History doesn’t repeat, but rhymes.
Fourteen-and-a-half years ago, in September 2008, I was a global banks credit analyst watching a succession of big-name dominoes fall. After Lehman Brothers’ default, Merrill Lynch ran overnight into the arms of the Bank of America. Over the next week, Morgan Stanley came very close to danger. I distinctly remember attending a sombre institutional client meeting with a fund manager colleague the following Monday morning, at which the principal asked me for my view on their Morgan Stanley bonds. I replied that there was one and only one thing that gave me some comfort, namely, the Federal Reserve’s (Fed) decision just a few hours prior to designate Morgan Stanley and Goldman Sachs as bank holding companies. This allowed the investment banks, who would have been cut off by deposit-taking banks in the inter-bank funding market, to tap the Fed for liquidity. Just as importantly, it also signalled the Fed’s support for them.
Writing this email in the early hours of another Monday morning in March 2023, the powers of regulators to give and take away were again on display. This time, the big story unfolding is the takeover of Swiss banking giant Credit Suisse (CS) by its rival, UBS, in a deal force-brokered by the government. The deal was consummated at an estimated US$3.25b, at around SFr0.75 a share (1 UBS share for 22.48 CS share).
Yet the CS situation was also triggered by sentiments after the collapse of mid-sized US banks earlier this month. If we rewound things to just one weekend earlier, the buzz then was the failure of Silicon Valley Bank (SVB), which core segment of venture-capitalist and start-up depositors made a run on the bank, leading to the Federal Deposit Insurance Corporation (FDIC) taking over. Not long before that, Signature Bank had also been seized.
How did this historic failure-cum-takeover of a 167-year old institution in Switzerland with US$575b in assets and two bank failures in the US happen? Do they portend a second global financial crisis in just 15 years?
Banking is a confidence game and banks are, by definition, highly levered. No bank has the cash to pay all its depositors all at once. To make a return, a bank has to take some of the money you deposit with it, to either lend it longer-term for interest income or to buy assets to earn a return. Under the Basel regulatory requirements, the official regulatory Tier 1 capital (highest quality capital available to absorb losses immediately) requirement is at 8% of risk-weighted assets (the riskier the bond your bought, or the entity you lent money to, the higher the risk weight on that asset). A bank won’t be an attractive investment for its shareholders if the regulatory capital is set too high.
What this means conceptually is that a bank can fail if it has bad assets that, when marked down, can wipe out 8% of capital. In a full-blown crisis, it isn’t difficult for that to happen. It was the case with sub-prime mortgages during the 2008 Global Financial Crisis (GFC) engineered into leveraged packages of mass destruction, the now-defunct Collateralized Debt Obligations or CDOs. But in reality, even if you had a 14%, Tier 1 ratio, as CS had; and even if you had been pronounced to be meeting capital ratios by a regulator, as CS had been; all this means nothing when client confidence is shaken. All it takes for a bank run is for depositors to suspect that you have a lot of these bad assets. Even the Swiss National Bank’s (SNB) massive SFr50 billion liquidity line to CS announced just a few days ago was insufficient, hence this drastic move.
Comparing the 2008 GFC and the situation now, from the vantage point of a former bank credit analyst, I would like to offer a few perspectives:
1. Regulators are demonstrating that they will take swift and deep actions, to prevent the situation from turning into a full-blown financial crisis.
The GFC is recent enough for regulators to have seared into their memory the importance of swift and decisive action. In the US, the FDIC acted quickly in taking over SVB, and thereafter guaranteed deposits, making SVB now the safest bank in the US. There is nothing to stop this guarantee from being extended to more banks. The Fed also opened a Bank Term Funding Program which would help similar mid-sized banks bridge liquidity needs. The Fed has shown, time and again, that it would be willing to stretch to accept the type of collateral it accepts in return for providing cash.
As for CS, it has had a terrible run in terms of high-profile losses and governance issues, and was in the midst of a restructuring plan, but market action forced the timeline. CS is one of only 30 banks regarded as being systemically important globally in the aftermath of the Global Financial Crisis – and one of two in Switzerland, the other being UBS. The fear, as always, was contagion – had CS’ credit default swaps (or CDS, the additional cost of insuring against default of CS debt) continue to trade at distressed levels, UBS’ CDS would not stay low for long, and UBS’s own non-Swiss franc funding would be under strain.
The Swiss authorities will still face criticism over how they are providing a guarantee or “put” to floor UBS’ losses, reportedly up to SFr9 billion. The liquidity line is increased to SFr100 billion. Alternatively, it could emerge that CS was not as bad after all, and the Swiss authorities would then be blamed for being unnecessarily pre-emptive and draconian. Whichever way it turns out, that the Swiss authorities would risk all this shows that it is willing to take acute, short-term pain to secure a robust financial system for the longer term.
2. The tide has turned strongly against Central Banks bailing out bank shareholders and bondholders. Regulatory capital regimes might be revamped yet again.
One of the costliest assumptions made by some large investors in 2008 was that the Fed, having saved Bear Stearns by brokering a purchase by JP Morgan in March that year, would not let Lehman default. As a result, they bought into large equity stakes of banks and brokers, many of which turned sour after Lehman and the other dominoes fell.
Governments have been subject to more criticism about bailing out Wall Street – socialising losses and privatising gains. Under the UBS deal, CS shareholders would be all but wiped out, and a shareholder vote dispensed with. The takeover price is way below CS’s tangible book value of SFr41.8b as at the end of 2022. As for bondholders, CS was one of the first issuers of Contingent Convertible Capital bonds (CoCos), which will absorb losses upon certain capital events. It was reported that up to SFr16 billion of CS bonds could become worthless. This is a rare event, if not a first of its kind.
That Basel and its capital regime did not prevent the failure of CS could result in yet other tweaks to the regime. Likely, this would result in lower return on capital for big banks in the medium term.
3. Regulators will create as many innovative tools as they need to resolve banking issues, beyond interest rates.
A lot of market talk is focused on the purported dilemma of Central Banks between continuing to increase rates to fight inflation and decreasing rates to deal with the banking crisis. I think this is an unnecessary distraction. From 2008, we know that Central Banks can be innovative in various ways – there was an “alphabet soup” of programmes for different market instruments. There is nothing to prevent the Fed from providing liquidity at terms different from a Fed Funds rate, using some creative way.
On the US banks, what is interesting this time round, is that SVB seems to have failed investing in US Treasuries – is this the first time a bank failed because it had too many Treasuries? What has been reported is that SVB took too much duration risk by buying too many long-dated bonds, which value tanked when yields shot up. There was then this curious transaction whereby SVB sold the bonds to Goldman, crystallising the losses, and then going to market to raise equity. This spooked their VC and start-up clients into making a run on the bank. We expect more things to be uncovered and we will get some hints from prospective buyers’ interest in SVB, or lack of. If the risk was really restricted to interest rate risk, rather than bad credit risk, the mid-sized bank turmoil in the US should be much more manageable.
What does this mean for investors? Allow me to offer three suggestions:
- The determination and speed at which the regulators are moving should give us comfort as investors that another full-blown GFC is highly unlikely. Volatility from bank turmoil thus presents opportunities. No matter how bad the gyrations are, we can expect a good recovery in time – except that we do not know when, or how bumpy the road would be. But even if we go through something like the GFC, we know that the stock market always recovers from a crisis and goes up in the long run. I think you would agree with me that looking back, the GFC was an excellent opportunity for wealth-building for disciplined, long-term investors.
- However, we do not recommend betting on the individual sectors or on individual banks/ stocks as “potential good deals”. Stay diversified. The banking turmoil came out of the blue, at an unexpected time. It is not conventional wisdom that banks suffer during times of rising interest rates. Even if a bank were rescued, like CS, not all investors in every single part of the capital structure will be preserved. “Always recovers and goes up in the long run” does not apply to individual stocks, sectors or even countries, but only to the broad-based market.
- Look at whether an untested group of counterparties dominate a fund. SVB offers a case of how VCs and start-ups might have run a bank out of business because of the bank’s concentration in these counterparties. One of the things we look at when assessing an investment fund is whether its unit holders are concentrated in say, VC-funded roboadvisers, just in case the fund is subject to huge withdrawals and forced to sell assets at very poor prices to meet redemptions. We have come across at least one such ultra-short duration bond fund used in many pseudo-“cash management” solutions with such concentration risk, which we would hesitate to take into our portfolios for this and other reasons.
A final reflection – fourteen-and-a-half years ago, my ring-side seat in the 2008 GFC showed me how a lot of clever financial engineering, nice-sounding analysis and experience in big-name banks crumbled in the face of the severe shaking of the banking system. Beyond the financial losses, there was huge bewilderment among institutional and retail clients alike, and even among professional fund managers. Those who did the best were those who were not panicked by fear and who stayed invested, while clients and fund managers who switched to cash had the biggest regrets. Some fortunes and careers were made then, and some were lost.
Today, I see that the banking turmoil is met by swifter Policy responses with greater clarity, and like with all market movement in the short term, this, too, will pass. Having an investment philosophy you can stick with anchors you through the ups and downs of market turbulence, and rewards you with healthy returns over time. Except where you have an urgent need, the worst thing you can probably do is to panic-sell, and turn a temporary decline into a permanent loss. The second worst thing is to “take profit” and try to wait to the right time, because the right time will never come psychologically, and you would have totally missed that big ride-up when the recovery comes on fast and furious. The way to have a great investing journey, including during turmoil, is to be disciplined in our mindset and look beyond the concerns of today, to the long-term potential of the markets. I strongly recommend that you invest in MoneyOwl’s low-cost market-based investment solutions in a regular savings plan (RSP), if you haven’t already started investing. If you are already an investor, continue to invest regularly, and if you can, put some dry power to work when markets are “cheap”! Finally, if you have any concerns about how your financial plan may be affected, please reach out to us. Our advisers will get in touch.
Chuin Ting Weber, CFP®, CFA, CAIA
CEO and Chief Investment Officer
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