When I was *much* younger and a relative neophyte on Wall Street, the ”carry trade” was a new trader staple. It arose out of a 1985 agreement whereby the U.S., Japan, the U.K., France and West Germany sought to lower the value of the U.S. Dollar against the currencies of the other nations. It almost seems quaint now.
Basically, the trade involves a play on currency yields. It consists of borrowing a low-yielding currency (in those days, Japanese Yen) and investing in a currency that is offering a higher yield (in those days — hard as it may be to believe now – typically U.S. dollars). The yield difference provided the profit (after costs). Currency risk provided the largest potential problem.
Most traders saw this as easy money with low risk and “levered up” to give the trade some real juice since the initial transaction itself only yielded relatively small profits. Leverage was needed to accentuate and accelerate returns. Thus a feedback loop of sorts was created and kept repeating, with leverage extending to ten times and often much higher. This trade was a consistent and enormous success for a number of years.
In 1995, five years after the Nikkei 225/property bubble had spectacularly burst, the Kobe earthquake hit. Japanese interest rates (which had been inching down since 1991) fell below 1%, and the Yen became a funding currency for various forms of speculation all over the world. At that point, the Yen had been weak and kept on depreciating sharply for several months relative to the USD. Still mixed and weak economic data were coming out of Japan and short-term interest rates there were 0.25 percent while they were closer to 5.5 percent stateside. Massive carry trade volume using the Yen led to sharp increases in leveraged positions by traders who had been shorting the Yen to make the carry trade bet.
But then the Yen started to appreciate – by 9 percent in one month alone – largely due to Russian debt problems — and the spread between Japanese and U.S. yields tightened dramatically in a flight to quality and liquidity. One piece of good news from Japan (the Japanese government offered a plan to recapitalize its problem banks) and in a matter of 72 hours the Yen had appreciated by another 12 percent. Julian Robertson’s Tiger Fund lost $2 billion dollars in 48 hours on the Yen unraveling. LTCM lost even more; it was forced to restructure its operations and was bailed out via a deal brokered by the Fed (and its positions eventually wound down over a year or so).
After years of success, the carry trade death spiral was quick and violent (only to be resurrected in various forms thereafter). Ongoing carry trades unravelled as quickly as the Yen rallied; margin calls were triggered, levered positions went belly up and the entire financial system went into seizure. The Fed was forced to cut the Fed Funds rate in between meetings by 75bp (in spite of still solid domestic GDP growth) in order to avoid a financial meltdown, a collapse of U.S. financial markets and a global recession. And, as always, the principals in the trades kept asserting that the models were fine, it was the markets (and the world) that were wrong.
Leverage — like excessive speeds on the highway — kills and often kills quickly. Whether that leverage is undertaken by hedge funds (as in the example above, even though LTCM resisted being labelled a hedge fund), Wall Street banks (think Lehman Brothers) or retail consumers (think people with multiple investment properties in 2008), troubled times are very difficult to manage by firms and people laden with excessive debt, especially when the items purchased using the leverage (and acting as collateral) are declining swiftly in value. And the more illiquid they are, the worse the problems become.
It should be obvious but it bears repeating — relatively innocuous and seemingly low-risk trades can become death-traps in a hurry on account of leverage. If you operate with borrowed money, you lack the luxury of trying to wait until prices “correct” if (when!) the lender demands his pound of flesh. Even so, it’s a useful (and sometimes necessary) tool. Use leverage wisely and never underestimate its risks.
My series on risk is available at these links:
- Reckoning with Risk (1) begins to look at how to deal with risk.
- Reckoning with Risk (2) explains and categorizes different elements and types of risk.
- Reckoning with Risk (3) shows our failings at dealing with low-probability, high-impact events.
- Reckoning with Risk (4) looks at what the Yale Endowment experience can teach us about risk.
- Reckoning with Risk (5) explains that professional managers face different risks than those for whom they manage money and that those differences matter.
- Reckoning with Risk (6): 9.11 Edition takes a look at “black swan” risks.
- Reckoning with Risk (7): Widening Your Lens suggests that dealing with risk requires that you actively manage your life.
- Reckoning with Risk (8): Risk Capacity, Appetite, Tolerance and Perception looks at the problem of (apparent) shifts in risk tolerance.
- Reckoning with Risk (9): Money for Nothing reminds us that risk and return generally correlate.
- Reckoning with Risk (10) deals with complexity risk.
- Reckoning with Risk (11) focuses on leverage.