Banking crisis, analysis of the takeover of CS by UBS, valuation and outlook for the equity markets
Chart of the week
The chart shows the value of CDS (credit default swaps) of various banks in Europe. A CDS is an insurance policy against default. The higher the value, the higher the market participants estimate the default or bankruptcy of the company.
Why this is important
That Credit Suisse has problems is undisputed. However, the chart shows that we are not currently dealing with a banking crisis in Europe, but that individual poorly managed banks are in focus. The CDS of other banks such as UBS, BNP Paribas or the financial sector in general have hardly changed.
So there is no reason to fear that it will now lead to a bank run on a large scale.
Why is the banking sector triggering a crisis again?
Many people will say: The banks are in crisis again, haven't they learned anything from the past?
All major financial crises or bankruptcies were triggered because one principle was disregarded. Money that has to be available in the short term is invested for the long term. This imbalance in liabilities has been the undoing of many. The hedge fund LTCM, the financial crisis triggered in the MBS sector, or now Silicon Valley Bank.
But now the bad news. It is the original business model of every bank that customer funds must be available at all times, but they invest them in mortgages or corporate bonds for the long term. That's how they create value for society. Ultimately, any bank can be brought to its knees if all investors want their money back at the same time. Regulation now has to ensure that banks back this imbalance in liabilities with sufficient equity and do not become too careless and greedy. Accidents will always happen, however.
As the world becomes more and more interconnected and banks get bigger and bigger, in fact only the central banks can prevent the crisis of one bank from spreading to the entire financial sector in an emergency
Of course, one can take the position that bad companies should go bankrupt and not be rescued by the state. That is correct. But it is important not to forget what happens when a company goes bankrupt. The bankruptcy trustee closes all the bank's operations. All mortgages are immediately recalled and all corporate loans are also terminated with immediate effect. This can lead to countless foreclosures of real estate and drive many more companies that are healthy into bankruptcy. In the case of a systemically important bank like Credit Suisse, an uncontrolled collapse would be devastating.
Following the collapse of two banks in the USA, many investors have moved their money to safety. Cash at banks in the USA is only insured up to an amount of USD 250,000. That is why many investors bought short-term government bonds of two years. The chart shows the weekly change in two-year government bond rates in the US. Last week we saw the biggest change since 1987, and since in 1987 the change was made up the next day, many market participants are also talking about the biggest change ever.
However, the money is only parked there and is likely to quickly flow elsewhere.
The chart shows the change in expectations of how the Federal Reserve will decide at its next meeting on March 22.
As recently as March 10, more and more investors thought the central bank would raise interest rates by another 0.5%. Now, almost 50% of investors expect the Fed not to raise rates at all, so as not to further destabilize the banking system. Fighting inflation is suddenly no longer a priority. Such a turnaround in expectations is unprecedented.
We view this development with concern. Fighting inflation should be the top priority and should not be lost sight of because of bailing out a few banks.
Things would look different in the event of a systemic crisis.
The chart shows lending by the big banks (left) and the regional banks (right). After the turnaround in interest rates, the big banks scaled back lending and reduced risks. Not so the smaller banks with total assets under USD 250 billion. Thanks to a new law by Donald Trump, the rules for these banks have been massively relaxed. They have taken advantage of this leeway. Some, like Silicon Valley Bank, too much.
The chart shows four common crisis indicators. Starting clockwise at the top left: yields on unrated bonds (junk bonds), yields on investment grade bonds, senior secured bonds (senior loans) and the volatility index (VIX).
If a systemic crisis were to occur, all of these indicators would have to shoot upward through the roof. This is not happening and shows that investors are reacting prudently.
The central banks have done a good job. They have drastically increased the money supply in the short term.
The chart shows the change in the U.S. Federal Reserve's balance sheet since fall 2021. Since the turnaround in interest rates, the central bank has steadily reduced the money supply. By increasing the money supply, it is stabilizing the system, but risks losing the battle against high inflation.
That's why we believe it would be fatal if the central bank were to refrain from raising interest rates now.
The chart shows how the central bank increased the money supply. This was done via a program in which banks can borrow money from the central bank on a short-term basis. Short-term money borrowing last week still exceeds that in the middle of the financial crisis from 2007 to 2009.
The chart also reiterates how historic and extraordinary last week's development was.
What does the takeover of CS by UBS mean for Switzerland and investors?
The chart shows again how much the credit default swaps for Credit Suisse, i.e. credit insurance, had risen on Friday.
Let's look at the acquisition from the perspective of the different stakeholders:
- CS clients
Everyone who still has funds with UBS can breathe a sigh of relief. Anyone who financed their home through CS or has corporate loans with CS can also breathe a sigh of relief. The funds are now safe and the loans do not have to be repaid.
- CS employees
For them, it is the most devastating solution of all. Of the 17,000 employees in Switzerland, 10,000 to 15,000 are likely to lose their jobs. Client advisors with direct client contact are likely to be taken on, but anyone in IT, marketing or asset management is likely to lose their job. The same applies to everyone in middle and senior management.
The fact that the authorities are not imposing any conditions under competition law is completely incomprehensible. The answer to a corresponding question at the press conference was that the stability of the financial center gives FINMA the right to exclude all competition law issues. Bankruptcy and liquidation according to the too-big-to-fail guidelines would have made it possible to preserve most of the jobs and sell the Swiss business to a partner interested in the jobs.
The Chairman of the Board of Directors of UBS, Colm Kelleher, made statements at the press conference only to reassure investors; for the employees of CS and also UBS, he increased the uncertainties to the maximum.
- Swiss banking center
In the short term, many can breathe a sigh of relief. The pressure from the financial markets and from abroad should cease as of Monday.
In the medium and long term, however, there are only losers. A gigantic wave of unemployment will be triggered, due to write-offs of the takeover, the new UBS will probably not pay any taxes for years and also the taxes of 10,000 who will become unemployed will fall away.
It should take 5-10 years until the job market in the financial sector in Switzerland gets back on track.
In retail banking there is still competition, but in many areas the new UBS will have a monopoly. The result will be higher prices and poorer services. It is completely incomprehensible that the authorities are not imposing any conditions under competition law.
UBS has resisted the takeover for good reason. The whole planned business strategy and transformation into a digital bank is off the table for now. In the next 3-5 years, UBS will be primarily concerned with itself. It will probably take months or years until the duplications are dismantled. During this time, employees will be primarily focused on their personal situation and not on that of the clients or the bank.
We would then also recommend anyone holding UBS shares to sell them now.
In our view, the worst and most despondent solution has been chosen. Even winding up and splitting the bank according to the too-big-to-fail guidelines would have been better.
There would have been other options. The SNB could have extended credit insurance to all customer funds, as it did in the USA. This would have stopped the outflow immediately. UBS could have financially supported CS alongside the National Bank. This seems illogical, but UBS benefits from a direct rival. From now on, UBS will be under constant control of the competition authority, as it has an absolute monopoly in certain market segments.
In addition, the CEO and Chairman of the Board of Directors would have had to be replaced immediately.
This path would have had only advantages for Switzerland in the medium and long term.
In this context, I recall an episode from 1997 when Microsoft rescued Apple. At that time, Microsoft had massive problems with the competition authorities because of the dominance of their operating system. Apple had lost 10% market share in one year and had a loss of USD 1.5 billion. The company was on the verge of bankruptcy. Then Bill Gates was videoed at the employee conference, where he was mercilessly booed. Microsoft invested USD 150 million in non-voting shares of Apple and saved Apple's life. The two companies became two of the most valuable companies in the world today. These are decisions that create value.
The chart from Fidelity shows the current valuation of stocks in America, based on the P/E ratio (price/earnings ratio). If you calculate the valuation and use the current interest rate of the two-year (red) or ten-year government bonds to discount the earnings, the valuation should be lower. This is a clear sign that based on current interest rate expectations, stock prices are too high.
The chart shows a Bank of America survey of major institutional investors. The majority expect prices to fall in the short term, but to rise sharply in the long term. There has never been a greater discrepancy between the short-term and long-term forecast since the survey was conducted. This shows that even the major investors are having problems assessing the current situation. They are reacting to this by reducing their risk.
Here, the active investment funds of the American asset managers were looked at. A beta of 1 corresponds to the risk of the market. The risk appetite is as low as it was last time during the financial crisis in 2009.
We also expect equity prices to consolidate. We have increased the proportion of cash in recent weeks, but remain invested in conservative and high-quality equities.
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