The carry trade is like financial narcotics. You can have a great time, and even get away with it indefinitely if used in moderation. However, it's prone to excesses and can ruin lives. My advice? Fellow Fools should avoid "carry traders" like the plague.
What's a carry trade?
A carry trade can be defined as borrowing at a low interest rate (usually a short-term loan) and lending at a higher rate (usually a long-term loan).
Before the housing and credit collapse, a relative of mine was thinking about taking a second mortgage out on his home at a 5% rate and investing the proceeds in land construction loans at a 10% rate. Thus, he'd earn a 5% "carry."
Something didn't smell right. I told him, "If it works, you make $15,000 to $25,000 a year, but if it doesn't, you lose your house." Luckily, my relative agreed that it wasn't worth the risk. I'm glad, because it's possible he'd be out of a house now.
Crashing on the rocks
The most famous example of the carry trade gone bad is Bear Stearns
Other examples of the carry trade gone bad include many now defunct mortgage REITs, including American Home Mortgages and New Century Financial, which held long-term mortgages and financed them through bank lines of credit. When the value of those mortgage loans fell, many couldn't pay up and went under.
The latest carry trade to rock the capital markets is the structured investment vehicle (SIV). In a nutshell, banks set up these entities to buy long-term assets and finances them by issuing short-term commercial paper. An estimated $400 billion in SIVs is outstanding, with players like Citigroup
Why it doesn't work
In my opinion, two of the biggest reasons carry trades fail are liquidity and leverage. The typical carry trade might involve a spread of anywhere from 2%-4%. Thus, to earn 10% on your money, you'd have to leverage the trade anywhere from 2.5 to 5 times.
Many investors demand in excess of 10% returns, and hedge fund managers earn bonuses based on performance, so it's easy to see how Bear's hedge fund managers were tempted to leverage the fund up to (reportedly) 10 and even 15 to 1 to juice returns.
For many years, the carry trade worked and the hedge funds raked in the chips. However, leverage magnifies losses as well, and when Bear's carry trade unwound, the leverage quickly reduced the hedge fund's value to almost nothing.
The other problem with the carry trade is it often involves borrowing short-term debt (such as commercial paper or bank lines of credit) and investing in long-term illiquid assets (like collateralized debt obligations and mortgage-backed securities).
Thus, "carry traders" are at the mercy of the liquidity of the short-term debt markets. Often, the times you need liquidity most (like right now) are when it evaporates, as banks and lenders either shut down or yank back short-term funding, leaving carry traders to dehydrate.
The last problem with the carry trade is that it's extremely difficult to gain a competitive advantage. Some companies, like Wells Fargo
On the other hand, for more generic carry trades, almost anyone can do it! Bear actually planned for a downturn. It hedged its positions shorting the ABX index, which was designed to hedge its long subprime bond position.
The problem was that other traders had put on similar positions. When those other traders unwound their positions, Bear lost money on both sides of its hedge, and the funds collapsed. In other words, Bear's funds didn't have a competitive advantage.
Foolish final thoughts
As you can see, I'm not a big fan of the carry trade. Given the leverage and liquidity risks, and lack of competitive advantages, I think it's usually an investment strategy doomed to failure in the long run. So whenever anyone tells you about an "easy" way to make money involving borrowing short-term and lending long-term, run -- run as fast as you can.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your feedback. The Motley Fool has a disclosure policy.