Friday, October 24, 2008

The Debts of the Lenders: The End of the Carry Trade Part 2

The West is not to blame for the second stage of the credit crisis. No, instead it is the Bank of Japan.

If I gave you a credit card w/ .5% interest on it and guaranteed that rate for 12-14 years...what would you do? I think you know the answer already.

Now instead of being a credit card company, replace the issuer with the Bank of Japan. Japan has had low interest rates for a long time now. These low rates were the result of repeated "fiscal stimulus" attempts to re-invigorate a moribund economy. However, the interest rate cuts did not have the desired effects and instead turned Japan's banking system into a series of zombie banks kept artificially alive through government largess.

Hedge funds took advantage of this situation and went on a global buying spree. I can't tell you exactly what they bought since hedgies are privately owned for the most part and have no disclosure requirements...BUT they evidently bought into emerging markets big time. Why?

Emerging markets were a pot of gold for the last 10 years. After the Asian, Latin American, and Russian markets collapsed in 1997-1998, the IMF forced these guys to raise interest rates to 2x digit levels to pay off their debt. The amazing thing is that the foreign governments were actually successful in servicing their debt on the backs of high commodity prices and cheap labor intensive exports.

BUT... along come the hedgies. Smelling a good profit, they used dollars to borrow yen. Then they used that money to buy high interest bearing debt in places like Turkey, Mexico, and Indonesia. The profits were amazing as long as they rolled in. Turkey for example was offering 17-20% interest rates earlier this year. Imagine getting 20% and only having to repay .5%. Even after inflation costs, these guys were raking in several hundred percent profit every quarter.

Currency traders have been talking about the currency trade implosion for YEARS and speculating on just such an event. Look at the Yen/USD and Yen/Aussie. These are the 2 top floating major currency pairs.

From here arb desks will "flip" the money into more illiquid but higher yielding projects (most developing countries have illiquid trading volume at best so bid/ask spreads are poor). In many cases hedgies did private side deals. Infrastructure projects (aka project finance) were really popular - they financed power plants, roads, ports, sewage plants, and similar projects. High yields at the time. Unfortunately the illiquidity of the self-same projects mean that it's hard to find a buyer in times of crisis.

Fast forward to the Fall. The Fed bans shorting (another hedgie favorite). The sell-off builds and they're unable to profit so they're forced to sell existing long positions. Redemptions increase. Several emerging markets teeter on the brink of default. The sell-off began in earnest.


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