Banking badly: What went wrong at Credit Suisse

Hopping off the train at a busy station in Sydney this week, legendary Australian investor and fund manager John Hempton is, surprisingly, not in the mood to brag about his prediction in 2021 that Swiss bank Credit Suisse’s huge appetite for risky investments would spark serious problems at the bank.

“I covered my short ages ago,” says Hempton, referring to his sharemarket bet that Credit Suisse’s shares would fall as the result of its loose investment protocols made by its even looser bankers. “It was clearly too early,” he adds.

“The problem [with Credit Suisse] is you had bankers who were overpaid and who confused their position with genius. The Swiss banks had great reputations, and then took immodest risks.

“The description in the public press is that they were accident-prone. And there was accident, after accident, after accident.”

This week, the injuries from those accidents finally killed off the once-great bank. Amid a run from depositors, Credit Suisse on Monday was forced by Swiss regulators into a shotgun marriage with its much bigger rival, Swiss bank UBS. Under the deal, many holders of bonds issued by the bank would be wiped out and shareholders’ value was drastically reduced. A brand built up over 166 years of banking is now likely to disappear.

The demise of one of the world’s biggest investment banks sparked fears of contagion in the global banking system. In the US, the increasing interest rate rises by its central bank were beginning to hurt the country’s swathe of smaller and specialised banks. In the past two weeks, Silicon Valley Bank has collapsed, the stressed Signature Bank has been forced into a merger, and another bank, First Republic, would begin its death throes.

While the collapse of Credit Suisse and the problems with America’s smaller banks may seem part of a broader malaise, they are more likely the victims of their own poor decisions.

The Suisse short

Back in his office at Bronte Capital in Bondi Junction, and in a less noisy environment, Hempton – who has made a career out of spotting undervalued good companies and overvalued bad companies – explains that he initially placed his short on Credit Suisse because of serious concern about the bank’s model and conduct.

“Old Fashioned Swiss banking had a bullet run through its head on September 11, 2001. After 9/11, you could not have banks that had utter secrecy because you might be laundering money for al-Qaeda. And so, there was an inevitable path after 9/11 by which banks gave up banking secrecy.

“There were two responses. One response was to shrink down to the reality of your new circumstance. The other response was the response bankers like to take, which is if you can’t make enough money, take more risks.”

Credit Suisse went hard into risk investing in a range of concentrated or shadowy businesses and effectively on-selling these investments to its rich client base. This included investments in Archegos Capital Management, a US hedge fund that had leveraged bets on a group of tech stocks; and Australia’s-own Greensill Capital, a group that provided funding support to other large companies. When returns were high, the customers were happy. But soon things started to go wrong. Investment after investment failed.

“Then two ‘accidents’ came once and those two were Archegos and Greensill. So Archegos cost Credit Suisse a shitload of money and after that they had to raise money. But Greensill cost Credit Suisse a shitload of reputation,” Hempton says.

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“The reason is that they had put all of their valuable clients in this cash management account, which they told everyone was low risk – and then they were exposed as idiots. Then, when Credit Suisse had to say in recent weeks that its deposits were low risk, the same rich people didn’t believe them. So you’ve got a run.”

It was the run in the end that killed a bank that had a huge reputation globally, particularly in Australia, where it had played a pivotal role in brokering major deals and providing top-tier wealth management to some of the country’s richest people. This week, Credit Suisse’s former Australian chairman, John O’Sullivan, described the collapse as a sad day for the investment banking giant.

“Credit Suisse [Australia] and its predecessor CSFB [Credit Suisse First Boston] was a fabulous force and a fabulous name in Australian investment banking. I’m very sorry for the really talented people who will suffer because of its global difficulties,” O’Sullivan says.

It’s a sentiment echoed by leading local fund manager Russel Pillemer, who cut his teeth at the bank’s Australian arm as a young trader.

“Nobody would have ever predicted this before, that UBS would eat Credit Suisse, and equity holders would get nothing out of it and some of the bondholders lost all their money. The notion that that could happen was totally unforeseen beforehand.”

The American problem

But Credit Suisse is only part of global banking’s problems right now. The US regional and specialised banking industry has also faced bank runs in recent weeks.

Hempton also recently shorted Signature Bank and Silicon Valley Bank after a closer look at both groups, but believes his positions were too small in retrospect.

While Silicon Valley Bank’s problems were foreseen by some in the market as early as January 19, when it released its quarterly result, if not before, its collapse was still a surprise to many in the market.

The bank specialised in providing services to start-ups all over America that traditional banking would often eschew. It was initially quite popular as it filled a gap in a growing market. And as the tech sector boomed in 2021 and 2022, so did the bank.

In a very short period, less than 12 months, the Silicon Valley Bank’s deposits jumped from $US60 billion ($89 billion) to more than $US200 billion. To make a bit of tidy cash on this huge increase in funds, it bought a host of longer-dated US government bonds to reap a higher return than it would by holding those deposits or buying shorter-dated bonds. It was a model that was stress tested for a 100-basis-point increase in rates. It was not designed to wear a 400-basis-point increase or more, as has been recorded in the US. Soon major depositors in the bank such as billionaire Peter Thiel were raising the alarm, inadvertently sparking another bank run.

“The way that Silicon Valley Bank blew up was by being too good. The truth is that they made a bad decision. The bad decision was to try and make money on deposits, as they always had in the past. But it was a bad decision that cost what was otherwise a very good bank.”

Pillemer, the chief executive of Pengana Capital Group, is keeping an eye on what impact the problems of America’s smaller banks have on the US banking system.

One of Pengana’s funds, the listed Pengana International Equities Fund, had a small exposure to Silicon Valley Bank representing less than 2 per cent of its investments.

“It will be interesting to see how it plays out in the US because it’s quite frequent in the US that small banks go under,” Pillemer says.

“Will the US stop any banks from going under now for the next while because they don’t want any contagion, or will they still let some smaller banks go under if they have been mismanaged?

“It ends up being this whole moral hazard issue. Because if you’re going to be protected by the government, you can do whatever you want.”

Sydney-based Peter Morgan, the former head of equities at Perpetual and now a private investor, says the ructions in US banking and the problems for the Swiss banking sector are signs of a shift in the economy.

“I think simplistically what you’re seeing in banking at the moment is very much a reflection of years of easy money from central banks – near-zero rates and [central bank stimulus known as quantitative easing, or] QE – and governments putting enormous amounts of money into the system to provide COVID relief, withdrawing,” says Morgan, who is travelling in the US.

“As rates have risen quickly and stimulus has reduced or stopped, the music has stopped somewhat.”

Safe as Australian houses

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Interest rates have also been rising here, but Pillemer says our banking sector is very different to that of the US.

“We’ve got a small number of banks here, [banking regulator] APRA ensures that our banks are well regulated, we’ve got a strong economy and the government has lots of firepower,” he says.

“The notion that an Australian bank would go under is an anathema to everybody in this market. I can’t see any circumstance under which an Australian bank would go under, it just makes no sense. APRA wouldn’t let it happen. The government wouldn’t let it happen.”

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