An Explanation of the Carry Trade & how Banks are Looting Taxpayer Money
Posted by Jeff Pruitt - 1/29/10 @ 6:50 pm - Filed Under Featured, National Politics
Since the President is finally heating up the rhetoric on big banks and their looting of taxpayer money I thought I’d do a post explaining how the banks are using the Federal Reserve to essentially steal your money. The President, and others, are focused in on the $200+ billion hole still left from the $750 Billion TARP bailout. While it is important that taxpayers be paid back in full for this, it is also important that taxpayers understand that this was only the tip of the iceberg in regards to the financial sector bailout.
I’m not going to go into the details of all the various programs being used to bail out these institutions but I do want to focus on what I believe is the most important – the easy monetary policy being used by the fed. It’s what helped cause the current crisis and it will likely be the cause of the next one as well.
Currently the federal reserve is loaning money to banks at near 0% interest rates and politicians are pretending that they are SHOCKED that the banks aren’t lending that money to consumers and small businesses.
This is all bogus and those making the arguments know it. There are very good reasons why the banks aren’t lending money and one of them is related to a concept called the “carry trade”. The carry trade is how the banks game the system to ensure they make billions of dollars and pay massive bonuses all the while the real economy continues to struggle. So let me explain how this works:
As a banker you borrow from the fed at 0% interest and immediately convert the money into some other foreign currency. You use this money in the foreign currency to buy stocks, bonds or other risky assets in that foreign currency. Because the fed is printing so much money many other banks are doing the same thing you are and that tends to inflate the prices of these assets even further. Think of it this way, if everyone is given a bunch of free money then they are likely going to find ways to spend it.
Now what makes this even more profitable is that the fed’s decision to continue to print money is driving the dollar even lower against these other foreign currencies. So, for example, if you borrowed $100 million US dollars and converted it to South African Rand you may only have to pay back $80 million US dollars because the fed’s policies are driving the dollar lower and lower. This means you are effectively borrowing at -20% interest rates AND what you are investing in continues to increase because there’s so much extra money that it has to be spent somewhere.
But that isn’t the best part for you as a banker. The best part is that all the while this is going on you make a lot of money for your bank and in turn pay yourself massive bonuses for your “genius”. Never mind the fact that it doesn’t take any skill or intellect to pull this off – all you need is access to the federal reserve’s cheap money supply.
So you continue to borrow money, leverage it up in some foreign currency and buy risky assets while paying yourself millions and millions in bonuses for your investment wherewithal. But at some point, things go bad and a credit crunch ensues. This can happen for a variety of reasons but all of a sudden people can’t borrow money as cheaply and everyone who was flooding the market driving up risky assets is in panic selling mode trying to get out before they lose their shirt.
This drives the asset prices you were invested in through the floor and forces everyone to flee to the safety of US treasuries. This causes the dollar to increase and now you are really screwed (or at least the taxpayer is) because your assets have plummeted and now you are paying dollars back at +20% interest. If you are leveraged up 10, 20 or 30 to 1 then you can imagine it doesn’t take long before you are entirely wiped out – you no longer have the capital reserves to cover your losses.
But don’t worry because your bank is special! Since the government has declared you Too Big To Fail they will come along and bail you out once again. And even if you get the boot, which isn’t likely, you’ve paid yourself hundreds of millions in bonuses during the time you were making risky investments pretending that you were some kind of investment whiz kid.
The bad news for taxpayers is that when the system blows up we are left to pick up the pieces and our debt-to-GDP goes from 40% to 80%. Beyond that, the carry trade is driving investment out of the US into bubble-laden assets in foreign countries. Why would a bank lend to small businesses here in the US when it’s much more profitable, in the short term, to send the money elsewhere? Of course unemployment skyrockets as well which hurts the real economy even further.
You would think that given the history of our meltdown-bailout cycle in this country that somebody would actually try and stop the madness. Somebody might actually say, “You know what, if banks want to play these games then they need to be broken up so that when they inevitably fail they don’t take the rest of the economy with them.”
Or heaven forbid we put the smack down on the bozos running these banks that are paying themselves massive bonuses with taxpayer dollars for doing something a monkey could do – borrow money at -20% interest and invest in bubble assets with the rest of the sheep. But no, what we get is a government that talks tough but sets policies that only serve to reinforce the bad behavior…
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9 Responses to “An Explanation of the Carry Trade & how Banks are Looting Taxpayer Money”
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Jeff,
This is an excellent post and is dead on target. That being said I want to point out another large reason why banks are not loaning as much money.
Banks have finally realized that for a decade or more they have been loaning money to people they had no business loaning money to. The fact of the matter is that banks are currently applying appropriate due diligence to the loan process.
The idiots in Washington are “crying” about the fact that the banks need to loan money at the same levels they did two or three years ago which is insane.
Mike
Actually, a carry trade investment has risk, just as any investment would. If use dollars to invest in yen, which you use to buy U.S bonds, then you are betting that the yen will yield more value than the dollar . . . but if the yen value falls in its relationship to the dollar, you lose money. Technically, it matters not where the dollars came from or what interest you paid to use the dollars; it only matters what direction the currency exchange rates take in relationship to one another.
The fact is that banks are not loaning money is because people and businesses are not going into debt in this economy. Check out the decline in consumer credit.
Yes, and that’s almost exactly how I explained it in the post.
That is simply incorrect. The currency exchange is only one portion of the carry trade. Like any trade if I can borrow the money at better interest rates then I can absorb a larger currency swing before I lose money. The big banks are using leverage to borrow the money at 0% (or negative rates in reality) interest from the federal reserve - you and I can’t do that.
There are numerous reasons why the banks aren’t loaning money but right now they are being given free money to buy foreign assets with little short term risk so why do anything else?
And they do all this with fractional reserves and taxpayer bailouts. Heads they win, tails we lose. Like I said, a monkey could do that…
Jeff,
Thanks for this excellent post!
Can you also explain what the term “unwinding of the carry trade” means? Is it already happening and what are the consequences?
Thanks.
Jeff
I get the feeling that you think that the private banks are somehow responsible for the Fed’s near-zero interest rate policy. I think it is time to quit blaming capitalists for the financial bubble and start blaming government interference in the capital markets. I find it indeed remarkable that the large banks have repaid close to $500 billion of the $700 billion bailout made under TARP. None of the ill-conceived automaker bailout money, including GMAC, has been repaid.
Yaron Brook summarizes our problem:
Too bad that the people have allowed the power-hungry redistributionists to take control.
Greeze,
The unwinding of the carry trade is what happens when things begin to go south as I described in the post.
What happens is that at some point the asset bubble(s) that the carry trades are investing in burst. The most likely cause of this is a stoppage of the dollar depreciation. The dollar cannot fall to zero so at some point it will at least level out and when that happens the advantage of paying back negative interest rates goes away.
In fact, once this begins to happen investors will get spooked and race back into the dollar which will actually cause it to appreciate.
Now all the people who borrowed money expecting the dollar to depreciate are in serious trouble since they have to pay their loans back in dollars that are worth significantly more than when they borrowed them.
This mad dash to get out of the bubble market and pay back the loans before the borrowed currenty appreciates is the “unwinding”.
And no, I don’t think it’s started yet, but since there’s been absolutely nothing done to prevent the biggest banks from taking on more and more risk, I think it’s inevitable…
Gadfly,
I think I’m firmly on record as stating that the Federal Reserve is chiefly to blame for the current crisis.
Also, I do blame government interference for without it every single major bank would be bankrupt - an outcome that I think should have been allowed to materialize. Actually, I should say that the government needed to do something in the interim while these banks failed but that’s beside the point. The capitalist outcome would’ve been to allow the “capitalists” to fail. That didn’t happen. So now the biggest banks are “capitalists” in the same sense that China is a “capitalist” country.
And I hate that everyone focuses on TARP. There have been TRILLIONS of dollars funneled to the banks above and beyond TARP.
I guess my problem is this. If the government isn’t willing to let the biggest banks fail then they need to be “broken up” in a way that mitigates their
potentialinevitable future failure.That’s what Paul Vocker seems to want to do and since he’s basically the most well-respected central banker on the planet and the only one to have ever made the market take its medicine I think we should listen…
Investing in the currency market or using US dollars to buy non US Dollar Denominated assets is no different than “Trading Places” where Murphy and ??? said SELL!
Why are people buying gold? The US Currency is falling and all the other currencies are just as bad. No one know what to do.
Can banks borrow from the Fed at near zero rates, then perform an all-domestic “carry trade” with US Treasury bonds at 2.5%? If so, there is no exchange rate risk - the arbitraging is all in one (our) currency.
Through which, if any, Fed facilities can banks borrow for this? Not the discount window, which is supposed to have penalty interest rates.