Friday, August 28, 2009

The Debts of the Spenders: The Dollar Carry Trade - Cheaper to Borrow than Yen

The Wall Street Journal reports that the dollar is now more cheaper to borrow than the yen for the first time in 16 years. LIBOR rates have fallen dramatically during the past year as central banks the world over have flooded the systems with liquidity.

There are 2 stories going on here: 1) liquidity 2) solvency.


This deluge of cheap credit has several important effects, namely a dramatic increase in prices for nearly ALL asset classes - equities, debt, and even credit (agriculture being a sore exception). The intended beneficiaries, multi-national banks, have put this cheap credit (courtesy of the taxpayers) to good use speculating. After all, it's easy to gamble with other people's money and reward yourself even for losing bets.

And even where LIBOR isn't available, banks still have access to quantitative easing measures such as the unconventional TALF, POMO, TOMO, and European equivalents.

In such an environment, it is nearly suicidal to short any asset class favored by the large bank trading desks (agriculture again being an exception . . .I guess watching corn reports isn't as sexy as trading naked CDS instruments and gunning ES futures).


However, keep in mind that this government largesse is only available to large banks and financial institutions. Smaller, less politically connected institutions do not have access to quantitative easing measures (e.g. access to Fed discount window) and sometimes have to use the LIBOR market. When they do, these smaller banks have to pay a premium above the going LIBOR rate b/c of their smaller status. I cannot speak for other banks but in the US at least, commercial banks are required to maintain adequate capital ratios.

In the past, this requirement was met by holding shares of preferred stock in GSEs like Fannie Mae and Freddie Mac. Some banks also bulked up their portfolios w/more exotic asset classes like auction rate securities (whose value and return was determined in periodic auctions) that later proved to be less than liquid. The result has been for the FDIC to shut down 3-4 banks every weekend for the past year since these holdings are often not enough to satisfy regulatory requirements.

Ah, but what about the multi-national banks? Aren't they also suffering from a solvency crisis? Yes and no. There are 2 sets of rules: 1 for the big boys and another for everyone else. But you already knew that, right?
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