Are the Banks Teetering on Collapse? Or Do You Not Understand How Bonds Work?

The Federal Reserve just conducted a stress test on the banking system, and the subject of unrealized losses came up, which were first brought to broader public attention in the Silicon Valley Bank collapse. A realized gain is what you make when you sell a security, which means that it is unrealized until you smash that sell button. Unrealized losses are not reported into earnings, but they do go on to balance sheets. By definition, they are something that banks do not need to worry about until they very much do, as SVB’s overnight immolation demonstrated for all to see.

There is a lot of data out there that looks big and scary, and it’s very easy for people who don’t understand how this all works to misunderstand it.

Speaking of people who don’t understand how this all works, permabears like famed bad market predictor ZeroHedge! They are a right-wing finance blog who have amassed a large following of people over the past decade-plus who all seem to believe in the imminent collapse of the United States economy. That may sound a bit hyperbolic, but that’s pretty much the base case for most of the site’s market analysis.

ZeroHedge first came to prominence in the wake of the 2008 Great Financial Crisis when an editor at the New York Times learned of it after a Goldman Sachs computer programmer was arrested for allegedly stealing code for Goldman’s high frequency trading platform. The NYT published a front-page article on the news ZeroHedge had helped go viral, and soon after the finance blog became much more well-known. New York Magazine wrote about it, discovering that “the founder is a 30-year-old Bulgarian immigrant banned from working in the brokerage business for insider trading.”

Below is a very popular chart shared by people who have convinced themselves that a bank collapse is just around the corner, and who can blame them? This chart, viewed without any other context, does look really scary!

number of mentions of “unrealized losses” in the 66- page “stress test”: one

The unrealized losses in question pic.twitter.com/RrBTsG5ubF

— zerohedge (@zerohedge) June 26, 2024

The right-wing American Enterprise Institute has also written about their concern over unrealized bank losses, asserting that “these unrecognized losses dramatically increase the probability that the federal government will have to intervene and provide blanket deposit insurance guarantees to stop systemic bank runs should depositors lose confidence in the safety and soundness of the banking system.”

The kernel of truth at the heart of this misunderstanding is that if all of us were to freak out and sprint to our nearest bank to withdraw all our money, this chart would be predictive of a crash. The fact of the matter is that for all the pomp and circumstance and supposed logic of finance, at its core it’s just a confidence game. If no one trusts your institution with their money, it doesn’t matter what kinds of financial tricks you play. This car needs gas to run, and gas is cash.

However, I’m not running to get all my cash to stuff under a mattress. You likely aren’t either. The domino effect feared in the wake of SVB was contained to tech-focused banks and the crisis proved to be a quirk of that weird world more than a foreboding predictor of a widespread crash to come. There are very stringent requirements on what assets banks are allowed to hold, and this leads them to mainly own United States Treasuries, meaning that those unrealized losses are concentrated in the safest assets in the world, literally called “risk-free”.

The New York Times detailed how COVID left banks awash in cash in 2021, which led them to load up on Treasuries (emphasis mine):

Rates on Treasury bonds are still near historically low levels, but banks have been buying government debt like never before. In the second quarter of 2021, banks bought a record of about $150 billion worth of Treasurys, according to a note published this month by JPMorgan analysts.

Scroll back up and look at ZeroHedge’s tweet again. A hundred and fifty billion dollars is larger than most bars on that chart. The very first context that is vital to understand here is that WE PRINTED A LOT OF FREAKIN’ MONEY DURING THE PANDEMIC! YOU BOZOS CONSTANTLY SCREAM BLOODY MURDER ABOUT IT! You don’t think that might be why that chart exploded? The road to ruin in finance is paved by people who look at absolute changes instead of percentage changes.

The second point is what I bolded, this buying spree by banks occurred at the pico lows of short-term United States Treasuries. After forcing banks to purchase record amounts of United States government debt both through policy and law, the Fed jacked up interest rates at one of the fastest paces in history, dramatically decreasing the value of the bonds that banks were holding.

That is, shall we say, suboptimal policymaking. The banks are squeezed a bit right now, but the government established the Bank Term Funding Program (BTFP) to help capitalize banks until these securities mature, and it did a lot to stem the bleeding.

Do You Know What a Bond Is?

Here’s the important thing that ZeroHedge and this style of right-wing market thinker really miss here: bonds aren’t stocks!

If I buy a share of Coca-Cola at $1000 and it falls to $900, the only way to recoup any money from my investment is to sell it at a $100 loss. If I buy a two-year Treasury at a face value of $1,000 and a one percent annual coupon payment, I get my $1,000 back at the end of two years no matter what, along with receiving semi-annual coupon payments totaling one percent, even if the rate on the two-year treasury goes up to five percent. Bonds are just loans, which is why unrealized losses are less of an issue so long as the loan payments are being made.

Sure, they’re small, but banks are still profiting off of all these bonds with unrealized losses. ZeroHedge whined that the Fed only said “unrealized losses” once in their report, but they addressed his primary concern on the first page, as the most recent data in ZeroHedge’s chart indicates the potential for a maximum bank loss of about $500 billion, which is less than the Fed believes that banks can absorb:

The 2024 stress test shows that the 31 large banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and businesses under stressful conditions. In the immediate years after the 2007–09 Global Financial Crisis, banks subject to the stress test substantially increased their capital, which has remained largely level for the past few years (see figure 2).

The 2008 Financial Crisis sits at the base of our politics in so many ways, and a repeat of that is the existential dread overhanging all of our views on the economy. The greed and excess that led to that calamity seems to have only gotten worse, and witnessing a high-profile bank collapse can’t help people’s confidence.

Add in the fact that the government royally screwed the banks over by forcing them to buy securities the government instantly devalued, and it’s reasonable to be concerned about the banking system. That’s why the Fed conducts these regular stress tests, and as the Wall Street Journal noted, “Banks overall saw a bigger hit on this year’s Federal Reserve stress test. But it may not slow them down as much as it might have in the past.”

Banks have become leaner as they anticipate the final phase of the regulatory environment established in the wake of 2008, known as Basel III, to be put into motion. Their risk profile really has improved since 2008, as the Fed said in their report, and demonstrated as well by a move away from the more volatile corporate bonds that really became a problem in the crisis, as banks held 13% of all corporate bonds in 2007, compared to just five percent in 2018.

Other than fundamentally misunderstanding how bonds work, what fuels ZeroHedge’s misinterpretation of this chart is that the Fed is lying, and banks are apparently more distressed than this stress test indicates. Supposedly only they and the other doofuses continuing to sell and short an up-only market are privy to this chart based off of publicly accessible FDIC data. There are a lot of problems in our economy, but an imminent bank run is not one of them, and if you listen to people like ZeroHedge, history proves that you will vastly under-perform the market while wildly misunderstanding it.