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Where did Credit Suisse go so badly wrong?

8 Oct 2022 , 09:41 AM

They were once called the troika of Swiss Banking. Then in 1998, Swiss Banking Corporation merged into Union Bank of Switzerland to create UBS. Now the third part of the troika is in deep trouble. We are talking about Credit Suisse, which like the others in the original troika, was also established in the mid-nineteenth century. Credit Suisse was the bank to which the wealthiest in Europe entrusted their wealth. What went wrong for Credit Suisse?

A meme doing the rounds on Twitter is that if Credit Suisse also merged into UBS, the combined entity of 3 Swiss banks with over 400 years of history would be valued at less than ICICI Bank. That was on the lighter side. The real question is what went so wrong with Credit Suisse in such a short span of time? The toxicity had been building for quite some time and it is just manifesting in recent months.

Credit Suisse came out unscathed in 2008

Back in 2008, when most global banks were in a deep crisis, Credit Suisse came out  unscathed. That was the time Bear Sterns and Lehman went bust, Goldman and Morgan were on the brink while ABN AMRO, Merrill Lynch, Dresdner Bank and GE Countrywide were forced into mergers. Amidst this chaos, Credit Suisse had been largely unscathed.

This de-coupling could be attributed to Credit Suisse being more focused on wealth solutions and its investment banking business not as aggressive as others. One argument is that escaping the 2008 crisis had made Credit Suisse too sanguine. Unlike other big banks, Credit Suisse did not learn the perils of peregrination and is paying the price 15 year later.

3 blunders that define the crisis at Credit Suisse

Insiders admit that many of the big scams and losses in recent years can be attributed to two things. Firstly, aggressive investment banking and skewed incentive structures led to excess risk taking by the sales team. Secondly, Credit Suisse allowed the sales and business development team to overrule the risk and compliance team, which triggered bad decisions.

1)      The first big crisis for Credit Suisse manifested when Greensill went bankrupt in March 2021. Credit Suisse had an exposure of $10 billion. Greensill was a supply chain financer and these supply chain receivables were securitized and converted to bonds and sold as safe assets to wealth clients. It has only been able to recover part of the funds and may end up with losses, although it would depend on insurance claims and realizable value.

2)      There was no such confusion on the quantum of losses in Bill Hwang’s Archegos Capital. The family office of Bill Hwang was heavily funded by Credit Suisse. Eventually, Credit Suisse ended with losses of $5.5 billion in Archegos. The Archegos losses would have been much lower had it exited positions like Goldman Sachs and Morgan Stanley.

3)      The third problem involved slush money.  Credit Suisse handled cash for a cocaine trafficker and is facing criminal money laundering charges. Credit Suisse has been fined £350 million over the Mozambique tuna bonds scam, which were loans arranged for the Republic of Mozambique. Credit Suisse has funded high risk assets like private aircraft and superyachts for Russian oligarchs and that is in trouble with amidst the Ukraine war.

Things could have really worsened for Credit Suisse as it was the second largest financer for Evergrande of China. Fortunately, it learnt its lessons from Archegos and exited well in time.

How is the crisis at Credit Suisse manifesting itself?

Like most financial crisis, the first manifestation is in the stock price, which has fallen to a multi-year low of SFR3.52. Its current market cap stands at around $10 billion, around one-tenth the market cap of HDFC Bank. The second manifestation is the quarterly profit declared by Credit Suisse. In the last one year, when all global banks were reporting record profits, Credit Suisse reported combined losses of $4 billion in the latest 3 quarters.

The bigger source of worry is credit default swap (CDS), which has gone above 250, which is higher than the CDS level of Credit Suisse at the peak of the global financial crisis in 2008. Currently, banks like Morgan Stanley and UBS have CDS rates below 150. In probability terms, the Credit Suisse credit default swaps are pricing in a 23% probability of bankruptcy. That is scarily high and raises the spectre of becoming Europe’s Lehman moment.

Macros are worsening in Europe and that is the worry

Like Lehman, Credit Suisse may just be a manifestation of a much bigger problem, which has a number of parts. Firstly, inflation in the EU region is close to double digits. That has forced the ECB to also adopt a hawkish policy and that is making the cost of funds very high. The second big concern is on the energy crisis that Europe is currently facing. There are concerns that many of the European energy companies, dependent on Russia for gas, supplies may have to eventually file for bankruptcy.

Finally, the trillions of dollars that are held as pension assets across Europe are facing a unique problem. With sharply higher bond yields, these pension funds are sitting on billions of dollars in bond losses. It remains to be seen how these banks look after these bonds are written down. It may leave a huge unfunded pension gap and that is a big macro worry. All these factors may only compound the crisis at Credit Suisse?
So, will Credit Suisse go the Lehman way?

Most likely NOT, and there are several reasons for the same. Unlike 2008, the systemic risk management measures are much stronger and the banking system much sounder. Hence a broad-based crisis looks unlikely. Credit Suisse may still have problems, but that is something the Swiss government should be able to support.

For Credit Suisse to survive this crisis, a lot will depend on how the restructuring plan is presented by the management of the bank on 27th October, when Credit Suisse announces its September quarter results. In 2006, Credit Suisse had absorbed the First Boston investment banking business into the bank. That may have to go now. Most certainly, the restructuring deal may either entail selling off the investment banking business or hiving it off into a separate entity. That will allow Credit Suisse to preserve the value of its core banking and wealth management business.

The cost of allowing Credit Suisse to fail is too large since it is classified among the global TBTF (too big to fail) banks. The sheer domino effect of a Credit Suisse failure would be huge and would pervade all markets. The answer may be to capitalize Credit Suisse and let the show go on. For that, a lot will eventually boil down to the plan presented on 27th October.

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