reasonable levels those businesses will have to do one of: increase prices for their products, cut costs, improve their products, positioning, or model, accept a much lower return on equity, or fail. Most of them are beyond salvaging and need to fail.
This is why cheap money is the worst possible curse than can be placed on an economy. It is far better to let the market set rates and use sound money that does not distort the market by losing some large but arbitrary and hard to guess part of its value every year. As an example of this, I would be happy to lend gold to highly creditworthy companies at 12% for 10 years. But there are few such creditworthy companies and none willing to pay 12% on money that will not depreciate. They can't; it would eliminate all profits. So the deleveraging continues...
It's the pride where instead their should only be confidence.
It is the merely the process of comparing oneself to another that causes the demon inside.
On Nov 02 03:31 PM OctoberFaith wrote:
> Its not the dollar or the oil that causes the problem.
>
> It's the pride where instead their should only be confidence. <br/>
>
> It is the merely the process of comparing oneself to another that
> causes the demon inside.
"The problem is that borrowers are either out of capacity to borrow or unwilling to offer a fair rate. In both cases, that is a sign not of malfunctioning credit markets but of a marginal business..."
Then why the dramatic spike in LIBOR rates? Why the huge increase in TED?
"In a world that has enjoyed interest rates of much less than 5% for most of the past decade, most businesses are marginal."
It might surprise you to learn that between 1930 and 1965, the prime rate was NEVER as high as 5%.
"This is why cheap money is the worst possible curse than can be placed on an economy. It is far better to let the market set rates and use sound money that does not distort the market by losing some large but arbitrary and hard to guess part of its value every year."
Psst. Hey buddy - the market does set rates. Bank lending rates are determined by a free, highly competitive market. And by the way - the cheap money that you bemoan? It wasn't inflationary.
"As an example of this, I would be happy to lend gold to highly creditworthy companies at 12% for 10 years. But there are few such creditworthy companies and none willing to pay 12% on money that will not depreciate."
First off, won't depreciate? Gold's down against the dollar 16% over the last five weeks. Second, why would a "highly creditworthy" company (whatever that means) borrow from you if your rate isn't competitive?
"They can't; it would eliminate all profits. So the deleveraging continues..."
You're missing a link here. At 12%, nobody borrows and nobody lends, and nobody makes any money. As risk tolerances normalize, rates come down, borrowing makes more economic sense, and a new equilibrium is reached. And if you continue to demand 12%, you will continue to hold an asset earning no interest.
central banks, banks and other bond holders from Brazil to Korea, including Singapore.
In Europe the governments are rescuing the money of deposits in failed banks, with large injections of equity into their financial systems. To finance these rescues, the governments are selling bonds to their local central banks that are under the control of the European Central Bank, which creates money to buy those bonds, so large deficits are being built. As the credit intermediation activity is paralyzed by the lack of trust between the banks, the increase in the ECB monetary base by the new debt emissions has not been inflationary (and gold prices noted that).
The most competitive financial systems of Germany, France, Netherlands, Belgium, probably will start to create credit soon as the
rates are returning to normal, maybe this week. Less competitive and “highly leveraged” consumers and construction firms
in Spain, Portugal, Greece will need to be refinanced.
The EU common monetary policy will face a hard option soon: to print more euros to buy all the EU bonds (inflation) or to establish
some discipline (deep recessions for some members and shallow recessions for others ). An unavoidable decision for the ECB that
probably will be taken in the next days. If the criteria is to minimize the European inflation I don’t see any option but a mayor adjustment
in the member countries with more risky government bonds.
At the end of the day, the FED transformed a monetary problem in a fiscal restriction, and the same can be in the US, any public spending initiative will be hardly funded, not a good time for love promises.
have a nice day...