Companies mentioned: Credit Suisse, Lehman Brothers, Deutsche Bank, Unicredit, Fortis, Dexia, Societe Generale, UBS, Greenshill, Archegos
While bond markets remain ensue in the same paradoxes between latent interest of investors with regard to the level of yields, tetany given the falls in valuation, the uncertainties and the extreme volatility linked to illiquidity and contradictory news flows, few ‘significant events occur on the business front.
But it is without counting on the traditional investment banks, in particular those which would like to be one without having the content, nor perhaps the means.
Thus, as soon as an episode of crisis occurs in financial assets, a few names invariably come up and shake the markets as interbank flows are intertwined and the fall of one of these behemoths could destabilize the system.
Everyone thus remembers the Lehman moment, paragon of the excesses of these trading banks with resounding fall, but many other banks have, at the same time and for a whole decade, worried the financial markets by the weight of the derivatives they carried, their errors, not to say faults, of recurrent control and always accompanied by significant losses, the significant variations in their income statements not favorable to the bondholder or the shareholder. Each European country thus had its sword of Damocles, whether it was Deutsche Bank in Germany, Unicredit in Italy, Fortis or Dexia in Belgium or Société Générale in France…
Although most of these establishments ended up cleaning up in the last years of the 2010s and considerably reduced their CIB activity under regulatory and shareholder pressure, some have retained a certain tradition of scandal and one of them them has been talked about again in recent days, after repeated business in recent years between Greenshill or Archegos, so many vague names causing very concrete holes in its cash flow: the famous Credit Suisse.
Already, during the financial crisis of 2008, the Swiss bank and its congener UBS had suffered more than their European counterparts, less linked to the financial markets and especially less established in the USA. Very quickly UBS carried out restructuring and then showed more prudence, also benefiting from the stability of its retail banking and wealth management. Already, at the time, Credit Suisse had to appeal to the State of Qatar to carry out a capital increase in extremis and avoid sinking into a disastrous path.
Like fashion, finance is an eternal beginning and Credit Suisse would find itself today in a critical situation, as evidenced by leaks in the press, eager announcements of restructuring and bond buyback offers to reassure the market, or well the famous level of CDS, which we hear about every fear of bankruptcy.
As a reminder, the CDS, or Credit Default Swap, is insurance paid to protect against the bankruptcy of an issuer. In theory, it is useful, for example, for a creditor who would like to keep his bonds or loans from the company in question (or cannot sell them) but fears bankruptcy or needs to reduce this risk. In practice, it is mainly used for speculation, like most market derivatives… CDS are over-the-counter contracts, whose counterparties are generally a few investment banks.
Although it is not used by a very large number of end investors, the CDS nevertheless gives an indication of the level of credit premium that a company must pay to borrow, since this premium generally costs the same price as the level of yield of an issuer: it is thus logical that a bond whose final risk of non-repayment is covered in full yields almost 0%.
Finally, the CDS has the advantage of being able to compare, over a long period, issuers with equal maturities and conditions: 3, 5, 7, 10 years; while bonds expire on their maturity and are often accompanied by specific features that make their comparison more complex: different maturities, calls, guarantees, clauses, etc.
So let’s go back to the level of Credit Suisse’s CDS whose graph below will show the current stress of the markets on the establishment.
The crisis that Credit Suisse would go through today would therefore be, according to the markets, major since it was worse than that of 2008, which almost brought down the company. “According to the markets” because we are talking here about the price that counterparties ask to ensure the bankruptcy of their colleague.
If we will not dwell here on an in-depth analysis of Credit Suisse credit, long, daunting and above all impossible as the balance sheets of these investment banks are precisely riddled with “off-balance sheet” – Note here that as a bond manager , we are precisely not investing in banks whose share of CIB is too significant and we are concentrating on network banks, which are more legible and more stable – , we will share a market and situation analysis:
1. It is first useful to compare the spread of Credit Suisse to its peers, European or Swiss. Is it indeed a purely idiosyncratic crisis or a more general one? It should be noted that banks are, in general in Europe, in a much better situation than throughout the 2010s, during which the regulator forced them to correct the excesses of the 2000s. market volatility, as evidenced by this comparison between the CDS of Credit Suisse and that of BNP. It is clearly seen here that
- Credit Suisse’s probability of default, according to the markets, is at its highest since 2005, and much higher than in 2008
- The spreads of banks like BNP increased slightly in 2022 but remain quite contained
2. The major problem of the banking sector is its interconnection and the famous “systemic risk”. It is the one that had pushed the governments and the European Central Bank to act in 2008, it is the one that comes back as a threat with each crisis… If the world banking system has tried to put fuses through the Basel regulations (bonds subordinated at several levels, reinforcement of capital, etc.), it is still very systemic. We also imagine that the Swiss banking system could be even more so, so powerful it is in relation to the country’s GDP, closed and correlated. If UBS does not make headlines like its counterpart, we will notice that its probability of default is linked and has been climbing for a few days, although still remaining at moderate levels, as evidenced by the graph below:
It should be noted all the same that the CDS is, as we said above, a derivative product exchanged between financial players, in a market monopolized by a few large investment banks, in particular American. Which raises several questions:
- The entire market is currently paralyzed on all asset classes and does not wish to take positions. Can we really trust the level of an OTC derivative in this context?
- The current illiquidity is the source of all possible manipulations and we could quote many bond prices displayed on multiple screens, which ultimately turn out to be fake prices. Credit Suisse CDS is not said to be tradable on these insurance premium levels either.
- When investment banks are the only ones to give the measure to assess the probability of bankruptcy of one of their competitors, is there not a latent conflict of interest?
Please note that we are not suggesting here that the entire market is a deception, simply that the price levels of vanilla and liquid assets are currently often erratic. This may also be the case for a more confidential and less liquid derivative product.
4. Finally, we note that banks are a strategic business and that the stability and wealth of Switzerland can attract many private or public investors. Like Qatar in 2008, Credit Suisse could thus see a few white knights come to its bedside in this difficult period. The Swiss National Bank, concerned with preserving a banking system, the keystone of an entire economy, should also watch out and use a few cartridges to calm things down, although less interventionist than the ECB on certain other subjects.
And since we are discussing CDS today, we will end our weekly with a remark that we often hear about yield levels or market spreads. Many investors are thus tempted to seize the opportunities for widening historical yields that we are currently experiencing, but conclude by saying: “we are not at the highest spreads, I will wait a little longer”.
If we do not wish here to try to convince anyone, we will simply provide a few details. As we said above, the most widely used means of comparing credit premium levels over a long period is the CDS. Thus, many investors look at the history of the CDS index of ‘high yield’ companies, the famous crossover, below:
They find thus:
- Spreads are still low compared to the 2008 peak
- We are barely at the level of 2020 and not on that of 2012
And conclude that it is better to wait…
Let us remember a few points here:
1. CDS are an over-the-counter derivative product that is essentially banking. Thus, to buy protection against an ordinary issuer, the investor exposes himself to bank counterparty risk. We will remember here the poor investors who had the good idea to hedge their portfolios with CDS before the 2008 crisis but who had the bad luck to choose Lehman as counterparty for their CDS… They lost everything. Thus, if CDS spreads in 2008 were much higher than today, it is also because the major risk came from the financial system itself and a CDS is not a simple obligation of a company. It is a derivative on a business through the financial system. There are therefore sometimes significant mismatches between cash bonds and these products, particularly when banks are the main market risk. Thus, assuming that we deduct from these CDS premiums the banking risk of a bank like Crédit Suisse at the time (approximately 300bps), we would no longer be so far from current levels… But it is good to concrete corporate bonds that are in question for 90% of end investors…
2. Let’s also not forget that the credit spread is only one component of the rate that the investor receives. The total return is thus made up of the base rate to which the credit spread is added. However, base rates have risen sharply and are now combined with the rise in spreads, which they did not do during the crises of 2016 or 2020, for example, since base rates remained crushed by the ECB. Between the end of 2021 and today, 5-year base rates have gained 300bps! Who thinks in relative terms when investing their money? Few people apart from a few trading room traders… We must therefore add these 300 basis points to the remuneration and the following graph clearly shows that the yields of real BB or B bonds, not relative derivatives, are indeed much higher than in 2020 by at least 2%.
3. Finally, note that peaks in spreads on CDS as on bonds are generally very short and occur in a phase of major illiquidity. Already these days, as yields approach 7% on the 5-year BB and 10-12% on the B, it is becoming difficult to find available bonds. When the yields offer a remuneration that can cover up to 40 to 50% of bankruptcies over a 5-year horizon, who would sell their portfolio? When short selling costs 10% a year net and you have to add a massively rising bank funding cost, what investment bank would short bonds to these levels just to ensure liquidity? The market is not yet a buyer, but it is no longer specifically a seller either. Admittedly, a peak could occur in a phase of capitulation, but it is not necessarily more prudent to wait for it than to invest at these levels of returns, which have rarely been seen over the decade.