If a canary in a coalmine drops dead, do you spend your time debating whether bird flu is contagious or not? That’s what all the bank crisis kerfluffle in the media and on social media is about. And all the reassurances are driving me completely bonkers.
I have never seen such a blatant example of missing the forest for the trees. And the enemy isn’t even pretending to be Birnam Wood on its march to Dunsinane – the threat is plain for all to see.
But still experts are arguing that the particular banks which failed merely made mistakes of various sorts. They’re still pretending that the underlying cause is not the real issue. And they claim that those pointing out the vast losses are missing the point.
Last week, I attended a meeting of the editorial team of our Australian cousins. And their discussion of the banking crisis in the US, which hadn’t spread to Switzerland yet, was more than a little annoying too.
Today, we dig into the mistake everyone is making…
The short version is that cripplingly large losses are sitting on bank balance sheets across the developed world. But, balance sheets are static things, unlike profit and loss statements which show what actually happened. In other words, because banks have not realised the vast losses, and may never have to, everyone is pretending we’re all just fine.
My question is whether you want to punt on this presumption or not given the size of those (admittedly unrealised) losses. Silicon Valley Bank depositors decided they didn’t.
I’m not pretending to know the odds of those losses actually crystallising, by the way. Just that the size of the risk is big enough to make the odds irrelevant, because the crisis would be so severe. Just as you insure your house without expecting it to burn down, you shouldn’t own bank stocks.
But I suppose I better explain the nature of the combustible gas that’s accumulating in the caverns of our banking systems…
When interest rates fall, as they have since the early 80s, this means asset prices go up. This is true for a variety of reasons, which are actually worth digging into, at last. At least, they’re no longer boring, unless you haven’t been following the news lately.
Lower interest rates make bond prices rise because higher interest paying bonds become more valuable in a low interest rate-paying environment. The specific maths is complicated, but a bond that was issued years ago and pays 5% interest, while the prevailing market interest rate is now say 1%, will be rather popular with investors. This results in its price being bid up. The price eventually rises so high that the 5% interest payment equates to a 1% return, equalising the return across similar bonds.
If this is confusing, ask yourself why it is intuitive when discussing dividend-paying stocks. If a company’s dividend is yielding 5%, while its peers yield only 1%, the price of the stock will go up until the dividend yield is 1%. It’s the same with bonds.
But it’s not just bonds. Other assets get bid up in much the same way. A bond with a 5% yield is quite enticing relative to a stock. But a 1% bond yield encourages you to buy shares instead. And this bids up share prices. Which is how cutting interest rates boosts the stock market.
Furthermore, companies that use debt to finance themselves are more profitable at lower interest rates, pushing up their shares even more.
So, since the 80s, bonds and stocks have had this tailwind of ever lower interest rates bidding up bond prices directly, and the price of everything else indirectly.
But over the past year, this trend reversed itself. And did so in spectacular fashion, with an epic interest rate hiking cycle which was coordinated by central banks in much of the developed world. Suddenly, the tailwind to financial market prices became a headwind.
Just as rate cuts push up prices, rate hikes drag them down. Bonds issued at 0% over the past few years now have to fall in price in order to deliver 3.5% returns – the new prevailing rate.
What sort of losses are we talking about? Well, some UK bonds fell 60% in value over the course of almost a year last year, for example.
My point is that those holding bonds are sitting on vast and severe losses.
But those losses are largely unrealised, like a stock in your portfolio that is down, but you haven’t sold yet.
And that also means these bond holders are stuck. If they sell these bonds, they will be realising those losses. But not all of them can afford to.
What might force such a sale? A bank run, as we saw in the US. The bank had to sell assets to meet depositors’ demands for money.
What makes banks so fragile is that they both borrow and lend. If their lenders pull funding from the bank, the bank is forced to sell assets to meet these redemptions. That is why banking crises are so dramatic. They inherently spread defaults beyond the bank.
If you and I are forced to realise losses, we just lose some of the money we invested. If banks lose it, they could go bust and drag lenders to the bank with them.
There are some additional things to keep in mind here.
It’s not entirely clear to what extent these losses at banks are hedged away to someone else by way of derivatives. This is one argument put forward why you shouldn’t worry your little bank depositors’ minds about any of this. Those clever bankers at places like Credit Suisse have got it covered.
But hedging risk just means passing it on to someone else. And we don’t know who holds the other side of the trade for the losses that have been hedged away. In 2007, it was often the same bank that thought it was hedging away the risk…
The 2008 version of this question is to ask, “Who is AIG?” – the company caught providing derivatives on the losses that caused 2008’s crisis.
Secondly, and perhaps most importantly, the losses are largely on government bonds – the assets that are held as a safe haven. This makes any loss matter more because everything in financial markets is risk adjusted.
If you presume something is safe and it loses you a lot of money, it causes a much bigger problem than a risky bet going wrong because you hold reserves that reflect this risk. Banks tend to hold no reserves against losses on government bonds because regulations don’t require them to.
A closely related point is that government bonds are supposed to surge during market crises, such as a banking crisis. That’s because they’re a safe haven, which everyone piles into to avoid everything else, especially money in the bank, during a bank crisis.
But the current bank crisis is being caused by losses on bank holdings of sovereign bonds in the first place. It’s like saying that the foundations of a building are crumbling rather than a loose doorknob. It’s not safe to stay in the building.
Ironically, anyone betting a crisis will happen, or using government bonds to hedge their other higher positions in financial markets, is seeing their trusted safe asset add to the pain instead of offsetting it. Again, this makes the underlying situation much worse, like putting the weight in the keel of a ship on top of the mast instead of in the keel.
Last but not least, we are talking about governments’ ability to finance themselves here. If they fail, that’d have some rather large consequences for anyone and everyone.
Tomorrow, we’ll put some numbers on all this so you can get an idea of the size of the problem which the banking system faces, unless you want to pretend it doesn’t.
Good luck until then…
Nick Hubble
Editor, Fortune & Freedom
