In the year 1157, the Republic of Venice was engaged in a bitter trade war with its archrival the Byzantine Empire.
While the rest of Europe was barely surviving thanks to the stupidity of their centrally planned feudal economies, Venice was a place where anyone, even the most illiterate peasant, could work hard, take some risks, and become fabulously wealthy.
In short, it was the medieval America. And unsurprisingly its economy was booming.
Trade was the bread and butter of the Venetian economy. Venice had the fastest ships, the boldest captains, the shrewdest merchants, and by far the best legal and economic system.
In the other corner was the Byzantine Empire, a superpower in decline. Even the emperor at that point was more of a figurehead as nearly everything in the economy was controlled by incompetent career bureaucrats.
Even despite its decline, however, the Byzantine Empire still controlled regional trade in the Black Sea and Eastern Mediterranean. And Venice dominated trade in the Western Mediterranean.
It was only natural that the two– a rising power versus a declining power– would lock horns in a trade war.
Bear in mind that medieval trade wars were not what we think of today. In our modern era, a trade “war” is mostly harsh words, barbed tweets, and now potentially tariffs.
A thousand years ago, a trade war was almost an actual war– naval battles, piracy, wanton slaughter… pretty much standard medieval warfare short of a full-blown ground invasion.
And like any war, a trade war was expensive.
So, in the year 1157, rather than raise taxes, the Venetian government launched a special loan program from its citizens. Participation was pretty much mandatory. But the basic idea was that, unlike taxes, the government would pay back the money, with interest.
Investors were issued paper certificates as a guarantee of repayment. And since nearly everyone in Venice had paper certificates (since the loan was mandatory), merchants and bankers began trading certificates to settle transactions.
The government loan certificates had essentially become a financial security– and even a form of money. And the world’s first real bond market was born.
These days bonds are considered a boring, ‘safe’ investment. And most individual investors seldom bother to even learn about the bond market, let alone actually buy any bonds.
After all, bonds aren’t nearly as sexy as the stock market.
But bonds are still a critical piece of the global financial system. And just like in medieval Venice, bonds are almost a form of money, i.e. large corporations, banks, and governments consider bonds a “cash equivalent”.
Banks in particular are massive hoarders of bonds. When you make a deposit at your bank, most of the time they use that money to buy bonds.
That’s because, again, bonds are considered safe and boring. Especially US government bonds. And banks are supposed to be safe and boring.
But a serious problem started to creep into this ‘safe and boring’ asset class around ten years ago.
You might recall back during the 2008 financial crisis, central banks around the world printed tons of money and slashed interest rates to zero.
Governments also started spending like crazy in an effort to bail out their economies, and most of them went very deeply into debt.
The US national debt was $9.5 trillion just prior to the 2008 financial crisis. Barely three years later it had risen to $15 trillion.
But because interest rates were so low, most of that $5 trillion in new debt had a yield of roughly 1%.
And it was America’s commercial banks (along with insurance companies) which bought up a huge portion of those 1% yielding bonds.
Well, eventually the economy emerged from its crisis… so the Fed began to hike interest rates. But in doing so they created a huge problem for banks.
If there’s one thing to understand about bonds, it’s this: bond values fall when interest rates rise.
Think about it– the banks bought trillions of dollars’ worth of bonds during the financial crisis. And their bonds were locked in a ~1% yield.
When rates suddenly rose to 2%, the value of the banks’ 1% bonds obviously fell. After all, why would a bond with a 1% fixed yield be worth the same as a new bond that pays 2%?
So, the new, higher rates caused the banks’ bond portfolios to suffer huge losses. Some banks were even heading towards insolvency. But they used a bunch of clever accounting tricks to hide their losses and pretend that everything was fine.
I first wrote about this nearly ten years ago and predicted that some banks will fail as a result.
Fortunately for the banks, the interest rate hikes were short-lived. By 2019 the Fed reversed course and started cutting rates. Then came the pandemic, and rates once again went to zero.
You’d think the banks would have collectively breathed a sigh of relief, learned from their mistake, and vowed to never load up on low-yield bonds ever again.
Yet the opposite happened. Banks bought trillions of dollars’ worth of US government bonds throughout 2020-2021 with yields as low as 0.01%. Crazy.
Today bond yields have risen to more than 4%… and, SHOCKER, the same effect has taken place: banks’ bond portfolios have suffered enormous losses.
The FDIC recently reported the total ‘unrealized’ bond loss to be over half a trillion dollars. That’s a lot.
The US banking system as a whole has enough equity to cover that loss. But individually, many banks do not.
In fact, this is precisely the reason that Silicon Valley Bank (among others) failed in 2023. So if rates don’t fall dramatically (or worse– rates go up), then we could see more banks fail.
Bank of America is one of the naughty banks with nearly $90 billion in losses from higher interest rates. That’s over a third of the bank’s total equity.
This means that Bank of America is not insolvent; but at some point, the regulators could force them to reinforce their balance sheet by suspending their dividend and raising more capital. This is likely a big reason why Warren Buffett dumped so much Bank of America stock.
(Bizarrely, since reporting massive bond losses in their most recent quarterly report, Bank of America’s stock price has shot up nearly 20%. The same thing happened with Silicon Valley Bank’s stock in 2023.)
But, again, while there’s currently still enough capital in the US banking system as a whole to fend off a major crisis, there’s a MUCH bigger problem lurking– and I’ll write to you about this soon.
In the meantime, if you’d rather avoid the mess entirely, definitely consider short-term T-bills in Treasury Direct (it’s like having a four-week CD), or dollar-pegged tokens like USDC.
There’s also the option of a foreign bank account in a financially secure jurisdiction, which includes the added benefit of asset protection and diversification.
