Vikram Pandit is not the only bank CEO who is trying desperately to find that tricky balance between contraction and shareholder value; across the Atlantic, Europe’s banking giants also know that they must dismantle the financial-supermarket model. Shares of Union Bank of Switzerland (UBS), Credit Suisse (CS) and Deutsche Bank (DB) have been declining this week on earnings and balance sheet concerns; but short positions could still be worth 30%, from Wednesday opening levels, over a period of 3-6 months.
Citigroup (C) is in the process of charting a course to becoming a classic deposit-to-loan bank. And Deutsche will have to follow suit shortly. The problem UBS and Credit Suisse confront is that (a) a fair proportion of the traditional banking market in Switzerland is in the hands of cantonal institutions, and (b) their core asset management divisions are involved in a daily struggle to slow the tide of withdrawals.
On the surface, UBS and Credit Suisse represent a diversified-income profile; but when one digs deeper into their business models, it becomes apparent that core line items like trading profits, brokerage fees and underwriting commissions are heavily reliant on the vast international pools of money which both banks and, for that matter, the numerous Swiss private banks have accumulated since the end of the Second World War. When (not if) that money starts to move away from Zurich, Geneva and Lugano in a decisive manner through the course of 2009, UBS and Credit Suisse share prices will be due for another sharp downward adjustment, even below November lows.
As if to signal the beginning of an asset-outflow trend, a US court has declared former UBS asset management head, Raoul Weil, a fugitive from justice after finding that he assisted 17,000 Americans to “hide” $20 billion from tax authorities. By considered estimates, at least 40% of the foreign funds under Swiss management are derived from sources which require anonymity from tax officials in more than 50 jurisdictions around the world. Another 10% is contributed by corrupt politicians in Asia, Africa, South America and even Europe. “Swiss banks have benefited enormously from the hot-money factor,” a Vienna based private banker pointed out Wednesday. “This factor, which has never been properly recognized by the investing community, is going to come into play now as governments everywhere try to close revenue-related loopholes in their underground economies.”
Of course, it must be pointed out that Berne will not allow any of its big banks to fail. Together, UBS and Credit Suisse are responsible for 40% of total taxes paid by the banking sector, 40% of banking personnel, 40% of local banking transactions and 40% of earnings-related value. And the “40% factor” tells only the Swiss side of the story. While the wealth management divisions of UBS and Credit Suisse are significant contributors to a wide range of hedge funds and mutual funds (including emerging market funds), their investment bankers have been busy arranging loans for the transition economies of Eastern Europe. This short call on UBS and Credit Suisse is not predicated on default risk at maturity (as Standard & Poor’s likes to define it) but on a deteriorating earnings and equity-dilution profile.
Credit default swap spreads on UBS and Credit Suisse have tightened, from 200 bps-plus in late November to around 150 bps today. CDS spreads for Deutsche Bank have remained in the 120-140 bps range for nearly eight weeks. So, at first glance, investors can be misled by relatively low default risk perceptions; default risk for Italy and Greece, for example, trades at a much higher premium than Europe’s banking giants.
However, CDS indicators are no longer providing credible insights into share prices. Like with the domestic bailout targets being propped by Washington, one can safely assume that the Swiss government will do whatever it takes to keep its banks afloat. But government intervention does not translate into shareholder value, particularly in a climate which is exposing fundamental flaws in underlying business models.
Disclosure: Author holds short positions in C, UBS