CSGKF - UBS: Why The Market Is Right To Be Cautious

2023-03-27 13:11:23 ET

Summary

• After an early burst of volatility, UBS shares are flat compared to before the Credit Suisse merger announcement.
• This matches my early view that nobody is out of the woods yet.
• Given the enormous implications - and largely bullish investors - this seems a bit odd.
• Here are some possible reasons why the market remains cautious.

Huge news, zero effect

Last weekend started with clear indications that UBS ( UBS ) would merge with its troubled competitor Credit Suisse ( CS ) ( CSGKF ), and on Sunday evening we got the announcement. I covered the story in an article which concluded that UBS was not the screaming buy the majority of other analysts here were seeing, but merely a Hold.

My position is rather isolated on this site. After all, UBS itself projects a TBV increase of 74% on day one and huge cost synergies. Its AUM will balloon, and it will get rid of a strong competitor in Switzerland and abroad.

Yet the market so far seems to agree with me, as the stock - after an initial burst of volatility - is simply flat.

This seems odd, but in my opinion, the question still remains: How much cheese will UBS get besides the holes?

In this article, I will propose some of the key reasons for further caution.

AT1 bonds

One week ago, I already mentioned the surprising "appropriation" of Credit Suisse's AT1 bonds. While the Swiss regulator FINMA apparently had the right to wipe out these bonds in the event of a state guarantee for Credit Suisse, given the large CHF 16B sum involved, you can always try to get some of it back. Lawyers are already looking for a way, and some specialized hedge funds are loading up on these loans, hoping for a large payback. So there is a possibility that UBS might actually have to render some of this money in the future.

New regulations

No large banking crisis ends without a call for stricter regulations and stronger capital requirements. While this banking crisis has just started, Switzerland already wants to discuss a better framework for dealing with troubled international, systemic relevant banks. The public is tired of dealing with greedy "banksters". Hence, while no bank has ever been entitled to a robust ROE, achieving it might get even harder (or riskier ) going forward. The 74% TBV increase might be worth a lot less.

It's politics, stupid

When a large Swiss bank fails, it is not like a U.S. bank getting into trouble - the entire country of Switzerland is involved and thus the matter immediately becomes deeply political. As CNN points out :

At roughly $1.7 trillion, the combined assets of the new entity amount to double the size of Switzerland's annual economic output. … At 333 billion francs ($363 billion), local deposits in the new entity equal 45% of GDP - an enormous amount even for a country with healthy public finances and low levels of debt. … The two banks collectively employ more than 37,000 people in the country, about 18% of the financial sector's workforce, and there is bound to be overlap. … UBS now has "quasi-monopoly power," which could increase the cost of banking services in the country.

About $6.5B out of the projected $8.9 total synergies will come from job cuts.

In last week's early assessment, I had already highlighted a rather harsh commentary by Swiss pundits.

Investors have to consider that no final agreement has been signed yet, and the devil will likely be in the detail. While UBS certainly has some bargaining power, it also knows that letting this deal fail is not an option. UBS itself would get into deep trouble if the Swiss financial marketplace suffered even more reputational damage than it already has. This lets me conclude that from now politicians will be in the driver's seat.

In fact, one week after the initial deal announcement, Swiss authorities have already put some stakes in the ground : They are exploring how to make current Credit Suisse managers responsible for their failures. Moreover, and most importantly, the Swiss finance minister also reflected on the possibility of merger-related losses exceeding the CHF 9B limit:

...then one would have to talk to UBS not only about the loss, but about profit sharing as well. Because UBS securities could later yield profits again.

Let that sink in.

You can drown in a river deep just a few dozen inches on average

I guess very few investors doubt that ten years from now, UBS will still be a strong bank. It is by far the most likely outcome. Yet, many things can happen until then.

For example, if some hidden skeletons emerged from Credit Suisse's closets and the impact was similar to Archegos or Greensill , UBS shares would suffer heavily. Suddenly, UBS would need to pay out the first loss allowance of CHF 5B built into the deal and maybe eat into the 50/50 shared state guarantee of CHF 9B. - Could Switzerland really afford to let this issue run wild? Wouldn't the country need to immediately build up a firewall around UBS?

From now on, even more than ever, UBS is Switzerland. Since a bailout using taxpayer money would be extremely unpopular, if necessary, the country would likely not simply lend money or issue guarantees, but inject equity to assure financial markets and basically take over the bank. Yet the dilution would probably be massive to current shareholders.

A few years later, UBS would probably be ok, while today's shareholders hoping for a huge windfall from the Credit Suisse "shotgun wedding" would be disappointed. Much or all of the 74% TBV increase might have been diluted by then.

Investors are well-advised to keep in mind what Arturo Bris, a Professor of Finance at Swiss business school IMD, has to say :

One of the most established facts in academic research is that bank mergers hardly ever work.

Shotgun weddings probably even less. This notion is clearly at least partially factored into today's share price of UBS.

What I miss in today's discussion

One of the key differences between professional and retail investors is that the pros think probabilistically :

The ability to think probabilistically is important for many reasons. Lack of it makes one prone to a variety of irrational fears and vulnerable to scams designed to exploit probabilistic naïveté, precludes intelligent assessment of risks, ensures the operation of several common biases, impairs decision making under uncertainty, facilitates the misinterpretation of statistical information, precludes critical evaluation of likelihood claims, and generally undercuts rational thinking in numerous ways.

Once we have figured out the key issues affecting the likely outcome of a UBS investment, we understand how unpredictable it is. We also see that it is not enough to see the enormous opportunities offered by this merger - a thorough understanding of the potential paths to success or failure is paramount.

To some extent, UBS' situation is similar to that of a traveler getting thrown out of a taxi in the middle of the night and in a horribly dangerous neighborhood - and with five suitcases full of money.

Ironically, it might be the sheer amount of money that gets him into trouble.

If he manages to reach a safe place fast, this will just have been a short-lived headache. Unfortunately, for UBS, there is no getting to a safe place fast. The night will be long and dark, and the neighborhood doesn't look like it is improving. So good luck.

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