I spent most of 2022 asking anyone who would listen a simple question: Why has nobody blown up yet? Why hasn’t there been a bank crisis? Why has no pension fund imploded? Why haven’t insurance companies gone haywire?
You see, we had one of the worst years ever for financial markets, in the US in particular. That was especially true because bonds and stocks had fallen together during a period of inflation.
A balanced portfolio of US stocks and bonds would’ve delivered the worst return since before the Great Depression, according to my calculations.
The result was unusually bad because stocks and bonds are supposed to offset each other. A bad year in stocks is supposed to be offset by a good year in bonds. That’s the whole point of owning such a diversified portfolio. But the theory failed in 2022. Both plunged, with inflation adding insult to injury.
And yet, no financial institution had blown up in spectacular fashion. There was no Lehman Brothers moment. No sovereign default or currency peg breaking. We couldn’t even come up with a proper name for the 2022 crash because there was no single — particularly noticeable — event to name it after.
This completely mystified me at the time. How could ‘risk free’, 30-year UK Government bonds crash 60% without sending UK financial institutions into meltdown, for example?
I asked a series of famous thinkers this question over and over again, usually in the moments after recording an interview with them on some other topic. They all told me a variety of reasons that weren’t very convincing.
Some said that banks had hedged their exposures and risks to the crashes in derivatives markets.
Others said that financial institutions didn’t hold the long-term bonds that had fallen especially badly.
Others said that the revenue benefits of higher interest rates outweighed the capital losses for financial institutions. (Higher interest rates mean more profits for banks and insurance companies.)
This all seemed fair enough. Even if I didn’t see how it could quite offset the vast losses that financial institutions must have suffered on the value of their assets.
For example, if you use derivatives to evade losses on bond prices falling, that merely transfers the loss to someone else. It’s still being suffered by someone.
Another reason experts frequently gave me to explain the financial system’s stability in the face of such losses particularly annoyed me. In fact, I remember losing my temper and interrupting one patient colleague about it in a rather rude way.
The former banker, who had quit his job in anticipation of the 2008 financial crisis, claimed the post-financial crisis reforms had made banks and other financial institutions less risky. They held more capital in reserves.
This seriously annoyed me because it was like claiming that banks were safe in 2006 because of securitisation. A claim that many people did make at the time, pointing to the AAA-rated mortgage bundles held by banks.
But the thing that was supposed to make them less risky in the eyes of regulators was precisely the thing delivering unexpected and unprecedented losses to financial institutions.
Instead of securitised subprime loans, this time around, it was government bonds at the centre of both the claim that banks were safer and the source of the losses in the crash.
People claimed that banks were less risky in 2022 because they held more liquid and less risky assets in reserves. But it was precisely those assets, government bonds, which had melted down so badly in 2022. The claim made no sense.
The issue almost drove me mad. How could the very bedrock of the financial system in government bonds be in meltdown without buildings toppling over?
But then, late in 2022, the meltdowns began. It started in the UK’s pension fund industry. And losses on UK Government bonds were the underlying issue.
The funds had held UK Government bonds for a particular reason. To be able to sell them quickly to meet redemptions. We call this liquidity. Just as you keep some cash in your bank account to meet expenses, financial institutions keep some government bonds that can easily be sold and used to meet payment demands.
But the poor returns from holding those government bonds during a period of low interest rates and high inflation had pressured the funds into doing deals in derivatives markets known as Liability Driven Investments.
These went belly up during the bond market crash, forcing the funds to dump government bonds as intended. But that triggered a self-sustaining spiral of having to sell the bonds to meet liquidity demands, which in turn crashed the bond prices even lower, adding to the liquidity demands and the need to sell even more bonds to meet them.
In the end, the Bank of England had to step in to prop up bond prices and thereby the pension system.
Next, although many months later, came US banks with a surprisingly similar iteration of the problem. Except the banks used an accounting gimmick instead of a derivative position to sabotage themselves.
Banks were required to hold large amounts of government bonds by regulation. This wasn’t quite an outright requirement. But banks were forced to hold a lot of safe assets. And government bonds were defined as safe by regulations because governments are so incredibly unlikely to default. (Just as AAA-rated subprime mortgage-related investments were deemed safe in 2006.)
This means that governments and central bankers loaded up banks with gunpowder and then lit the fuse by hiking interest rates rapidly, after promising not to.
Sure, default risk might be near zero on government bonds. But that’s not the only risk a bond faces. They also have price risk, meaning the price can go up and down. And when central bankers engineer high inflation and hike interest rates fast, bond prices fall fast. That loss can put a bank at risk of failure because they don’t expect it to occur on the asset they hold to protect them from risk.
The solution to this was supposed to be simple. If a bank simply assumes it’ll hold a bond to maturity (when the bond is repaid by the government) then there is no price risk.
This makes sense and I’ve advocated that investors do much the same thing in their personal portfolio by building what’s called a bond ladder. If you buy bonds that mature when you need the money, you don’t face price risk. Unless you have to sell out early to meet an unexpected bill.
But a bank is not the same as a personal portfolio. It has vast liabilities that are ‘on call’. Meaning that a lot of people lent banks a lot of money under the agreement that they can withdraw that money at any time. Those people are called depositors.
In order to meet depositor’s redemptions, the bank must sell something to raise the money to give to depositors. And they tend to sell things that are easy and quick to sell — government bonds.
Indeed, a good chunk of the whole point of having banks hold so many government bonds is that they can sell them easily to meet rapid withdrawals of deposits quickly and easily. It’s not like they can sell your home loan tomorrow.
But do you see the contradiction? It’s a three-way contradiction, making things confusing, but it’s an important one, so let’s review…
Banks hold a lot of easy-to-sell government bonds in order to shore up their reserves and to meet deposit withdrawals by selling those bonds.
But government bonds have price risk, which can put the bank at risk if they hold too many bonds and those bonds fall in value.
This price risk can be overcome by simply assuming the bonds will be held to maturity, meaning they won’t be sold.
The three factors, each designed to reduce risk, actually increase it on an overall basis once you combine them.
The combination encourages banks to hold too many government bonds, encourages them to presume they won’t need to be sold, and then encourages them to sell quickly when there’s a deposit flight, which tends to happen when bond prices have fallen.
The line of dominos is lined up perfectly. Banks hold too many government bonds and assume they won’t have to sell them. When the price of the bonds fall, the bank gets into trouble because the value of their assets has fallen. This is precisely when they do have to sell the bonds in order to meet deposit flight.
In other words, the bonds which are supposed to derisk the bank actually add risk precisely when you need their low-risk characteristics to shine.
It’s the ultimate house of cards, just waiting for a spark. And rapid interest rate hikes from the central bank was precisely that spark. They both crashed bond prices and encouraged people to move their deposits from the bank into bonds and funds that earn the central bank’s higher interest rate.
Now, if you accept all this, you need to reach a rather intriguing conclusion about our own banking system here in Australia. Not to mention others around the world.
Central banks in many nations continue to hike interest rates. They started later than the US Federal Reserve. And often hiked slower. But the same damage applies to local bond markets.
The harshest example comes from the UK. Which is why the pension drama unfolded there.
But who might be next?
Australia, despite lagging on interest rate hikes and experiencing a less severe bond crash too, may not be so far from the top of the list for a simple reason. The RBA effectively promised not to hike rates until 2024. That makes its hikes since especially unpredictable, and thereby dangerous.
To be fair, there are factors in Australia’s favour too. Our mortgage interest rates rise with interest rates, keeping banks’ incomes and expenses better balanced than in the US. But, again, this only transfers the burden and risk to someone else — homeowners.
My point is that the underlying issue of losses on assets presumed to be safe (government bonds) are the cause of the crisis. The pension fund meltdown in the UK and the bank crisis in the US are symptoms. And those symptoms are likely to spread as central bankers continue rate hikes.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
