Before the UBS – CS take-over conditions were finalized, Ms. Keller-Sutter consulted with her US counterpart, Janet Yellen, Secretary of the Treasury.
Here are some facts that emerged since the coerced deal:
- The UBS – CS merger should be finalized by end 2023;
- The Swiss Government (Swiss tax-payer) provides the UBS a loss guarantee of up to CHF 9 billion;
- The Swiss National Bank (SNB) grants UBS and CS a liquidity line of credit – called by its true name, a “bail-out” – of CHF 200 billion, of which the Swiss Government (tax-payer) is guaranteeing any uncovered amount.
- Compare the CHF 200 billion with the CHF 50 billion the SNB offered CS to restructure and sanitize itself – which a day earlier was assessed as being sufficient;
- In the context of the huge “bail-out”, it may be worth mentioning that on 5 March, two weeks ago, the SNB announced one of its biggest losses in recent history, of CHF 132.5 billion;
- The leadership of the merged banks will remain with UBS;
- The volume of the combined UBS/CS-managed assets will be about US$ 5 trillion.
- This banking giant is expected to gradually control 30% to 50% of the Swiss market and will become an important player in the international arena, next to BlackRock (US$ 10 trillion) and Vanguard (US$ 7.2 trillion).
Credit Suisse Takeover in a Black Box
The complexity of the highly interconnected financial and economic system makes predictions about the exact sequence of events in a crisis foolish.
Founder of GMO Jeremy Grantham once noted in October 2008: "I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."
The problems currently are within the global banking and financial sector. But financial dislocations feed back into the real economy. There are two primary channels. First, reductions in income and losses of capital affect earnings and savings. Depending on magnitude, it may decrease consumption and investments.
Second, a banking crisis reduces the availability of funding and increases its cost. Small and medium-sized banks play an important role in economies. In the US, banks with less than $250 billion in assets provide roughly 50 percent of all commercial and industrial lending, 60 percent of residential real-estate lending, 80 percent of commercial real-estate lending, and 45 percent of consumer lending. More stringent regulation, tighter lending standards and the likely consolidation in banking will also reduce the supply of funding.
The real-economy effects will intensify any economic slowdown driving new stages of the adjustment.
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The relative geopolitical stability of 2008 is in the past. Current tensions between major powers mean that the likelihood of a co-ordinated response is low. Instead, trade restrictions, sanctions, deglobalisation and containment now dominate discourse. It is difficult to see China rushing to the aid of Western economies and institutions at a time when the US and its allies are keen to restrict the rise of the Middle Kingdom as an economic challenger and great power rival.
The probable response is low rates, government support and generous infusions of money, the policies popularised by former Fed Chairman Alan Greenspan, the 'Maestro' to sycophants. Because it is expedient, easy money is seen as a solution when it is the issue. In essence, it will be another kick of the can down the road although the available tarmac is now much diminished.
The global economy may now be trapped in an easy money-forever cycle. A weak economy or financial crisis forces policymakers to implement expansionary fiscal measures and more monetary expansion. If the economy responds and the financial sector stabilises, then there are attempts to withdraw the stimulus. Higher interest rates slow the economy and trigger financial crises, setting off a new round of the cycle.
If the economy does not respond or external shocks occur, then there is pressure for additional stimuli, as policymakers seek to maintain control. All the while, debt levels continue to increase, making the position ever more intractable.
Economist Ludwig von Mises was pessimistic on the denouement.
"There is no means of avoiding the final collapse of a boom brought about by credit expansion," he wrote. "The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
In a new global financial crisis, where are the dead bodies buried?
The need for funding coincides with a decrease in the amount of new money available. New inflows into private equity have declined by around two-thirds from the 2021 level of around $600 billion. Start-up investments worldwide fell by a third in 2022. The number of funding mega-rounds (fund raisings of $100 million or more) fell by 71 percent. New unicorns (private firms valued at $1 billion plus) fell by 86 percent. It remains to be seen whether VC tourists, who have been amongst the largest losers, return. Most private investments are liquified to realise returns and generate cash, by trade sales or IPOs. With these markets now closed for an unknown period, the ability of investors to free up funds for new investments is constrained.
There is the additional problem of valuations. Between 2021 and 2022, the valuations of private start-ups tumbled by 56 percent. The average value of recently listed tech stocks in America dropped by 63 percent. In 2022, Klarna, a Swedish buy-now-pay-later (also known as point-of-sale (POS) instalment loans) firm, suffered a 87 percent slide in value in one year. In March 2023, payment processing firm Stripe raised more than $6.5 billion implying a valuation which was $50 billion, some 47 percent below its 2021 peak. The cases are not isolated. Lower valuations affect fund-raising options, especially as founders and existing investors would be reluctant to recognise large losses on existing positions. The coincidence of losses on investments and capital calls may lead to a general liquidity contraction for investors, requiring them to undertake forced sales. The position is not confined to the US but also exists in Europe and emerging markets.
A mitigating factor is a record amount of undeployed capital held by managers ($300 billion) and sovereign investors (undisclosed but believed to be, at least, comparable). However, new investments will need to meet stricter criteria with a focus on profitability, cash flows, strategic sectors, and longer holding periods. Since the global financial crisis, higher risk or more complex lending or trading moved into the opaque and less regulated shadow banking system -- non-bank financial institutions which include insurance companies, pension funds, mutual or hedge funds, family offices and speciality financiers. The Bank of International Settlements estimates its size at $227 trillion as at 2021, almost half the size of the global financial sector up from 42 percent in 2008.
Traditional banks are deeply embedded in the shadow banking sector through trading relationships, custody and clearing. Some are minority investors in these off-balance-sheet vehicles as well as arrangers of capital. Banks also provide leverage, often using derivative products or other off-balance sheet structures. Alternatively, they provide direct funding – 'lending to the lender' -- frequently backed by collateral. As the collapse of hedge fund Archegos illustrated, the extent to which it eliminates risk is debatable.
The position is reminiscent of 2000 when the dotcom bubble deflated and also 2008. On both occasions, private funds did not fully recognise or report impairments and were able to take advantage of liquidity fuelled recoveries. It is not clear whether the same will occur this time. An unpleasant revaluation shock in private markets and large write-downs are not impossible.
Under the terms of the UBS merger, Swiss Franc 16 billion ($17.3 billion) of Credit Suisse's Additional Tier 1 ("AT1") capital bonds were written off in their entirety. Around Swiss Franc 1 billion ($1.1 billion) of other capital was also written off. Retail and private banking clients globally, especially wealth management investors in Asia, hold significant quantities of complex, highly-engineered derivative-based products. Bought in search of yield during the prolonged period of low rates without a full understanding of the structure and review of the detailed documentation, potential losses could be significant.
After the Credit Suisse AT1 write-offs, the Financial Times published a primer of the structure which might have been useful to investors especially prior to purchase. The extensive use of derivatives to provide exposure to prices and leverage (especially via the ubiquitous carry trade where low-cost funding is used to purchase higher-returning investments) may prove another source of instability. At a minimum, higher volatility across all asset classes will create increased margin requirements triggering cash needs. A true stress test to the central counterparty ("CCP") system designed to reduce credit risk on derivative transactions is possible. Any malfunction would cause a major disruption for financial markets.
Euro-zone banks hold around €3 trillion ($3.2 trillion) of sovereign bonds, around 9 percent of total assets. A dislocation would set off the sovereign doom loop: Rating downgrades of a country result in falls in the value of government bonds held by banks who face calls for additional collateral draining liquidity from markets. The deterioration in a sovereign’s credit quality increases the amount of capital that banks must hold on certain transactions, not only with the sovereign but entities in that jurisdiction. Banks are forced to hedge this risk, usually by purchasing credit insurance on the sovereign or shorting government bonds exacerbating losses. Alternatively, they can use proxies, shorting equity indices, major stocks or the currency spreading losses and volatility into other asset markets. Correlation between major asset classes becomes unstable, especially in a risk-on risk-off trading environment. The increasing financial risk, higher funding costs and reduced market access of banks adversely affected by losses on government bond investments and the reduced ability of the government to provide emergency support sets off a chain reaction of actual losses in the inter-bank markets, requiring further hedging, compounding the spiral. Loss of trading liquidity, uniform rules, similar risk models and herding behaviour, where participants have similar positions and strategies, can prove additional accelerants. Individual Euro-zone nations' lack of independent monetary policy, fiscal capacity, currency flexibility and ability to monetise away debt would re-emerge as policy constraints. Any new debt crisis will expose simmering divisions between debt and inflation-phobic creditor and debtor nations.
The risk of unexpected trading losses and disorderly and uncontrolled liquidation cannot be discounted.
John Kenneth Galbraith in The Great Crash, 1929 described 'bezzle' -- theft where there is an often lengthy period of time between the crime and its discovery. The person robbed continues to feel richer since he does not know as yet of his loss. Bezzle, which increases under benign conditions, is only exposed by changes in the environment. Over the last decade, investors have been 'bezzle-d' by investments offering high returns which did not adequately compensate for the real risk that only emerges much later. If a major financial crisis develops, losses on these bezzle-based investments will impoverish investors. Ç
For the moment, financial markets are holding. But as one analyst of the 1929 crash observed: "Everyone was prepared to hold their ground, but the ground gave way."
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