I didn’t expect Credit Suisse to go but it has now gone. In a “shotgun wedding” of the first order, UBS was dragged up the aisle and chained to CS with a bevy of regulators and Swiss National Bank officials as witnesses with their peers across the world shaking their hands and slapping their backs. Disaster averted! The most likely irreparable damage that has been done to credit markets in the process has been signalled by those who can see the profound implications of the way in which the rescue has been structured but of course that has happened in bond markets and most people will just stand there, shrug their shoulders and repeat the mantra “Oh, I don’t understand bonds”. The wiping out of the holders of Credit Suisse’s AT1 or Additional Tier 1 hybrid capital notes will mean little to almost anybody who has never dealt in them but this is to bond markets as seismic an event as the recent earthquake in Syria and Turkey was to its people.
AT1s, also known as Contingent Capital notes or cocos, were the idea of regulators in the aftermath of the GFC aimed at creating an additional layer of deeply subordinated debt instruments in which the holders would, in the event of a bank sinking into deep trouble, bear some of the capital risk. Prior to the GFC, there were in broad terms and by no means comprehensively five levels of unsecured capital. There was senior unsecured debt, senior subordinated in the form of Lower Tier II and Upper Tier II perpetual debt and then junior subordinated debt, known simply as Tier I. Below that came common equity. Moving down the scale, the risk borne by each level of investor increased with the equity investors holding the unlimited risk at the bottom of the capital structure. Everybody knows that dividends can be suspended. Coupon payments on Tier 1 debt can be too and is therefore known as non-cumulative. If coupons are not paid, they’re gone. On Upper Tier II coupons can also be suspended but they are cumulative which means that they will still have to be settled at some time in the future. On Lower Tier II or Senior Unsecured bonds, a non-payment of the coupon triggers an automatic default as does the failure to repay capital on any one of the four levels of debt is, as and when it falls due. During the GFC, banks had to be propped up with public money in order to insure the timely payments of interest and principal, lest the institutions in question would have fallen into default.
There was, and not entirely without justification, much moaning and wailing and gnashing of teeth that the banks had to be bailed out at all cost and that bondholders had therefore in essence escaped the disaster scot-free. So, to counter the process of bailing out, the concept of bailing in was devised. There should be bonds which would permit a non-repayment of not only coupon but also principal without a default being triggered. This was known as hybrid capital which could, depending on the bank’s circumstances, be treated as either debt or equity. It would be at the bank’s discretion to repay the debt at maturity or, if necessary, to convert it into equity. And somewhere in the small print was enshrined a much overlooked or maybe disregarded to option not to repay it at all.
I very well remember the debate at the time and my own thoughts on the subject being reprinted in the International Financing Review. Every risk has a price but unlimited risk has no price at all. That was of course a lesson learnt incredibly painfully by Lloyds names as they found themselves lumbered with unlimited personal liability during the scandal surrounding historic asbestos claims. The spread offered on AT1 bonds – often referred to amongst the cognoscenti as “81s”- appeared to be generous and after a somewhat stuttering start the market took off. Currently, there are around US$ 275 billion in the market. It is an irony of history that the first bank to issue an AT1 was indeed none other Credit Suisse. The wipe-out will take down roughly US$ 17.5 bn of CS AT1s.
But we have a problem. As deeply subordinated as the AT1 hybrid debt is, it stands one level above common equity and the decision to put equity holders above AT1 holders upends the capital structure and flies in the face of every single rule of both accounting and bankruptcy practice. As of yesterday, and at what appears to be the whim of regulators, bondholders’ interests can be placed below that of shareholders which in turn renders the lower end of a bank’s capital structure fluid, opaque and essentially impossible to price correctly. The rescue of Credit Suisse has created clarity on an idiosyncratic front but has also brought huge uncertainty and unpredictability on a more general one.
Hybrid capital notes are the bond markets’ new equivalent of Schrodinger’s cat. They are neither debt nor equity while being both at the same time. They have become an asset class with unpredictable risks embedded in them and when the risk can’t be established, neither can a fair price. It is quite likely that this week will begin with a significant reassessment of the risk carried in hybrid capital positions, many of them held in funds specialised in the asset class, and with a massive downgrade in the price of the bonds. That said, markets have notoriously short memories and although the new equilibrium price will surely be a lot lower than the one we saw on Friday, it will most probably be higher than where bonds will be traded today.
I am in a way reminded of the day in 1986 – or was it 1987 – when the BIS ruled that perpetual subordinated bank debt could no longer be held with a 20% capital weighting but that it had to be backed at 100%. A game of pass the parcel between Japanese banks which were swapping perpetual debt to bolster their capital ratios was suddenly brought to a close and the bonds which will run in perpetuity lost as much as 70% of their capital value. For the following 20 years “perp” was a dirty word.
When contingent capital was first proposed by the banking authorities, the concept of undermining the principle that debt was debt and equity was equity and that a bond could be issued that overrode the axiom that failing to repay principal would trigger a default was as good as unthinkable. But the GFC had enforced the cleaning up of banking, the reassessment of how risk was reported and the stress tests imposed by the regulatory authorities must surely guarantee that even risky hybrid capital as represented by AT1s were money good. Ooops, that’s just gone up in smoke.
At the end of January, Credit Suisse’s market cap was still US$ 14 bn. On Friday at the close it was US$ 8.3 bn. Yesterday, UBS agreed to pay CHF 3 bn or US$ 3.2 bn for the bank at the same time as writing to zero CHF 16 bn or US$ 14.7 bn of bond debt. So, in fact it is being paid over US$ 3 bn to take over CS. Bond holders are crying “Foul!” and I suspect the last word has not yet been spoken. Forget not that JP Morgan initially bought the failing Bear Stearns at a headline price of US$ 2.00/share, although by the time the dust had settled, the price had had to be increased to a more realistic US$ 10.00/share. That said, by the time JPM had paid all the fines that had accrued on the back of some the Bear’s less salubrious practices, Morgan’s shareholders most probably wished the US$ 2.00 price tag had stuck. Bank of America was stupid enough to pay US$ 50 bn for Merrill Lynch which was rapidly heading the way of Bear Stearns and maybe even Lehman Brothers and it too spent years paying billions fines for Merrill’s many misdeeds along with those attributed to the business of Nationwide which it had also acquired, pretty much sight unseen. I have of course not seen the details of the takeover agreement – none of us ever will – but I suspect UBS will have been smart enough to have negotiated immunity, should any criminal nasties emerge from the vaults of Credit Suisse’s headquarters on the Paradeplatz in Zurich.
Over the weekend there has been much correspondence on the subject, much of which I’d love to share but have decided against. There remains, however, one piece from a long time Credit Suisse employee who contributed the following “Thought of the day: I left SBC 6 months before the merger with UBS. Several years later I left Credit Suisse, 13 years before the takeover by UBS. Do you think I should join UBS and finish the job?”
Markets fear that although the story of Credit Suisse and its travails is much older than the recent inversion of the yield curve, that the troubles in America which embroiled SVB and First Republic, not to mention Silvergate Bank and Signature Bank, might be just the tip of the iceberg. The Fed has rushed to the rescue and has opened up swap lines in order to increase US dollar liquidity on a global scale. In the background, however, I was made aware of an article by the controversial writer Paul Sperry in which he wondered what the San Francisco Fed and its boss Mary Daly had been doing whilst its local banks were busily impaling themselves? If Sperry’s observations are to be believed, Ms Daly, a decided dove, was more interested in BLM and gender rights than in fighting inflation and keeping a sharp eye on the performance of regional banks within her bailiwick. In other words, the San Francisco didn’t drop the ball; it never even picked it up.
The same might be said about the Swiss regulators. It’s not as though they had that many systemically important banks to look after. I think the number might have been just about two. Credit Suisse has been struggling for years and yet its position has done nothing other than to deteriorate since, as I suggested on Friday, the 1997 reverse takeover of UBS by Swiss Bank Corporation. There is a term in Swiss German which is “süffisant” which translates roughly as “self-satisfied”. The Swiss do that in spades. The way in which the incomparable Swissair came to grief in its takeover of Sabena, that dreadful Belgian airline, was a case in point. Whatever is the airline equivalent of Gresham’s Law took hold and Swissair went to the wall. If you are Swiss and you have grown up with all the world admiring you, it’s easy to fall into the trap of believing in your own infallibility. That said, Credit Suisse’s domestic banking network – in the past I was a client myself – is amazingly comprehensive, efficient and profitable. UBS has been handed a bargain.
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