Musings to start the week (and it's all about banks)
Credit Suisse has “shotgun” marriage to UBS
The situation with Credit Suisse was sorted over the weekend, just as I had expected it would be. The global banking system, already under severe stress, would have found itself on even thinner ice had this situation not been contained quickly during the two day hiatus. When there’s a financial crisis of any sort, you’ve got to love the weekends because that’s when these things can be addressed away from the stress of news and (often) misinformation.
I have no view on the stitch up with UBS other than what I’ve read, but my guess is that UBS isn’t particularly comfortable with this shotgun marriage. The only way that a deal like this could be done was with government support because it would be impossible to conduct sufficient proper due diligence on a situation this complex over a weekend. One thing this transaction showed is that the SfR 50 billion liquidity line provided by the Swiss National Bank to CS mid-week did not stem the bleeding. It makes you wonder if the $30 billion of deposits that 11 banks made into US-based under-stress First Republic Bank last week will matter, a topic I will touch on further in the next section.
CS needed to be sold or nationalised (or perhaps even allowed to fail fast), because in any event, it was “death by a thousand cuts” given the many missteps by the bank in the last decade. This situation was a cloud over risk markets, with investors already shaken to their core by fears of further contagion and on-going concerns about systemic risk in the global banking system.
I am just reading the details of the SfR3.25 billion stock transaction in the FT and on Bloomberg as I am writing this. The transaction has government support as expected, and CS’s AT1 investors are squashed (as they should be, although there is perhaps a valid argument as to how CS shareholders walk away with UBS stock and CS AT1 investors walk away empty-handed). Here are the details of the transaction as I understand them:
The transaction is stock for stock with CS valued at around 40.8% of its closing price on Friday,
The Swiss government will provide a SfR100 billion liquidity line to UBS,
A loss guarantee on certain asset portfolios of up to SfR9 billion will be provided by the Swiss government once UBS has absorbed SfR5 billion of losses (sounds generous for the government because UBS bears first losses and guarantee is capped), and
AT1 (contingent capital) securities of CS totalling some SfR16 billion (equivalent) are wiped out. I would not want to be an investor in AT1 securities of any bank tomorrow when the market opens!
You might recall that when the FDIC / Treasury tried to find buyers for Silicon Valley Bank as the bank was failing, no buyers emerged because the bank was offered on a “take it or leave it” basis without any government backstop. Nearly 10 days have passed and SVB still hasn’t been sold which speaks to the uncertain nature of the liabilities of the bank, or of any bank for that matter. I think CS is much more complicated, so for a deal to be put together over the weekend had to have government support / backstops for UBS.
About those other US regional banks under pressure… It was crystal clear on the 12/31/22 balance sheet of Silicon Valley Bank that the mark-to-market value of their investment portfolio was substantially below book value. It did not even require going through the footnotes in the 10-K – the mark-to-market value was right there for investors, depositors, regulators and rating agencies to see in the bracketed part of the “Held-to-maturity” investment line.
The difference was $15.2 billion between book and market value as of year-end for “Held-to-maturity” securities, and with total equity of $16.3 bln, the bank was barely solvent. I don’t believe that Moody’s threatened a downgrade until early March, a few weeks after the 10-K was published. Depositors are not “trained” to focus on this, either. Perhaps questionable (meaning overly-aggressive) loans might raise an eyebrow or two, but not duration risk in US Treasuries and Agency MBS. Have you ever looked at your banks investment book or their cash-to-deposit balance? I haven’t, and I especially wouldn’t bother if I were banking at one of the top US banks by size (16th) and reputation. For a bank under stress, threat of a rating agency downgrade is often a red flag. When the media jumps on the bandwagon as it usually does, and investors work each other up on Twitter and other social media platforms, a run-on-the-bank can easily occur as depositors flee to the exits to get out ASAP.
For the avoidance of doubt, no bank has sufficient cash and liquid investments on hand to fund a 100% deposit outflow. Banks exist primarily to fulfil a mission of channelling deposits and savings into corporate and personal loans, realising a positive net interest margin. Simply stated, banks are in the business of lending, not blatant risk taking. Silicon Valley Bank had unique attributes like a very lumpy deposit base that was mostly uninsured (because of the large average deposit size), a deposit base consisting mainly of corporate (as opposed to individual) deposits, and a sector-focused and rather concentrated customer base. The bank also had a unique franchise that was worth something “off balance sheet”, including a leading market share position in investment banking services for the tech / life sciences businesses. If and how value will ever be extracted from that leading "intangible" franchise remains to be seen, but the passage of time is likely to destroy it quickly. Underwater investments and the threat of a downgrade increased the focus on liquidity at Silicon Valley Bank and depositors eventually ran for the exits all at once, leaving the FDIC little choice but to step in because the bank ran out of money to pay to depositors. And that was the end of that. Naturally, this failure – followed by the failure of Signature Bank – injected a significant amount of fear in the banking market, and if care is not taken by central banks and governments to tamp this down, this could worsen, even though – in my opinion – it shouldn’t.
Let me repeat - no bank has enough cash on hand plus liquid investments to pay out depositors overnight. I looked quickly at the balance sheet at 12/31/22 of “under stress” First Republic Bank, which seems most in the spotlight since the failures of SVB and Signature Bank.
As you can see from this balance sheet extract, the market value of FRB’s “Held-to-maturity” investment portfolio at year-end was less than book value, but not nearly to the extent of Silicon Valley Bank in comparison to its capital base. The erosion to their capital base of MtM adjustments was 27% in the case of FRB, whereas SVB was 93%, more of less wiping out the entire capital of the bank. Having said this, recall that it’s not destruction of the capital base that leads to a bank’s sudden and harsh demise, but rather running out of cash when all depositors want their money back at the same time. Should FRB fail – especially after being given a $30 billion deposit injection from 11 large US banks – I suspect it would lead to even more panic. Is that possible given the fragility currently in the market? Absolutely. Is it likely? I would say it is not for two reasons.
A further large failure of a US bank would undermine the entire US banking system, which is why 11 “competitor” banks stumped up $30 billion in deposits last week for FRB, hoping that this would buy FRB time and that fears in the market would eventually subside.
Although US regulators, the Treasury and the Federal Reserve seemed to have failed in terms of overly-lax regulation, I doubt seriously that they will let this situation go further.
I view the current market reaction as fear more than the imminent demise of the global banking system. It works like this: banks screw up, regulators screw up, rating agencies act too late, depositors and investors panic. Even with this occurring in the background, somehow risk markets have not really followed suit, at least not yet. It is hard to imagine that the NASDAQ Composite was up in a week like last week that was chock full of turmoil, but in fact it was (+4.4% WoW).
Banks are under stress and there are warning signals are continuing to flash, but my bet (hope) is that this will be contained. I am afraid you won’t find me in a cave somewhere surrounded by gold, at least not yet. Look at this as opportunity for those that are not faint of heart.
 If you have access, the FT article is here and the Bloomberg article is here.  You will note that the “Available-for-sale” securities were marked to market on the balance sheet, $2.5 billion lower than cost.
 As an aside, the yields on the 3- and 5- year US Treasuries are now 54bps and 55bps lower, respectively, than at 12/31/22, meaning the “Hold-to-maturity” investment portfolios of banks are generally higher (i.e. closer to book value) on a mark-to-market basis.