There has been an abundance of commentators, analysts and even government officials explaining the causes of our financial meltdown and, to be sure, there are many. But the one that bears the greatest responsibility is scarcely mentioned, if at all.
Whenever someone volunteers an opinion, it reminds me of the story of the man searching for his car keys in his garden. He explains that he lost his keys in the garage, but it’s dark in there and there’s light in the garden. Is anyone really convinced that subprime lending in Las Vegas caused the bankruptcy of Iceland? Or that flipping condos in Miami and widespread foreclosures caused the crippling of the global banking system? Is anyone convinced that normal supply/demand factors were the reason for the price of oil to go from $60 to $145 per barrel and back to below $50 in a period of 18 months?
OPEC members meet when they see a need to adjust the price of a barrel by a few dollars. Often, even with their clout, they fail. There must have been a source of almost limitless funds that generated such a round trip and caused the havoc witnessed in the world’s financial fabric. And it most likely originated in the metaphorical dark garage, the equivalent of which is the foreign exchange currency market. That’s where unregulated hedge funds commanding trillions of dollars go to work leveraging their positions by dozens of times. Their instrument of choice was the carry trade. It entails borrowing in the currency with the lowest yield and buying the one with the highest yield. With funds at hand and high relative returns, they would turn around and speculate in stocks, commodities and whatever else is out there.
Let’s put some numbers in perspective. The market for the most toxic of speculative instruments, credit default swaps, was estimated to be between $30 trillion and $60 trillion. If that amount is doubled to include all of the other failed instruments, the number would reach $120 trillion. Compared to the turnover in forex, it represents the volume of trading for less than 60 days.
For no less than five years, hedge funds sold trillions of U.S. dollars and Japanese yen and bought pounds, Australian and New Zealand dollars. The banks were only too happy to provide the leverage needed. Finally, in June and July of 2008, the strains on the system began to affect the over-extended commitments. The reversal of positions slowly built into a rush to the exit doors. Positions had to be liquidated and carry trades needed to be unwound.
The party was now over and the hangover was wide-spread. At the time when the speculative appetite was insatiable, governments around the world, led by the U.S., refused to regulate these markets. Once the cycle reversed and the financial system became dysfunctional, there was a lot of blame to go around, but the carry trade hardly gets a whisper.
Some of the repercussions can be found in the flow of funds around the globe. All those who shorted the U.S. dollar and the yen had to cover. The demand outstripped the available supply. At a time when on one side of the Atlantic the U.S. Treasury began offering trillions, there were no dollars to be found in London. At one point, the overnight Libor got to more than 16%. The high-yielding currencies lost more than 30% of their value vs. the dollar in less than six months. During the same period, the yen appreciated 15% against the dollar. Hedge funds were hurting and losses were mounting at such an alarming rate that many suspended redemptions, preventing investors from accessing their funds.
The correlation between the commodities’ speculative excesses and the carry trade bubble is made clear in “Exiting the carry.” For such seemingly unrelated trading instruments as the Aussie dollar and crude oil to be totally in sync is quite telling. As long as the Aussie was being bought against the U.S. dollar, the price of oil headed higher. When the funds from the carry trade dried up, the price of oil and other commodities began to drop. Other commodity currencies with lower yields had a different performance. The carry trade was the major culprit. The subprime lending mess, the rising foreclosures and the failures of various financial institutions just added to make it the perfect storm.
