Time, money and options are fast running out for Switzerland’s second largest lender, Credit Suisse.
After a string of hugely costly, self-inflicted crises (sound familiar?), Credit Suisse appears to be in the process of prising the mantle of Europe’s most troubled systemic lender from Deutsche Bank, which the German bank has held for most of the past decade. As the Wall Street Journal noted a few days ago, “Credit Suisse has taken pole position in a race to the bottom among big, but weak, European banks.”
The scandal-splattered bank has already reported losses of over $2 billion in the first half of this year, significantly under performing expectations as revenue at its investment bank has continued to plunge. That was after reporting an annual loss of $1.7 billion in 2021. Since the second quarter of 2021 CS’ asset base has slumped in value from $937 billion to $735 billion. Net revenues are also falling. Over the past nine quarters the bank has only managed to muster one quarter of actual year-on-year growth.
A Torrid March
It was in the Spring of 2021 when Credit Suisse’s current crisis began. And that crisis has revealed glaring flaws in its risk management processes.
As readers may recall, two of the bank’s major clients — the private hedge fund Archegos Capital and the Softbank-backed supply chain finance “disruptor” Greensill — collapsed in the same month (March 2021). By the end of April 2021, Credit Suisse had reported losses of $5.5 billion from its involvement with Archegos. Its losses from its financial menage á trois with Greensill and its primary backer, Softbank, are still far from clear, as the bank is trying to claw back almost $3 billion of unpaid funds for its clients (more on that later).
What is clear is that 2021 was a watershed moment for Credit Suisse. The bank’s then-CEO Thomas Gottstein called it “a very challenging” year. The irony is that the year before, when financial markets almost fell off a pandemic-induced cliff, the bank managed to generate a net profit of $2.84 billion while many of its peers posted record losses. Credit Suisse was even lauded for its risk management in the weeks leading up to the lockdowns, picking up Risk.net’s Credit Derivative House of the Year award in February 2021:
Within weeks, the US credit markets were in meltdown. The Covid-19 pandemic crippled corporate earnings and everyone wanted credit protection. CDS indexes jumped to their highest levels on record, according to Bloomberg data.
Credit Suisse was a step ahead of the tide. The moves it made in February paid off in a big way. The put options on LQD returned 30 times the initial premium outlay. The desk was also actively sourcing front-end single-name CDS protection from issuers of synthetic collateralised debt obligations in the second half of 2019 and early 2020.
All of this meant it was in a good position to offer liquidity when credit spreads blew out in March. “When volatility escalated, we were able to help clients with what they needed to do without needing to protect ourselves,” says David Goldenberg, Credit Suisse’s head of global index and options, and head of US credit derivatives.
A month after receiving that award Credit Suisse’s reputation for risk management was in tatters. As banks offering prime brokerage services to Archegos Capital began liquidating billions of dollars’ worth of various stocks on which Archegos owned options after the hedge fund had failed to meet a margin call, CS was slow to react. As the Wall Street Journal reported at the time, Goldman Sachs and Morgan Stanley were able to minimize their losses relating to Archegos by responsing more quickly than Credit Suisse and Nomura Holdings. Even Deutsche Bank was able to close its substantial positions rapidly and avoid any losses.
A Long-Term Trend
But like most financial flag carriers in Europe, Credit Suisse’s problems date back to the massive build up of private debt during the pre-crisis years. Many banks in the Euro Area never got over the resulting Global Financial Crisis and the European sovereign debt crisis that followed shortly after. In Switzerland, it was UBS, the country’s largest lender, that landed itself in serious trouble in 2008 through its exposure to US mortgage securities. UBS was bailed out with public money while Credit Suisse was able to raise capital from the private sector.
But ever since then, Credit Suisse’s stock has been in a death spiral, having lost 95% of its value since 2007. This, again, puts it on a par with Deutsche Bank. This year alone, CS’ shares have fallen by 55%. Given that European bank shares as a whole are tumbling once again as credit conditions rapidly deteriorate and a full-blown economic crisis beckons, there is likely to be little in the way of respite for some time to come.
“CS’s revenues keep trending down, costs are described as not flexible this year and limited flexibility next year, and the succession of quarters with a net loss is destroying capital,” said Jefferies analyst Flora Bocahut in a research note. “CS shares will be challenged until revenue momentum turns, which is going to take several quarters at best.”
Credit Suisse’s price-to-book ratio — the equation often used to reflect the value that market participants attach to a company’s equity — is currently 23%, which is exactly the same as Deutsche Bank’s. Normally, when a company’s P/B ratio falls below 1, it means the market is either undervaluing it and thus it could be good value, or the company is in serious trouble. When the ratio slumps as low as 23%, it’s far more likely to be the latter than the former.
This may explain why the spreads on five-year credit default swaps (CDS) on Credit Suisse debt are close to their highest level since the collapse of Lehman Brothers. CDS are derivative instruments that are supposed to act as an insurance policy against a credit event on an underlying asset, but can actually exacerbate financial crises by increasing counterparty risk, as happened in 2008 (Yves wrote extensively on this matter at the time, including here and here).
Another Structural Overhaul
So, Credit Suisse needs to raise money, and sharpish. And that is not easy when the bank’s revenues are plunging. To steady the ship, CS’ new management is planning another deep structural overhaul, just one year after the last one.
The new strategic review will be officially announced on Oct 27. In the meantime rumours are flying. According to the financial press, it may divest all of its wealth management operations in Latin America with the exception of Brazil. The bank is also reportedly considering offloading its securitized products group as well as bringing back the First Boston brand name for its US investment banking business. It could even leave the US market altogether. It is also apparently mulling laying off 5,000 of its investment bankers and splitting its investment banking business into two, or even three units.
These, of course, are all rumours. But what the bank desperately needs is stability, having churned through three CEOs in five years and three chairmen in two. Its biggest challenge will be raising fresh capital, for the fourth time in seven years. Credit Suisse needs to plug a capital gap of at least $4.1 billion to bolster its financial position, according to Deutsche Bank, which must be enjoying a spot of schadenfreude right now,. But CS has chosen the worst possible moment to go cap in hand to investors, with global financial conditions deteriorating rapidly and its market cap now valued at just $10.6 billion, less than half its value nine months ago.
It is far from clear whether investors will be willing to part with yet more cash, having already poured $12.2 billion into the lender — more than its current market value — since 2015. You can hardly blame them if they don’t.
After all, this is a bank that has not earned its cost of capital in more than a decade. In the past two years alone it has been fined for arranging a fraudulent loan to Mozambique, for laundering money for a Bulgarian cocaine trafficker and for misleading shareholders over its risk exposure to Archegos Capital. It recently set aside a further $1.2 billion to cover more litigation provisions in the future. It has also been rebuked by regulators for spying on its executives and has been sullied by its involvement with defunct financier Greensill Capital.
The fallout from that scandal has done immense damage to Credit Suisse’s reputation among its most important client segment: ultra high net worth investors. As I mentioned earlier, Credit Suisse is trying to claw back just under $3 billion of funds from Greensill clients and insurers, so that it can then pay back the investors trapped in its supply chain finance funds. But it’s going to take a long time and the investors are growing impatient. Per Swiss Info:
The bank revealed last week that the 1,200 investors trapped in its funds were unlikely to recoup their losses for at least another five years, if at all.
“We have seen an absolute change in the mood among investors in recent days – the reaction to Credit Suisse’s latest disclosure has been one of fury, particularly as they gave the bank the benefit of [the] doubt,” said Natasha Harrison, managing partner of Pallas law firm, which is representing fund investors preparing litigation against Credit Suisse. “Nobody is going to be prepared to wait five years to get their money – and even then there is no certainty they will get it all back.”
Despite anger from clients, Credit Suisse quickly decided it would not make up the shortfall, in part because executives feared it would set a precedent. If the bank offered to underwrite clients’ investment losses, it would lead to a large increase in the bank’s regulatory capital requirements.
Since the Greenhill debacle Credit Suisse’s wealth management division has suffered large outflows. This is a problem given that wealth management, particularly in China where the bank expects the number of millionaires to grow significantly in the coming years, is expected to be a core driver of the bank’s future success. As Australian Financial Review notes, “the failure of Credit Suisse to understand the importance of maintaining an image as a financial fortress is perplexing given it sees its future in wealth management and asset management.”
If the bank fails to raise fresh capital, it can always turn to a “white knight” investor like Warren Buffett, as the Washington Post kindly suggested in an article today. Failing that, if its financial health continues to decline at the current rate, Credit Suisse could be left with only two unappetizing options: a shotgun takeover by UBS, which would create the mother of all banking monopolies, or some international entity; or it could do what UBS did back in 2008-09 — ask for of a government bailout, and perhaps get a bail-in thrown in for good measure.