The Banking Crisis, Chapter 3: Credit Suisse

Hey everyone,

The contagion has hit European shores. Credit Suisse, the 2nd largest bank in Switzerland, could be imploding in real time.

The drama hit mainstream consciousness on Wednesday when the embattled bank began to get beaten up in the stock market.

Before we dive into the details, let’s take a step back.

Many of the greatest investors in the world have been ringing the Doomsday bells for financial markets in the wake of the Fed's loose monetary policy for quite some time now.

It's always hard to imagine what a world-ending event looks like when Charlie Munger, Warren Buffett's business partner, predicts it without sharing details of what breaks.

Well, we're seeing that thing break this week. While SVB could've been an isolated event, the prospect of one of the largest European banks collapsing has made the market think twice about whether or not 2023's Black Monday is around the corner.

On that note, let's get stuck in. If you need to get up to speed with SVB and what's happened, we broke it down last week.

How did Credit Suisse get here?

The lazy answer to this question is that it's just contagion from SVB. The reality is quite a bit different. Credit Suisse's problems have been ongoing for many years.

Their stock price is down 98% from its all-time high, peaking in 2006 - more than 15 years ago.

One could say that this has been coming. Per ZeroHedge:

The bank has been embroiled in multiple scandals over the past decade, ranging from money laundering to their CEO spying on former employees.

A Cliffsnotes summary of Credit Suisse's struggles is as follows:

• They posted losses of over $6 billion from their involvement in Greensill & Archegos Capital in Q1 2021 alone.

• Then, in 2022, it was revealed that the bank had been servicing clients involved in torture, drug trafficking and money laundering. Swiss banks, right?

• On top of all of this, the bank's assets managed for wealthy clients fell by a stunning $200 billion in 2022

• And the bank is also suffering an ominous talent bleed, with at least half a dozen senior bankers having walked out.

To put insult to injury, the bank lost $134 billion of customer deposits in 2022, contributing to a yearly loss of over $7 billion. As you can see, Credit Suisse is not unfamiliar with struggle.

That brings us to February 2023, when things start to get interesting.

It was reported earlier this month that Credit Suisse’s losses would unexpectedly continue well into 2023, if not 2024.

On top of that, they stated that the 2022 bank run was worse than they feared, with their Chairman allegedly lying about how bad the bank run was in the hopes of "stabilising outflows." In exchange for sharing this, their share price got pummelled.

The stock tanked again in mid-Feb when Credit Suisse announced it’d offer exorbitantly high deposit rates to attract new customers and stop the bank run.

Their offer jacks the annual deposit rates given to customers to 6.5%. This rate is way above the risk-free rate determined by the ECB. Still, it blows away similar rates of competitors, per Bloomberg:

Now, remember that banks make money through the difference in the rate they lend money out versus the cash they pay depositors.

In essence, customer deposits fund loans issued in a fractional banking system.

These rates are derived from the central bank rate. With the European Central Bank (ECB) rate at 3%, Credit Suisse is paying depositors way above this rate - meaning they'd have to borrow at 9% plus to generate profits.

That business model isn't sustainable, with prospective borrowers opting for cheaper alternatives to access capital.

So what does Credit Suisse have to do? First, they have to eat a fat loss on their P&L by loaning out money cheaper than they pay customers on deposits.

The hope for the bank is that once they've gotten enough customers back in, they can quietly lower the deposit rate and start profiting again. But, unfortunately, as we've seen with all the 2022 DeFi blow-ups, it rarely works out that way.

(Yes, we just compared a Swiss bank's potential failure to DeFi.)

The market saw straight through its ruse to draw liquidity by attracting deposits at an unsustainably high yield. The bank is, therefore, understandably on the edge of disaster.

The kicker is that this all happened before the SVB crisis. Once Credit Suisse came into the spotlight on Wednesday, the market reaction was stunning:

• As previously mentioned, its share price was down another 30%

• The value of the bank's dollar bonds due in 2026 plunged to distressed levels, i.e. the risk of investing in their bonds materially increased.

• Credit Suisse's one-year credit default swaps reached highly distressed levels. These instruments ensure your investment in the banks' bonds if they default on the debt they owe you. For context, Credit Suisse was 18 times rival Swiss bank UBS and nine times Deutsche Bank.

• Because of this move, markets implied a 47% probability that they would default on their debt, sending them into liquidation.

• And as any contagion event goes, Credit Suisse wasn't the only bank getting smashed. Major US & European banks like Goldman, JP Morgan & BNP Paribas were down badly, with some even having trading halted.

• And then, because of the contagion risk being priced in real-time, US short-term treasury yields (the market's implied expected central bank interest rate) plummeted by as much as 1% on the day, indicating that the markets now expect the Fed to cut rates imminently to fight back against the contagion.

• And to end the day, we had well-known investors such as Peter Schiff, Robert Kiyosaki, and Carl Icahn going on finance talk shows calling for the collapse of financial markets.

I wasn't around for Black Monday in 1987 or the GFC in 2008, but this week feels like it's nearing that level of distress.

It's plain to see that the failure of Credit Suisse would be a way bigger deal than SVB - besides the fact that it has more than double the assets - this would be the collapse of a truly reputable global bank with assets spread all over the world.

The contagion risk of unwinding these assets into global markets could be catastrophic.

Who can save them?

I'm pretty confident Credit Suisse would be doomed if no one came to their rescue.

Unsurprisingly, the Saudi National Bank, their largest shareholder who holds 9.9% of the bank's equity, immediately distanced itself from the situation, citing the reason for non-involvement as a regulatory one.

But I think they didn't want to lose more money in this dumpster fire of an investment. So hold onto this thought as we go forward from here, as we'll need to read between the lines a few more times.

Their obvious saviour is the ECB. However, all they did on Wednesday was ask around European lenders to get an idea of their exposure to Credit Suisse.

So, enter the Swiss National Bank.

Late Wednesday, Credit Suisse announced they plan to borrow up to $54 billion from the Swiss National Bank under a covered loan facility "fully collateralised by high-quality assets." However, it wasn't entirely clear what precisely these high-quality assets were.

Again, an exercise in reading between the lines.

The bailout from the Swiss National Bank seemingly arrived at the perfect time, causing markets to rally and stem the tide. However, I believe the market will soon realise this bailout is a band-aid solution.

The Swiss National Bank's intervention allowed the European Central Bank to stick to its mandate and hike rates.

Interestingly, the market expectations fluctuated quite a bit leading up to the event.

On Tuesday, a statement from ECB vice president Luis De Guindos cited that some European Banks could be vulnerable to rising interest rates causing the probability of a 50 bps hike to go from 60% to just 35%.

The market choked on the reality check with European IG credit spreads (basically the riskiness of investing in corporate bonds) shooting up.

De Guindos was on a roll and continued to add that a loss of confidence could trigger further contagion, warning people not to become complacent. He also highlighted the balancing act between the ECB's mission to fight inflation and the potential damage inflicted upon financial institutions resulting from higher rates.

However, the ECB went ahead and hiked 50 bps yesterday. And De Guindos, during the press conference, was silent on the points he had made on Tuesday, opting to be a puppet and repeat everything that Christine Lagarde, the ECB president, had to say.

Remember, everyone, read between the lines.

While the ECB remained steadfast on its position of beating inflation down to the 2% target and declined to comment in detail on the emerging banking crisis, the essential point coming out of the press conference was that the ECB refrained from providing any forward guidance and didn’t signal any future rate hikes in the statement, something it hadn't done previously.

The European stock market took this as dovish sentiment and ran with it, trading up at the end of yesterday. The lack of forward guidance implies that the ECB is not biased toward further rate hikes, giving policymakers the flexibility and time to assess the banking crisis and make appropriate decisions.

In the game of cat and mouse, the central bankers have won over the market this week and have instilled a false sense of security into it.

Over to the Fed

With the ECB's time in the limelight over for now, it's all eyes on the Fed for next week Wednesday.

It feels like a lot could happen between now and then but, for now, we should ask ourselves two vital questions:

1. What does the Fed choose to prioritise next week? Inflation or supporting the banks and preventing further contagion?

2. Has the ECB set a precedent that forces the Fed's hand?

Without diving into the details right now, besides the crazy move in the market's expectations of where the Fed Funds Rate may sit after the meeting, we need to remember that a week ago, Jerome Powell alluded to the possibility of having to hike 50 bps again if the data showed the decision was warranted.

Remember that the market is a prediction mechanism that makes the best guess of what may happen; it's only reality once he says what he has to say.

Ultimately, the facts on the ground remain unchanged despite what the market is speculating.

The ECB held firm to their mandate on inflation - the Fed may have to do the same.

The Fed can't lose credibility and pivot out of nowhere, not now when we are on the cusp of an all-out banking crisis. This is reflected in markets now, with a 25 bps hike expected over anything else.

Following the ECB's path, the Fed's intervention with SVB may have given it the perfect reason to continue hikes as "the situation is under control."

So, is the contagion over?

When it comes to answering this question, we have to come back and revisit whether SVB and Credit Suisse were events that happened in isolation or not.

On the one hand, yes - SVB is isolated when weighed against the global financial system, and they cater to a specific niche of customers. And Credit Suisse has had its head in a vice for the past 20 years due to its poor management.

But on the other hand, we've seen clear signs of contagion with regional banks caught in the crossfire. At the extreme, banks like First Republic have been downgraded to junk status and are being floated for sale.

We also know that, from a macro point of view, aggregate bank deposits are declining (which has yet to be seen since 1948), causing banks to trim their balance sheets (and book losses on their bond portfolios) to meet spiralling withdrawals.

Only time will tell whether this becomes a full-on financial meltdown or blows over. What's evident is that the central banks are flip-flopping between maintaining credibility and actively engaging in quantitative easing below the surface to support floundering banks.

Reading between the lines, as we've done this whole report, it seems that the central bankers are panicking but don't want you to know about it.

And from a macro long-term position, opinions & data seem divided on whether or not there's a big crash coming…

Whereas, Michael Burry, who famously predicted the big short of 2008, doesn't see any danger here and thinks that the history of 1907 will repeat itself.

I realise that this is data vs some guy's opinion, but that's neither here nor there. Uncertainty is at an all-time high, systemic risks have materially increased, and the market is in a precarious position.

So pay attention, keep your ears close to the ground, read between the lines and think critically about what's happening with your position in the market relative to the amount of risk you're taking.

But most of all, stay safe out there.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for reading,

— Luca