Yesterday’s analysis of the banking crisis we face was disappointingly vague. But at least we got much of the theory out of the way. Today, we add a few specific figures to the blurry picture and discuss why they might not matter anyway. At least, that’s what the media says…
So, how many trillions in unrealised losses do banks need to chalk up before they matter? I mean, if your bank faced tens of billions in losses, but pretended it wasn’t, would you want to know about it?
That’s a surprisingly difficult question to answer, believe it or not. If depositors decide they don’t like what they see, that is precisely what causes the bank to fail after all. Unless you believe that the banks’ management should be blamed for making poor investment and lending decisions.
As explained yesterday, higher interest rates mean falling bond prices. Some have tried to calculate the level of unrealised losses that higher interest rates have imposed, which I assume do not account for hedges (which only transfer the losses elsewhere).
“The Fed’s interest rate moves have likely cost banks [US]$900 billion,” estimates Fundstrat. And the FDIC, which insures bank deposits in the US, estimates losses of US$620 billion – about the market value of the US’ two largest banks…
Remember, it’s largely unrealised losses. Declines in asset values that, theoretically, need only matter if banks are forced to actually sell those assets. Or if the derivatives counterparty defaults – part of what made 2008 so dramatic.
While the canaries in the US and now Switzerland have been dropping dead and looking mighty sick, the biggest hint that we’re in trouble actually comes from central banks. Their transparency means we have some reliable figures.
Central banks hold a lot of government bonds after doing a lot of quantitative easing. That means they are sitting on vast unrealised losses on those bonds, just like banks.
As they attempt to rein in inflation, they will be selling these bonds in a process known as quantitative tightening (QT). The trouble is that this means realising losses on those bond positions. They actually sell the bonds at a loss.
We’re talking a £200 billion unrealised loss for the Bank of England. The Federal Reserve’s is around half-a-trillion US dollars. The Swiss National Bank made a loss of 132 billion Swiss francs last year alone! Several European central banks could face negative equity this year already, according to Bloomberg.
And so central banks around the world are discovering that they may be insolvent and some don’t have the money to fund their own operations. Governments may need to bail them out.
If central banks are facing such losses on their government bond holdings, which may or not matter as discussed in past editions of Fortune & Freedom, then banks, who also hold a lot of government bonds, must also be facing such losses.
And by facing I mean that they have them on their books, but aren’t realising them. They aren’t selling the bonds at a loss because they don’t have to carry out QT like central banks do.
One of the reasons why the global financial crisis got so bad was because banks had rules about how much risk they could take, known as value at risk (VAR). The estimates on how risky mortgage-backed securities were suddenly rose when house prices dipped and defaults rose. Banks were forced to either increase reserves to offset the increased risks of their positions, or reduce their exposure to those investments. This implied selling those investments, thereby crystalising the losses and dumping the price through the floor at the same time – a bad combination.
In other words, it was the risk management rules that forced selling regardless of market prices – the same shemozzle that caused a bond market meltdown in the UK late last year.
Now I’m not sure how a liquidation sort of event might play out again. But given one already did in the UK bond market recently, and given they can happen for a variety of reasons, do you want to stick around to find out whether banks will have to sell out, as some American banks did?
The whole point of the canary in the coalmine analogy is that canaries are especially vulnerable and so their death is a warning to the rest of a much larger problem. Concluding that they’re just canaries is precisely the wrong conclusion.
I do realise all of this remains a bit vague. “I’ve got a bad feeling about this,” makes for a good line in a movie, not good financial advice. But consider what we know.
Someone is sitting on vast unrealised losses on assets, which weren’t supposed to cause such losses, and which are integral to the functioning of economies.
All it takes is for them to be forced to realise those losses, or to be caught out holding too many derivatives betting those losses wouldn’t happen. And then the crisis has its next series of victims.
For more on this idea and its implications, consider this truly excellent video with Daniel Lacalle, which explores these issues in more detail. And, as ever, avoid financial stocks.
In the midst of all this financial chaos, it’s important to remember that not all businesses are financialised. Some deal with very real widgets and do not implode at the shift of an interest rate or the transfer of a pound. So, while the financial system goes into meltdown, why not consider reallocating some of your capital to something more stable and productive?
Nick Hubble
Editor, Fortune & Freedom
