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Log inMore Money Than Brains: How This Financial Mess Began
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More Money Than Brains: How This Financial Mess Began
by Sean on Mon May 12, 2008 2:54 am
Greetings Currency Traders! 
I explained how the carry trade is a technique based on flimsy and flawed assumptions about the future. And that future changed tremendously in July 2007. In short, the real world of irrational and flawed expectations changed the game dramatically for the carry trade.
Now let me introduce you to the quintessential carry trade currency, the Japanese yen, and its starring role in the Great Unwind.
The Beginning of the End of Free Money
I date the start of the Great Unwind to July of 2007. That was when we first began to hear talk of the sub-prime real estate market problem. Of course when these problems became public, the pundits believed, or at least touted as such, that this was just a small problem in a small corner of the U.S. real estate market - not to worry.
But, little did most people understand that derivatives were the securities involved with this mess. And we all now understand that derivatives have a nasty habit of spreading small problems through the entire financial system. Derivatives can do this thanks to the interlocking web of relationships each derivatives security is based on.
We Can Trace This Stupidity Back to 2001
But the explosion in derivatives began in earnest back in 2001. First came the crash of the Nasdaq stock market. This crash led the U.S. Federal Reserve Bank to slash interest rates from 6.5% to 3.5% in a just a few short months.
Then the terrorist attacks on the World Trade Center and Pentagon on September 11, 2001 hit the U.S. economy. The Fed reacted by slashing interest rates to a historic low of 1% by July 2003. This massive dose of liquidity set the stage for a surge in many asset classes: Stocks, bonds, commodities, housing, and a huge explosion of derivatives (which in turn provided even more credit to bid up the other asset classes).
The Bank of Japan (BOJ) was already willing to lend all you could take at 0.5%. And by June 2003, the European Central Bank (ECB) had followed the Fed's lead and slashed its interest rates to barebones 1% too (and kept them there until December of 2005).
Thus, we had a situation where three of the world's major central banks were basically giving money away for free. This surge of free money fueled a boom in housing prices and an alphabet soup of derivatives tied to housing and other assets.
What Happens When They Create Derivatives Based on Derivatives
This period sparked a mania in securitized debt tied to housing and all other types of things. All this liquidity allowed investment banks to generate huge fees by creating derivatives of derivatives - I'm not making this up.
If you want to see the best example of how this mania credit exploded, you only need look at the seemingly arcane market of "credit default swaps" or CDSs. This market basically represented insurance on loan portfolios and other securities. This was already a risky market with a counterparty structure that looked like an octopus. But, it was only about a US$1 trillion market in 2000 and most of the counterparties to these securities were relatively stable players.
As the central banks opened the monetary spigot, and ratings agencies turned a blind eye because they loved the fees. Meanwhile, the CDS market exploded to a nominal value of US$46 trillion in outstanding contracts by 2007. That's represents four times the value of the entire U.S. gross domestic product.
Using the phrase "debt explosion" to describe the period from 2001 through 2007 is conservative.
And by the way, this derivatives explosion continues today. Just last week, we had another drip of bad news flow from this explosive derivatives market.
The last comes from Ambac - aka the premiere U.S. bond insurer that got caught up in the derivatives craze - not because they were experts in the derivative area, but because there were fat fees available. Last week, Ambac Financial Group Inc., having staved off a credit-rating downgrade, posted a wider loss than analysts estimated after taking US$3.1 billion in charges for subprime-mortgage securities.
Ambac's management wasn't happy with sticking to what it knows best - issuing plain vanilla municipal bond insurance that produces a steady, trusty stream of income. No! The company's management bought into the idea that adding more risk to the company's balance sheet would be a great way to grow. Now the company's shareholders are paying the price.
Why This Led to the Sub-prime Mess and the Carry Trade Explosion
And what does this have to do with the sub-prime and the carry trade?
As I said, derivatives are a web of interlocking counterparties. Many of the same players who held sub-prime market derivatives also held CDSs (another major class of derivatives). And many of the counterparties to these derivatives (i.e. hedge funds) were massive borrowers of Japanese money at around 0.5% or less.
It's estimated there was well over US$1 trillion in borrowings in Japanese yen, effectively constituting a huge carry trade position. And remember, this borrowing was leveraged up 10, 20, 30, even 50 times over. Thus, the Japanese yen carry trade was tightly linked to the explosion in derivative credit.
Take last week' news. Ambac is just another poignant example of why the unwinding of credit will be a long-term affair and continue to provide background support for the yen.
Why the Yen and Not Others?
Given that the Fed and the ECB pushed rates all the way down to 1%, why wasn't the dollar or euro considered to be a carry trade currency - why just the yen?
Well, it's because the Bank of Japan held their official discount rate at 0.5% or less for many years. The rate hit 0.5% in January 2001 and dipped to 0.1% in September of that year. The BOJ rate stayed at 0.1%, incredibly, from September 2001 until July of 2006, when it jumped to 0.4%. That is what I call easy money!
Most people anticipated both the Fed and ECB would raise rates once the global economy shook off the effects of the deflationary impact of the Nasdaq crash and 9/11. And they did.
So you can see why the Japanese yen was the key carry trade currency for the globe. I think if most of us could have borrowed Japanese yen at 0.5% to fund our mortgages and stock investments we would have done the same thing.
It appeared to be a no-brainer, as they say. But when it comes to actively traded markets in the real world, there is no such thing as a no-brainer...
I explained how the carry trade is a technique based on flimsy and flawed assumptions about the future. And that future changed tremendously in July 2007. In short, the real world of irrational and flawed expectations changed the game dramatically for the carry trade.
Now let me introduce you to the quintessential carry trade currency, the Japanese yen, and its starring role in the Great Unwind.
The Beginning of the End of Free Money
I date the start of the Great Unwind to July of 2007. That was when we first began to hear talk of the sub-prime real estate market problem. Of course when these problems became public, the pundits believed, or at least touted as such, that this was just a small problem in a small corner of the U.S. real estate market - not to worry.
But, little did most people understand that derivatives were the securities involved with this mess. And we all now understand that derivatives have a nasty habit of spreading small problems through the entire financial system. Derivatives can do this thanks to the interlocking web of relationships each derivatives security is based on.
We Can Trace This Stupidity Back to 2001
But the explosion in derivatives began in earnest back in 2001. First came the crash of the Nasdaq stock market. This crash led the U.S. Federal Reserve Bank to slash interest rates from 6.5% to 3.5% in a just a few short months.
Then the terrorist attacks on the World Trade Center and Pentagon on September 11, 2001 hit the U.S. economy. The Fed reacted by slashing interest rates to a historic low of 1% by July 2003. This massive dose of liquidity set the stage for a surge in many asset classes: Stocks, bonds, commodities, housing, and a huge explosion of derivatives (which in turn provided even more credit to bid up the other asset classes).
The Bank of Japan (BOJ) was already willing to lend all you could take at 0.5%. And by June 2003, the European Central Bank (ECB) had followed the Fed's lead and slashed its interest rates to barebones 1% too (and kept them there until December of 2005).
Thus, we had a situation where three of the world's major central banks were basically giving money away for free. This surge of free money fueled a boom in housing prices and an alphabet soup of derivatives tied to housing and other assets.
What Happens When They Create Derivatives Based on Derivatives
This period sparked a mania in securitized debt tied to housing and all other types of things. All this liquidity allowed investment banks to generate huge fees by creating derivatives of derivatives - I'm not making this up.
If you want to see the best example of how this mania credit exploded, you only need look at the seemingly arcane market of "credit default swaps" or CDSs. This market basically represented insurance on loan portfolios and other securities. This was already a risky market with a counterparty structure that looked like an octopus. But, it was only about a US$1 trillion market in 2000 and most of the counterparties to these securities were relatively stable players.
As the central banks opened the monetary spigot, and ratings agencies turned a blind eye because they loved the fees. Meanwhile, the CDS market exploded to a nominal value of US$46 trillion in outstanding contracts by 2007. That's represents four times the value of the entire U.S. gross domestic product.
Using the phrase "debt explosion" to describe the period from 2001 through 2007 is conservative.
And by the way, this derivatives explosion continues today. Just last week, we had another drip of bad news flow from this explosive derivatives market.
The last comes from Ambac - aka the premiere U.S. bond insurer that got caught up in the derivatives craze - not because they were experts in the derivative area, but because there were fat fees available. Last week, Ambac Financial Group Inc., having staved off a credit-rating downgrade, posted a wider loss than analysts estimated after taking US$3.1 billion in charges for subprime-mortgage securities.
Ambac's management wasn't happy with sticking to what it knows best - issuing plain vanilla municipal bond insurance that produces a steady, trusty stream of income. No! The company's management bought into the idea that adding more risk to the company's balance sheet would be a great way to grow. Now the company's shareholders are paying the price.
Why This Led to the Sub-prime Mess and the Carry Trade Explosion
And what does this have to do with the sub-prime and the carry trade?
As I said, derivatives are a web of interlocking counterparties. Many of the same players who held sub-prime market derivatives also held CDSs (another major class of derivatives). And many of the counterparties to these derivatives (i.e. hedge funds) were massive borrowers of Japanese money at around 0.5% or less.
It's estimated there was well over US$1 trillion in borrowings in Japanese yen, effectively constituting a huge carry trade position. And remember, this borrowing was leveraged up 10, 20, 30, even 50 times over. Thus, the Japanese yen carry trade was tightly linked to the explosion in derivative credit.
Take last week' news. Ambac is just another poignant example of why the unwinding of credit will be a long-term affair and continue to provide background support for the yen.
Why the Yen and Not Others?
Given that the Fed and the ECB pushed rates all the way down to 1%, why wasn't the dollar or euro considered to be a carry trade currency - why just the yen?
Well, it's because the Bank of Japan held their official discount rate at 0.5% or less for many years. The rate hit 0.5% in January 2001 and dipped to 0.1% in September of that year. The BOJ rate stayed at 0.1%, incredibly, from September 2001 until July of 2006, when it jumped to 0.4%. That is what I call easy money!
Most people anticipated both the Fed and ECB would raise rates once the global economy shook off the effects of the deflationary impact of the Nasdaq crash and 9/11. And they did.
So you can see why the Japanese yen was the key carry trade currency for the globe. I think if most of us could have borrowed Japanese yen at 0.5% to fund our mortgages and stock investments we would have done the same thing.
It appeared to be a no-brainer, as they say. But when it comes to actively traded markets in the real world, there is no such thing as a no-brainer...
