INSIDE THE FEDERAL RESERVE 111They had encouraged everyone to borrow money and le-
ver up and do maturity mismatches (borrow overnight in the
repo market and go out and buy some risky asset like stocks
or other assets). Because of that, they wanted to give people
lots of warning that they’re going to raise rates.
If I’m a dealer, I can borrow money overnight in the repo
market and go out and buy a 10-year note, which until recently
was about 2%. I have zero cost to funds and I make 2% of my
10-year note, but I can leverage that trade 10-to-1 because I
can get more than 90% margin in the repo market.
A 2% profit levered 10:1 is a 20% return on equity, so with
a government security as my asset, it’s not like I have to go buy
some junk bond. As long as rates were at zero, it was pretty
easy to make 10%, 20%, or even 30% returns on equity with a
highly leveraged trade.
You might be saying to yourself, “That sounds a little too
easy; what’s the risk in the trade?” Well, there’s no credit risk
in the trade because you’ve got a treasury note as your asset.
The risk is that they may raise short-term rates while you’re
sitting there with overnight money holding a 10-year note.
All of a sudden the overnight money gets to be more ex-
pensive, the trade is upside-down, and you’re losing money.
The Fed was saying we encourage everyone to do these cra-
zy carry trades, do these maturity mismatches, make a lot
of money, and rebuild the bank balance sheet. The time will
come when we’re going to raise rates, but we’re going to give
you years, literally, to get out of the trade or wind it down or
hedge it. Anybody who’s caught out, shame on them, as you
can’t say you weren’t warned.
The Fed wants to raise rates to normalize things. They’ve been
talking about it for almost two years because they want to give
people plenty of warning, but the markets don’t listen so well, at
least there’s always somebody who doesn’t get the message.
As I look around, there’s still a lot of leverage in the system,