Anatomy of a bank failure and why Coolabah was shorting Credit Suisse in 2022

When it comes to bank failures, they are typically borne by some miscalculation of risk and overexposure to a collapsing asset - think mortgages in the US during the GFC or, more recently, US government bonds in the case of Silicon Valley Bank. 

That was not the case with Credit Suisse, however. Rather, it was death by 1000 cuts (or more precisely, scandals) that weakened and ultimately broke the global bank. 

Over the past decade, Credit Suisse and its employees spent a lot of time in front of the regulator, doing their best to explain money laundering, corruption, tax evasion, and corporate espionage scandals. But it was the exposures to the collapses of US hedge fund Archegos and UK finance firm Greensill Capital that really twisted the knife. 

The hammer blow, however, was a tweet from a journalist that the investment bank was 'on the brink'. That led to massive outflows, a big hole in the balance sheet, and Credit Suisse reporting that it had found 'material weaknesses' in its financial reporting. 

Despite some attempts by the Swiss National Bank to rescue Credit Suisse, there was ultimately no confidence from the market and the bank was eventually sold to UBS. 

As with any blow-up, there are winners and losers. Typically there are many losers and only a handful of winners - with the latter managing to both anticipate what was happening and take advantage by moving quickly. 

In this Expert Insights, Head of Credit Research at Coolabah Capital, Jason Lindeman, tells the story of Coolabah's short position in Credit Suisse, and how he and the team are viewing the current landscape. 

Edited Transcript

LW: Why was Coolabah short-selling Credit Suisse securities in 2022?

Jason Lindeman: Credit Suisse was a middling investment bank, and we don't like investment bank structures because they tend to have more variable earnings, and the earnings had been very poor. But more specifically, Credit Suisse was prone to negative shocks. Whether it be Greensill, Archegos or Mozambique. There were actually 15 of these that we were monitoring. So we had a ban on investments in the Credit Suisse Hold Co structure as early as May 2020, and we were advising our clients in February 2021 to exit their exposures with Credit Suisse.

Now, with respect to the short position, in 2022 we were negative credit spreads more broadly. It was our view on the direction of interest rates relative to the markets. And Credit Suisse was one of the $10 billion worth of shorts we made at the time. 

But it is worth mentioning we were not involved in a speculative short-selling attack on Credit Suisse in March 2023. We did tell our investors that Credit Suisse would be targeted after the Silicon Valley Bank and hedge funds would turn their attention to Deutsche Bank, but Credit Suisse didn't deserve to die from a digital deposit run. 

If Swiss authorities had been quicker to provide support, to guarantee deposits, as they did in the US, Credit Suisse would most likely still be around today.

And the counterfactual is Deutsche Bank. Rather than shorting Deutsche Bank, we were in contact with senior management, we were writing in the financial press in Europe about what was required from the governments and the regulators to stabilise the situation. And when the German chancellor signalled that they'd be protecting their national champion at the same time as European regulators announced that they'd be investigating Credit Suisse and Deutsche Bank security transactions for market manipulation - well, the result for Deutsche Bank was very different. 

Now, there were some Aussie investors who were allocating to Credit Suisse hybrids, whether it be as a diversification play or as an attractive high-yield investment, but this wasn't our analysis.

What investment actions did Coolabah take, if any, after Credit Suisse was bought by UBS?

On the night of the acquisition, when it was announced, UBS Hold Co Senior Bonds were trading 300-350 basis points above Bunds. This was equivalent to where major bank-subordinated hybrids were trading. 

There are many ways to present the numbers, but UBS was paying 3 billion (swiss francs) for a business whose domestic Swiss banking unit was worth more than three times this. And the transaction was good for both equity and credit. 

It removed their number one competitor, they became the undisputed monopoly provider of wealth management in Switzerland. Number two, globally. 

It was actually 7-10 years of organic growth in one hit. 

They received emergency liquidity support from the Central Bank, loss-bearing agreements from the government. And UBS actually had quite a good track record stabilising banking operations post the GFC. 

So on the night of the transaction, we were buying UBS senior bonds and we bought $600 million over the next three sessions.

Why are the Aussie banks different from Credit Suisse?

Well, Aussie banks aren't investment banks. 

Just simply 80% to 85% of Aussie bank business is taking deposits and making loans. And this was only 25% of the Credit Suisse business. 

Aussie banks are actually regarded as some of the safest in the world. And APRA, like it or not, is one of the toughest regulators in the world. One of the reasons is that Aussie banks are among the best capitalised globally. 

The reason for this is they were forced to massively de-lever, raise extra equity, and provide unquestionably strong capital following the financial system inquiry in 2014. It involved de-risking their business, unwinding vertical integration structures, and offloading those non-core investment banking, insurance, financial advice, and wealth management businesses. 

It's to the point where Aussie banks tend to benefit from a flight to quality during periods of financial instability.

What are you seeing across the landscape now that has you concerned?

More broadly, the soft landing narrative continues to build but we're more focused on the impact of the rapid increase in interest rates and the higher for longer rates. 

There's no doubt that the economy received significant stimulus during the pandemic and the savings buffers grew, but the defaults are increasing. 

The ASIC Australian insolvencies are actually at the highest level since 2016. And the S&P global defaults are the same - ex the 2020 pandemic year. 

The numbers for August were actually the highest since 2009. And similar numbers to the EU and US bankruptcies.

More specifically, regulators have discouraged banks from lending to high-risk borrowers since the GFC. So a lot of these borrowers are being forced into the unregulated non-bank sector. 

The concern is that none of these non-banks existed during the last genuine default cycle - the 1991 interest rate led recession with 11% unemployment. And as we said, they're not regulated by APRA, so their lending standards can be very different. 

One example is that regulated banks have to provide a 3% serviceability buffer to determine loan affordability, whereas some of the non-banks apply a 1% buffer, and they've been doing this for some time, and the results come through in the delinquency data.

Another concern is with respect to zombies. We've been tracking zombies since 2019. The strict definition of a zombie is a firm that has an interest coverage ratio of less than one time for greater than three years and the business has been in existence for greater than 10 years. 

In the EU, US, UK, and Australia, 10% to 15% of listed companies are zombies. In Australia, that's 14%. And those numbers were taken in February '22 before 3.25% of additional rate increases. 

In terms of where zombies live, of listed real estate firms, more than 20% are zombie firms. So we're concerned there'll be a cleansing of those firms who were overly reliant on the zero interest rate environment.

Which areas of the private lending market are worrying?

Year-to-date, Australian construction insolvencies are double the next highest category. 

APRA has been advising banks for decades that the most common killer of banks during downturns is exposure to commercial property and residential construction. 

Non-banks have been focusing on these areas the banks have avoided.

It's well known that during the pandemic, the Australian Tax Office had delayed its enforcement actions. Now liquidators and bankruptcy trustees are seeing those smaller SMEs, those smaller businesses, which arguably should have filed in the last couple of years, but what they're expecting and what they've seen before is the next stage. 

When you get those larger businesses that have smaller businesses that rely on them, that's when you get the chain reaction. So these are some of the concerns we have for the unregulated non-bank lenders.

What parts of the market are you bullish on and where are you hunting for opportunities?

It's been a while... I've been doing this for 30 years and it's been 15 years since you can say that cash is again king. 

You just don't need to reach for risk to achieve decent yields. 

Those asset allocation decisions that were made between 2008 and 2022 are very different now. 

So we're bullish on liquid, high-quality, investment-grade credit. 

This is very clear when you look at the relative yields on cash, versus equity, versus bonds.  We know that we can get term deposits greater than 5%. The equity dividend on the Australian All-Ordinaries, fully franked, is 5.7%, but highly rated bank bonds carry interest rates of 6-7%.

It's hard to justify investing in commercial property when they're yielding the same levels as government bonds. These assets are illiquid, so the prices need to fall 22-35% to achieve the historic spread over the risk-free benchmark of 3-5%. And we are seeing inflows from asset allocators into higher quality, investment grade fixed income.

I mentioned earlier that some Australian investors were allocating to Credit Suisse hybrids whether on the basis of diversification or illiquidity premium. It was similar during the pandemic with the Virgin Senior Bonds, and both these investments were wiped out. 

At Coolabah, we're focused on avoiding endogenous credit risk and avoiding blind diversification by concentrating on the safest firms in the world.