How Carry Is the Velvet Glove of Power 

The first time I heard the term “carry trade” was in June 2007. I was standing by an elevator bank as bond trader Dan Fuss explained to a cluster of anxious money managers the essence of Bear Stearns’ bailout of a pair of its hedge funds announced earlier that day.

It had been a carry trade, Fuss told them, harder to understand than a classic currency carry because it involved mortgage market derivatives, but otherwise no different in its fundamental structure:  borrow at low rates in one market in order to invest in high-yielding assets in another, and hope that nothing changes.

But things had changed. With doubts proliferating about the funds’ underlying assets, which happened to be subprime mortgages, overnight lenders were putting up rates and investors were withdrawing their money.  Bear had no choice but to close the funds and absorb their losses. Seven months later, the firm itself failed and was merged out of existence.

Looking back, I see how wise was Fuss in his concise description that day, though I noted yesterday that Bethany McLean and Joe Nocera took ten pages in All the Devils Are Here: The Hidden History of the Financial Crisis (2010) to explain in detail how Bear’s High-grade Structured Credit Strategies Enhanced Leverage Limited Partnership had come to grief.  The episode was the first hint of events that fifteen months later would culminate in the Panic of 2008.

I remembered my innocence as I spent part of last week reading The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis, by Tim Lee, Jaimie Lee, and Kevin Coldiron (McGraw-Hill, 2020). It is quite a good book, clear and strongly argued, likely to command a wide audience among financial cognoscenti, Silicon Valley guru Tim O’Reilly’s online learning club, for instance. Sufficiently confident are the authors of the freight-train qualities of their argument, with its 39 figures and tables, that they reserve their punchline for the very last paragraph.

That argument is this: carry trades, when they can be arranged, are especially attractive to well-to-do investors because they resemble selling insurance. They deliver a flow of income or accounting profits eventually punctuated by large losses when unforeseen events occur. These surprises may not threaten a strong and well-managed balance sheet when they occur, but they will certainly be dangerous to those who have underestimated the risks.  Carry trades flourish when “nothing happens,” the authors say. Let underlying asset prices, currencies, or commodities begin to fluctuate and things get interesting. Volatility is the enemy of carry.

Central banks were invented to manage the risks of carry trading – after all, the whole idea of banks is to borrow short in order to lend long. But as the global economy has grown, so has the “moneyness” of all the other financial instruments with which central banks are today concerned. Central banks have become the foe of pooled risk.  When credit arrangements are threatened by volatility, central banks are expected to “supply liquidity” – that is, to serve as lenders of last resort.

The more carry, the more vulnerable is the economy to unanticipated shocks of one sort or another, the authors say, and therefore more prone to requiring periodic bailouts. They note that carry trades today can be arranged “by writing insurance or credit default swaps, buying higher-yielding equities or junk debt on margin, taking out buy-to-rent mortgages to finance  property investments, writing put options on equities or equity indexes, or buying exchange-traded funds” that do the same. But that’s not all, the authors say:

Carry trade can also include dealings such as companies issuing debt to buy back their own equity, or private equity leveraged buyouts, plus a whole gamut of more complex financial strategies and financial engineering.  In all cases the carry trader is thus explicitly or implicitly betting that underlying capital values will not wipe out his or her income return; the carry-trader is betting that asset price volatility will be low or will decline.

In other words, carry trades have found their way into every nook and cranny of present-day finance, and central banks are committed to keeping volatility low, lest these arrangements fail en masse. Whatever the business cycle was, it has come to be dominated, since 1987, by long and tame business expansions, threatened at intervals by potentially catastrophic crises. And with each such subsequent government intervention, insiders are rescued, outsiders (like the widely-resented Bear Stearns) are permitted to fail, the rich grow richer and inequality increases, according to the authors. Carry, they say, is about power.

The opportunity to decisively lean against carry was lost in 2008, the authors conclude, when governments chose not to allow banks to suffer catastrophic losses. What lies ahead, they say, is more of the same: carry bubbles and carry crashes, financial concentration, growing inequality, fewer opportunities for workers, more nationalism and populism.  Properly examining the fire-or-ice possibilities discussed in the last chapter of the book, “Beyond the Vanishing Point” (at which carry trades eclipse all other possibilities), would take a month of Sundays. It is for sustained discussion of this sort that book clubs and online learning venues exist.   And then there is that last paragraph.

Ultimately the verdict of history will likely be that the post-Bretton Woods experiment with fiat money failed. But technologies that have emerged could possibly provide the basis for future, workable monetary systems. Whatever it is that eventually arises from the ashes of the present monetary system, we have to hope it will be more effective in restraining the rise of carry.

It may turn out to be so. But for all its learnedness about the logic of cumulative advantage, The Rise of Carry leaves out a great deal in the realm of democratic politics and taste-making that is important, especially the effects of continuing technological and climate change on attitudes toward taxation and income distribution.  Independent central banking, financial regulation, and antirust policy will continue to be tested, along with all other democratic institutions. But surely it is too soon to judge the modern experiment in self-government a failure.

The Panic of 2008 was only the first modern encounter – or perhaps the second or third – with the consequences of rapid economic growth. Experience – as in Surviving Large Losses: Financial Crises, the Middle Class, and the Development of Capital Markets, by Philip Hoffman, Gilles Postel-Vinay, and Jean-Laurent Rosenthal – remains a great teacher.

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