Thursday, March 16, 2023
Just as the market was starting to make some progress digesting the news of the Silicon Valley Bank (SVB) failure, another source of potential financial stress popped up in the form of Credit Suisse (CS). Here’s what we know about this situation right now, what it could mean, and some investment ideas investors may want to consider in light of this week’s volatility.
Credit Suisse shares were down more than 30% at one point on Wednesday to record lows before rallying back to end the session down 14% (excluding the after-hours rally—more on that below). Markets were already jittery after the SVB news over the weekend (and the failure of Signature Bank of New York), and Credit Suisse’s struggles have been widely known for some time (new management is in the midst of a turnaround plan), so perhaps the weakness wasn’t surprising.
The selloff was sparked by the news that Credit Suisse’s largest shareholder, the Saudi National Bank, would not consider raising its stake in CS because of regulatory concerns regarding exceeding the 10% ownership threshold. Without that potential source of capital, markets worried about the solvency of Credit Suisse.
Swiss central bank and financial regulator to the rescue
By late afternoon Wednesday, at least some of those worries look to have been put to rest. Even though the market reflected nervousness about CS’s ability to meet its obligations, reflected in a blowout in credit default swap (CDS) pricing, the bank is simply too big to fail. And bailouts are more politically palatable in Europe, making this development almost a foregone conclusion. That message was (finally) delivered straight from the safety nets themselves, the Swiss central bank (the SNB) and the local banking regulator (FINMA), who issued a joint statement:
Credit Suisse meets the capital and liquidity requirements imposed on systemically important banks. If necessary, the SNB will provide Credit Suisse with liquidity.
Credit Suisse did not hesitate to leverage the facility, exercising its option to borrow up to CHF 50 billion from the SNB late Wednesday night, collateralized by CS assets. European stock futures rose on the release of the statement.
Gauging contagion risk
Even though we believe market participants overwhelmingly expected CS to be backstopped by the SNB, the news sparked a nearly 10% rally in the shares in the aftermarket (as of 6:20 p.m. ET Wednesday). This assurance that CS would not be allowed to fail will no doubt help assuage fears of broader contagion, though those fears have not intensified as much as some may have anticipated based on the cost of credit default swaps for some of the biggest U.S. banks. As shown in the chart below, the cost of this insurance against default by CS has skyrocketed in recent days to full-scale panic levels, well above 2008 highs. For comparison, 5-year CDS at around $800 is a similar price to where Bear Stearns’ CDS were trading before that investment bank was sold to JPMorgan back in March 2008.
But here is the good news. While CS CDS were blowing out, the cost of this insurance for the four biggest U.S. banks (by deposit base) has remained relatively calm, matching levels seen in moments of market stress last year, but nowhere near what would be considered crisis levels. The four banks are Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC). The story is the same if we look at spreads on the investment grade bonds of these issuers. Bottom line, the market is telling us contagion risk to the broad U.S. banking system is low and we agree.
Now that doesn’t mean midsized or smaller banks won’t have to pay up for deposits or incur additional marketing and regulatory costs as a result of this banking scare. While the solvency stage of the crisis may be over soon, profits may be constrained for a quarter or two, if not more, until this blows over. Even contained banking crises, as we expect this one is, can have ripple effects for a while. Confidence takes time to be restored. One consequence may be more limited credit availability, which could have a negative impact on economic growth in the near term.
Now that deposits are effectively guaranteed at Credit Suisse and debt holders are unlikely to experience any haircut in a possible (but very unlikely) bankruptcy, we can take the next steps to move beyond this crisis. One step is seeing buyers come in to take assets from the failed lenders in the U.S. and inject capital into CS. The company is spinning off its U.S. investment banking business and rebranding it as First Boston, previously its entrée into the U.S. market via acquisition in the mid-1990s. We would also like to see deposits stabilize, the Federal Reserve either pausing or signaling a pause, and some smarter bank regulations in terms of interest rate risk at midsized banks (we’ll see tougher regulations whether we like it or not, we just want them to be smarter and better).
Potential investment implications
LPL Research is not a buyer of the U.S. banks just yet while we wait for more confidence to be restored. However, the LPL Research Strategic and Tactical Asset Allocation Committee (STAAC) is maintaining its neutral view of the financials sector and its slight preference for value over growth. The Research team is watching technical analysis signals closely for potential signs of a change in the medium-term trend for the growth style.
The STAAC remains comfortable with its neutral weighting in developed international equities, but maintains a slight preference for U.S. equites at this time.
Finally, the STAAC recommends preferred securities as a way to take advantage of these depressed valuations while waiting for more confidence to be restored, while precious metals look well positioned during this period of banking stress and potential U.S. dollar weakness.
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