Last week, Credit Suisse’s credit default swaps yield, or CDS spiked more than 5% (500 bps) in a day, rising more than Barclays’ and Deutsche Bank’s CDS.
Now, credit default swap is like an insurance policy against a default event on an asset – for example, a bond.
Investors pay the yield on the CDS, also called an insurance premium.
In some ways, a CDS measures an asset, or company’s default risk.
This implies — the higher the CDS yield, the more expensive insuring a riskier asset.
This spike in CDS yield spooked me right away. Plus, markets were speculating the Swiss second largest bank is in deep trouble.
So, what’s exactly going on? Let’s unpack this.
How did Credit Suisse CDS spiked so much — and why?
The whole fiasco started when investors were worried there were initial rumours of Credit Suisse trying to raise capital from private investors.
This shook the market, which suspected Credit Suisse might be in financial danger.
But Credit Suisse denied such rumours.
They claimed their “shares were already so low”. And and there was no way Credit Suisse would do a rights issue. What’s more, Credit Suisse just got a credit ratings downgrade, which may force the Swiss bank to borrow debt at a much higher interest cost.
Also, the bank’s new CEO, Ulrich Koerner and management had to come out to assure their employees, clients and investors the bank is still in good shape — “strong capital base and liquidity.”
I don’t believe this one bit.
Credit Suisse — What you need to know
In 2021, Credit Suisse was hit by two major financial scandals – Archegos Capital Management and the Greensill scandals.
Credit Suisse suffered losses — took a US$5.5 billion hit from the blow up of Archegos Capital Management, a family office run by Bill Hwang.
Then, in March 2021, Credit Suisse shut down its US$10 billion of supply chain finance fund linked to the blow up of a UK lender, Greensill.
Next, Credit Suisse’s financial numbers surprised me.
The thing is, only 40% of Credit Suisse’s total assets – currently CHF727 billion — accounted for loans.
This was lower than our Singapore banks’ loans proportion — all of them have loans more than half of their total assets.
This also tells me one thing: Credit Suisse isn’t the predictable, steady type of traditional commercial bank anymore.
Today, Credit Suisse is more than that.
It has evolved into an investment banking powerhouse that also trades and invests in riskier financial assets.
What’s more, in their latest 2Q2022 financial results, Credit Suisse reported lower revenues — — down 17% from a year earlier — and recorded big losses of CHF1.6 billion.
According to the bank, these weak results were driven by: “…lower net revenues in the Investment Bank, mainly driven by reduced capital markets and sales and trading revenues due to challenging operating conditions, including high levels of volatility and a seasonal decrease in client activity.”
In some ways, Credit Suisse’s financial position doesn’t look that healthy.
Credit Suisse — A Lehman Brothers moment?
During the 2008 global financial crisis, subprime mortgages and highly complex financial products killed the US investment banks.
Back then, interest rates rose and forced many “subprime” US homeowners to default on their mortgages.
And high-risk corporate borrowers were unable to pay back loans to banks such as Lehman Brothers. The result?
These financial products blew up.
Overnight, Lehman was caught with their pants down — unable to refinance their short-term debt.
Imagine this in 2007: investment banks realized they were holding on to “risky” assets, then tried to sell them in a fire-sale. But markets found out, and other bank lenders stopped lending to Lehman.
What’s crucial to note — in 2007, what worsened Lehman’s situation was the US investment bank doesn’t own any deposits. Because it wasn’t a Federal Reserve-regulated bank.
o finance the bank’s lending operations, Lehman borrowed a lot of “short-term debt” to finance the lending of subprime mortgages and invested heavily into highly risky complex financial products.
When the market realized Lehman was holding a bag of financial dirt and knew Lehman couldn’t repay its lenders, the market went into a frenzy.
Will Credit Suisse collapse?
Now, I don’t think Credit Suisse is a Lehman moment.
Unlike Lehman, Credit Suisse still holds deposits, rather than relying only on borrowing debt from other banks.
What’s more, Credit Suisse’s trading assets account for just 20% of the bank’s total assets – which means management still can contain the bank’s risks should some of these assets fail.
And lastly, Credit Suisse recently came out to calm investors by proposing to buy CHF3 billion of its own debt back. This would help reduce the bank’s debt load.
An opportunity in a crisis?
Frankly, Credit Suisse shares are trading cheap.
The second largest Swiss bank’s shares plunged more than 60% over the last year.
And guess what?
At today’s share price, the bank’s P/B ratio, a quick measure of a bank’s valuation, is heavily discounted at 0.26x.
Source: Yahoo! Finance
Credit Suisse’s recent CDS spike in a way felt like American Express’ salad oil scandal in 1962 – the US bank lost over US$140 million, and shares plunged more than 50%.
Back then Warren Buffett saw value in American Express and loaded up its portfolio with American Express shares, eventually profiting massively from the scandal.
A Credit Suisse blow up seems like a “low probability” event.
But what’s clear is the second largest Swiss bank isn’t the type of safe, predictable traditional “savings and loans” bank. Credit Suisse has evolved to running more trading and investment activities, placing the bank at a higher risk in the business.
While the current financial event for Credit Suisse makes a perfect, speculative trade.
As a conservative income investors, I’ll probably be more careful with the stock.
Plus, credit rating agencies like Moody’s have also warned about potential losses that could reduce Credit Suisse’s capital ratios.
Sometimes, investing can be simple.
Willie Keng, CFA
Founder, Dividend Titan