The man who predicted the 2008 banking crisis has a new blip on his sonar screen: “underwater” bonds that he says make up a dangerously large chunk of the sector’s assets.
Nouriel Roubini, professor emeritus at the Stern School of Business of New York University — a.k.a. Dr Doom — warned this fatal flaw in bondholdings, which lay at the heart of the sudden downfall of Silicon Valley Bank last week, could could cause any instability in the U.S. or European banking sectors to quickly spiral into a rout. Pension funds, asset managers and other large investors are also at risk, he warned.
Markets are jittery after SVB collapsed last Friday, in the biggest bank failure since 2008. U.S. agencies scrambled to contain the damage, but banks’ share prices on both side of the Atlantic took a beating, with long-troubled Credit Suisse finding a new record low on Wednesday, prompting a lifeline intervention from the Swiss National Bank.
Roubini zeroed in on the heart of the problem. SVB had built up a big bond portfolio while interest rates were near zero, but the value of those bonds plunged when rates rose and newly issued debt became far more attractive to investors. The old bonds started to represent “unrealized losses.”
When troubles in the tech sector pushed SVB’s depositors to start making large withdrawals, the bank was forced to sell its bond portfolio in an unfavorable market. Those “unrealized losses” were realized, and SVB suffered a $1.8 billion loss, leading to the bank’s eventual collapse.
Any other shock could have a similar domino effect, Roubini warned. “Official data of the FDIC [U.S. Federal Deposit Insurance Corporation] said there are $620 billion of unrealized losses on securities and the capital of banks in the U.S. is $2.2 trillion, so the average U.S. bank has about a third of its tier one capital at risk,” he told POLITICO, referring to a metric that indicates how easily a bank can absorb losses on its financials.
Over in Europe, unrealized losses on bond portfolios could be much graver, Roubini said. Europe, and specifically Switzerland, were among the first places in the world to push ahead with negative interest rates, meaning the sensitivity of local bond portfolios to rising interest rates was likely to be much larger. Bank profitability on the continent has also been much lower, putting further strain on capital buffers and, by extension, the value of bank shares.
An extraordinary exposure?
An unrealized loss is a sort of limbo state for a financial asset, where it can be worth either exactly what you paid for it plus interest, or much less if you are forced to sell it before its maturity date.
Imagine you took out a loan to start a business, using your house as collateral. If the property market falls by half, that’s OK: you can still make the repayments and you still have your house. But now imagine that the business cycle turns against you and you have to sell the house. All of a sudden, it’s not enough to cover your liabilities and you go bankrupt.
In this case, the collateral is the bondholdings, and their value has fallen precipitously over the past year as central banks across the Western world have hiked interest rates aggressively. As such, Roubini says, banks’ bondholdings wouldn’t be worth enough to cover their liabilities if they had to make a quick sale. That means that any shock could trigger a full-blown banking crisis — exactly what the post-2008 reforms were meant to prevent.
From a regulatory standpoint, Roubini said the system had been blind to the severity of the issue because banks, unlike other financial institutions — and despite all the crisis regulation — were never required to mark these assets to their present value, known as “mark-to-market” accounting. This, he noted, was a big regulatory failure.
“There is $20 trillion of U.S. Treasuries [government bonds] alone in the system right now, so those losses are sort of emerging because banks don’t have to mark to market,” he said.
Not everyone is convinced. Ratings agency S&P Global pushed back against Roubini’s narrative today, saying that it viewed risks from unrealized losses as manageable at this stage for the banks it rates. Credit Suisse, perhaps the European bank under the most pressure, denied today that it had any exposures related to bad bondholdings.
Dr. Doom has been wrong before: he has predicted a lot of catastrophes that didn’t happen, as well as the one that did. The next big jitter in the global economy will show whether regulators should have listened to him this time around.
