A Lehmann restructuring

To begin with, Credit Suisse has been doing very badly. The Swiss bank has only been profitable for two of its last nine quarters. This is in large part due to its investment bank division which has made staggering losses from investing in collapsed hedge funds, plus money laundering scandals, and hefty fines. As a result, revenue and earnings have been gradually declining since 2017, while operating expenses have risen. Then there’s the weak outlook that indicates tough times are here to stay.

This all led to Chairman Axel Lehmann proposing a restructuring when he took over earlier this year. But what spooked investors was an employee memo from new CEO Ulrich Koerner in late September. The note stated that Credit Suisse is at a “critical moment”, although he said that the bank’s balance sheet remains robust.

This sent alarm bells ringing with echoes of the warnings heard from the likes of Lehmann Brothers and Bear Sterns before they collapsed during the 2008 global financial crisis. Subsequently, Credit Suisse stock went into freefall.

To mitigate this, the board spent a weekend trying to soothe nerves by calling its largest investors to reassure them. However, given the history of scandals, these calls alarmed them further. This then led to a further crash in the stock as credit default swaps (CDSs) for the company saw a sharp increase. In other words, this is how likely investors think a company is to default on its bond repayments.

Spreading it thin

Due to these alarming events, Credit Suisse saw its five-year CDSs jump to as high as 375 basis points. This is more than four times higher than what a standard CDS is or should be, thus hinting that there’s a high likelihood that the company may not be able to make its bond repayments in five years.

The rise in the bank’s CDSs sent shockwaves across financial markets. That’s because bank defaults don’t only affect the bank’s own creditors. They also affect its loans to other banks, which can impact overall solvency and create a domino effect throughout the entire financial system. And given the size of Credit Suisse, its collapse could potentially trigger another financial crisis.

But could fears of Credit Suisse collapsing be unfounded? Possibly. For context, most companies’ CDSs have risen this year on the back of the problematic global economy. Deutsche Bank and General Motors, for instance, have very high CDS spreads too.

From the Russia-Ukraine war to spiralling inflation and surging energy prices, the risk of defaults has risen as fears of a recession grow. Not to mention, currency headwinds from higher interest rates and a strong US dollar present an even bigger challenge for corporations seeking to report satisfactory earnings.

But what’s worth pointing out is that the spread between Credit Suisse’s one-year and five-year CDSs has now widened. This means that investors don’t think that a default is on the cards within the next year, although the likelihood of a default within five years remains elevated due to its increasingly worrying losses.

Strong credit

If I were to filter out the news and the panic of recent weeks, Credit Suisse doesn’t look too bad financially. Despite loss-making ventures, the institution’s balance sheet remains fairly robust. Here’s why.

1. Assets cover liabilities comfortably.
2. Its CET1 ratio and tier 1 capital are within minimum regulatory requirements and remain at healthy levels.
3. The liquidity coverage ratio (LCR) is strong enough to cover any short-term liquidity shocks from client withdrawals.

That being said, there are still risks involved that aren’t included on the firm’s balance sheet. Credit Suisse has CHF136bn worth of off-balance sheet exposures that are considered to be risky. These instruments could impact the balance sheet if they drop in value.

Nonetheless, the level of risk surrounding these instruments isn’t known as the bank doesn’t disclose them entirely, so any fears remain speculative. But given the bank’s track record, the state of its balance sheet could have fundamentally changed as a result of these instruments, since its last earnings report. On that account, its financials could be in a precarious position when it reports its Q3 results later this month. Only time will tell.

A much-needed plus

Having said all that, the past couple of days have been a little more soothing for investors. This is because Credit Suisse opted to buy back $3bn worth of bonds in a show of financial strength. Since then, its stock has recovered by approximately 20% from its all-time low. Moreover, its five-year CDSs are back down to 298 basis points at the time of writing.

Nevertheless, Credit Suisse isn’t in the clear. Poorly rated bonds and a very low stock price mean raising capital will be hard. And with the sale of one of its Zurich hotels, it’s clearly still in need of an injection of liquidity.

Investment worthy?

So would I buy Credit Suisse stock? Well, despite a decent balance sheet, is remains loss-making and has a record of poor capital management and scandals. Therefore, its leadership team has a tough task on its hands.

There’s talk of Credit Suisse potentially spinning off its troubled investment bank division. This could relieve Credit Suisse of some dead weight and allow it to recover profitability. But until such a move is confirmed, I won’t invest my money in it.

I will, however, be paying close attention to it and what happens leading up to its Q3 results on 27 October. After all, the state of the global economy and our stocks could very well be resting on the shoulders of Credit Suisse.

So, let’s take a closer look at the earnings report, and whether the stock now looks like a buy for my portfolio.

What did the bank say on Wednesday?

On Wednesday, Credit Suisse posted a CHF1.59bn second-quarter loss, badly missing market expectations. Analysts had expected a net loss of CHF206m. The Zurich-based bank’s losses exceeded expectations by eight times!

Losses were driven by the poor performance of the investment bank and trading businesses, as well as higher litigation expenses. Credit Suisse also saw net outflows of CHF7.7bn as clients traded less and reduced risk to fluctuating equity markets.

It was the lender’s third straight quarterly loss.

The bank announced a strategic review into its operations and parted ways with its CEO. Gottstein’s two years in charge had been marked by scandal and huge losses. He was brought in to stabilise the bank after it was embroiled in a spying scandal. But things didn’t go to plan. Gottstein only announced a new plan for the bank, going easy on investment management, at the end of 2021.

Credit Suisse named asset management expert Ulrich Koerner as its new chief executive.

Reputation in tatters

Credit Suisse has been hit by scandal after scandal in recent years. From failing to prevent money-laundering by a Bulgarian cocaine trafficking gang between 2004 and 2008, to a spying scandal that saw chief executive Tidjane Thiam hire private detectives to snoop on its former head of wealth management Iqbal Kahn.

The bank also pleaded guilty to defrauding investors out of $850m in a deal to fund a Mozambican fishing fleet. Credit Suisse bankers received $200m in returned loans as kickbacks.

More recently, a Bermuda court ruled that former Georgian prime minister and billionaire Bidzina Ivanishvili was due hundreds of millions in damages after a former Credit Suisse executive was found guilty of forging the signatures of clients over eight years.

And then there was the Greensill collapse.

This is by no means an exhaustive list of the Credit Suisse scandals.

Outlook

There is some good news for Credit Suisse. Its CET1 equity ratio — a metric that compares cash against assets — stood at 13.5% of risk-weighted assets, hitting its near-term target of 13.5%.

It also remains one of the largest asset managers on earth, with over CHF1.6trn under management. It’s an A-rated bank and has 50,000 employees around the world.

There has also been progress in terms of its restructuring and absorption of bad assets. Global markets, investment banking, and APAC markets have all been rolled into a a larger investment-banking segment.

Its wealth management business is also hugely profitable. And investors will be happy to see a pivot back in this direction. Although it’s worth considering that the world’s billionaires may be increasingly concerned about the bank’s reputation.

However, Credit Suisse is still reliant on its low margin, higher-risk investment banking operations. It’s worth noting that Swiss peer UBS has completely abandoned its investment banking segment.

Personally, I’m keeping well away from Credit Suisse, so I won’t be buying this stock.

Is that fair? After all, the company is far more robust than it used to be. Antonio Horta-Osorio was brought in after the financial crisis to reduce the bank’s exposure to risk. He’s since been knighted for his time in the head office and it looks like a much lower-risk investment.

The market is pretty depressed right now, but I think Lloyds can thrive when the market recovers. Here’s why.

Low risk, low valuation

UK mortgages represented 61% of Lloyds’ total gross lending at 2021 year-end. And two-thirds of the bank’s income comes from the UK. While it’s trying to develop its investment arm, I see the portfolio as fairly low risk.

I appreciate housing prices can go down, but they fluctuate less than prices of stocks and shares. House prices might well go down in the near term, as growth slows and interest rates rise. But there are no signs of a crash. And in the long run, housing demand is likely to stay ahead of supply. I’m pretty confident that this is a good business to be in.

Lloyds is also moving into the rental market, buying a reported 50,000 homes in the UK over the next decade. I also don’t see this as a high-risk strategy, but one that might yield some pretty solid returns.

But this lack of exposure to high-growth markets and segments is also reflected in its relatively cheap valuation. The stock has a price-to-earnings ratio of just 5.8.

Margins

Rates are important for a bank like Lloyds. And interest rates have been depressed for nearly a decade now. This is one of the reasons bank earnings have been lower over the past decade.

But interest rates have been rising in 2022, and they are due to rise further. Higher interest rates generally help Lloyds’ net interest margin, as rates on its assets typically rise in line with rate hikes. The impact of rate rises on the entirety of its portfolio will take time to show, but the bank already seems to be benefiting.

Higher rates even mean that Lloyds will earn more interest on the money it leaves with the Bank of England.

Interest rates may stay higher even when the economy recovers.

Would I buy this stock?

I’ve already bought Lloyds shares for my portfolio, but I’d buy more at today’s price. Credit Suisse recently made Lloyds its “top pick” in the UK banking sector and gave it a target price of 71p.

I can certainly see the share price rising sharply from the 43p it trades at today.

One of the biggest issues, in my opinion, is market sentiment. Lloyds is something of an unloved share, and this is reflected in its valuation. But there’s also a lot of negativity surrounding the UK economy post-Brexit right now.

Yet over time, sentiment should improve and the market should recover. For me, Lloyds is a no-brainer buy right now. I’d buy more today as I see it as a bigger winner when the market recovers.

In an addendum to February’s 2015 results Credit Suisse (NYSE: CS) explained to investors that, among other things, it would be accelerating the pace of its restructuring and further downsizing its Global Markets business. This was after a series of bad bets on junk bonds and complex derivatives pushed the bank into the red.

Soured trading positions cost Credit Suisse $633m in the fourth quarter after spreads widened and client activity fell off the edge of a cliff. They also cost it a further $346m in the first quarter, prompting management to exit some parts of the market and reduce scale in others.

It remains an open question as to how soon the bank will be able to walk away from some of these lines of business given that the current illiquid condition of the underlying assets has been a major driver of the above trading losses.

The elephant in the room

The source of Credit Suisse’s trading woes are largely the result of conditions at the lower rated end of the bond market.

Many will remember how the financial world shuddered in late 2015 as a deteriorating junk bond market, which was mostly the result of Fed tightening, forced a small number of US mutual funds to suspend client withdrawals in a series of events that almost echoed those of 2008.    

The problem today is that these conditions have not eased so far into the new year. Spreads are still prohibitively wide and uncertainty pervades.

Moreover, Bloomberg recently reported that 40% of US junk bonds didn’t trade, or change hands at all, in the first two months of the year. This is while most high yield corporate bond indices have fallen to 2009 lows, surpassing levels last experienced during the taper tantrum of 2013 and the European debt crisis.

Casualties and other implications

This article isn’t meant to be a prediction of pending doom or anything close to it. After all, the Fed now appears to be taking a slower path toward a tighter policy environment, while the shift to negative rates in Japan and the increasing scale of the ECB’s intervention may also mean that a certain level of ‘reaching for yield’ continues regardless of what happens in the US.

However, it does not take a rocket scientist to see the potential for casualties on both sides of the market in the coming quarters. Some investors are clearly concerned about the implications of tighter policy in the US and economic conditions elsewhere in the developed world, while there remains a large universe of highly leveraged companies out there, many of whom depend upon access to capital markets for survival.

If the current environment persists then there are going to be further implications for investor confidence in the ability of these companies to service and eventually repay their debts. Such concerns may even spread to encompass some of the more highly rated, but similarly geared issuers.

Other banks with large fixed income operations, like Barclays, could suffer from trading losses if the market does not improve, while some of the lower rated issuers could face insolvency if the market deteriorates further and they are deprived of access to funding.

One thing that seems almost certain is that, as private investors, it is probably time to rethink expectations for returns from the banking sector and to steer clear of highly geared companies. Particularly those at the lower end of the ratings spectrum.