Dan Kitwood
Credit Suisse (NYSE:CS) is a major European bank and one of the world’s largest investment banks. The company’s global footprint makes it one of the most interconnected parts of the global financial system. While its investment banking and asset management platforms are extensive, the firm’s traditional “asset” banking portfolio is smaller – the 45th largest globally and 16th in Europe. This factor is essential when considering the firm’s massive decline over recent years, as it alters the importance of crucial bank statistics, such as capitalization ratios when determining the firm’s health.
Credit Suisse has lost a staggering 63% of its value this year and is still around 95% below its 2007 peak. The stock has declined most years since the 2008 financial crisis and seems to be on a long road to bankruptcy. This year, the firm’s staggering decline comes from multiple fronts – the largest being immense losses from its massive investment banking division. However, the firm has also faced losses from litigation, wealth management outflows, and declines in its capitalization ratios. The bank has also worked on decreasing exposure to oil and gas (and has been for years), causing it to miss out on the only well-performing sector this year. Of course, the Euro has also declined in value compared to the US dollar, creating excess losses for the USD-based ADR.
While the stock is down tremendously, it trades at a low forward “P/E” of just 6.4X and a price-to-book of nearly 0.2X. These are extremely low valuation ratios for any firm and are particularly low for the banking sector. Given this, many investors are curious whether or not the bank is a “fire-sale” discount opportunity or one of the most significant value traps on the market today.
Credit Suisse is on The Slow Path to Failure
Credit Suisse’s significant declines have spurred speculation that the firm might face bankruptcy over the coming year or two. Indeed, there are many strong historical indicators of this, such as falling capitalization ratios, sharp declines in all segment revenues, sharp rises in credit default swap prices (default risk), and aggressive restructuring plans.
Of course, there are numerous differences between the company today and historical precedents like Lehman Brothers. Credit Suisse has declined for over a decade, so investors are generally aware of its high-risk exposures and weak business model. Lehman Brothers was a comparatively large investment bank, but at the time, it was performing quite well and only failed once risks surfaced from its semi-off balance sheet subprime mortgage loans. Lehman, or perhaps FTX, are comparatively explosive, while Credit Suisse, and most of its European peers, are very slow-moving declines.
That said, events this year have certainly accelerated Credit Suisse’s downside toward a pace that could become explosive. Some analysts argue that its losses stem from one-off events such as restructuring costs, litigation, and credit losses from counterparties such as Archegos and Greensill Capital. These expenses have created significant losses over the past two years, but that does not mean they will not continue for years to come. Rising global interest rates and curtailed economic activity have a habit of causing “surprise” failures of businesses and financial institutions. Warren Buffett once said, “when the tide goes out, you see who’s swimming naked.” The economic tide has withdrawn over the past year. It may continue to do so over the next, raising the probability of Credit Suisse facing “black-swan” event-driven losses, which can be challenging to predict.
Credit Suisse ended Q3 with a “CET1” capitalization ratio of 12.6%, which is roughly average for US counterparts. Some may see this as pointing toward a “low risk of bankruptcy” since it is not too low. However, it should be noted that its CET1 ratio fell 90 bps QoQ and nearly 2% over the past year (10-Q “key metrics”). In my view, the level of a CET1 ratio is less important than the pace of its change since that better indicates the risk of a significant fall in capitalization. CET1 ratios are also somewhat flawed because they may underweight risk in certain asset classes, such as mortgage-backed securities and other “government-sponsored” debts (which generally only carry 20% weighting). Many banks, including Credit Suisse, hold a great deal of these assets, potentially causing the CET1 ratio to be too far above simple asset leverage. At the end of the last quarter, Credit Suisse’s assets were 16.2X its common equity, a high figure to me, but much lower than the 32X level from the 2000s.
Capitalization ratios are also not too crucial for Credit Suisse since it generates most of its income (and losses) from investment banking. Last quarter, the bank’s investment banking & capital market fees were down 64% YoY, with the equity markets division down a staggering 83%. This reflects substantial declines in global IPO and equity issuance volumes. Mergers and acquisitions deals have also declined dramatically. Fixed-income sales and equity trading activity have collapsed this year as investors switch preferences for lower-risk assets. This change has caused Credit Suisse’s net IB division revenues to fall 56% YoY (and 89% from capital markets specifically), resulting in a $646M division loss last quarter.
Credit Suisse also faced significant quarterly declines in assets under management in wealth management, asset management, and its bank. The firm noted “negative press and social media coverage” as a cause of deposit and asset outflows. Other factors include significant negative global equity and bond market moves. Declines in recurring fees partially magnified wealth and asset management losses. The broad reduction in this segment is substantial for the company’s future since its restructuring plan focuses on shifting away from investment banking and security marketing toward asset management.
Credit Suisse’s “radical” restructuring plan is essentially the same as that of most major banks today. Deutsche Bank (DB), Goldman Sachs (GS), UBS (UBS), and many others are pursuing the same strategy amid massive declines in investment banking deal flow and losses in trading & sales. The wealth and asset management industry is seen as superior due to its far more consistent and predictable revenues. Investment banking and trading & sales are far more cyclical and dependent on the economic cycle. The IB segment was highly profitable in 2020 and 2021 when many firms were pursuing IPOs and M&A deals, and trading activity soared but collapsed this year as the rate and inflation shocks (and end to massive global QE) led to large pull-backs in new money entering the market.
That said, I do not believe shifting focus toward asset and wealth management will necessarily improve profits. Indeed, since more large banks are making the same move, asset management fees are declining at a quickening pace. Further, with global bonds and stocks falling simultaneously in 2022, fee revenues are considerably lower since asset values have declined. Credit Suisse still earned a profit in this segment last quarter, but I suspect that could end in 2023 if competition continues to rise and asset prices remain as low or lower as they are today.
Can Credit Suisse “Fail”?
Looking at Credit Suisse’s core business declines over the past decade and how they have accelerated in the past year, it is apparent that the company is at risk of some sort of failure. This is not to say the bank appears to be at immediate risk of failure or will necessarily go “bankrupt.” It is generally well-capitalized and, outside of more black-swan events (litigation, counterparty failures, or liquidity events), appears unlikely to face “sudden” failure. Of course, with the global economy facing high recession risk (virtually guaranteed), the probability of new black-swan financial risk events occurring is higher than in recent years. Thus, while there is no direct hard evidence of Credit Suisse becoming a “Lehman moment,” as many fear, it is not impossible.
That said, the firm is already facing “forms” of failure that are negative for shareholders. Due to immense losses and growing strain, the firm is issuing 889M new shares worth around $2.4B US dollars, diluting existing shareholders by roughly 22%. In my view, that is a substantial dilution and signals trouble as it sells shares at ever-low equity prices. The fact that the company was willing to sell that many shares at a price-to-book of 0.21X implies an immense desire for liquidity. If its capitalization were so strong, it would likely be unwilling to sell equity at such an extreme discount.
Credit Suisse is expected to lose an additional $1.6B in Q4 due to various factors, including a “substantial rise in outflows” from depositors. The quarter is not over, so actual losses may be even higher, potentially bringing the company’s annual loss to around $7.5B, nearly as high as its market cap before the latest equity raise. Even if Credit Suisse is relatively well-capitalized, the public fears that it is at risk of failing may be sufficient to cause Credit Suisse to fail by causing an en masse decline in depositors. Again, capitalization ratios may be flawed and can move rapidly under financial volatility or economic events.
The Bottom Line?
Is Credit Suisse a buying opportunity? To me, the answer depends mainly on one’s risk tolerance and macroeconomic outlook. For one, the stock is trading well below its book value and, if we assume conditions improve its earnings, then maybe at a forward “P/E” of 6X, as many analysts believe. If economic conditions improve from a more significant energy supply (particularly in Europe) or an end to China’s lockdowns, financial services demand may be restored. If monetary conditions improve from an end to rate-hikes or a slowing of Q.E, then strain on asset management and investment banking divisions may be lessened. Accordingly, it is possible that CS is making its “long-term” bottom and is on the verge of seeing an immense recovery return over the coming years.
However, in my view, CS is not a good opportunity today, and, with everything considered, I believe it will continue to decline in value. Based on other analyses, I expect energy and other vital shortages to continue to grow, particularly in Europe, where the war has wrecked supplies. Over the past week, it has become clear that China does not plan to end its lockdowns, potentially spurring massive unrest – an important black-swan manufacturing activity risk factor. As long as these stagflationary factors persist, the global economy will weaken. Most importantly, central banks will have to remain hawkish and avoid liquidity creation since it may exacerbate inflation even more. In other words, Credit Suisse likely cannot depend on a bailout or renewed Q.E. to save it if need be.
While I have a bearish outlook on CS, I would not bet against the stock. Its downside risk is considerable, but its upside potential is also quite significant – with the outcome largely dependent on external macroeconomic factors. Today, CS is like a scale with two heavyweights on both ends of the balance. To me, all aspects considered point to relatively high risk, mainly due to my bearish economic outlook and view that central banks can not come to rescue banks as they have multiple times over the past fourteen years. If it were not for that aid, Credit Suisse would have likely become defunct long ago and has persisted as a “zombie bank” due to ultra-low interest rates, Q.E, and a direct bailout. For now, I do not believe it will see “sudden failure,” but it may continue to see new equity dilutions to offset immense losses over the coming one to three years. Further, due to high public risk perception, its most significant immediate risk is an en-masse exit from depositors or large AuM outflows.
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