REMINDER: Don’t forget to enter Round #5 of the Money Movie Giveaway – you could win a copy of “Casino” or the original “Ocean’s Eleven” on DVD! Click here for more details – free to enter, contest ends October 31st, 2008.

Yesterday’s post described the Carry Trade, and specifically the pesky Yen Carry Trade which is currently being unwound. I suggest reading that post before continuing with this article.

Possible Ramifications

We discussed how borrowing Yen on the cheap and investing the proceeds in higher yielding securities in other countries earned a return basically equal to the differential in interest rates. Further, a carry trader could magnify this return through leverage. Well, if you aren’t happy enough with that you could increase the return further by seeking out higher yielding investments, like say real estate in the form of sub-prime mortgages packaged into triple-A rated investment bundles.

So what happens when there is hundreds of billions if not trillions of dollars carry traded from Yen to sub-prime mortgages and real estate prices start to fall due to defaulting homeowners or exchange rates change and your leveraged carry gets a margin call from your forex broker? You need to unwind your carry trade fast. The Yen skyrockets with all the short covering and assets are sold at a loss in order to cover the Yen short. Japanese exports get more expensive for the rest of the world so this is bad news for Japanese companies and the Nikkei 225 plummets.

Unwinding of the carry trade also exacerbates real estate downward price pressures and the home equity which had been the source of American discretionary spending evaporates, which triggers a recession. Recession means less spending which equals less earnings for companies and since stock prices are basically fueled by earnings, stock prices drop.

Stock prices drop causing margin calls which are covered by forced selling of more stock which creates more downward pressure on stocks. Many hedge funds had redemption notice deadlines of September 30th which means investors could get money out by requesting it by that date – a lot of investors did and hedge funds may be selling assets to fund the redemption requests (which may be required to be paid out 45 days later) – so you might get a lot of selling pressure (and a lot of rally-killing pressure). It’s vicious out there, and these are only but a few of the possible causes for all the volatility.

Precedence

The Russian Financial Crisis. There was a Yen Carry Trade back in 1998 with proceeds going into Russian debt which was paying high interest rates. When those Russian debt securities started defaulting, short-covering the Yen pumped up the Yen by about 30% in the span of two months. Many hedge funds were wiped out.

Currently, it’s hard to really guage how much money is/was tied up in the Yen Carry Trade. If you look at the actual amount of shorted Japanese treasuries it’s only a fraction of the picture. Shorting Japanese currency futures does not show up on official records for the Bank of Japan’s reports – these are essentially side bets which have the same price effects on the currency. Needless to say, what’s happening is a mess and there are a lot of secondary and tertiary negative pressures at work beyond just market fundamentals (which themselves seem to be out to lunch).