U.S. Bailout: the mother of all carry trades?

There are some great ideas out there about what the U.S. bailout is all about. Earlier, I mentioned my belief that it had everything to do with marking to market. Just a while ago, I caught a post that has a very intriguing angle on the plan: it’s the mother of all carry trades (hat tip Brad DeLong).

For those of you who don’t know what a carry trade is, it is a term used when investors borrow money where it is cheap and then invests that money at a higher rate. The quintessential example of the carry trade was the Japanese carry trade. Japanese investors (and many foreigners) borrowed money in Japan at near zero percent and invested the money abroad at much higher interest rates, often with significant leverage.

Could Hank Paulson be looking to do a carry trade?

There might be a gem in the Treasury’s plan to buy $700 billion of dubious mortgage-related assets.

Call it the biggest carry trade in history. It might just put as much as $60 billion a year in the government’s coffers.

All of the discussion of risk has focused on whether the government eventually could sell the assets it buys from financial institutions for more than they cost. In other words, whether the government — and therefore taxpayers — would incur a loss or a gain.

“I am very uneasy with the proposal to spend a trillion dollars to buy illiquid assets, toxic securities from large financial institutions, and have the taxpayers pay for that,” Representative Spencer Bachus, the top Republican on the House Financial Services Committee, said on Sept. 23.

The government will get the $700 billion by selling a range of Treasury securities to the public with yields of 3 percent to 4 percent. With investors around the world clamoring to buy risk-free Treasuries, the market should be able to absorb the jump in supply without a significant increase in yields.

Contrast that with likely yields on the troubled assets for which there currently is no market. No one can be sure how big a haircut there will be on the assets Treasury buys, though if it’s 50 percent or more, their yields should be 10 percent or higher.

That is, the government will be borrowing at 3 percent to 4 percent to buy assets yielding 10 percent or even 12 percent. Conservatively, that spread on an investment of $700 billion should generate income of $40 billion to $60 billion annually.

This is an interesting twist to the bailout speculation. And while these toxic assets are not ideal vehicles for a carry trade since they can blow up, the interest rate differential would help to reduce the cost of the bailout.

Click the link below for the full article.

Source
Bailout May Be Granddaddy of All Carry Trades: John M. Berry – Bloomberg