Dumb Money, Day 1

This week I want to write about one very technical finance subject and the implications for the housing market and, by extension, for cities and the great reset we are going through (to borrow a brilliant phrase from Richard Florida). There are a number of people I am not trying to reach this week, including those who believe this Great Recession is cyclical (classic Keynesians), those who believe the suburban housing market is coming back, those who think their community is well positioned for growth (meaning a resumption of 2005-style growth) and those who find what we do here at Strong Towns to be a cute and convenient foil in your battle against "sprawl", but otherwise believe we need an active centralized approach to managing the economy. If you fit into one of those categories -- or a closely aligned to one -- go ahead and take a week off. Next week I promise to pivot back to planning, engineering and urban-related issues.

This week I'm writing for the choir, for those of you that generally buy into the Strong Towns approach. I want to bolster those of you that inherently believe that there is something rotten at the core of the economy. I want to give you context for all the propaganda being thrown at you about how our economy is getting back on track (record stock prices and accelerating housing market being two oft-repeated benchmarks). I especially want to support those of you that are actively working to realign your communities around resilient, Strong Towns principles. I don't want you to slide back into the Ponzi Scheme, especially since the market's need for dumb money is so intense right now. This week is about giving you confidence to stay the course.

First we are going to start with a lesson on debt and something called the "carry trade." Let's start with a very simplified explanation of how debt is used to magnify returns.

Let's say I have $1,000. I use it all to go out and buy a 30-year treasury note paying 3.5% (which is roughly the current rate). I now own a $1,000 note that will pay 3.5% ($35) annually for each of the next 30 years, after which my original $1,000 will be returned to me.

With that $1,000 note as collateral, I now go and borrow $900. I have 10% equity here -- some skin in the game -- but I'm still pledging the entire $1,000 so I can borrow another $900. I get the additional $900 and use that to buy 30-year treasury notes at 3.5%. Understand what I've done: I started with $1,000 and now, after one iteration of leverage, I have $1,900 in treasury notes along with a $900 debt. It's the same amount of money -- $1,000 -- but deployed differently in the market.

Now I take my $1,900 in treasury notes and I go through this leverage process again, essentially pledging that collateral for a loan of 90%, or $1,710. I promptly buy another $1,710 in AAA rated 30-year US treasuries. Good as gold. My $1,000 has now gotten me $3,610 in treasury notes along with $2,610 worth of debt. I still have more assets than liabilities, meaning I still have equity and everything I owe is fully collateralized with AAA securities.

This cycle continues again and again and again until my $1,000 yields $47,046 in 30-year treasuries along with $46,046 in debt. This is roughly the ratios of leverage that firms like Goldman and Bear Stearns were at when they went under and, reportedly, the levels that many of the remaining Wall Street banks are at today.

Why would a bank take on so much debt? The answer is something called the carry trade. While I said that our $1,000 is being used to buy 30-year notes at 3.5%, I didn't say what rate we were borrowing at. Obviously, if we had to borrow at a rate higher than 3.5% -- which you and I would have to for something like this -- we'd lose money in this trade. That's not how things work for banks, however.

A bank can borrow overnight today at essentially no cost. The bank borrows $46,046 this morning and promises to repay you at the end of the day. There is a tiny charge, but not much. Even if they were borrowing for a term -- say 90 days -- the rate is going to be really low (say, 0.1%) thanks to the Federal Reserve artificially supressing interest rates. At the end of 90 days, you just roll that debt over into a new 90-day loan.

So the carry trade is simple. You borrow at a low rate and lend back at a high rate. In this case you borrow for 90-days at 0.1% and then lend out at 3.5% for a 30-year note. In the first year, you have to pay 0.1% on your $46,046 debt (that's $46), but you make 3.5% on your $47,046 in 30-year treasuries (that's $1,647). 

I know this is a lot of numbers, but pause there for a second and understand what you just read. You started this exercise with $1,000. Due to your ability to leverage and the artificially low rates you pay on that debt, you pay $46 in interest expense and have $1,647 in interest earnings. In other words, your $1,000 earned you $1,601 in pure profit. You can sell all your securities, pay off all of your debts and walk away at the end of one year with a profit of 260%. (Now just imagine that, instead of $1,000, you were talking about $100 billion.)

Whoa Chuck, it can't be that easy.

Generally, it's not. The carry trade has some obvious risk involved. By financing short term to purchase a long term security, you are taking a very real risk that short term rates could rise and invert the trade. Let's say short term rates rose to 5%, the historical average over the past thirty years. Now you have a 30-year security paying just 3.5% but you are paying 5% on your financing. You are going to burn through your $1,000 in equity very quickly and then you're insolvent. Nobody is going to lend to you short term (or any term) and it's all over.

But what if you just sold your long term notes to pay off the debt? Well, when short term rates rise, long term will rise as well. If I am going to take a long term risk, I'm going to demand a higher interest rate than I could get for a short term risk. So if short term rates go from zero to 5%, long term rates would make at least that bump, from 3.5% to 8.5% (the rate of my first 30-year mortgage back in 1996 - how quaint).

Why is that important? Well, if I'm in the market trying to buy a 30-year note and I can get one paying 8.5%, how much am I going to be willing to pay you for your $1,000 note that is paying just 3.5%? The answer: a lot less than $1,000. In other words, as those long term interest rates rise, your long term securities are now worth less. This trade is now blowing up on both sides; your financing costs are rising while your asset value is falling. That's a deadly combination.

So the carry trade has a lot of risk.....that is, unless the Federal Reserve signals very clearly that they are going to keep interest rates low and stable for an extended period of time. When that happens, the carry trade is on and becomes a relatively low risk way to make a lot of money very quickly.

Let's end there for today, but first let me summarize.

• Big banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt.

• One form of the carry trade takes advantage of the interest rate difference between short term and long term securities.

• Interest rates kept artificially low and stable reduce the risk associated with that form of a domestic carry trade.

Tomorrow we're going to talk about the theoretical relationship between savings and investment as well as mortgages and the mortgage-backed securities market. Wednesday I'm going to explain how the Federal Reserve is now held hostage by their own zero-interest rate policy, to the point where their own policy advisors are pointing out the obvious. Thursday I'm going to bring it all together and show how the current growth in stock prices and housing is a debt-fueled illusion, one begging for dumb money. Finally, on Friday I plan to lay out two scenarios -- one optimistic and the other pessimistic -- for how this could all play out.