It’s Time For UBS To Take An Axe To Credit Suisse

(Bloomberg Opinion) -- The key number for UBS Group AG shareholders in its takeover of Credit Suisse Group AG wasn’t the $3.25 billion price or the $17 billion of junior bonds being wiped out, but a data point much easier to miss.

The number that showed just how good a bargain UBS got was the 74% jump in tangible book value per share it will record on the day the deal completes. If that sounds obscure, try this: Based on UBS’s valuation before the deal, its share price nowought to be almost 30 francs rather than Friday’s 17.26 francs.

UBS is trading at a huge and uncharacteristic discount to its prospective value for a string of reasons. All banks are getting hit right now by an inchoate fear of disaster looming. Also, UBS has lost its main attractions: Investors owned it as a relatively low-risk wealth manager that offered steady stock buybacks and dividends, as Flora Bocahut, analyst at Jefferies put it. It won’t be that again for several years — at least.  

But the really tricky question is how much of this cheaply bought book value will be lost by selling assets, cutting staff and litigation bills from Credit Suisse’s past bad behavior. By analyzing UBS’s likely plans and estimating costs and losses, I reckon more than half could get burned up. But that still leaves it with a huge gain on the deal.

First question: What will UBS keep? Wealth and asset management are set to stay mostly intact, although with some likely risk reduction and changes in how they are run. Iqbal Khan, UBS’s head of global wealth, has already gone to Asia to sweet talk the local Credit Suisse teams, which had been shedding senior bankers. Risk could be cut because Credit Suisse was more aggressive in lending to rich clients than UBS. That shows up in higher risk weighted assets compared with Credit Suisse’s total assets: It uses more capital per dollar on its balance sheet.

The domestic Swiss universal bank will also be kept. It was Credit Suisse’s most profitable and valuable business and in terms of risk it looks similar to UBS’s domestic bank. The Swiss government has said it is unconcerned about the effect on local competition of the consolidation. That attitude might not last — more than half of the population don’t like the tie-up — but for now changes should be minimal.

It is the investment bank where all the action — and the losses — will be. UBS has said very little, but the early indications are that it will keep many dealmakers and bankers focused on equity raising, especially in the US and in trendy industries like technology, pharmaceuticals and telecoms. It could also keep much of the American research teams too. Bankers in Asia and those who advise private equity firms could also be kept.

On the markets side, UBS could find much of the equity-trading business attractive, especially the electronic and algorithmic capabilities. It will have work to do to make up lost ground however. If these businesses had merged in 2019, the combined group would have been number four in the world by revenue, behind Morgan Stanley, Goldman Sachs Group Inc. and JPMorgan Chase & Co. Credit Suisse’s share has almost halved, partly because it ditched its business dealing with hedge funds in the wake of the Archegos disaster. Last year’s combined equity-trading revenue put them fifth, some way behind fourth-placed Bank of America Corp. UBS will need to get to the people involved in these areas and convince them to stay as quickly as possible – much like Khan is doing in Asia.

Fixed-income trading, which covers bonds, currencies and interest rates, will face the biggest cuts. UBS decimated its own fixed-income desks after 2008 as the main thrust of its move to a less risky, lower capital strategy and UBS Chairman Colm Kelleher made clear that this kind of risk reduction was what UBS would do.

The surprising thing I hear that UBS might want to keep is parts of Credit Suisse’s leveraged-finance business, which raises debt funding for private equity deals. It’s a high-risk, higher-return business where Credit Suisse long punched above its weight. The question is whether it can keep this given its target to cut risky assets from Credit Suisse’s balance sheet. Likely cuts elsewhere mean that it could easily fit within UBS’s desired balance sheet size.

When the deal closes, UBS wants its combined investment bank and trading arm to make up 25% of group risk-weighted assets and capital needs. Everything it doesn’t want will be sold as quickly as possible. To hit that target it needs to ditch at least $27 billion of risk-weighted assets, based on accounts for the end of 2022.   

Credit Suisse already agreed to sell most of its mortgage bond business to Apollo Global Management. If UBS gets Apollo to take the rest, the sale would clear $22 billion. The remaining markets business has $22 billion of risk-weighted assets: If all the bond and rates-related trading is also excluded, that should easily get UBS to its target. Credit Suisse also has $25 billion in its own non-core assets, which includes a lot of hard-to-sell long-term derivatives contracts that UBS said it wants to offload quickly.

Selling these unwanted assets quickly is where losses could come. We don’t have a detailed breakdown of Credit Suisse’s investment bank and trading positions, but assume based on the above that it sells 60% of assets at a 10% discount to their plain value (not risk-weighted), that could mean about $14 billion of losses.

Litigation is the other source of losses. Credit Suisse has a likely exposure of $1.2 billion from known lawsuits that it hasn’t provisioned for, according to Elliot Stein of Bloomberg Intelligence. Let’s be conservative and put that at $3 billion. Lastly, UBS wants to slash about $8 billion of costs from Credit Suisse, mainly with huge staff cuts. Assume it has to spend a dollar to save a dollar, not an unusual ratio, and that’s another $8 billion of upfront losses.

That all adds up to $25 billion of losses to take away from the 74% boost to tangible book value that we started with, which was equivalent to $42.4 billion. As a rough and ready calculation UBS book value per share would still increase by more than 27%. There are capital ratios to consider too, of course. Cut all these assets and take all these losses on day one and the combined bank’s common equity tier one capital ration would drop from just over 14% to 11% — that would be uncomfortably low for management, but is still ahead of UBS’s current minimum requirement of 10.3%.

There will be challenges and unforeseen costs along the way, no doubt, but there will also be continued strong profits and organic growth from the UBS side at least, so long as the integration doesn’t distract management too much. But the size of the gains UBS gets from this deal still look huge. Expect UBS to swing the axe brutally and quickly. It can afford to do so.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.

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