A reader writes (via the Blowback page):
I have read many very good explanations of how the carry trade works.
My number one question is still unanswered.
Who can borrow dollars at what ever the low rate is? Is it banks, or brokerages or individuals? Is the actual borrowing a series of trades and transactions done by individuals or institutions?
Is there no one person that can be seen that we can say, “He is a carry trader and he borrowed $1,000,000 from BoA and invested in T-bills”? or gold or whatever?
This is not an idle question. I have asked a number of knowledgeable people, [potentially embarrassing names deleted]. They either don’t know or are not saying or I get an off the cuff bs answer.
I would be grateful to know the answer to this question. I am sure others that share the same thought but are too shy to ask for fear of looking foolish.
D – thanks for the question.
In my worldview, the carry trade is the business model of every financial company — borrow at a low rate, and lend(invest) at a higher rate.
It’s really that simple.
The two most common forms are credit spread carry trades and maturity spread carry trades.
Credit spread is when your bank takes in deposits and CD money, and bolstered by the FDIC guarantee, is able to lend it out to individuals and businesses at a higher rate. Their credit risk, with the guarantee, is clearly lower than the credit risk of those individuals or businesses, so the rate paid on those CD’s or deposit accounts is lower, allowing a spread to be extracted.
The bank can also choose to buy MBS or even Treasury Notes of a longer maturity and higher interest rate with your deposit money. This form (maturity spread) is the type of carry trade most often used by hedge funds and even individuals.
If I can afford the million dollars to buy a GNMA MBS, I have the Full Faith and Credit of the US Government backing my investment. If I then turn around and offer that GNMA as collateral for a short-term loan (margin), I have given the lender the first part of a good loan. The next part to make that a good loan is the advance rate – the percentage of the value of the GNMA that the lender actually lends. The last part is my personal credit to cover the loan even if the GNMA drops in value so far that cushion from advancing less than 100% of the market value has been eaten up.
Having actually tried to do this when I left the Street back in the late 1990’s, I can tell you what the terms were for me as an individual vs. the terms I could have gotten if I were a hedge fund, at least at that time. I’ll also tell you what it took to become a hedge fund to get the better terms.
Since I discussed it with dealers and my main bank at that time, I got a pretty good picture. By the way, I decided not to do it, because the hassle factor was high for getting good terms, and the terms offered to me as an individual were so lousy that I couldn’t bring myself to volunteer to be ripped off that blatantly.
As an individual with excellent credit and more than million dollars in (real estate) loans outstanding with my bank, I asked to be put in contact with their GNMA trading operation. I already had a brokerage account with them, but that was trading listed stocks and options, and could not handle bonds for anything other than a straight cash purchase.
With the GNMA trader, I proposed to put up $1.2 million in cash, and to buy current coupon GNMA’s on margin. They came back with the following offer:
I could buy $10 million in GNMA’s, and borrow $9 million (90% advance rate). I had to commit to keeping the extra $200K in cash in the account at all times, and they would charge me Prime + 1 for the borrowing. At the time, Prime was already a couple hundred basis points above LIBOR, and LIBOR was about 10 basis points higher than the GNMA repo rate. They also quoted me a purchase price a quarter point point higher than the market.
I found these terms offensive. If I were a small hedge fund, I would only have to put up 5% margin “haircut,”, not 10%. I would have no restriction on the remainder of my account and I would pay no more than a 10 to 20 basis point premium over the regular GNMA repo rate I could read on my Bloomberg screen. It was really the last term – the rate they were charging – that made me say “no.”
I next looked at setting up a small hedge fund. I could get an attorney at a major shop I had given plenty of business to in the past to quote a start-up fee of $50,000. Then I needed to open an account with a Prime Broker, who would hold my securities and cash, and lend me money for leverage. The Prime Brokers I spoke with all wanted a minimum commission payment if I didn’t hit their minimum assets requirement. Those minimum (unlevered) asset requirements were $10 million to $50 million. The minimum commission was also pretty hefty, ranging from $10,000 per month up to $25,000 per month.
Any way you cut it, the big boys wanted about a quarter of million per year in excess interest or fees from me to let me play on the main court. Having only a million and quarter in risk capital, I realized that the no-limit table was too rich for me, and I needed to go back to the $10/$50 table with my pathetic pile of chips.
Given the scare of a lifetime most bond investors and bond margin (repo) lenders had last year, I can guess it’s only gotten worse. Watching all the amREITs holding their leverage in the single-digit range these days says it must be so, because they have billions in assets to finance.
The best option is to become a bank. That is truly a great thing to be if you don’t have any bad loans or investments on your books. The capital requirements for holding Agency MBS are just as low now for banks as they were before the crisis. That means a bank only needs to hold 3% to 8% capital against its MBS positions.
On a pure capital basis, they have anywhere from 11:1 all the way up to 32:1 leverage available. It boggles the mind how much carry that can be, even with mortgages yielding only 4.5% or less. After all, deposits, CD’s or Fed borrowings average less than half a percent if you’re willing to take the rollover risk on the liabilities resetting next year.
Of course, you could take a shot at predicting the paydown curve for your newly minted bank’s MBS investments, and enter swaps to lock in LIBOR (which will be very close or slightly above your repo rate). Two year swaps are hovering just above 1%, three-year swaps are around 1.60%, and you have to go all the way out to seven years before you crack 3%.
That would be the way to go if you had enough extra dough to deal with margin calls if spreads widen. By laying on a series of swaps from 2 years out to 10 (3.44%), you could probably lock in financing on 80% or so of your MBS at an average cost around 2.25%.
I used to work with a rule of thumb that I didn’t want to hedge more than 70% of my MBS balance, simply because of the cost of being wrong when rates move and the prepayments shoot way up or drop to nothing. That kind of wrong can put you into the dreaded “negative carry” trade. That’s a place you don’t want to go.