Is this the Fed’s Catch-22?

Despite the Swiss National Bank announcing late on Wednesday that the “challenges faced by certain banks in the USA do not pose a direct risk of contagion in Swiss financial institutions” and that Credit Suisse will be provided with a liquidity backdrop if necessary, the Credit Suisse Credit Default Swaps (CDS), an indicator of uncertainty and fear among market participants, traded at record levels this week.

On the back of the volatility we are seeing in the Credit Suisse share price, the constant news headlines and jump in the Credit Suisse CDS levels, an analysis of CDS spreads across the banking universe may provide investors with useful insight into which banks the market believes are at higher risk of default.

Credit Default Swaps are derivative instruments that allow bond investors to transfer the risk of default to another party. Typically, the buyer (for example: fund managers and banks) of the CDS owns the underlying bond and pays a periodic fee to the seller (for example: large banks and insurance companies). The fee is determined by the CDS spread, which is set by the market, and the seller of the CDS agrees to pay the buyer a specified amount in the event that the bond issuer defaults.

Essentially, it provides credit investors with insurance against default.

This is best illustrated by way of an example.

Assume party A holds a R1 million five-year bond issued by company X. Party A wants to hedge their default risk so they buy a five-year CDS from party B. If, for example, the CDS spread is 350 basis points, then party A agrees to pay party B R35 000 (3.5% per R1 million), per annum until the contract expires. If the bond issuer fully defaults, party B will have to pay party A the full principal amount (R1 million); or if the issuer partially defaults, the seller of the CDS pays the holder the partial default amount.

Amid fears of a potential global banking crisis, not only did Credit Suisse’s share price plummet 32.3% between 10 March and 16 March, but the five-year CDS spread reached an all-time high of 983.66 basis points during intraday trading on 15 March, indicative of market participants’ increased demand for insurance against a default.

CDS spreads were pricing in a probability of default of 55.94% during the five-year life of the contract.

The increase was exacerbated by Saudi National Bank, which has a 9.88% shareholding in Credit Suisse, announcing it will not provide any further financial assistance partly due to regulatory restrictions. To put it into perspective, the five-year CDS spread was trading at less than 300 basis points on 13 March, with an implied default probability of approximately 22%.

The one-year CDS spread also reached a historical high of around 4 000 basis points, causing an inversion in the CDS curve, and an implied probability of default of 48.7% within a one-year period. The inversion indicates that market participants envisage default as imminent and as such it now costs significantly more for Credit Suisse bondholders to insure themselves against default risk in the shorter-term.

Credit Suisse is one of thirty-three banks that are part of the Basel Committee’s Systemically Important Banks list which, in the event of failure, is expected to trigger a wider financial crisis and threaten the entire banking system and global economy.

With the global banking system facing liquidity challenges, it is likely that CDS spreads will continue to trade at elevated levels, specifically for those banks that don’t have strong liquidity positions to withstand a run on the bank, or where they take significant interest rate risk in their longer-term bond portfolios.

Global banking scrutiny

The current global banking system is under increased scrutiny by the investor community following the Silicon Valley Bank failure and the desire for depositors to be saved.

Investors will no doubt tighten their examination of the funding mechanisms of banks and the status or stability of their longer-dated bond holdings, with a view to understanding whether positions have been hedged against weaker markets resulting from the unprecedented, aggressive rise in interest rates (specifically in the US).

Until recently, the US Federal Reserve (Fed) has indicated that, in order to combat relatively high inflation levels, the path of hiking rates would likely be continued. The outlook for the stability of the banking system may however change or halt this outcome for some time.

It is now expected, by some analysts, that the Fed may not hike rates at its upcoming meeting on 21-22 March 2023, compared with a previous expectation between a 25bp and 50bp hike.

It remains to be seen how the Fed will manage rates in an environment of elevated inflation and a banking system that may be in need of interest rate stability or relief. Is this the Fed’s Catch-22?

Antonio Senatore is an investment analyst at Cartesian Capital