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Mark-to-market is striking financial markets again. But it wasn’t supposed to be that way.
Regulators spent years poring over the risks in the financial system. Volumes upon volumes of bank regulation were rolled out to make sure a global financial crisis could never take shape again. And yet, here we are. In a crisis created by the very interest rate policy central bankers themselves initiated.
It’s called duration risk. And while it’s supposed to be well hedged at banks and financial institutions, the pressures of finding yield in a zero and negative interest rates environment meant many banks couldn’t always neutralise the risk of what the industry calls “Held-To-Maturity” bond portfolios.
These bonds, however, are now heavily underwater because interest rate hikes have forced their principal components to adjust lower to stay competitive with higher-yielding paper coming on the market from primary issuers.
The kicker is that under Basel III, banks never had to book the unrealised losses on their financial statements. Only bonds held in banks’ trading portfolios did. And now, markets are panicking, because banks that are facing deposit withdrawals have a problem. They can either sell the assets at a loss, eating into their capital position and pushing them into insolvency or repo the securities at rates even higher than what the Fed is charging, creating a potential negative margin exposure.
Where are the bodies buried?
Nouriel Roubini, now professor emeritus at the Stern School of Business of New York University but popularly known as Dr. Doom for correctly predicting the last financial crisis, told me so-called unrealised losses on bond portfolios could be lurking almost anywhere. Central banks, banks, pension funds, asset managers, sovereign wealth funds or beyond. Hence the market jitters.
“Official data of the FDIC said there are $620bn of unrealised losses on securities and the capital of banks in the US is $2.2 trillion, so the average US bank has about a third of its tier 1 capital at risk,” he said, noting that pretty much any institution sitting on legacy bond purchases was weathering losses. “There is $20 trillion of them in the system right now, so those losses are sort of emerging because banks don’t have to mark to market.”
The battering of European and US bank stock prices on Wednesday was evidence of the market slowly realising the problem, he noted.
The slow-burning realisation that hold-to-maturity bonds were not worth what Silicon Valley Bank thought they were is what finally toppled the bank last Friday. SVB’s attempt to sell some of its bond portfolio to raise liquidity to meet depositor withdrawal demand generated a $1.8bn loss and forced the bank to appeal to equity investors in a last-minute capital raise. When that failed, the bank had no other option but to go cap in hand to the Federal Reserve, but by then it was too late. The bank had been deemed insolvent.
But could things be much worse in Europe?
Europe and, specifically, Switzerland, were among the first regions in the world to push ahead with negative interest rates, meaning the sensitivity of local bond portfolios to rising interest rates is likely to be much bigger. Bank profitability on the continent has also been much lower, putting further strain on capital buffers.
Things got even more heated in Europe on Wednesday, however, when Saudi National Bank, which bought 9.9 per cent of Credit Suisse last October, confirmed it was no longer prepared to plough any more capital into the long troubled bank. Market concerns centred on the fact nobody can really be sure of the depth and scale of its exposures, Roubini said.
Adding to its troubles were Swiss regulatory measures, following the 2008 crisis that had enforced a resolution model protecting Swiss investors and depositors before international equivalents, making it even harder for the bank to raise external financing.
The day saw a broad bank sell-off in European bank stocks, with Swiss, French, Italian, German and British the worst affected.
Late on Wednesday a joint statement by the SNB and FINMA, aimed at rebuilding confidence in Credit Suisse, confirmed the Swiss central bank was prepared to offer liquidity to the bank if needed but that “Credit Suisse meets the higher capital and liquidity requirements applicable to systemically important banks”. More news was expected Thursday morning.
What about the hedges?
Regulators were unwilling to attribute the problems in the market to higher interest rate policy or poor regulation. One former British central banker, who spoke on the condition of anonymity, said for banks to have missed this sort of risk would have amounted to incompetence. “It’s bog-standard interest rate exposure, not sovereign default risk,” he said, but admitted that if some failed to do it then perhaps some others were exposed.
Roubini agreed banks could have taken better precautions by investing in shorter-duration Treasury or government securities that rewarded lower coupons. “There would have been no intermediation margin, but you’re parking it without any market risk,” he said. “They took a huge risk and they f***ed up, big time.”
But traders pointed to the difficulty of hedging such securities in a negative interest rate climate, adding that, at some major banks, it was standard practice not to do so. “It’s quite hard to hedge a move from normal to curve inversion,” said one former trader.
The importance of par value facilities
Another former trader who had previously worked for a major Swiss bank in the last financial crisis explained this is why the Federal Reserve’s intervention on Monday was so significant. By offering to lend cash to banks against bonds at par rather than at the underwater market rate, they would be plugging the gap that had materialised in “held-to-maturity” portfolios.
“This sort of duration mismatch is not an issue for HSBC, as the diversity of their deposits means they are never looking at having to crystallise the true value of their hold-to-maturity portfolios,” he explained. What had made the SVB crisis so much worse was the size of individual deposits and the concentration of the lending base.
“Governments created that debt and they forced the banks to buy it, and that’s ok as long as you don’t get a bank run where all the depositors start taking the money out at once,” he said, predicting that banks with a diversified depositor base should be just fine.
The Blind Spot view
Held-to-maturity portfolios are only problematic if you have to sell them. And the main reason for having to sell them is a sudden draining of deposits. Of course, it was always going to be this way because, by design, any contraction of the reserves created by QE would lead to a game of musical chairs where eventually someone would be left without the capacity to fund longer-term duration assets.
It’s all very well saying these institutions should have hedged these positions, but I’m not sure they all could have done so effectively.
Firstly, the act of hedging only passes the risk to someone else. From a broad market perspective, the risk remains somewhere in the system. If those hedges are in the money, as they were with the liability-driven investment crisis, someone else is out of the money. What’s more, if you’re engaged in a counterparty trade, as was the case with the LDIs, when the value of your base position falls you have to post more margin, which you have to do by selling (potentially hedged) collateral. The doom loop proceeds.
Secondly, hedging is not free. Market execution of hedges costs money, and in some cases so much so it might not allow for any positive margin on a hedged position at all.
In most cases, if a bank has very well-diversified funding it needn’t worry about duration risk of high quality assets like government bonds. Whatever deposits go out tend to come back in. That’s why, for the system as a whole, the focus should be on sectors of the economy that are most exposed to one-sided deposit outflows, such as regional or specialist banks. These are most likely to be impacted.
Was it Trump’s fault?
Some say this crisis is manifesting because the Trump administration opted out of implementing the full range of Basel III measures in the United States, applying them only to large systemic institutions. But, really, the fact that European lenders were also wobbling on Wednesday undermines this argument. Also, informed parties tell me the deregulation of large regionals was a Trump, Senate, Fed and FDIC combination — albeit, with dissenting votes in both the Fed and FDIC.
What about the repo markets?
ICMA’s European repo market survey came out on Wednesday and revealed a new record outstanding value of €10.3 trillion at year-end of 2022. Specifically, the report noted (my emphasis):
The market turmoil, arising from uncertainty over the rate and extent of central bank interest rate increases and the shock of the UK mini-budget, occurred against a backdrop of rising activity in the repo market, with an incongruous combination of increased cash-driven trading in response to rising and positive interest rates and increased securities-driven trading in the face of continued collateral scarcity. The market turmoil fuelled an exceptional surge in trading as dealers sought to cover short positions against further interest rate increases and against bond futures, and investors sought safe-haven assets. These events helped to boost demand for German and, to a lesser extent, other core eurozone government securities. However, the sell-off of UK gilts by LDI pension funds (which was partly the result of constraints on the intermediary capacity of the repo market and its ability to refinance pension fund holdings) may have sapped subsequent activity in the gilt repo.
The events in September took place at a time of increasing concern about the capacity of dealers to intermediate repo flows at the end of the year, in the face of regulatory and other constraints. Year-end is a time when dealers typically “window dress” their balance sheets by shrinking them in order to minimise the regulatory and other costs and consequences linked to end-year balance sheet size. In 2022, such concerns manifested themselves as early as the summer and forward prices implied severe market tightness by the year-end.
They also noted:
One unexpected fall-out from increased market uncertainty and the consequent volatility in the price of securities was a contraction in tri-party repo. This cash-driven sector of the repo market had declined for several years in the face of excess liquidity from central banks but had started to revive as monetary policy was normalised and positive interest rates pulled cash back into the repo market. However, concern over rate changes and volatile collateral prices stymied this recovery in the second half of 2022. Collateral price volatility was also reflected in a significant rise in haircuts on almost all types of tri-party repo collateral.
What is interesting about that is that it shows, very clearly, that repo markets are in flux with demand for the monetisation of bond portfolios growing.
What about the UK?
Over in the UK, safe and stable Rishi Sunak and Jeremy Hunt at first sight pulled off an OBR approved budget. Except, it turns out, it wasn’t the OBR that we should have been worrying about this time around. The Debt Management Office’s chief, Sir Robert Stheeman, said on Wednesday that global financial markets were stressed and volatile and that, despite everything, the UK’s 2023/2024 financing needs were a very large amount of money, and this is why the agency was now focusing on issuing more short-dated gilt supply. “Short-dated gilts are the easiest way to raise large sums.”
The reason that’s concerning is that it puts government financing increasingly at the mercy of short-term market conditions. This would be coupled with an £7.5bn expansion of the government’s national savings & investment products to tap retail savings.
What’s the ECB TLTRO recalibration factor?
Back in October 2022, the ECB published a hugely important piece of news that went mostly unnoticed by markets but upset many bankers. It announced it would be recalibrating the third series of targeted longer-term refinancing operations (TLTRO III) to ensure the rates it charged were consistent with broader monetary policy.
The bankers had not seen this coming, which was a problem. Their market positions were calibrated around the presumption that these rates would stay at zero, not suddenly, retrospectively changed. At one high-powered gathering of bankers in Spain, I had the opportunity to be tuned into some heated dialogue in which bankers claimed that this sort of thing was in breach of contract law and that the ECB should not be allowed.
Some said they would not trust the ECB’s terms and conditions again. Here’s how the ECB saw it however:
These changes to the terms and conditions of TLTRO III will apply to all TLTRO III operations still outstanding and will be implemented via a sixth amendment to the Decision of the ECB of 22 July 2019 on a third series of targeted longer-term refinancing operations (ECB/2019/21), as amended by the Decisions of the ECB of 12 September 2019 (ECB/2019/28), 16 March 2020 (ECB/2020/13), 30 April 2020 (ECB/2020/25), 29 January 2021 (ECB/2021/3) and 30 April 2021 (ECB/2021/21). The amendment will shortly be published on the ECB’s website and subsequently in the Official Journal of the European Union.
The Governing Council stands ready to adjust all instruments within its mandate to ensure that inflation stabilises at the 2% medium-term target.
The bottom line on NIM
Why did nobody see this coming, you might be asking? Well, actually they did. Over at Alphaville I had for many years been very concerned about what zero and negative rates would do to bank profitability. I feared the regime would kill the business as a whole, because paying people to borrow money is very bad business.
Large banks however largely survived the era by relying increasingly on other profit centres, such as market-making, advisory, broking, wealth management, other fee-based businesses and higher risk-based lending. Getting the banks to take more risk was entirely the point.
All of this came in the face of ever more challenger banks, funded to the eyeballs with cheap money from VC backers whose main business strategy was coming to the market with ever-snazzier services, a tolerance for zero profits and a desire to gain market share by undercutting the competition.
The point is that making risk-free profits was very hard. This is why, when interest rates started to rise, banks were delighted at the prospect of finally being able to generate some healthy net interest margin, and were quite perturbed by government calls for their profits to be slammed with windfall taxes. “We were hurt in the low-interest era, and we are entitled to these profits now — not least to buffer up for potential credit deterioration-related losses in the future,” is how they viewed it.
So where are the unrealised losses?
Probably everywhere. As Nouriel Roubini says they’re to be found across the system — from central banks to asset managers, and derivative desks. Anyone who was taking the duration risk in a non-matched way is potentially exposed. One major source are central banks themselves (the BoJ especially comes to mind). It was back in 2013, when fears of unrealised losses on central bank balance sheets first began to circulate through the market in response to rising interest rate expectations. As Scott Minerd, Global Chief Investment Officer at Guggenheim Partners, noted at the time:
Although the Fed does not value its portfolio on a mark-to-market basis, the spike in interest rates over the second quarter has already reduced the market value of the Fed’s portfolio by about $192 billion, wiping out the entirety of the past year’s unrealised portfolio gains. Higher rates would continue to reduce the value of liquid assets available for sale, thus eroding the Fed’s capital cushion. Given that the Fed’s capital currently sits at only $55 billion, a continued increase in interest rates could potentially erase the Fed’s capital base. This could impair the Fed’s ability to sell assets and protect the purchasing power of the dollar, which in turn could reduce the value of Treasuries and push interest rates even higher.
But I thought central banks can’t go bust?
This is technically true only if the government finances underpinning a central bank are healthy. If the government itself is frozen out of the borrowing markets in an inflationary environment, then, for the overall state position to stay funded and market neutral (in terms of inflationary impact), every central banking loss has to be compensated for, either with a cut in government spending, or something else. If that’s not possible, Argentina conditions beckon.
Is Credit Suisse a good buy?
If what the SNB says is true it could be the purchase of a lifetime. The main question that needs answering before you rush out to buy Credit Suisse stock is whether it can continue to maintain a diversified pool of depositors from Thursday onwards? If the answer is yes, and enough people keep banking with it, while the SNB continues to guarantee it, any duration risk on its books should be manageable. The bigger concern about Credit Suisse is related to unexpected positions like Archegos or Greensill on its books, say traders. *none of this is investment advice!
CBDCs to the rescue
While I have no proof, I don’t personally think it’s a coincidence that all the major central banks are pushing ahead with CBDC projects. The duration risk situation can for the interim be managed with central banks offering to liquefy held-to-maturity portfolios at par for a broad amount of market players. But eventually doing so will get in the way of their inflation-fighting agendas, because what liquidity they will be taking in with one hand, they will giving right back out with the other.
When inflation really bites, and funding markets dry up entirely, then chances are it will be handy to have a CDBC around to help keep payments ticking over based on data sharing and a cost of privacy (rather than a cost of funding). I could be dead wrong but it seems a likely contingency.
And finally, the dollar…
For now, market risk still engenders a rush into safe assets like the dollar, US Treasuries and other related high-quality sovereign debt. But, as Jay Newman, formerly of Elliott Management and author of “Undermoney”, wrote in a New York Post oped last week, it’s wrong to presume the dollar isn’t going to be challenged in the months and years to come.
As he noted:
While a chorus of experts still insists that there’s no alternative to the dollar, this is untrue. The dollar will dominate as long as it serves the interest of those who use it. Once the dollar begins placing assets at risk, alternative tools of commerce are certain to emerge. And they already are.
He added that the challenge doesn’t just come from the fact that Saudi Arabia is now prepared, for the first time in 48 years, to trade in currencies other than the US dollar, it has come from a combination of other factors, too:
At the 2022 BRICS summit in Beijing, Vladimir Putin announced plans to expand the Shanghai Cooperation Organization (SCO) and develop an alternative for international payments using a currency basket of Chinese RMB yuan, Russian rubles, Indian rupees, Brazilian reals, and South African rand. For reference, the SCO is the world’s largest regional organisation, representing 40% of the world’s population and 30% of global GDP.
A new currency is only part of the picture. China is pioneering new exchanges to shift commodity trading from Western institutions like the troubled London Metal Exchange and the New York Mercantile Exchange.
Even the Europeans have gotten into the act, by creating a special-purpose vehicle — INSTEX — to facilitate non-dollar, non-SWIFT humanitarian transactions with Iran to sidestep U.S. sanctions. Russia, predictably, expressed interest in participating and the first transaction was completed in March 2020 to facilitate a medical equipment sale to Iran to combat COVID.
That last one about INSTEX is particularly interesting since it recognises the degree to which the weaponisation of finance comes with real humanitarian costs. What we don’t know, of course, is whether this system will be able to sort the good and worthy from the bad and corrupt any better than a correspondent bank.
So, what are the consequences of all this?
As Newman concludes: “If there is less demand for dollars, the value of the dollar will decline. Everything will become more expensive. Not all at once, but over time — making deficit spending more costly or, unthinkably, impossible.”
And if things get more expensive, that means more underwater bond portfolios not less.
The ride has likely just begun.
