In general, I don’t like dredging up the 2008 financial crisis to make comparisons about the current market and economic situation. The financial crisis was a pretty unique series of events. But the stuff that’s going on at Credit Suisse is eerily similar to the conditions that brought the global economy to a standstill in 2008–9.
Last month, Credit Suisse said it would fire 4,000 people in an effort to cut costs. Yesterday, the bank upped the headcount for the chopping block to 6,000 as it seeks to save $4.5 billion in expenses.
The problem for Credit Suisse — and many other banks — is that trading revenue is down. A lot. Credit Suisse says first-quarter trading revenue will be down 45%. That’s a huge number, way worse than similar forecasts from JP Morgan (-20%) and Citi (-25%).
In 2014, Credit Suisse posted about $1.85 billion in net profit. (Not bad, but nowhere near what a healthy U.S. bank earns in a year. Bank of America, for instance, will earn around $10 billion this year.)
2015 was off to a similar profitable start until the fourth quarter. Massive asset write-downs and goodwill charges cost the bank nearly $6 billion. Net income for all of 2015 will not exist — instead, Credit Suisse lost a total of around $3 billion.
Now, the problem is that this reversal of fortune is something of a surprise. Just this year, the stock has fallen nearly 40%, from $22 to as low as $13.50. In July, Credit Suisse was a $30 stock.
A big sell-off is one thing. But the fundamental issues at Credit Suisse are spiraling quickly, and when things spiral quickly, it can get dangerous. As much as anything, it was the speed of the rise in mortgage delinquency that made the financial crisis so bad (especially following the Lehman bankruptcy), because there wasn’t time to make adjustments.
The CEO’s Letter
Last week, Credit Suisse CEO Tidjane Thiam had to send a letter out explaining why the bank is getting desperate. This sentence in particular explains the bank’s dilemma:
Regarding our Global Markets [division] activities, the combination of a high and inflexible cost base, exposure to illiquid inventory in fixed income, historically low levels of client activity and challenging market conditions has led to disappointing financial results.
If you don’t know, fixed income means bonds. So this statement overall can be translated like this: We paid too much for high-yield bonds, we can’t sell them, our clients don’t want to buy them, and debt concerns for companies that issue high-yield bonds have crushed prices.
The whole point of a bank owning bonds is that it gets an asset that pays it some money, and it can sell that asset for cash anytime. But that’s the not the way it is right now. Bloomberg reports that 40% of the bonds in the $1.4 trillion U.S. high-yield bond market didn’t trade in January and February. That’s $560 billion in bonds that simply didn’t trade in two whole months. You can see how this would be a problem…
What if the bank needs to sell to raise cash? It will get absolutely reamed as buyers lowball it. That, in turn, makes it very hard to value these bonds (assets?) at all. High-yield bond prices fell 20% in 2014 and another 38% in 2015. And that’s why Credit Suisse lost $495 million in the fourth quarter and has already written down its assets by another $258 million.
One bond fund manager at Loomis Sayles said, “It is probably going to be the worst quarter in history for a number of the fixed income-oriented hedge funds… A few are already known but there are some that were wiped out and just wound down.”
Why It’s Like 2008
Banks keep a large portion of their cash (i.e., your deposited money) in bonds that are easy to sell, like Treasury bonds. That’s how they make money and how you can have a free checking account. They will also put a smaller amount of money in things that pay better interest rates, like mortgage securities and high-yield bonds, in order to make more money.
Back in 2008–9, you’ll recall that banks had been buying more mortgage-backed securities because the real estate market was so hot. It worked fine until default rates started rising. Suddenly, the value of the mortgage securities was called into question and no one wanted to buy them. So banks couldn’t get their cash out, and they were also forced to start writing these assets down.
This is known as a liquidity death spiral. And they can happen fast. On Thursday, March 13, 2008, Bear Stearns was a ~$55 stock. The next day, Friday, March 14, it closed right at $30. On Monday, the stock opened at $3.17 a share.
The question is, can such a collapse happen to Credit Suisse?
It seems to me that Credit Suisse is not in danger of an outright failure. Its Global Markets division (where much of the trouble is happening) has something like $85 billion in assets and appears to be leveraged about 3X. That said, I wouldn’t be at all surprised to see things get worse for Credit Suisse before they get better. Earnings estimates for 2015 have been cut in half in the last two months, and there’s no reason to think more cuts won’t come, especially if global growth doesn’t pick up.
I’d also be very concerned about that dividend. Back in February, Credit Suisse was expected to pay a $0.70 annual dividend. But that was before the CEO was replaced. The high-yield bond market hasn’t improved much, and with the current CEO focusing on cost savings, he may well target the dividend next. That would crush the stock.
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Why It’s NOT like 2008
The biggest difference between today’s high-yield bond problems and the 2008 financial crisis is size. As I said earlier, the entire U.S. high-yield bond market is $1.4 trillion. Today, the mortgage bond market is worth around $8 trillion. So the mortgage bond market is way bigger and therefore can cause way bigger problems than the high-yield bond market.
Another big difference has to do with banking regulations. After the financial crisis, regulators changed the way they rate the bonds that banks hold in lieu of cash. Today, U.S. banks simply aren’t allowed to hold as much in high-yield bonds. That’s a big reason why the high-yield bond market is less liquid than it once was.
Now, European banks like Credit Suisse are supposed to be held to similar standards as U.S. banks, thanks to Basel III regulations. But European banks have been slower to trim their exposure. So now that high-yield bonds have been crushed and the market has gotten even less liquid, European banks are at much higher risk than U.S. banks.
So the situation is not like 2008–9 in that we are not at risk of seeing the global economy grind to a halt. Still, 2008–9-like risks to individual banks, funds, and companies are out there right now. I think it is highly likely that we see an investment fund or two blow up. And we may well see a bank or two approach crisis-like valuations.
Like always, a crisis is a buying opportunity. So always keep some cash ready — it’s likely you will get the chance to buy low at some point this year.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
