The Federal Reserve has been keeping short-term rates artificially low. Banks and hedge funds can borrow from the Fed at 25 basis points and use this money to buy treasuries yielding 3.5% to 4%. This is called a carry trade.

Banks and hedge funds can leverage their assets by 10 to 30 times. Remember that banks consider loans to be assets and deposits are liabilities. This means that if a bank or hedge fund has a loan for $1 million (let’s pick a round number for this example) they can go to the Federal Reserve and borrow up to $30 million (30 times) against that loan. They can then buy treasuries and earn an easy 3.5%, or $1,050,000. At 10 times leverage, they can borrow $10 million and earn $350,000.

The Fed is subsidizing the banks and hedge funds; paying them for their bad loans; actually, taxpayers are paying the banks and hedge funds. The banks are in no rush to liquidate the bad loans because the longer they hold the assets, the longer they can take advantage of the carry trade. The government is in no rush because the carry trade means a steady stream of buyers for treasuries. Together, the government and the banks will drag out the loan modification game. Yes, there is still a foreclosure every 8 seconds in the US, but it is possible to extend the foreclosure process for months or even years.

If the banks and hedge funds were to recognize the losses on the bad loans it would trigger credit default swaps (CDS). The credit default swaps are a type of (largely) unregulated insurance against risk. One of the big problems with CDS is the writers of these financial instruments did not set aside reserves to pay claims in the event of default. If the bad loans were to default, it would trigger a massive cascade of defaults by banks and hedge funds. So, the banks and hedge funds and Fed are playing a game of extend and pretend. They pretend the loans are not soured; they extend the life of the assets, which allows them to profit from carry trades. Soon, the banks and hedge funds will be fully compensated for the bad loans.

The carry trades are big, around $500 billion and growing. The carry trades will continue to grow as long as the Fed keeps rates artificially low. What happens when rates move slightly higher? There will be a stampede of sellers. What could push rates higher? Damn near anything: a geopolitical event, bad financial news, a rumor, or speculators may try to push to matter. Quite simply it is a fragile scenario that could unravel very quickly. What happens when it unravels? Most probably we will see an enormous surge in inflation. Is there any chance the carry trade bubble will not burst? Well, the Fed can’t set rates much lower than current levels. There is only one direction for rates to go from here, which means this whole mess has a strong probability of ending badly.

Sinclair Noe

Eat the Bankers

TrackBack URI for this entry

Comments (0)

Subscribe to this comment's feed