Is Credit Suisse About to Become the Next Lehman Brothers?
A New Financial Contagion is Infecting the Global Economy
The world economy is suffering from a long dormant infection.
Many analysts right now attribute interest rates, inflation, and supply shocks to the financial contagion caused by Covid-19.
But in addition to these, there are other lingering symptoms of a different, longer-lasting infection…
And investors are terrified that this dormant contagion will reemerge to wreak havoc in 2022 or 2023.
I’ll give you an example of what I mean.
Consider what happened last year, in September 2021, when the concern in the markets was about the collapse of Evergrande and the Chinese real estate market.
Forbes ran stories with the headline…
The BBC ran the story…
And Franklin Templeton published the article…
“Evergrande and China: A Lehman Moment—or Less ‘Grande’ Than That?”
I’ll explain what a “Lehman Moment” is shortly, because it’s at the heart of the fear that a different kind of contagion has returned to the markets.
But essentially, the fear was that large Chinese developers like Evergrande that had borrowed money from international financial institutions would be unable to pay it back.
That is the core of any “financial contagion”: That the losses of one company will be so impactful that it will spread to other businesses and industries.
If you’re not familiar with what happened with Evergrande, here’s a quick summary:
Evergrande is a Chinese property developer and was the most indebted corporation in the world. It defaulted on its debt after failing to make interest payments on $1.2 billion of international loans, even after multiple “grace periods” and selling many assets.
The default triggered shockwaves through the Chinese economy. Many Chinese investors, with no alternative but to invest in Evergrande properties or in compulsory pension funds, lost their life savings. 22 other Chinese real estate developers defaulted. And regular people had their bank accounts frozen by Chinese banks to prevent people from withdrawing their cash, sparking protests.
China is still struggling with the fallout of the Evergrande crisis.
And just as markets declined in September 2022, so too did the Evergrande default spur a huge stock market selloff in September 2021.
But when I originally analyzed the situation in September 2021, it did not look that dire to me for two reasons.
For one, Chinese financial markets are fairly isolated. While there would be losses in international markets if a default occurred, it would be well contained and manageable.
So far this has proved true. Even though Chinese shares on the Hang Seng China Enterprises Index have slumped to their lowest valuation on record, and even though more developers have defaulted on their debt, these losses have mostly affected the people of China.
Secondly, I predicted that the Chinese government — notorious for reacting to problems by “stepping in” to save face — would step in to save face.
So what happened?
As predicted, the Chinese government stepped in to save face by securing $501 billion in total bailout funds.
And while this story and the possibility that China is entering an economic recession are ongoing…
Ultimately, the threat of “contagion” posed by Evergrande’s collapse was not a true “Lehman moment.” (Again, I promise to explain what this is shortly.)
I bring all that up because, over the past month, we’ve been seeing similar headlines for a different company…
Markets Insider just published an article with the title, “Credit Suisse is fending off concerns about its financial health, fanning fears of another Lehman Brothers moment that could roil the global financial system.”
And The Street poses the question, “Is Credit Suisse the 2022 Lehman Brothers?”
Once again, investors are worried that an enormous and indebted company is about to fail…
And potentially bring down the world economy with it.
How Financial Contagions Are Born
To understand the background of the contagion scaring the global economy right now, you have to understand two things: The Great Financial Crisis of 2008 and a financial derivative called a Credit Default Swap.
The Great Financial Crisis: Explained
In 2008, the entire banking sector in the U.S. almost collapsed, nearly bringing the world economy down with it.
Much of this collapse was due to extensive speculation, specifically banks taking on too much leverage to purchase mortgage-backed securities (MBS) and collateralized debt obligations (CDO), as well as Credit Default Swaps.
Ignore the financial jargon. Here’s the sentence above in simple terms:
Banks borrowed a lot of money to buy certain assets because they thought were “low risk.” However, these assets actually turned out to be “high risk.”
When these high-risk assets began to implode, the banks lost the money trapped in the imploded assets AND still owed money on the loans they took to buy them.
(If you ever get a chance, watch the movie Margin Call or The Big Short, which are both fantastic movies about this event.)
Lehman Brothers, a big bank that went bankrupt on September 15, 2008, is often considered “Patient Zero” that ultimately began the pandemic we now call the Great Financial Crisis.
A “Lehman Moment,” then, is any situation where a huge company fails and fails so spectacularly that it damages practically every other aspect of the global economy.
The fear of a contagion like this is, I think, pretty justifiable.
The 2008 crisis wiped out some $11 trillion of the U.S.’s wealth and destroyed more than eight million American jobs by September 2009. It froze up the nation’s credit system, leaving thousands of firms too short of cash to operate.
It also forced the federal government to spend $2.8 trillion and commit another $8.2 trillion in taxpayer funds to bailing out failing corporations, including General Motors, Chrysler, Citigroup, Bank of America, AIG, and other “too-big-to-fail” companies.
As a result, the U.S. government put strict limitations and regulations on banks. And any “too-big-to-fail,” systemically important financial institution (SIFI) was required to keep a large cash reserve to cover any big losses in the future.
So that’s 2008. That’s the origin of the dormant contagion I’ve been talking about — a virus we might call “systemic financial risk.”
There’s one other thing you need to understand, though, in order to make sense of the big problem we’re currently seeing…
Credit Default Swaps: Explained
Credit Default Swaps are like insurance policies that banks and hedge funds can take out for loans.
Pretend you’re a bank and you give out a loan to someone. As part of that loan agreement, you mandate that, for example, if the person does not pay you back (i.e., defaults on the loan) you get to foreclose on their house.
Now, foreclosure is expensive. And time consuming. And you, a person pretending to be a bank, have bills to pay today and you don’t have time to get your money back.
Rather than going through this process you can buy a Credit Default Swap on the loan.
Here’s how it works:
You are “Bank A.”
You give a loan to a Person.
You also buy a Credit Default Swap from “Bank B.”
If the Person defaults, “Bank B” pays you, “Bank A,” the full value of the loan and they take over the loan obligations.
It is now “Bank B’s” responsibility to foreclose on the house.
This is good for you, Bank A, because you just lowered your risk if the loan is bad. It’s good for Bank B because they can still recover money by foreclosing on the home.
Understandable so far, right?
Now here’s where things get infuriating and complicated.
When a bank buys a normal insurance contract, the insurance policy is considered a liability. Banks that sell these policies are required by regulators to maintain a cash reserve big enough to cover any expected losses if the policy buyer files a claim and activates the insurance.
But Credit Default Swap policies were considered an “asset” for accounting purposes. Not a liability. (Why? Because the policy seller gets to foreclose on the underlying asset: the house or whatever else is being used as collateral.)
Before the 2008 crisis, because U.S. banks could treat the Credit Default Swaps they sold as assets, they did not have to have cash reserves.
So when the housing market collapsed in 2007 and 2008, banks needed a huge amount of money to offset the declining value of their Credit Default Swaps.
How big of an impact did this have on the world economy?
In 2008, the Credit Default Swap market totaled $57.3 trillion. A value totaling nearly three-fourths of the world’s entire GDP.
Naturally, after 2008, there was a huge regulatory clampdown on Credit Default Swaps.
These derivatives entangled banks together, such that if any SIFI bank experienced trouble, it would cause a ripple of damage throughout the financial system and economy.
As a result, governments didn’t want banks making derivative “side bets” with each other.
After all, these risky behaviors and assets nearly destroyed the world economy.
Thankfully, governments did the right thing and made sure banks would never become “overleveraged with high risk derivatives” again.
I’m joking, of course.
It might be happening again with Credit Suisse (and, to a lesser extent, Deutsche Bank).
Credit Suisse, a systemically important financial institution as well as a “Global Systemically Important Bank,” appears to be in distress…
And in my next post, I’ll answer the question: Is Credit Suisse going to be the next Lehman Brothers?
Stay tuned…
