The opening line of Leo Tolstoy’s novel Anna Karenina is: “Happy families are all alike; every unhappy family is unhappy in its own way.” And, as my colleague Natale Labia points out, it’s the same with banking crises. From the outside, they all seem the same, but they are not, and the current one is no exception.

So allow me to try to explain in my simplistic, journalistic way how this crisis is different. Part of the mandate of this column is to try to make complex financial issues easier to understand. But sadly, there is one subject that is just impossible to make simple, and that is bond pricing.

The first problem is that bonds are perverse; when interest rates go up, bond prices fall. That is so nuts. Every other investment (well, almost every other investment) on the planet works logically and simply: up is good and down is bad. Not bonds.

But sadly, bond investments are crucial to this story, so there is no avoiding trying to understand this particular perversity. Bonds, by the way, are huge. I mean really huge. Often, casual investors think the bond market has something to do with housing loans, but alas, this is just a tiny corner of the bond market. The government of South Africa, for example, is now borrowing just under R1-billion a day.

Visit Daily Maverick’s home page for more news, analysis and investigations

Most bonds — debt — are sold by governments in huge quantities and large volumes because politicians throughout history typically have a simple choice: either they renege on their extravagant pre-election promises or make future generations pay for them by borrowing heavily.

Being the honest, responsible, and sensible people they are, they tend to go for the borrowing option. Having opened the door, corporates, of course, got in on the act, and now corporate bonds are a huge part of the market, as are municipal bonds. So now the global bond market is twice as large as the equities market.

Why did this all happen? Partly because it’s so simple: bonds are just an IOU. You borrow money, and every year you pay it back plus interest. There is a record of debt instruments that date back to 2400 BC with the terms very specifically described on clay tablets discovered at Nippur, in present-day Iraq. Things have moved on since then. The value of the global bond market is around $120-trillion. I am not making this up.

Investors love bonds; they are certain, they don’t bounce around like equities, and they are generally liquid. They tend to parallel longer-term obligations, so life insurance and wealth management companies like them because their clients often want to invest during their working lives and draw down the investment when they retire. They match.

The wrinkle

But there is one little complicated wrinkle. Say you loan a customer (who could be a government or a person or a company), R100 for five years at 2% interest. (I’m using an example cited by Bloomberg columnist Matt Levine in his Money Stuff column here).

Just for kicks and giggles, let’s assume you (the bank) want to sell that loan the day after you made it, how much would it be worth? Easy. It would be worth R100 — exactly what you paid for it. But now let’s assume that interest rates go up from 0% to 3% on that day. Then the market interest rate would probably go up by the same margin, from 2% to 5%. The loan is still only paying you 2%, but its sale price has suddenly gone down.

Why? You could work it out like this: before interest rates rise, this loan would earn you what you agreed: 2% of R100 every year for five years, which is R10. After interest rates go up, the same loan would have paid you 5% on R100 for five years, that’s R25.

So now, after interest rates go up and you try to sell the same loan, you could only sell it for R100, less the reduction in its value, R15, so call it R85. (Actually, this is a crude calculation but it illustrates.) This is why the bond market hates interest rate increases and loves interest rate decreases. And this is why interest rates and bond yields move in different directions.

Right… now, on to the second part of this problem: equally complicated, I’m afraid because it’s about accounting. Banks have to value their bond portfolio every year, and sometimes more often, for display to shareholders. How do they do that? The one option is that they could account for them at cost: this would be in our case, the value of our loan, R100. But actually, as we have now discovered, that loan is only really only worth R85. In accounting terms, that would be the mark-to-market rate, or the fair market value.

So which one do we see? It would be reasonable to always refer to the mark-to-market rate, but then income would jump up and down in a crazy way. So, the accountancy profession has worked out a compromise: if the bond is going to be held to maturity, it is valued at cost. Otherwise, it’s valued at fair market value, and the difference is specified in the notes to the accounts, because, of course, everybody reads those.

Generally, this is fine. But interest rates have now gone up eight times in the past year and a bit in the US, from 0.25% to 4.75%. In SA, they have gone up by more or less the same proportion. So now, all of a sudden, banks have got a huge problem, and this problem became visible first at a bank that had loads of bonds on its balance sheet, Silicon Valley Bank (SVB). But this bank is just the canary in the mineshaft, because all banks are, to a much lesser extent, sitting with the same problem, depending on the size of their bond portfolios. See why banks are getting hit in the markets now?

This is all the more perverse as many banks probably didn’t want so many government bonds on their balance sheets because they were earning so little from them. But because the 2008 Global Banking Crisis was about liquidity, what did the regulators do? They required banks to hold more capital. This is why Financial Times journalist Gillian Tett wrote last week about how the demise of Silicon Valley Bank demonstrates the perils of regulators fighting the last war.

Credit Suisse

But the woes of SVB and a few other small banks in the US don’t entirely explain why very big banks around the world are now being affected. Leading among these is Credit Suisse, the Swiss giant, whose shares dropped by 30% in a few days before Wednesday, but rebounded by about 17% on Thursday. The rebound followed the Swiss National Bank saying it would provide a liquidity backstop and the bank revealed plans to borrow about $54-billion.

One doesn’t like to be overly critical, but it’s hard to imagine a bank that has messed up more convincingly over the past few years than Credit Suisse. Just to list a few of its transgressions: a criminal conviction for allowing drug dealers to launder money in Bulgaria, entanglement in a Mozambique fishing boat scandal, a spying scandal involving a former employee and an executive, and a massive leak of client data to the media. 

When a banking crisis hits, short sellers look for weakness and banks that have been through the wringer are hot potential targets. That explains Credit Suisse, and perhaps a few others. But there is also the systemic risk with banks, because if there is a crisis, all bets are off and even good banks who have stuck meticulously to the rules also get hit. As we now know.

The general rule to remember is this: in the final analysis, banks really only have only one asset: their reputations. Once that is gone, generally speaking, so is the bank — unless the government decides it has to be saved.

This is our world; don’t we just love it? DM/BM