Bank Canaries Drop Dead, but Don’t Worry, They’re Only Small...

The news of the latest banking crisis is unravelling fast, which makes writing this a real pain in the neck. By the time you read it, anything could have happened. Indeed, this week, the Fat Tail Investment Research editorial team had our quarterly CPD event and went on to discuss the recent bank failures in the US. By the time we’d finished, much of the discussion proved moot as the banking crisis had already spread to Europe’s Credit Suisse. Now, Credit Suisse didn’t even give me a job interview coming out of university. Admittedly, it was 2009, but I have nevertheless enjoyed their struggles since. Unfortunately, they’ve started to struggle so badly that everyone else is worried too. Could the contagion have begun already? Are our Aussie banks safe? And so, we cannot ignore what’s melting down stock markets worldwide, even if my discussion may be out of date by the time you read this. Today, I’d like to make a point about what’s behind the shemozzle you’re seeing in the headlines. A bit like discussing subprime in 2007, before we knew what it was and what it’d do to us. The simple fact is that vast financial losses must again — by definition — be sitting somewhere. We know this for certain, as I’ll explain. The question is whether it will matter. The banks that are struggling in the US and Europe are, in my view, the canaries in the coal mine. Those worried about the health of canaries are missing the point, badly. They aren’t seeing the forest for the trees. The capacity of the mine to explode is the real issue. My conclusion is that the mine is filled with enough explosive material to require evacuation, even if it doesn’t end up exploding because nobody causes a spark. The dead canaries are the give-away, not the thing to be worried about. We’re talking about an explosion, not whether avian flu is contagious. What’s the combustible gas? Vast, perhaps even unimaginably large losses are lurking on balance sheets across the financial system. But it’s not entirely clear whose balance sheets. This was exposed by the US banks that failed, kicking off the domino chain reaction for several reasons. Firstly, they funded themselves with particularly fickle deposits. This made them especially vulnerable to a bank run. That’s why they’re canaries and not coal miners. Secondly, they invested a lot of money into assets that were either hard to sell or that would fall in price badly should interest rates rise. They were working at the coal face at the bottom of the mine where the gas concentrates. Thirdly, they didn’t hedge this risk by wearing the right safety gear. Now, financial derivatives have a bad reputation. Financial weapons of mass destruction, Warren Buffett called them. But they can and are supposed to be used to reduce overall risk. For example, a bank like the one that failed in the US could’ve made a bet in derivatives markets that interest rates would rise. This position would’ve been profitable because they did. But the net effect would’ve been to offset the losses, which ended up sending the bank broke. But remember, I’m trying to point out the overall situation. The loss in such a derivatives transaction is merely shifted elsewhere. It still occurs. Someone has to bear it. 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. Today, I want to warn about that problem, rather than discussing how banking crises can spread through contagion. Here’s what’s gone wrong… 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. 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 10 years ago and pays 5% interest, while the prevailing market interest rate is 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’s 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 these bid 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 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. My point is, those holding bonds especially are sitting on vast and severe losses. But those losses are largely unrealised, like a stock in your portfolio that’s down, but you haven’t sold yet. And that also means these bond holders are stuck. If they sell these bonds, they’ll 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 borrow and lend. If their lenders pull funding from the bank, the bank is forced to sell assets to meet these redemptions. That’s why banking crises are so dramatic. They inherently spread beyond the bank. There are some additional things to keep in mind here. As mentioned earlier, it’s not entirely clear to what extent these losses at banks are hedged away to someone else by way of derivatives. And we don’t know who holds the other side of the trade for the losses that have been hedged away. The 2008 version of this question is to ask: Who is AIG?. The company was 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 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 that 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. Finally, we are talking about governments’ ability to finance themselves here. If they fail, that’d have some rather large consequences for anyone and everyone. 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. Central banks hold a lot of government bonds after doing a lot of quantitative easing. That means they’re sitting on vast, unrealised losses on those bonds, just like banks. As they attempt to rein in inflation, they’ll be selling these bonds in a process known as Quantitative Tightening. The trouble is, this means realising losses on those bond positions. We’re talking £200 billion for the Bank of England. 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. And so central banks worldwide are discovering that they may be insolvent and don’t have the money to fund their own operations. Governments may need to bail them out. This is a bit like the foreman of the mine making a quick exit back up the shaft. He’s not sticking around to see who gets shafted. What about those left in the mine? Some have tried to calculate the level of unrealised losses that higher interest rates have imposed, which I assume don’t 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’s two largest banks… Remember, it’s largely unrealised losses. Declines in asset values that, theoretically, need only matter if banks are forced to sell those assets. Or if the derivatives counterparty defaults — part of what made 2008 so dramatic. Do you want to stick around to find out whether banks will have to sell out, as some US banks did? I realise this is all 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 that 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. Until next time, Nickolai Hubble, Editor, The Daily Reckoning Australia Weekend The post Bank Canaries Drop Dead, but Don’t Worry, They’re Only Small… appeared first on Daily Reckoning Australia. [Image] Here are Some More Investing Tips and Resources. Enjoy! 5 Experts Reveal Their Secrets To Investing [Please join us at the FREE Candlestick Forum Multi-Speaker Event!]( [Bank Canaries Drop Dead, but Don’t Worry, They’re Only Small…](?site= The news of the latest banking crisis is unravelling fast, which makes writing this a real pain in the neck. By the time you read it, anything could have happened. Indeed, this week, the Fat Tail Investment Research editorial team had our quarterly CPD event and went on to discuss the recent bank failures in the US. By the time we’d finished, much of the discussion proved moot as the banking crisis had already spread to Europe’s Credit Suisse. Now, Credit Suisse didn’t even give me a job interview coming out of university. Admittedly, it was 2009, but I have nevertheless enjoyed their struggles since. Unfortunately, they’ve started to struggle so badly that everyone else is worried too. Could the contagion have begun already? Are our Aussie banks safe? And so, we cannot ignore what’s melting down stock markets worldwide, even if my discussion may be out of date by the time you read this. Today, I’d like to make a point about what’s behind the shemozzle you’re seeing in the headlines. A bit like discussing subprime in 2007, before we knew what it was and what it’d do to us. The simple fact is that vast financial losses must again — by definition — be sitting somewhere. We know this for certain, as I’ll explain. The question is whether it will matter. The banks that are struggling in the US and Europe are, in my view, the canaries in the coal mine. Those worried about the health of canaries are missing the point, badly. They aren’t seeing the forest for the trees. The capacity of the mine to explode is the real issue. My conclusion is that the mine is filled with enough explosive material to require evacuation, even if it doesn’t end up exploding because nobody causes a spark. The dead canaries are the give-away, not the thing to be worried about. We’re talking about an explosion, not whether avian flu is contagious. What’s the combustible gas? Vast, perhaps even unimaginably large losses are lurking on balance sheets across the financial system. But it’s not entirely clear whose balance sheets. This was exposed by the US banks that failed, kicking off the domino chain reaction for several reasons. Firstly, they funded themselves with particularly fickle deposits. This made them especially vulnerable to a bank run. That’s why they’re canaries and not coal miners. Secondly, they invested a lot of money into assets that were either hard to sell or that would fall in price badly should interest rates rise. They were working at the coal face at the bottom of the mine where the gas concentrates. Thirdly, they didn’t hedge this risk by wearing the right safety gear. Now, financial derivatives have a bad reputation. Financial weapons of mass destruction, Warren Buffett called them. But they can and are supposed to be used to reduce overall risk. For example, a bank like the one that failed in the US could’ve made a bet in derivatives markets that interest rates would rise. This position would’ve been profitable because they did. But the net effect would’ve been to offset the losses, which ended up sending the bank broke. But remember, I’m trying to point out the overall situation. The loss in such a derivatives transaction is merely shifted elsewhere. It still occurs. Someone has to bear it. 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. Today, I want to warn about that problem, rather than discussing how banking crises can spread through contagion. Here’s what’s gone wrong… 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. 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 10 years ago and pays 5% interest, while the prevailing market interest rate is 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’s 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 these bid 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 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. My point is, those holding bonds especially are sitting on vast and severe losses. But those losses are largely unrealised, like a stock in your portfolio that’s down, but you haven’t sold yet. And that also means these bond holders are stuck. If they sell these bonds, they’ll 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 borrow and lend. If their lenders pull funding from the bank, the bank is forced to sell assets to meet these redemptions. That’s why banking crises are so dramatic. They inherently spread beyond the bank. There are some additional things to keep in mind here. As mentioned earlier, it’s not entirely clear to what extent these losses at banks are hedged away to someone else by way of derivatives. And we don’t know who holds the other side of the trade for the losses that have been hedged away. The 2008 version of this question is to ask: Who is AIG?. The company was 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 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 that 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. Finally, we are talking about governments’ ability to finance themselves here. If they fail, that’d have some rather large consequences for anyone and everyone. 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. Central banks hold a lot of government bonds after doing a lot of quantitative easing. That means they’re sitting on vast, unrealised losses on those bonds, just like banks. As they attempt to rein in inflation, they’ll be selling these bonds in a process known as Quantitative Tightening. The trouble is, this means realising losses on those bond positions. We’re talking £200 billion for the Bank of England. 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. And so central banks worldwide are discovering that they may be insolvent and don’t have the money to fund their own operations. Governments may need to bail them out. This is a bit like the foreman of the mine making a quick exit back up the shaft. He’s not sticking around to see who gets shafted. What about those left in the mine? Some have tried to calculate the level of unrealised losses that higher interest rates have imposed, which I assume don’t 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’s two largest banks… Remember, it’s largely unrealised losses. Declines in asset values that, theoretically, need only matter if banks are forced to sell those assets. Or if the derivatives counterparty defaults — part of what made 2008 so dramatic. Do you want to stick around to find out whether banks will have to sell out, as some US banks did? I realise this is all 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 that 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. Until next time, Nickolai Hubble, Editor, The Daily Reckoning Australia Weekend The post Bank Canaries Drop Dead, but Don’t Worry, They’re Only Small… appeared first on Daily Reckoning Australia. [Continue Reading...](?site= [Bank Canaries Drop Dead, but Don’t Worry, They’re Only Small…]( And, in case you missed it: - [Will the Banking Mess Spill Over into DeFi?](?site= - [Evolia Protocol: Using blockchain and AI technologies](?site= - [Are U.S. Government Bonds the New “Toxic Asset” in 2023?](?site= - [Thursday’s Huge Movers, 4-Pack of Fresh Plays](?site= - [Weekly Stock Market Commentary 3/17/2023](?site= - FREE OR LOW COST INVESTING RESOURCES - [i]( [i]( [i]( [i]( Sponsored [Why This Crypto Bear Just Turned Bullish…]( You might be surprised to learn that, after years as a crypto skeptic, investment expert Nilus Mattive now says THIS could be the very best time to start buying certain cryptos.  And not just Bitcoin or Ethereum, either! [Click here now to watch this shocking interview.]( [Privacy Policy/Disclosures]( - CLICK THE IMAGE BELOW FOR MORE INFORMATION - [i]( Good Investing! T. D. Thompson Founder & CEO [ProfitableInvestingTips.com]() ProfitableInvestingTips.com is an informational website for men and women who want to discover investing and trading products and strategies to educate themselves about the risks and benefits of investing and investing-related products. DISCLAIMER: Use of this Publisher's email, website and content, is subject to the Privacy Policy and Terms of Use published on Publisher's Website. Content marked as "sponsored" may be third party advertisements and are not endorsed or warranted by our staff or company. The content in our emails is for informational or entertainment use, and is not a substitute for professional advice. Always check with a qualified professional regarding investing and trading guidance. Be sure to do your own careful research before taking action based on anything you find in this content. If you no longer wish to receive our emails, click the link below: [Unsubscribe]( Net Wealth Consultants 6614 La Mora Drive Houston, Texas 77083 United States (888) 983-9123