Will Credit Suisse’s Downfall Infect the Global Economy?
If We Look at These Two Signs… Maybe Not.
Credit Suisse, a systemically important financial institution as well as a “Global Systemically Important Bank,” looks to be in distress.
As we explored in my last post, there is a pervasive fear that Credit Suisse will cause a repeat of the 2008 financial crisis — a.k.a a “Lehman Moment.” The bank has been losing a lot of risky bets for the last 2 years that have cost a lot of their customers’ money.
For instance, Credit Suisse directed many customers to invest as much $10 billion in a lender called Greensill Capital.
Greensill would take investor money and use it to pay supply companies cash upfront in exchange for the money these supply companies had coming in from clients.
Well, in 2020 and 2021, there was a post-pandemic supply crunch.
Supply companies couldn’t deliver goods to clients, which meant clients wouldn’t pay for goods. Meaning: Greensill gave investor money away and didn’t get any back.
Unsurprisingly, Greensill went bankrupt in March 2021.
When Archegos Capital Management collapsed in March 2021 due to being overleveraged, Credit Suisse lost another $5.5 billion.
The problem with Greensill and Archegos were effectively the same: Credit Suisse poured money into investments that relied on high-risk strategies, derivatives, and lending.
Those losses also occurred at the same time the bank was going through a massive scandal: the former CEO, Tidjane Thiam, had to quit because he had been spying on Credit Suisse’s wealth management executive Iqbal Khan.
As a result of all these losses and scandals, Credit Suisse has been in dire straits. The stock price had fallen significantly.
The company’s corporate bonds are losing value because fewer people are willing to lend money to the bank. This means the yields on these bonds are going higher… which means that Credit Suisse has to pay higher and higher interest on its debts.
Simply put, Credit Suisse was in a bad financial situation to begin with.
Now Credit Suisse is dealing with a huge potential problem due to investors reacting to the prices of the Credit Default Swaps on its bonds.
“A bank robber dressed in a Swiss flag laying in a hospital bed on life support while economists attempt to resuscitate him by injecting dollar bills through an IV, digital art” - DALL-E
See, when a company issues a Credit Default Swap, the seller gets interest, called the “spread.” (If you haven’t yet, be sure to check out Part 1 of this current article, where I explore CDSs and their role in the previous financial crisis, here.)
The spread is like the cost of an insurance premium (for the buyer of a swap) or interest. Interest rises when prices fall.
So when spreads rise, it means that the value of the Credit Default Swap is plummeting in value.
Usually this happens because the asset underlying the Credit Default Swap is declining in value or appearing more risky.
In 2008? That asset was houses and mortgage bonds.
Banks lost value fast because the assets they owned (Credit Default Swaps) were losing value fast. And these Swaps were losing value fast because homes were losing value fast.
In the case of Credit Suisse, the spreads are rising for its corporate bonds.
To put that another way, the cost of taking an insurance policy out on Credit Suisse’s bonds is skyrocketing.
The one-year Credit Default Swap spread reached 5%, while the five-year hit just over 3%.
Basically, this means that the market thinks there is a 23% chance that Credit Suisse will default on its bonds during the next five years.
Why would this happen?
With central banks hiking interest rates, a recession looming, and inflation spiking, many businesses and individuals are expected to go bankrupt in the coming years.
When businesses and individuals go bankrupt, they can’t pay back their loans.
And who issues loans? Banks like Credit Suisse.
Institutional investors suspect that there’s going to be an economic collapse in Europe, which will cause Deutsche Bank and Credit Suisse to collapse.
This would ultimately have a contagion effect across world markets.
Many U.S. financial institutions have bought Credit Suisse bonds and stock.
As Dennis Kelleher, President of the nonprofit watchdog, Better Markets, put it [bolded emphasis mine]:
“As the financial condition of Credit Suisse continues to deteriorate, raising questions of whether it will collapse, the world and U.S. taxpayers should be deeply worried as multiple, simultaneous shocks shake the foundations of economies worldwide. Credit Suisse is a global, systemically significant, too-big-to-fail bank that operates in the U.S. and is deeply interconnected throughout the global financial system. Its failure would have widespread and largely unknown repercussions from the inconvenient to the possibly catastrophic.”
Unlike the Chinese Evergrande collapse, which ultimately didn’t affect the world very much because of how insulated Chinese investment markets are…
A Credit Suisse collapse could be a “Lehman Brothers Moment” for the world economy.
It would trigger losses and damage that might initiate other companies and investors to go bankrupt.
And if it caused a credit crunch? That is, if financial companies stop lending money?
The gears of the world’s economy would grind to a halt.
Forget inflation.
The world would likely face catastrophic deflation as consumer demand dries up and businesses scale back operations and fire their workforce.
How Likely Is This Contagion to Spread?
Here’s my professional opinion about the Credit Suisse situation:
Just as I correctly predicted in September 2021 that the Chinese government would race to bail out businesses harmed by the collapse of their real estate market…
And just as I correctly predicted in March 2022 that oil prices would go down again due to government intervention, reduced demand, and oil released from strategic reserves…
So too am I predicting that the E.U. will be quick to bail out Credit Suisse and Deutsche Bank if they were at risk of default.
These banks are, as I mentioned, “too big to fail.”
There is too much for these countries and economies to lose if they allow these banks to default.
In fact, the E.U. has already publicly stated that they have a plan to support the markets if there’s a truly serious selloff or shock to the bond markets.
And the Swiss government announced a plan to provide “state-guaranteed cash should one of the country's big banks fail.”
These announcements are literally signs that investors need to relax and that Credit Suisse will not turn into a “Lehman moment.”
But, honestly, I doubt things will even get so bad even if there is a massive recession in Europe with a lot of bankruptcies.
I’m not sure Credit Suisse will even get close to declaring bankruptcy or needing a bailout.
One thing many commentators fail to mention is a fairly simple fact…
In 2008, as I mentioned, the big problem was that banks borrowed money to buy risky assets. When the risky assets tanked, the banks did not have enough money left over to cover their losses.
That’s why they needed a bailout, and that’s why there are rules now about having enough cash to cover any potential losses.
Credit Suisse, on the other hand, has a “liquidity coverage ratio of 191%.”
That is, the bank currently has enough money to meet far more than its short-term obligations.
Here’s another, perhaps more slightly difficult to understand reason why I think the Credit Suisse panic is overblown…
The spread on Credit Default Swaps are being used by Wall Street commentators as a barometer of Credit Suisse’s financial health.
But Credit Default Swap prices are not an objective measure of anything, really.
Investors sometimes use them like options, to make speculative directional bets. Some hedge funds use Credit Default Swaps to hedge their exposure to risky sectors during tough economic times (like now).
All of this causes Swap prices to swing in a more extreme way.
To frame this another way, we can look at the iTraxx Europe Crossover, a junk bond Credit Default Swap tracker.
According to the Financial Times, this indicator is “currently predicting a wave of defaults over the next five years that’s comparable to the one expected in the first days of pandemic lockdowns. Yet, year-to-date, there hasn’t been a single default in the index.”
That is to say, these volatile Credit Default Swap prices look more like the result of volatile, overexaggerating markets…
Which makes the fear about a Credit Suisse default and subsequent contagion look a lot like an overexaggeration, too.
But if you want to be safe?
You can avoid U.S. financial companies that have a large exposure to Credit Default Swaps — like J.P. Morgan, Goldman Sachs, Morgan Stanley, and Citigroup — which hold trillions of dollars of derivatives on their books.
You can also avoid U.S. SIFI banks that have a large international exposure, since these would be susceptible to contagion.
Do you want to know the one bank you can invest in that avoids both of the risks I mentioned above?
This company has both minimal exposure to Credit Default Swaps and its exposure to financial systems outside the U.S. is extremely limited.
So if you’re hoping to avoid a financial contagion…
This stock looks like a good place to hide and protect your money. You can find it — along with my entire portfolio of recession-proof stocks — in the latest issue of Heritage Portfolio Quarterly, which you can access right here.
