Credit Suisse Numbers & Narratives
HEADLINES
Credit Suisse, one of the world’s most prominent global banks, has recently been in the news for all the wrong reasons. The current financial health of the bank has worsened to the extent that people have begun comparing it to the failure of the previous to-big-to-fail bank — 2008’s Lehman Brothers — when the US-based bank had to file for bankruptcy. The stock is currently trading at around 4 CHF (Swiss Francs), less than the price of coffee in most Zurich cafes. It is down by almost 90% from its peak, and has shed off more than 50% of its price in the last 1 year.
Panic gripped the global markets after Credit Suisse’s five-year credit default swaps (CDS), which began the year at 57 bps, jumped as high as 370 bp, as per S&P Global Market Intelligence data.
This article navigates through the causes that lead up to this situation, while exploring the extent of the catastrophe by pitting it against the likes of Lehman Brothers, and concluding off by understanding the procedure Credit Suisse intends to take to alleviate the current state of affairs.
UNDERSTANDING CREDIT DEFAULT SWAPS
Credit Default Swaps are an important part of the discussions around Credit Suisse, since it stays to be the primary reason for widespread panic and compels people and analysts to theorize that Credit Suisse’s potential fall may just be the impetus for a 2008 2.0.
A CDS allows you to buy insurance against default by a specific entity — government or corporate.
The buyer of a CDS makes periodic payments to the seller (a third party), called the CDS fee or CDS spread, until the credit maturity date. In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity in case of such a credit event.
The risk of default of a particular entity is swapped by the buyer to the seller
of the CDS, in exchange for premiums.
Usually, these sellers are banks, hedge fund companies, and insurance companies.
The reference entity or the underlying asset from which the CDS derives its value, can be a company, corporate, country, etc.
The CDS market was devised by a group of bankers led by Blythe Masters at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to hedge default risk in large positions. In the last two decades, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market.
The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil’s default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time.
Credit default swaps are loosely interpreted by investors as a gauge for default risk.
CAUSES FOR THE PLUMMET
Scandals
- The bank has been embroiled in a raft of scandals in recent years that have battered its image and balance sheet. A non-exhaustive list includes the Malaysia Development Berhad scandal in 2015, a $10 billion involvement with Greensill Capital which collapsed in 2021 of which the majority was collected and $5.5 billion in losses linked to the collapse of Archegos Capital, also in 2021. Amid the turmoil, the lender has lost nearly 60 percent of its market value this year alone.
- The firm rosters a record of fines and penalties that it had to pay for recklessly promoting and investing in risk capital, as well as playing around with the accounting and taxation practices. For example, in 2017 they were compelled to pay a $5.28 billion fine as compensation for overvaluing mortgage backed securities during the 2008 financial crisis. In 2009, the bank forfeited around $500 million for violating the International Emergency Econ Powers Act, and pleaded guilty in 2014 to USA taxpayers for filing false returns, in conjunction to paying around $2.6 billion fine.
Macroeconomics
- The looming threat of impending recession alongside the unsatisfactory inflation reports generally creates an environment that is not the most conducive for deploying risk capital. Latest inflation reports of 8.3% in the United States and expected September inflation of 10% extracted a response from the central banks, of continuing the policy of increasing interest rates.
- This causes a reversal of liquidity in the markets, and the amount of discretionary income available in the hands of the retail and institutional investors takes a significant beating. As a consequence, the tendency of people to invest in risky assets, which potentially have been underwritten by Investment Banking arms of banks like Credit Suisse, decreases.
14 year high CDS
- The firm’s CDS prices are the highest since the 2008 crisis, reaching a price of around $325. Many use this as a proxy for the increased fear of default and bankruptcy of Credit Suisse in the minds of the investors.
- This actually goes on to form a self-fulfilling prophecy, with a cycle of people buying and further pushing up the price of Credit Suisse CDS by looking at the already high CDS price, thus invariably contributing to poor share performance of Credit Suisse and corollarily increasing their chances of failure.
COMPARISON TO LEHMAN BROTHERS
The precipitous increase in the value of CDS in conjunction with the fall in stock price, Credit Suisse’s current scenarios naturally stokes analysts to draw comparisons to the company that pioneered the 2008 crash, Lehman brothers.
This comparison does no good in helping Credit Suisse’s case. As you can see from the below graph, the CDS market accurately predicts the fall of Lehman Brothers.
In the nascence of the crisis, Lehman Brothers had released a memo citing that they intended to spin off their investment banking divisions in order to circumvent the predicament. True to the trend, Credit Suisse's seeks outside investors to inject money and takes up a partial majority stake in the investment banking arm.
If Credit Suisse was to go defunct, it would be the highest crosshair in the bar chart of the biggest bankruptcy, going by the assets under management for every company.
Going up against Lehman Brother’s $700 million AUM, Credit Suisse would top the chart with its $2000 million + AUM.
Though these comparisons create room for some juicy theories of a bankruptcy for Credit Suisse being inevitable, and it being a precursor to a more systemic fall, it is important to compare the magnitude while we draw parallels in trends.
While Credit Suisse’s CDS is currently priced at 325 (according to CNBC), Lehman Brother’s CDS had reached a peak of 610 basis points before its collapse.
Moreover, Credit Suisse has a decent cash reserve to pave further runway and withstand any losses.
The bank’s total assets came to 727 billion Swiss francs ($732.7bn) at the end of the second quarter, about one-fifth of which was held in cash, according to a recent analysis by JPMorgan Chase.
When it comes to the bank’s liquidity levels, Credit Suisse has a liquidity coverage ratio of 191%, which is significantly higher than most of its peers. The ratio is a reflection of the amount of highly liquid financial assets the bank holds that can be used to meet short-term obligations.
“Credit Suisse had a CET1 capital ratio of 13.5% at June 30, well above the international regulatory minimum of 8% and the Swiss requirement of about 10%. Its liquidity coverage ratio is one of the highest among European and US banking peers.” — Bloomberg.com
It is also crucial to factor in the improved regulatory environment around the banking system since the 2008 crisis.
“Big banks generally are far better capitalized than they were in 2008, and my own view of Lehman has always been that a big part of the problem when Lehman failed stemmed from the fact that everyone was expecting Lehman to be bailed out. US regulators had signaled when Bear Stearns stumbled in March 2008 that they wouldn’t let a big bank fail, then surprised the markets by letting Lehman fail. I suspect the Credit Suisse situation won’t have knock-on effects, both because of generally high levels of capital and the very different circumstances of 2008.” David Skeel, a professor of corporate law at the University of Pennsylvania Law School, mentioned in an interview.
ROAD AHEAD
A catalyst which invigorated the discussion around Credit Suisse in public discourses was the tweet by the recently installed CEO of Switzerland’s second largest bank, in which he had sought to play down speculation surrounding the bank’s overhaul plans, which it expects to announce on Oct. 27. While arguing that the bank’s capital levels and liquidity are strong, he acknowledged that the bank is at a “critical moment.”
The firm’s intention of keeping the restructuring plans a secret until an official release, has not been faring out too well. It has been widely reported that they are poised to slash over 5000 jobs to mitigate burn.
Analysts at Goldman Sachs have postulated that Credit Suisse may face a capital shortfall to the tune of $8 billion. The analyst team continues saying that Credit Suisse needs a capital raise to fill a void of at least $4 billion, and with a market cap of $10.64 billion, raising $4 billion is a challenge. Raising and refinancing debt is going to be a challenge due to the credit default swap spread as well as the rising interest rates. Additionally, with the stock trading near 52-week lows, issuing equity at this diluted valuation is not attractive and is going to further significantly dilute existing shareholders. The company could also be looking at prominent asset disposals and spinning off parts of its business, but with stock prices being low and pressure to reorganize, one can wonder how good the pricing of asset and segment sales will be.
The firm also intends to fast-track radical cuts to the organization’s investment banking wing, severing ties with large parts of the business and hiving off its securitized product group, in hopes of adopting a leaner model and mitigating the prospects of further financial debacles and scandals.
CLOSING THOUGHTS
Inspite of the CDS skyrocketing to the highest levels, stock price plummeting to an unprecedented level and breaking all resistances, stress tests conducted on the bank attest to the grim scenario that Credit Suisse finds itself in, but with a additive note that surmises that Credit Suisse does retain enough stability to easily avoid a total defunct and bankruptcy. With a healthy capital and liquidity buffer of around $100 billion, most analysts echo Goldman Sachs opinion that although it’s a particularly tight situation, it is not the resurgence of a Lehman-style collapse that a certain faction of the markets vouch for.
However, the frenzy in the economy rolls up to seem like a self fulfilling prophecy, where the more people believe the bank to fail, the more actively they contribute to their failure by driving the price lower, thus making it all the more difficult for the management to pull off a hassle free and lucrative restructuring.
Realistically, despite the sensationalist headlines, the fact remains that Credit Suisse, with its $2 billion AUM, has reached the pinnacle of high finance, and is regarded as a Systemically important bank, implying that its failure could potentially destabilize the economy at large. In the event of the bank standing on the brink of such a failure, it is more likely than not that governments will extend monetary support towards the cause of ensuring that a systemically important bank does not collapse entirely.
