Money for nothing; or, how the Fed bails out the banks

At first there was one great game in town for investors. Then it went away, slaughtering investors as it went, and the banks and central banks began to play instead. We refer, respectively, to the ‘carry trade’ and the Federal Reserve printing presses.

The most recent incarnation of carry trade was all about Japanese retail investors borrowing yen at near-zero interest rates and buying high-yielding currencies such as the New Zealand dollar and the Brazilian real instead. You borrow at, say, 0.5% and receive 8.3%, in the case of the New Zealand dollar as of July last year. The 7.8% difference is pure profit.

Thrill seekers
Hedge funds gave themselves an extra thrill by gearing up enormously – perhaps as much as tenfold, turning a 7.8% turn into 78%. However, as Tom Vosa, senior economist with National Australia Bank points out, it is not for nothing that the carry trade has been described as “picking up pennies in front of a steam roller.” If the exchange rates shift against you, you get rolled to a very fine paste.

The new game of carry trade works the same way, but eliminates the forex risk by playing at different ends of the yield curve of a single currency, the dollar – and it’s only open to the banks. In the US, as Paul Kasriel, chief economist at Northern Trust explains, this gives the Federal Reserve a neat way of recapitalising the stricken banking sector.

The overnight rate at which banks borrow from the Fed has been cut to 0.25%. The banks can then invest in two-year Treasury bills for which they receive 0.90%, giving them a net gain of 65 basis points, or $6.5m per $1bn borrowed. It’s free money since the Fed is not a credit risk so it has no impact on the banks’ capital ratios. In other words, it does not impede in any way their ability to write further debt.

Meanwhile, the positive cash flow trickle charges the banks’ accounts with real money. The only risk faced by the banks is if overnight borrowing rates mov e sharply above the rate at which the banks have committed deposits for two years.

There is no direct equivalent in the UK, but with the Bank of England buying government debt and investment-grade corporate debt off the banks, with its potential £150bn, it is freeing up a tremendous amount of room on bank books for them to go out and write further business.

Essentially, the banks are paying 0.5% for money from the BoE and are in a position to lend it out – if only they weren’t so risk averse – at anything from 5% upwards. Again, nice money if you can get it. Many finance directors will look at this and look at how hard their companies have to work to generate a similar level of bottom line return, and wonder if they are in the right game.