Credit Suisse: What Twitter Won’t Tell You

Credit Suisse: What Twitter Won’t Tell You
Stéphane Renevier, CFA

over 1 year ago6 mins

  • Credit Suisse is probably not on as shaky ground as the scaremonger would lead you to believe: it has a decent capital ratio, its gross derivative exposure doesn’t involve equally massive risks, and the reasons it’s struggling likely have more to do with its business model than anything huge brewing under the surface.

  • Then again, Credit Suisse is likely more risky than its biggest defenders would claim: investors and businesses losing trust in the bank presents a real threat to its future, and there’s always the chance that something could go wrong with its derivatives. Remember, the fact that it’s well capitalized doesn’t mean it can’t go bust.

  • Most importantly, the cracks appearing in the financial system demonstrate that quickly rising rates are really starting to take their toll. So err on the side of caution, and don’t play hero.

Credit Suisse is probably not on as shaky ground as the scaremonger would lead you to believe: it has a decent capital ratio, its gross derivative exposure doesn’t involve equally massive risks, and the reasons it’s struggling likely have more to do with its business model than anything huge brewing under the surface.

Then again, Credit Suisse is likely more risky than its biggest defenders would claim: investors and businesses losing trust in the bank presents a real threat to its future, and there’s always the chance that something could go wrong with its derivatives. Remember, the fact that it’s well capitalized doesn’t mean it can’t go bust.

Most importantly, the cracks appearing in the financial system demonstrate that quickly rising rates are really starting to take their toll. So err on the side of caution, and don’t play hero.

Credit Suisse has sparked quite the outcry: half of Twitter is loudly proclaiming another world-shaking, financial-disaster-catalyzing Lehman moment, and the other half is bashing the first for being “ignorant scaremongers”. But if you want the true scoop, you’re going to need more than 140 characters.

What’s happening with Credit Suisse?

Credit Suisse’s stock has been sliding down a slippery slope for some time (white line below), but things have suddenly got a lot more treacherous for the big bank. The price of Credit Suisse’s “credit default swaps” (CDS) – which allow investors to pocket some money if a company defaults on its debt – has exploded, and that’s sparked speculation from investors the world over that the colossal, controversial bank might be on the verge of default.

Stock price (white) and cost of insuring against a default in the next 1 year (blue) and 5 years (orange)
Stock price (white) and cost of insuring against a default in the next 1 year (blue) and 5 years (orange)

Let’s debunk the scaremongering statements first.

“Credit Suisse is on the brink of default.”

Let’s get one thing clear: even if the cost of insuring against a default looks like it’s going through the roof, there’s no guarantee that an actual default will happen. In fact even after Monday’s spike, the implied probability of Credit Suisse defaulting on its senior debt within one year stayed under 10%. And while the one on its subordinated debt is higher, that refers to a much riskier type of debt, and isn’t a good representation of the real risk of Credit Suisse going bust.

In fairness, Credit Suisse looks financially healthier than banks were in 2008: its liquidity and coverage ratios – measures of how easily a bank can pay its debt – are strong, while its leverage is half of what it was before the financial crisis. Plus, tighter regulation makes it less likely that it’s followed in Lehman’s irresponsible risk-taking footsteps.

“Huge risks are brewing under the surface.”

Despite the scandalous social media theories (the chairman’s last name is Lehmann, you guys), the reasons behind Credit Suisse’s plight are probably pretty simple: it’s a struggling business in a struggling industry, facing significant challenges – not least costly legal battles and a struggling investment bank division – at a time of high volatility and even higher funding costs. And the fact that those issues are nothing new – they’re more symptomatic of the bank’s long-standing issues than of any bubbling conspiracies – means even if Credit Suisse does default, it’s unlikely to cause the same widespread damage we saw when Lehman went under.

“Credit Suisse’s $30 trillion derivatives exposure will blow up the entire financial system.”

That massive sum isn’t actually as scary as it seems. For one, contracts of the same value can have completely different risk profiles – $100 of cash in the bank is less risky than $100 in stocks, for example. And for another, many of Credit Suisse’s positions will offset each other’s risk. Just think, if you go long on $1 million of bonds and short on $1 million, your real risk isn’t $2 million: the risk in your short positions will offset some of the risk in your long ones. I’m not saying its hefty derivatives exposure is risk-free, but the conclusions you’ll see on social media are sure to blow the issue out of proportion.

Still, Credit Suisse might not be as safe as its staunch defenders want you to believe…

Escalating CDS prices could eventually put significant pressure on the bank’s business.

The probability of an imminent default is low, true, but it’s certainly rising fast. In fact, the cost of hedging against the bank defaulting within one year just flew past the annual cost of hedging against a default in the next five years. That’s a clear warning sign that investors are getting really worried, and key stakeholders are likely to start having doubts that the bank can pay its obligations.

That could impact Credit Suisse’s business more than the market expects: that lack of confidence would make funding impossibly expensive at a time when the bank desperately needs cash, encourage talented staff to leave, and push clients, suppliers, and partners to renegotiate terms on their deals. One Twitter user rightly said that “no investment bank goes under because it runs out of capital. It fails because it runs out of confidence.” After all, when there’s blood in a sea full of sharks, it’s a lot harder to swim back in one piece.

Credit Suisse exposure to derivatives is not as extreme as some believe, but it’s still a risk.

Credit Suisse’s huge gross exposure might be misleading, but so is its low net exposure. See, estimating a net exposure for derivatives products actually is, for once, a bit like rocket science: it relies on complicated models and assumptions, which – as 2008 showed us – don’t always reflect reality. What’s more, risks can emerge from a heap of unexpected places, like a trader forgetting to hedge a once-in-a-thousand-years scenario, or legacy risks from complex products that the bank sold years ago. Truth be told, I wouldn’t be surprised if the bank’s own management team doesn’t fully know the risks they’re exposed to.

The bank’s decent financial shape doesn’t mean it can’t still go bust.

Just because everything is fine today, it doesn’t mean it’ll all be fine tomorrow. Check it out for yourself: the chart below shows just how quickly the bank’s capital ratio could suffer without any new capital to fund the company’s restructuring. In fact, credit agencies have already started to downgrade the quality of its debt, a signal of doubts over its ability to actually cough up the cash, citing a potential fall in its capital ratio as a key reason.

Credit Suisse’s capital ratio could take a big hit with its restructuring. Source: RBC.
Credit Suisse’s capital ratio could take a big hit with its restructuring. Source: RBC.

So what’s the takeaway in all this?

Strong opinions make good headlines, good tweets, and good money – but that doesn’t make them right. Instead, the reality tends to sit somewhere between the scaremongering and the extreme defense: Credit Suisse is unlikely to be at the intense risk that social media would have you believe, but it might also be shakier than its apparent strong financial health suggests. So if you were thinking of being that brave dip buyer, you might want to think again.

What’s more, focusing on whether or not the bank’s destined to be the next Lehman might be missing the point. What matters for your portfolio is that cracks have started to show across the whole financial system, from the US dollar’s wrecking ball to the Bank of England’s forced intervention in the UK last week. Layer on this rising cost of protection of banks, and it seems like rising rates have really started to stretch things that little bit too thin. And with a macro environment this volatile and markets this fragile, it wouldn’t take much for something to really break – even if we can’t tell what that might be yet. So I’ll repeat my mantra for this year: if in doubt, err on the side of caution – and certainly don’t take any unnecessary risks. In fact, your best bet for now might be to stay in cash until some real opportunities start popping up. Oh, and take everything you read on Twitter with a bucketload of salt.

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