By Pam Martens and Russ Martens: October 18, 2022 ~

Credit Suisse presents a cautionary tale about creating so much innovation in the realm of credit derivatives that one gets named “Credit Derivatives House of the Year.” That award might sound like a good thing to traders who make their living cooking up and trading exotic derivatives but it might sound like a very bad thing to pension funds and mutual funds who own big chunks of the stock and bonds of that bank and remember how credit derivatives blew up much of Wall Street in 2008.

On September 28, Risk.net named Credit Suisse the “Credit Derivatives House of the Year.” Three businesses days later, Credit Suisse saw its own Credit Default Swaps blow out to more than 300 basis points and some of its own bonds trade at 63 cents on the dollar. Simultaneously, its shares traded at an intraday low of $3.70 in New York on October 3, closing at $4.01, and putting it in crisis management mode.

On the same day that its stock, bonds and Credit Default Swaps were exhibiting severe stress, Reuters decided to run an article in the early afternoon reminiscing on the serial scandals that have plagued the global bank: words like “cocaine,” “kickbacks,” “fraud,” and “spying,” reminded investment managers of just how voluminous and varied Credit Suisse’s scandals had been of late.

Losing billions of dollars on derivatives and being scandalized in news headlines is apparently no barrier to getting an award from Risk.net.

In late March and early April of last year, Credit Suisse lost $5.5 billion from the highly-leveraged, highly concentrated stock positions it was financing via tricked-up derivatives for Archegos Capital Management, the family office hedge fund of Sung Kook “Bill” Hwang. Archegos blew up on March 25, 2021 after it defaulted on margin calls to the banks financing its trades. (See our report: Archegos: Wall Street Was Effectively Giving 85 Percent Margin Loans on Concentrated Stock Positions – Thwarting the Fed’s Reg T and Its Own Margin Rules.)

To cover their backsides, the Board of Credit Suisse decided to hire the BigLaw firm, Paul, Weiss, Rifkind, Wharton & Garrison, to conduct an internal investigation of the matter. On July 29, 2021 Paul Weiss issued a 165-page report on its version of what happened. Paul Weiss found no fraud had occurred — just zombie risk management at a Global Systemically Important Bank (G-SIB). (We’re not sure if fraud might have been a less troubling determination.)

This is how the Paul Weiss report portrayed the zombie risk managers at Credit Suisse:

“The Archegos-related losses sustained by CS [Credit Suisse] are the result of a fundamental failure of management and controls in CS’s Investment Bank and, specifically, in its Prime Services business. The business was focused on maximizing short-term profits and failed to rein in and, indeed, enabled Archegos’s voracious risk-taking. There were numerous warning signals—including large, persistent limit breaches — indicating that Archegos’s concentrated, volatile, and severely under-margined swap positions posed potentially catastrophic risk to CS. Yet the business, from the in-business risk managers to the Global Head of Equities, as well as the risk function, failed to heed these signs, despite evidence that some individuals did raise concerns appropriately.”

And this:

“…a Prime Services business with a lackadaisical attitude towards risk and risk discipline; a lack of accountability for risk failures; risk systems that identified acute risks, which were systematically ignored by business and risk personnel; and a cultural unwillingness to engage in challenging discussions or to escalate matters posing grave economic and reputational risk. The Archegos matter directly calls into question the competence of the business and risk personnel who had all the information necessary to appreciate the magnitude and urgency of the Archegos risks, but failed at multiple junctures to take decisive and urgent action to address them.”

The report from Paul Weiss sounds very similar to the findings of the U.S. Senate’s Permanent Subcommittee on Investigations’ on how JPMorgan Chase dodged risk limits and lost more than $6 billion using bank depositors’ money to make high risk derivative trades in the London Whale scandal of 2012-2013. That 300-page report found the following:

“In the first three months of 2012, when the CIO [Chief Investment Office] breached all five of the major risk limits on the Synthetic Credit Portfolio [SCP], rather than divest itself of risky positions, JPMorgan Chase disregarded the warning signals and downplayed the SCP’s risk by allowing the CIO to raise the limits, change its risk evaluation models, and continue trading despite the red flags.”

And, of course, there were also the zombie risk managers at Morgan Stanley who allowed Howie Hubler to lose at least $9 billion on derivative trades following the 2007-2008 financial crisis. Bestselling author, Michael Lewis, wrote about Hubler’s losses in his book, The Big Short, describing Hubler as a star bond trader at Morgan Stanley, making as much as $25 million in one year. Hubler was one of the Wall Street traders who made early bets that lower-rated subprime bonds would fail. He used credit default swaps to make his bets. But because he had to pay out premiums on these bets until the collapse came, he placed $16 billion in other bets on higher-rated portions of the subprime market, according to Lewis. When those bets failed, Morgan Stanley lost at least $9 billion.

The really big problem in all this hubris is that Credit Suisse, JPMorgan Chase and Morgan Stanley are not just trading houses; each of these financial institutions accept deposits from the public. In the case of JPMorgan Chase and Morgan Stanley, their deposit-taking units are federally-insured and backstopped by the U.S. taxpayer. In the case of Credit Suisse, its New York branch accepts deposits, but they are not insured.

In the resolution plan for Credit Suisse that it filed with the Federal Reserve, it writes:

“Our New York Branch is not a member of, and its deposits are not insured by, the FDIC. CS’ biggest U.S. presence is through its broker-dealer related businesses. Typically broker-dealer activities are resolved with a rapid runoff of the businesses as long as the resolution strategy is supported by adequate operational capabilities, such as the ability to transfer client accounts to peer institutions while causing minimal disruptions to the broader financial markets.”

According to an historical timeline on the Credit Suisse website, it was previously known as Schweizerische Kreditanstalt, which was eventually shorted to SKA. The timeline notes that SKA’s New York Branch was granted a license to accept deposits in 1964.

Wall Street trading houses accepting uninsured deposits resulted in the banking crisis of the early 1930s when thousands of banks failed and people rushed to pull their money from uninsured banks. Congress passed the 1933 Glass-Steagall Act banning the combination of investment banks/brokerage firms with federally-insured banks. (Federal deposit insurance was also created under the Glass-Steagall Act to restore confidence in the U.S. banking system.) The Glass-Steagall Act served the nation well for 66 years until its repeal under the Bill Clinton administration in 1999, allowing trading firms to merge with federally-insured, deposit-taking banks. It took just nine years without Glass-Steagall for Wall Street to collapse in a replay of the crash of 1929.

It’s long past the time to restore Glass-Steagall and permanently separate the nation’s taxpayer-backstopped banks from the Wall Street casino.