Credit Suisse bites the bullet. It’s not enough

Paul J. Davies

Credit Suisse Group AG finally bit the bullet. A properly radical transformation is on the way. It will shut down, sell or spin off most of its investment bank and become a more focused international wealth and asset manager with some trading capabilities attached to a traditional Swiss bank.

The new leadership of Chairman Axel Lehmann and Chief Executive Officer Ulrich Koerner defied the skeptics – like me – with their appetite for change after years of previous managements fiddling around the edges. That’s the good news.

Tougher for investors to swallow is the cost of the revolution. The damage done to its business by months of uncertainty has seen it shed revenue and assets, especially in the third quarter, which it reported on Thursday, and after a social-media storm exaggerating risks of its potential failure this month.

This left it unable to avoid a $4 billion share sale at a painfully low valuation. Existing shareholders will have their ownership diluted by up to 30%, according to an initial estimate from Citigroup Inc. analysts.

More disappointing is how little profit its brutal overhaul will produce. By 2025, Credit Suisse expects to generate a return on tangible equity of just 6%. It ought to be an iron law of management that you under-promise and over-deliver, especially for high-risk projects. But this is setting the bar so low that it raises real concerns about what Credit Suisse’s executives see as even the best case. It’s no wonder the shares dropped by as much as 16% on Thursday morning.

And this project is high risk. A lot needs to go right. The bank is starting from a bad place: It reported losses of $4 billion in the third quarter, including a $3.7 billion writeoff of deferred tax assets, $180 million of litigation provisions and nearly $100 million of operating losses. Deferred tax assets are discounts to future tax bills on future profits that it could claim because of past losses. But the bank won’t ever make these profits because it is quitting the businesses they would come from.

A chunk of these cut into the bank’s equity and, along with the other losses, its main capital ratio fell in the third quarter from a healthy 13.5% to an anaemic 12.6%.

Further charges and losses are likely in the fourth quarter, including the first $300 million or so of $2.9 billion worth of restructuring costs over the next three years to cover staff cuts, and impairments to software and real estate.

The share sale that management wanted to avoid will be partly funded by new strategic investors, led by Saudi National Bank, while existing shareholders will be offered rights to buy the rest. That will get it back to a 14% capital ratio before the expected fourth-quarter losses.

As costly as this is, it is probably the easy part. The bank still has to cut large parts of its markets business. Selling its securitized products business to Apollo Global Management Inc. and Pacific Investment Management Co. could release about $3 billion of capital. Turning exclusive talks into a deal quickly would be a huge boost, but nothing is signed.

ext, a bunch of emerging markets and European loans and the remnants of its prime brokerage, which lends to hedge funds, will be added to a non-core unit. Shedding or running down these positions is riskier in terms of timing and costs, but the bank hopes they will release another $2.5 billion of capital by 2025. Lastly, there are other bits and bobs to be sold, including things like its trophy hotel in Zurich and its stake in SIX Group, which runs the Swiss stock exchange. Those could bring in another $1.4 billion of capital.

There’s a lot of “coulds” and “maybes” in there, which makes investors nervous. The final piece is to recreate a CS First Boston investment bank to advise executives, entrepreneurs and private equity firms on deals, leveraged finance and capital raising. Credit Suisse said it already has one big investor interested in taking a stake. Credit Suisse might list CS First Boston on a stock exchange and maybe sell its initial majority stake down to a minority over time.

If this works, eventually Credit Suisse will have much less of its own capital in this unit, and won’t have to fund its balance sheet either. But this is the most far-out part of the project, and it is complicated by the idea that Credit Suisse wants to keep using CS First Boston as the main adviser for its biggest clients.

All the uncertainty that existed about what Credit Suisse might do to repair and renew itself has been replaced by the uncertainty about whether it can achieve any of this. The bank remains a bet for investors with a big appetite for risk.

Koerner said investors should think about CSFB as “a journey.” Right now, the whole project still looks a bit like a Grail Quest.

—Bloomberg