Sinking the pound with the yen

The Yen Carry-trade was always a risky deal that was destined to blow up.

Friday 24 October saw the Pound Sterling fall 10% against the ailing Dollar in a single day, now down by 25% on the year: bad budget figures, a bad PSBR borrowing requirement, the Governor publicly using the “R” word for the first time, that and the fact that business confidence has fallen out of bed as panic grips the market as insurance companies are clobbered by the crashing stock market, and so on. There was, however, something else going on too, namely the end of the “Cash & Carry” game.

The Yen Carry-trade as it is, or was, called was always a risky deal that was destined to blow up and kill and injure those in the immediate vicinity, namely the highly-leveraged hedge fund and buy-out managers, but as we now see it’s also injuring the rest of us who were nowhere near the scene of this particular bank raid.

These managers had borrowed the Japanese Yen to finance their highly-leveraged deal structures, no doubt supported by derivatives in the ERS, IRS and CDS categories – that’s to cover exchange, interest and credit default risks.

This particular heist worked like this: Japan has been experiencing deflation for over ten years now; so interest rates are 1% or less, so you borrow Yen at, say, 1 to 2% and pay off your borrowings in Sterling which were costing you, say, 6 to 7%. Your temporary profit was termed the “Carry” – cash back in their pocket.

The risk, however, is that the Yen appreciates against Sterling and your debt in Yen rises by more than your interest rate saving. Ouch! Quick, unwind the carry trade and dump the assets, thus knocking Sterling and the markets yet again.

The Carry-trade involved borrowing strong currencies only, especially the Yen and Swiss Franc. As they were strong currencies, the downside risk to Sterling borrowers was consequently high. This all sounds so obvious, you say, why take this risk? Answer: simple, it was just good old greed at work again. And who pays for this now? Simple, Stupid! You and me, as our key strategic imports, such as oil and food, have to rise in price and our holidays abroad, as we try to escape all this nonsense, cost us much more, as the Carry-trade bubble bursts and damages the markets and all our pension funds.

In fact the correlation between the S&P 500 and the Yen-€uro rate from 2005 to now, October 2008, is exactly in step, ranging from 1200 on the S&P to 850 over the period, with a high in Q3 2007 of 1575.

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Should deal-makers be allowed to finance deals in a soft/softish currency, by resorting to borrowing in another, but much harder, currency?
Should any derivatives entered into to minimise these (and other similar) risks be transparently displayed on a global internet platform for all to see, to make the market transparent as opposed to opaque?
Is there a way, if these deals go wrong, of punishing the ever-so- greedy ones who took on these dangerous risks to maximise their own returns?
Or is it best left to the market which, unlike regulators, doesn’t charge for its services, to inflict the punishment by way of losses to investors and managers – the Adam Smith “preferred remedy”, the ‘Invisible, and cost-free, Hand of the Market’?
Or should regulators impose limits on these structures? After all, when they go wrong ‘It’s us lot what pays!’

What do you think? What are your ideas?