1. Reasons
Credit Suisse, one of the world's largest banks, has lost more than 90% of its 2007 highs and is in free fall, losing more than 60% since the beginning of the year. The situation of the Swiss giant is currently being compared to the biggest recent financial crisis: Lehman Brothers. Credit default swaps are at their highest levels since 2008 and the bank's solidity is in danger due to fraud, espionage and money laundering. The company's shares’ prices are in free fall and the cost of insuring against a default has risen to the highest level in two decades. Despite the CEO's claim that liquidity is solid, the market is betting against the Swiss bank and its credit risk continues to worsen.
Why did the shares suffer this collapse? In July, the bank announced its second strategic overhaul in a year. In fact, after replacing its CEO, it was looking to operate in disastrously performing branches, such as investment banking. The bank is now looking for efficiency, with the aim of implementing new business maneuvers for securitised products. The talk therefore revolves around the bank's profitability, as the market has doubts about both its profitability and its second strategic choice. There are also liquidity fears due to the sale of securitised products, the proceeds of which seem to be insufficient to pay off billions in debt. Deutsche Bank estimates a capital deficit of at least CHF 4 billion, due to both scandals and losses. The scandals relate firstly to the conviction in June for failing to prevent money laundering to a Bulgarian gang of cocaine traffickers, and secondly to the Tuna bond fraud, with an $850m loan to Mozambique, where $200m even went in bribes to bankers and government officials in the African country. The most famous scandals, however, concern the hedge fund Archegos where Credit Suisse lost more than 5 billion euros following a pr where Credit Suisse lent 30 billion dollars where Bill Hwang invested it aggressively in some technology stocks and when the shares collapsed Archegos was no longer able to meet its debts. There was also the collapse of the Greensill funds where the British company was a specialized lender of money to companies to pay suppliers. It bundled debts in financial instruments which were resold in the market with a precarious underlying and in fact everything started to crumble. The Swiss bank froze $10 billion of financial funds in March 2021 after Greensill collapsed due to losing the insurance cover for the debt it had issued. At first glance, there seems to be a problem of funding costs for restructuring and downsizing, but there would be other data to analyze such as the amount of impaired debt, the quality of loans, profitability, the value of its capital and market sentiment. It is therefore difficult to give an answer, having said that the market is starting to discount a CHF 4 billion capital increase, so the bank will probably have to divest itself of its investment arm and its securitised products, with asset sales and staff cuts. Let us now look in more detail at how Credit Suisse will have to move.
2. How to avoid - Restructuring plans
The day of the presentation of the restructuring plan, October 27th , the firm suffered its greatest drawdown in financial markets since records began in 1989 (-18.6%). CS’s CEO, talked about “a radical strategy and a clear execution plan to create a stronger, more resilient and more efficient bank with a firm foundation, focused on our clients and their needs”. The first steps concern the investment banking division, the firm’s Achilles heel (in line with the global IB environment, dealmaking down 33% y-o-y): it will lead to the creation of CS First Boston (thus returning to the name that was abandoned in 2006), in the hope of presenting a new, fresh image to investors, envisioning the attraction of third-party capital. The “new” CSFB is expected by the parent company to account for 14% of total group revenue by 2025, starting with annual sales of about $2.5 billion. An option that would eventually be advocated by CS is the IPO of CSFB, but this would be possible only if strong targets are met. A Capital Release Unit will be created, composed by a Non-Core Unit and the Securitized Product Group business. The NCU, with the purpose to release capital through the wind-down of non-strategic, low return and higher- risk businesses, is expected to release ~60% of RWAs and ~55% of Leverage Exposure by the end of 2025. Securitized Products Group will be sold in a great part to Pimco and Apollo, which agreed to manage the residual assets on Credit’s Suisse’s behalf. The SPG buys and sells securities backed by pools of mortgages and other assets, such as car loans or credit-card debt and provides financing to clients who want to buy these products and will “securitize” loans -- dicing them into new securities of varying risk and return -- on their behalf and sell them to investors for a fee. It appears that this division is, indeed, profitable (accounting for around half of the IB’s arm revenue in Q3 2022), but it’s capital intensive and holds a large amount of the Risk-weighted assets on the bank’s balance sheet. RWA, as of CS’s October 27th media release, are intended to be reduced by 40% by 2025, thus the need for the SPG release. The Markets business will be closely aligned with the Wealth Management and Swiss Bank franchises, in order to reinforce its position as a solutions provider to third party wealth managers. The share of RWAs in Wealth Management, the Swiss Bank and Asset Management, together with Markets, is estimated to increase to almost 80% by 2025, with the intention of growing the revenue share of these businesses to over 85% by 2025. This is not the first time that the bank has promised a shift towards an increased predominance of wealth management over IB, the concerns over the effective realization of the strategy hold. With regard to cost-reduction, measures already in progress include a targeted 50% reduction in consultancy spend and a 30% reduction in contractor spend with the benefits expected in 2023. Moreover, “Uli the knife” (nickname gained by the CEO Ulrich Koerner during his UBS’ experience) will lay off 9,000 employees by the end of 2025. CHF 4.0 billion are to be raised through the issuance of new shares to qualified investors and through a rights offering for existing shareholders, and 20 banks will be involved in the deal. The new investors are to buy 462 million of new shares at 3.82 CHF per share, corresponding to 94% of the volume-weighted average price. 9.9% of the equity goes to Saudi National Bank, which is, however, not interested in a seat on the Board of Directors and is unlikely to overcome the 10% threshold. "We were hoping for a larger investment banking shrinkage - in particular our hope was a closure of the execution business in the investment bank." Analysts at Jp Morgan commented on the matter, worried about the EPS dilution due to the capital raise and the risks in the restructuring plan, Reuters and Bloomberg reported.
3. UBS example
UBS in 2011 found itself in a similar position as Credit Suisse’s current one, announcing a change in the Bank’s underlying structure caused by a $2.3bn rogue trading affair, as well as unfavorable market conditions. The scandal marked UBS deeply, causing the resignation of the then current CEO Oswald Grübel, who found all his efforts against tougher regulation vanished due to the misconduct of an employee of the London’s Investment Banking Trading department, along with the death of any remaining ambition to compete with Wall Street’s Titans. Ambition which already started to collapse during the Global Financial Crisis, bearing in mind that UBS, along with Credit Suisse and Deutsche Bank, was one of the main investors in Residential mortgage-backed security collateralized debt obligations, a bundle of Subprime Mortgages, which were highly attractive to lenders who thought of RMBS CDOs as lucrative investments given the high risk they were taking, necessary to compete with major players on Wall Street. Furthermore, in 2012, the Swiss Bank found itself in a critical situation due to previous years poor performances of the Investment Bank Fixed Income Department, no longer profitable given the stricter capital rules on riskier business introduced after the financial crisis, those circumstances lead to the wind down of the entire Fixed Income division, the dismissal of 10’000 employees and the departure of Investment Bank co-head Carsten Kengeter from Sergio Ermotti’s top team. Ermotti was Grübel replacement as Chief Executive, his mission was an overhaul of the Bank’s structure, aimed at saving capital. This restructuring plan was defined as necessary, not solely for UBS but for the entire Banking industry, by Ermotti. Acting ahead of competitors and reshaping their core business, would guarantee a better position in order to deliver sustainable results over the long term. The layoff undertaken translated to 15% of the total staff, targeting mostly Investment Bankers, considering their high salaries and bonus. Therefore it can be seen how Ermotti’s strategy was to shift toward UBS roots, private banking, hence a smaller Investment bank, focused on handling equities, foreign exchange trading, corporate advice and precious metals trading would leave a stronger focus on high net worth individuals.
4. Solvency/liquidity analysis
In this paragraph we want to estimate the market value, in terms of money, taking into consideration factors such as risk, time and income expectation. To evaluate a bank we cannot employ the same models we adopt for other firms, because of banking specific characteristics.
One model that can be used for analyzing banks is the Dividend Discount Model (DDM): it is a quantitative method to predict the price of a company's stock based on the present value of future dividend payments. Taking as fixed the risk free rate of return, which is at 4%, the risk premium added to R𝑓 of 5%, which is the average return for buying bank shares and a projected growth of dividends of 7.1%. The last value takes into account the expected growth for the next 4 years, considering that 2022 will scarcely show a positive growth. However if the bank survives this period of turbulence it is feasible to go back to 2018-2020 level of dividends paid, which was around $700M, in 5-10 years. As a result of this model we ended up with an intrinsic value of $14 Billion, based on these assumptions. It’s crucial to understand that this valuation considers the hypothesis of no further worsening to the current situation, meaning that its divisions get back on track. This doesn’t include various risks related to errors from the management and the mutation of external factors. To better understand if the model expectations are conceivable we decided to take our analysis further, by studying different indicators. The first and most common one is Cet1 ratio (Common Equity Tier 1), introduced by the Basel Committee following the financial crisis of 2008 to avoid similar situations. It is a measure of solvency and it’s calculated dividing Cet1 by risk-weighted assets (RWA). Cet1 is the most exposed level of the capital structure, therefore every loss will affect Cet1 ratio. Its value must be over 15.1%, while Credit Suisse's was around 13.6% for the last three quarters. This means that the company is taking too many risks or that its Cet1 has dropped too much, in both cases it is a warning. The same applies to Tier 1 leverage ratio, which measures the core capital in relation to total assets. This ratio should be above 5% and Credit Suisse stays around 6.1%. As a consequence of this value we can see how the Cet1 ratio was caused by too many risks. Next we need to analyze the liquidity of the bank. Starting with the liquidity coverage ratio, which shows the ability of the bank to fund cash outflows for 30 days with high quality liquid assets. With an outstanding ratio of 191%, Credit Suisse differs a lot from Lehman Brothers in 2007.
To conclude the analysis of liquidity it could be interesting to examine the Net Stable Funding Ratio (NSFR), which compares the available source of stable funding with the required source of stable funding. The Available amount of Stable Funding includes the bank's capital, preferred stock, and liabilities with maturities greater than one year. Certain other types of liabilities with residual maturities shorter than 1 year that are not expected to be withdrawn during the stress period can also be included. The amount of RSF is calculated as the weighted sum of the value of assets held and funded by the bank including off-balance sheet exposure. The RSF factor represents the portion of an asset that could not be monetized during a liquidity stress scenario and which needs to be covered by a stable source of funding. The NSFR reached as of Q2 2022 the value of 132%, meaning the company is liquid enough to withstand a liquidity crisis.
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