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Traders watch screens as they work on the floor of the New York Stock Exchange on Sept. 29, 2008. U.S. Treasury bonds could be the next toxic asset at the heart of the financial system's latest chaos.© Brendan McDermid / Reuters/X01110

When trouble strikes in the financial system, there is often a toxic asset at the heart of the chaos.

In 2007, derivatives related to subprime mortgages set off the global financial crisis. This time around, the culprit could be one of the world’s safest and most widespread assets – U.S. Treasury bonds.

The collapse of Silicon Valley Bank exposed a crucial new vulnerability spread throughout the U.S. banking sector.

Banks have vast holdings of U.S. government bonds offsetting their deposits. While these securities have almost zero risk of default, they are susceptible to rising interest rates.

The rapid-fire rate hikes deployed by the U.S. Federal Reserve and other central banks to try to quell explosive inflation have made those holdings much less valuable on paper.

Under normal circumstances, that’s not a big issue. But when a bank is facing a run on deposits, those paper losses can become ruinous overnight.

Toxic Treasuries, spread across the thousands of banks that make up the nebulous U.S. financial system, could conceivably give rise to a cascade of turmoil that officials are unable to contain.

“It was a blind spot,” said Cristian Bravo Roman, Canada Research Chair in Banking and Insurance Analytics at Western University. While policy makers were aware of the stress that rising interest rates put on bank holdings, “they didn’t think there was a systemic risk threat arising from it,” Prof. Bravo Roman said.

To understand what has gone wrong, you have to go back to the start of the pandemic. Staring down the barrel of an economic depression, central banks and governments let loose a flood of stimulus. Previously unfathomable levels of asset purchases and fiscal support eventually found its way into bank accounts.

Deposit growth normally trails GDP by a decent margin. In 2020 and 2021, deposits at U.S. commercial banks rose by 35 per cent, or roughly US$5-trillion, according to Fed data.

The influx of deposits dwarfed what the banks could lend out. So they put most of what remained in U.S. government bonds.

Fast forward to the inflation boom. When consumer prices spiralled out of control in 2022, policy makers put the great stimulus machine into reverse. An era of ultra-low interest rates was suddenly over.

The banking system was not ready for what came next. A decade-and-a-half of ultra-loose monetary policy had oriented the financial world to near-zero interest rates.

The Basel III regulatory framework, for example, recommended that banks stress test their holdings for various interest rate shocks. For U.S. assets, it suggested using a short-term rise of 300 basis points as a stress scenario. The Fed has hiked its federal funds rate by 475 basis points in the past year. (A basis point is 1/100th of a percentage point.)

Silicon Valley Bank clarified the risk to banks with outsized bond holdings. The bank’s parent company had a US$16-billion unrealized loss on its portfolio of bonds. Held to maturity, those bonds would pay out in full. But when SVB was in desperate need of cash, it was forced to sell off a package of bonds at a steep discount, booking a US$1.8-billion loss in the process.

There is little to worry about when it comes to the big U.S. banks, which are much more tightly regulated. They have plenty of liquidity and are under no pressure to sell their long-term bond holdings at a loss.

The real risk lies with small and medium-sized banks, of which there are a multitude. In 2021, there were 4,237 banks insured by the Federal Deposit Insurance Corp.

“There are U.S. banks left and right that are at risk of bank runs,” said Sébastien Mc Mahon, chief strategist at iA Investment Management. “When people get scared, that’s when you have animal spirits take over. And illiquidity is the thing that can kill you in 24 hours.”

Once the psychology of bank runs takes root, it is a difficult thing to conquer. At that point, investors are looking for the next domino to fall.

After UBS announced it was buying Credit Suisse a week ago, at a 60-per-cent discount to the troubled bank’s value the previous trading day, tensions appeared to cool. U.S. Treasury Secretary Janet Yellen said “the situation is stabilizing.”

But few would be surprised if the turbulence quickly resumed. After the Fed raised rates for the ninth consecutive time last Wednesday, Moody’s Investors Service said tight financial conditions could cause banking instability to spill over into the broader economy.

“There is a risk that policy makers will be unable to curtail the current turmoil without longer lasting and potentially severe repercussions within and beyond the banking sector,” the analysts wrote.