Cash and Carry

Greenspan’s latest gift to the markets.

Last Friday’s surprisingly lousy employment report certainly troubled the White House, but it produced at least a few smiles on Wall Street. This evidence of economic weakness indicated that Federal Reserve Chairman Alan Greenspan would not raise short-term interest rates any time soon. And that gives banks a license to continue what has been one of Wall Street’s most lucrative lines of business in recent months—the “carry” trade.

Banks have always used their solid credit to borrow money cheaply and then put it into higher-return investments. Historically, that meant making mortgages, or lending to companies, or lending to consumers through credit cards. Of course, these types of loans expose the lender to credit risks. A borrower can default or get into trouble. So it’s easier to lend money to—or buy the debt of—a borrower who will never default, such as the federal government.

And it’s easiest of all when you can buy that risk-free debt with money that’s essentially free. This, in essence, is the carry trade. The carry trade depends on a nice, steady interest rate for short-term borrowing. Last June, Greenspan slashed the federal funds rate to 1 percent and has vowed to keep it there for a considerable period of time. Here’s how the carry trade might work, in its simplest form. A bank borrows money at the federal funds rate of 1 percent, then uses it to buy a security like the 10-year Treasury bond, which yields around 4 percent. The bank pays its tiny smidgen of interest every day—1/365 of 1 percent—and then collects the quarterly interest payments on the Treasury securities. When the difference between short- and long-term interests is great— that is to say when the yield curve is steep—this strategy is golden. And for much of 2003 the yield curve was quite steep. At a time like last year when fewer companies wanted loans, the carry trade was a reliable source of bank revenue.

How big is the carry trade? It’s hard to ferret out precisely how much money is involved. But you can get hints of it by studying the performance of large investment and commercial banks. Even though the rise in the stock market captured headlines last year, it was the bond business that led to mammoth profits at many large investment banks. Goldman Sachs’ year-end earnings release noted that revenues from the equities business rose 7 percent, while fixed-income revenues rose 20 percent to a record $5.6 billion. In its annual report, Lehman Brothers noted that “principal transactions”—revenues from bets made with the firm’s own capital—rose 119 percent in 2003, “principally reflecting record revenues from fixed-income products.”

There’s evidence that commercial banks are putting proportionately more money into Treasury bonds and proportionately less into loans to companies. The Federal Reserve reports how much government securities banks own. During 2002, banks increased their holdings of government securities from $835 billion to $1.03 trillion—a 23 percent increase. In 2003, such holdings rose another 7 percent and stood at $1.1 trillion in January 2004. In the past two years, government securities have risen from 15 percent of banks’ overall credit to about 17 percent. Meanwhile, bank lending to companies has fallen over the past two years, from $1.02 trillion in January 2002 to $898 billion in January 2004.

The benefits of the carry trade do trickle down to the rest of us. Those involved in the carry trade are constantly buying long-term securities—like the 10-year Treasury bond—and their constant demand is one of the factors that keeps long-term interest rates down. That translates into lower mortgage and credit-card rates for the rest of us schlumps who can’t borrow at 1 percent.

The carry trade seems like a way for banks to print money—they make whatever the spread is between their short-term loans and long-term securities—but it is not without risks. It only works when interest rates remain static. Once rates start rising, it’s possible to lose lots of money quickly. If long-term rates rise, the value of the long-term securities the bank holds will fall, exposing the bank.

A sharp rise in short-term rates also threatens the carry trade. The short-term rate is entirely dependent upon Greenspan & Co. If the Fed were to boost the federal funds rate, it would instantly become far more expensive to borrow the cash used in the carry trade. And that’s why bond-market participants still weight the Maestro’s every word carefully. A few words from him, and their money-printing machine could grind to a halt.