For over a year now, we have discussed the potential trouble with the Yen Carry Trade. With interest rates in Japan as low as .50% many Japanese and foreign investors were taking out huge loans of the yen at very low rates, then exchanging the ten for higher yielding currencies such as the New Zealand dollar, which was fetching over 7%. So with a spread of over 6% many investors jumped into this game, and for quite a while it has paid off nicely. But in July things started to change. The yen started to appreciate in value, bringing more investors back to the yen, which ironically exasperated the problem for investors who borrowed the yen to invest abroad. As the yen appreciated against other currencies such as the New Zealand dollar, those who borrowed heavily against the yen to buy the NZ dollar started to panic because their profits were drying up and they still had to buy back the yen at higher rates to pay off their loans. Up until mid July this year, this investment of borrowing yen to buy the NZ dollar was paying off nicely. But since mid July this ratio of the NZD/JPY has fallen over 20% from its high, meaning the Japanese Yen has appreciated 20% against the New Zealand Dollar in less than a month. This is a great example of how the carry trade can go wrong, because New Zealand was a country that Japanese investors flocked to in order to seek higher yields, and those investors were caught holding the bag. This carry trade issue is similar to what we saw in the US housing market the past few years. When US interest rates were very low and banks and mortgage lenders were offering very creative mortgages, everyone was buying homes. Many homeowners bought more than one home because they couldnt lose. Because housing prices kept going up, many borrowed against the new increased equity in their home and bought another home. Others who normally wouldnt qualify for homes were being offered great new mortgages, some with no money down and with extremely low interest rates for the first 2 years. It was all so easy. Buy a home for $150,000, make the low payments (say $575 per month) and in 2 years, sell the home for $170,000 or event $200,000. The only problem was that indeed, they could lose. In fact many have lost and many more are about to lose. Today that $150,000 home might only be worth $140,000. In addition their mortgage is now coming up for reset, meaning that the extremely low interest rate of 1%-2% is now going to be a much less affordable 7% - 8%, and their very reasonable monthly payment of $575, will go to a much less affordable $1200. When the balloon bursts.. Back in January when we published our 2007 Global Outlook Forecast, we warned that the sub prime mortgage defaults were going to cause trouble for the markets and the US economy, and we expected the problems to last longer than most would expect. Today, as we are in the throws of this sub prime melt down, we are concerned that the problems may be even greater than we had predicted. The subprime-mortgage failure started with higher-than-expected defaults, then led to hedge fund wipeouts, and most recently to mortgage broker bankruptcies (the latest count on bankrupt mortgage lenders is now up to 129). Up to this point, the problem was isolated to the subprime segment of the market. But because these mortgages were packaged together with thousands of other mortgages from many different underwriters, these subprime mortgages made their way into hundreds of financial institutions around the world. As we documented in previous articles, investment banks created a new type of security called an Asset Backed Security (ABS). in effect, investment banks would take a thousand mortgages or car loans or commercial mortgages or bank loans and put them into a security. As an investor you could invest in any one of the following bank instruments: a Collateralized Debt Obligation (CDO), a Commercial Mortgage Backed Security (CMBS), a Residential Mortgage Backed Security (RMBS) or or a Collateralized Loan Obligation (CLO). With all of these packaged investmentscontaining thousands of mortgages from different underwriters, its probable that hundreds of financial institutions around the world have a hint of weak subprime mortgage debt that they are carrying. Parts of these RMBSs and CDOs were rated AAA. Almost any financial institution could own them hedge funds particularly. The current problems started when investors in these Hedge funds caught wind of these poor quality mortgages in their portfolios, and started to ask for their money back. This started in the US, but the panic soon spread to France and Germany also. Mass psychology is a powerful market force, and when that force is driven by fear, the magnitude ramps up dramatically. In July as more and more hedge funds started feeling the pinch, no one wanted to buy mortgage debt as all mortgage debt was now being branded as bad which is crazy. We have seen companies such as Thornburg have seen their shares drop dramatically this past week or two.
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