- October 7, 2022
- Posted by: Ramkumar
- Category: Strategy
The Curious Case Of Credit Suisse
One of the biggest headlines in the global financial markets last week was the negative news on Credit Suisse and concerns that the bank would default on its payments, fearing a repeat of the Lehman crisis in 2008. In addition, investors globally have raised concerns over Credit Suisse’s liquidity after the bank’s credit default swaps jumped to a 10-year high last week. In this post, I provide my insights on the issues grappling with Credit Suisse, why its CDS increased last week and why some of the issues concerning the bank are due to the political crisis in the UK. Then, I analyzed Credit Suisse’s financials to assess the probability of a bank defaulting on its payments, its ability to raise money to pay the bondholders and if the bank will default, leading to contagion in global financial markets witnessed in 2008. Finally, I value Credit Suisse with Discounted Cash Flow Valuation. I then compare the value with its current share price to assess the risk (probability of bankruptcy) that the market has factored in Credit Suisse’s share price.
Credit Suisse Overview And Issues
Credit Suisse, headquartered in Switzerland, is the world’s 23rd-largest bank, managing $1.4 trillion in assets. The bank provides Wealth Management, Investment banking and Asset management services, employing 51,000 employees globally.
The bank’s performance has declined in the last five years. When we look at the revenues in the last five years:
However, its net income is negative due to higher operating expenses despite declining revenues.
This year, the losses have increased because of Greensill and Archegos Capital investments. In the case of Greensill (A non-bank provider of supply chain finance), the bank lent $10 billion in the capital; however, the firm turned bankrupt, causing losses to the bank. In the case of Archegos Capital, the family office borrowed money from Credit Suisse and gambled the money into investing in risky stocks (the family office faced a margin call when its bets on Discovery and ViacomCBS took a hit), eventually losing all their investments giving the bank additional losses of $5.5 billion. The two instances show the bank’s poor risk management capabilities and how they are unable to identify high-risk default borrowers or control the borrower’s actions with strong covenants.
Further, the bank has a history of violating regulatory norms and getting embroiled in lawsuits. Last year, the bank paid $275 million to settle legacy issues with UK, US and Switzerland regulators.
The combination of poor risk management and regulatory oversight resulted in low return on equity, crashing their stock prices. Moreover, with high global inflation and countries increasing interest rates, there are higher chances of recession. Due to these negative sentiments, Credit Suisse’s Investment banking division has not performed as there aren’t many M&A deals. As a result, in the last 12 months, the share price has fallen from 9.32 to 4.25, reflecting a more than 120% decline, with the market cap declining from $22 billion to $10 billion.
UK’s Mini Budget
After the recent election in the UK, the government announced a mini-budget to revive the economy by spending money; however, there was no clarity on where the money will come for investments. Further, the government announced unfunded tax cuts for highly wealthy citizens. This decision sent the markets into a frenzy as they thought the government would borrow money or issue currencies with spending on investments resulting in the weakening of the UK pound. Further, the UK GILT yields increased to 4.1% resulting in the bond prices crash. The bondholders decided to sell their bonds and purchase GILTS to get higher returns. This massive sell-off resulted in losses in the books of pension funds and investment banks. As the rates increased, it triggered a collateral call for the banks, and the banks had to scramble for additional cash.
The markets realized this and feared that the pension funds and the banks would default on their payments. Thus, investors went to the Credit default swaps market and bought CDS, which acts as insurance and will pay the investors if there is a default. As more investors rushed to buy the CDS market, the demand for CDS increased, increasing banks’ CDS.
To repay the investors, Credit Suisse must arrange funds. However, with the higher CDS, the bank’s cost of capital has increased, and if it has to raise money from markets, it has to get that at a higher cost. Further, with the share price plummeting, the bank will have challenges issuing equities to raise cash, resulting in a higher dilution which would further crash the stock prices. Thus, the bank has to sell its existing assets to raise money. However, the bank’s business, especially its investment banking division, is performing poorly and thus has decided to exit its securitized products business. If Credit Suisse defaults on its payments, it has to approach the government to bail out.
Valuing Credit Suisse
Now we understand Credit Suisse’s problems and its priorities not to default on its payments. Therefore, as a next step, I decided to value Credit Suisse and understand if the bank would collapse or tide out of this crisis.
As a first step, I looked at the bank’s Capital risk by getting its Tier-1 capital and risk-adjusted assets.
As of July 2022, the bank reported:
Tier 1 Capital = 37,049 million
Book equity = 46,066 million
Risk Adjusted Assets = 2,74,442 million
I calculate the Tier-1 Capital Ratio for the bank = 37049/274442 = 13.5%.
The tier-1 capital ratio gives insights into the bank’s ability to withstand financial distress by comparing Tier-1 capital with risk-adjusted assets. When we compare Credit Suisse’s tier-1 ratio against its peers, it has the highest Tier-1 capital ratio, implying that the bank’s capital position is strong.
Net Income of Credit Suisse = -3511 million
ROE = (-3511/46066) = -7.62%
As of 2022, the risk-free rate in Switzerland = 1.23%
As Switzerland is a developed market, I have taken its Equity Risk Premium = 5.83%, similar to the US.
With Credit Suisse’s CDS at a decade high (250 basis points) and the bank does not have quality assets to raise money, I take the levered beta as 1.6, implying its high risk (making it in the 90th percentile in the banking stocks).
With the above details, I arrive at the cost of equity for Credit Suisse = 10.55%
Now I have the Tier-1 Capital Ratio, the Cost of Equity and the Return on Equity; I forecast Credit Suisse revenues and net income for the next ten years with the following assumptions:
- Expected Growth in Asset base = 0.5% for the next ten years. I assume the bank’s assets will grow at less than the inflation rate, and Switzerland’s inflation rate is 3.3%. My rationale is that the bank will divest multiple assets resulting in a decline in the asset base itself.
- I assume Credit Suisse’s Tier-1 Capital will continue at 13.5%.
- Credit Suisse’s ROE at -7.6% is in the 4th percentile for the sector. However, I assume that with the restructuring and spinning off of assets, the ROE will improve to the 25th percentile of 3.9% in the next five years and the 50th percentile of 9% in the 10th year.
- In the terminal year, the bank’s assets will continue to grow at an inflation rate.
I get the DCF value/share = 8.95 Swiss Francs with the above assumptions.
With the current distress and the volatility the bank is facing, along with difficulties in raising capital at higher costs, I assume a 25% probability of a bailout where the equity value gets wiped.
When I incorporate the probability of bankruptcy of 25%, the value/share decreases to 6.72 CHF, which is still 58% more than the current share price, implying that the markets have overreacted.
When I further decompose the equity value, I assume that the bank must stop paying dividends and has to issue equities in the next three years to raise additional capital. Therefore, I have incorporated the new issues’ dilution effects and expected cost of equity wipeout.
My Final Thoughts
Credit Suisse’s current stock price looks cheap after incorporating a 25% probability of a bailout. In addition, the bank has a higher Tier-1 Capital ratio than its peers, indicating its ability to withstand financial distress. The bank’s liquidity coverage ratio is 191% (the best among its peers), implying that Credit Suisse can meet any short-term obligations. The widening CDS spread is the most significant cause of concern, and the bank must raise funds at a higher cost to meet payments or divest assets/raise equity which is equally challenging.
However, if the market is comparing the current crisis with Lehman’s fallout of GFC in 2008, then i think we are exaggerating.