This is the Mister here – Melanie asked me to write this after our discussions at home.
(Melanie here – it’s true. He keeps explaining the crisis to me and I think he does a good job of it so that everyone can understand what is really going on so I asked him to share. It’s worth taking the time to read it if you are interested in the history behind what is going on.)
Executive Summary: The Japanese and Quants (quantitative analysts) are to blame for where we are today
Long Story: I think that if there is any one thing that can be said about the recent activity in the markets/economy, shop it is that there is a very low signal to noise ratio about the goings-on. The Media tends to do that – distort, misrepresent and pander (at least I get my biases out in the open right off the bat :D).
Much has been made of the “Bankers’ Greed”, “Irresponsible Americans” (if you live in a non-American country and need a scapegoat at least), and “Sub-Prime Mortgages”. In fact, I would say that many of these phrases have become household icons for the troubles people are experiencing – from upside down mortgages to lay-offs to reduced contracting income from projects being halted.
I would venture, however, that the old market adage regarding “that which everybody knows is the least useful piece of information” holds true here as well. While people may be aware of the results of the underlying market turmoil, they have little to no knowledge of the causes behind it.
To do this, we need to venture back to 1991 – the world’s belle on the international exchanges (and the US one as well) is Japan. The economy is expanding, asset prices are going through the roof, and everyone is making cash (sound like the US last year?). The driving force behind this expansion was primarily undisciplined business transactions happening behind an opaque oligarchy. The people in the elite group all did what people in elite groups do – keep things going the way they think is best.
As always happens the market is unforgiving, and the elite causing unprecedented bubbles in their markets ends in tears. Someone goes one step too far and has to start selling, then asset values implode, which in turn leads to more selling. Always. (The whole trick is to be one of the first out of the door, however. 😉 )
In the peak times of the Japanese market bubble, real estate was the driving factor behind much of the asset expansion (sound familiar?) and over-insane-craziness. There were even entrepreneurs (or opportunists – take your pick of nomenclature) that would buy out companies on the exchange because the value of their real estate in downtown Tokyo was larger than the already-overvalued price of the company! They turned the property around and got free businesses for their efforts…
In any case, when real estate bubbles collapse the ensuing deflation of assets in the country is always severe – banks make the lion’s share of their money off mortgages, so all other assets are directly tied to the health of financial institutions’ mortgage portfolios.
As the Japanese economy spiraled into what can only be called a depression, the government did what governments have historically done to stimulate economic growth – lowered interest rates. This is supposed to cause an incentive to borrow money to undergo capital projects (like opening a grocery store, or building a new apartment building) as the interest rates you have to pay on the borrowed money are very low, and payments aren’t arduous.
Unfortunately (or fortunately), we don’t live in traditional economic times anymore – the velocity of capital in the international markets is at an unprecedented high, and international finance and commerce are the bread and butter of the markets. It is no longer difficult to move large quantities of cash through the ForEx (Foreign Exchange) market, or to purchase large quantities of government bonds, or to have large holdings in offshore accounts. What this means is that instead of people inside Japan borrowing money to stimulate internal growth, and driving the domestic economic engine – international arbitreurs said:
Interest rate in Japan: 0.25% (yes, that is 1/4 of one percent – as of last year)
Interest rate on AAA grade US government bonds: several %
So the trick is to borrow in Yen, and buy anything – anything at all – that is going up in value. Government bonds are great because they have a guaranteed rate of return, are rock-solid collateral, and are never turned down (unless the government in question defaults…)
Thus was born the Yen Carry Trade. This is one of those facts of international finance that remains in “voodoo” status for most people, as they think of it as some conspiracy theory trick to explain weird market events.
The fact is that the Yen Carry Trade is largely responsible for most asset appreciation over the past ~10 years or so. It is estimated to be on the order of tens of trillions of dollars, with unknown quantities of derivative risk. (which is short form for: we could easily have leveraged ourselves to 10X that amount)
There have been many asset bubbles and collapses that were (at least) exacerbated by the Yen Carry Trade, including LTCM (Long Term Capital Management) and the NASDAQ crash.
Basically you take any bubble that is forming, and then you add all sorts of fuel because funds can borrow for next to nothing in Japan and speculate anywhere in the world by making instant ForEx transactions and move their money around in hours (to days).
The biggest part of the equation we haven’t talked about yet is currency risk. Because you are borrowing Yen and converting them to other currencies, you have to worry about the cross. Talking about the “value” of the USD is basically meaningless. When you see a value quoted for the USD it is a blend of the price to convert to a whole bunch of other currencies. Funds don’t actually play the USD, they play the USD/EUR (euro) cross, or the USD/CDW (canadian dollar) cross, or the USD/XJY (yen) cross.
(of course I am simplifying a bit, as there are funds that specialise in providing a basket of currencies, but these are fringe enterprises compared to the net flows through the ForEx market)
And to give some perspective of just how large this market is, let’s say the stock market is worth “1”.
The Bond market is worth “5”.
The ForEx market is worth “50”.
This is where governments push money around to fund their country’s operations, international loans, debt, etc., etc., etc. So it is easy to imagine this massive market having a huge impact on the stock market, and the bond market. So really, watching ForEx and bonds is way more telling than watching stocks.
Back on track, the borrowing of this Yen to fund the Yen Carry Trade has a risk inherent in the movement of whatever currency you are buying relative to the Yen. If this cross moves too far you may find your entire profits from playing the Japanese-US bond spread eaten up. Fortunately you can hedge your exposure to this risk through various complex and exotic derivatives and many formulae.
Unfortunately, people can’t do math. The simple fact is that formulae used to calculate the risk-reward ratio for various derivatives may require graduate-level statistics or calculus knowledge, but they are still wrong. International research into the shape of the derivatives price curves is still in the dark ages despite several hundred years of work; I have attended many different talks given by internationally respected researchers in various exotic pricing methods, and they are still mistaken about how the market actually works.
And floor traders may be aware of how the market actually works, but they are human and forget the lessons of the past that cause extreme statistical deviation, so they get burned too.
What this means is that someone, or many someones, eventually screw up and miscalculate their risks (that is what the market is all about, however – you miscalculate your risks and someone else capitalises on it).
This then leads to panic selling, which causes margin calls, which causes more selling.
The most telling chart about the recent market movement follows:
(Canadian Dollar vs. Yen in yellow, Euro vs. Yen in pink)
Slowly, since before 2000 (when this chart starts), the Euro and Canadian dollar have been appreciating in value relative to the yen – as one would expect from the Yen Carry Trade. Funds sell Yen to buy Euros, so the price of the Euro relative to the Yen goes up. This buying of “risky” assets can be seen to have happened in most currencies – the Real, the Peso, Dinar, etc., etc., etc. The world was seeking yields in riskier assets because most of the juice has been squeezed out of the US – the US has traditionally been seen as “less” risky so its assets command a premium and therefore less yield.
To meet pension obligations, fund growth benchmarks, and from just plain greed of people in general (including shareholders and old people who want pensions), the world sought higher yielding assets, which also means taking on more risk. So as long as they were willing to buy risk, those currencies all go up. The spike at the back end of the chart is the recent market “crash”, however.
What took ~6 years to wind up took about 1 month to destroy. Entropy reigns supreme. 😀
So the story goes like this:
– Japan undergoes a massive market crash, and enters depression (~1991)
– Japan lowers interest rates to stimulate economic growth
– funds see opportunity in “money for nothing” and start leveraging up via the “Yen Carry Trade”
– bubbles like the NASDAQ are fuelled by the availability for cheap money (2000 onwards)
– to combat bubbles the US lowers interest rates to lower the spread to Japanese rates and discourage the Yen Carry Trade
– foreign institutions keep the long end of the US bond curve artificially low with all of the bonds they keep buying, flattening out the curve and making banks seek returns elsewhere (a positive yield curve “heals all ills” in the banking sector)
– low interest rates (good for homeowners) coupled with a flat yield curve (bad for bankers) incentivises the real estate boom in the US and mortgage insanity, when banks start packaging up debt to foreigners hoping to find a seat when the music stops
– ARMs start resetting triggering what everyone knew was coming (at least anyone who has studied history)
– margin calls abound, causing unleveraging of the Yen Carry Trade in size (see graph above) – which causes more forced liquidation
– selling begets selling, as it always does, and the trip down is always shorter than the trip up
– the IMF and Japan threaten to intervene in the ForEx market to stabalise currencies (Oct 24, 2008)
We are currently in a “bounce” mode, but beyond that who knows. The governments have pulled almost every trick out of their hat to contain this global epidemic, and as long as the currencies stabalise we should be able to get back to some sense of normalcy – currency insanity ruins legitimate businesses and global commerce, and screws with everything. The violence of the currency moves on the above graph relative to “normal” movements hopefully highlights just how serious this has been. Unwinding the Yen Carry Trade has caused a severe amount of damage to the markets.
We are back where we were after the crash in 1998, and the one in 2002, so we’ve basically done nothing for a decade. Japan is worse off as they have lost two decades.
The good news is that people are still living, driving, and eating. Babies are being born, and North America is not stuck in the demograpic nightmare that Japan is.
The bad news is that the Japanese tried raising interest rates last year to 0.5%, and the markets almost went into apoplexy when they did do it (imagine a quarter point causing such grief! But such is the nature of leverage). The Yen Carry Trade is so large that it will take a long time to unwind it, and only through force of will and international government cooperation can they move their rates in lockstep to prevent this from causing further asset bubbles. The Japanese recently lowered their interest rates back down to 0.3%… so two steps forward and one step back…
Asset bubbles will continue to inflate as long as the Japanese export their inflation to the world. And we will continue to see things like the recent real estate boom, fueled off of “your money for nothing and your diggs for free”.
I cannot blame the American homeowners or bankers for being human – greed is a natural instinct. I do blame the Japanese for their insane interest rates that are NOT driving internal growth but rather international speculation, and I do blame quants for their lack of understanding of bi-modal non-symmetric distributions. Taleb likes them however. 😉