The consequences of easy money

Two factors drove this summer’s financial market collapse: The first was an overheated housing market and the second was too much leverage — both of which were a direct consequence of “easy money.”

After the dot.com equity market bubble burst in 2000, Federal Reserve chairman Alan Greenspan cut interest rates from 6.5 percent to 1 percent to prevent a recession. Although some credit Greenspan for engineering the market’s recovery over the past few years, others have criticized his cuts for sowing the seeds of excess risk and debt appetite in the global market.

Low interest rates fueled a housing market boom so strong that both buyers and lenders became irresponsible. Existing home owners were refinancing their homes left and right, while renters dipped deep into their savings to scrape up money to buy their first homes. Most of these borrowers were pushed into “cheaper” adjustable rate mortgages that offered low interest rates for two to five years, after which the loans defaulted back to the current, higher, market rate.

Lenders did their part by offering loans with no down payment to buyers with unproven credit histories. In the housing bubble that resulted, home prices skyrocketed so high the Federal Reserve was forced to begin raising interest rates in the summer of 2004. Within two years, the Fed took interest rates from 1 percent back up to 5.25 percent.

During that time, adjustable rate mortgages were reset to increasingly higher current-market rates, causing borrowers’ monthly payments to rise significantly. This pushed many homeowners into default, starting with the lowest credit, or sub-prime, borrowers. Eventually the problem spread to the market as a whole.

At the same time, low interest rates fueled a huge rise in the global appetite for risk. Investors started piling into carry trades, as some central banks adjusted interest rates faster than others. The availability of easy money in the U.S. and Japan sent currency pairs such as the New Zealand dollar/ Japanese yen (NZD/JPY), British pound/Japanese yen (GBP/JPY), and Australian dollar/U.S. dollar (AUD/USD) to multi-decade highs. People sold low-interest U.S. dollars, Swiss francs, and Japanese yen to buy everything from higher-yielding currencies to international equities, assetbacked securities, and commodities. To make the returns meaningful, market players ranging from hedge funds to Japanese housewives used as much as 100:1 leverage. This magnified profits, but at the same time, magnified risk and, ultimately, losses.

Until July 2007, this was not much of a problem because carry trades and the stock market were one-way bets. However, the sharp, fast down moves in late July stopped out traders of all sizes in the financial markets. The carry trade died a painful death, taking down everyone who was leveraged up to their necks. In August, the drawdown in carry trades was the third largest since the inception of the euro. Between Aug. 8 and Aug. 17, currency pairs such as the GBP/JPY fell 2,500 pips, while the AUD/JPY fell 1,700 pips.

This liquidation was not limited to the yen cross rates. High-yielding currencies such as the Australian and New Zealand dollars also lost more than 900 pips against the U.S. dollar.