- The news of the merger between UBS and Credit Suisse shook the world of finance over the weekend.
- Bondholders are the first to jump in anger against the measures related to the takeover.
- Nearly $17 billion in the form of bonds were wiped out by government decree.
A recent paper reviewed the consequences of the fall of Credit Suisse, which was expressed in the takeover by UBS. At that time, several points linked to the event that could negatively affect the environment were touched upon. However, a new issue started to gain interest and it is related to the so-called Additional Tier 1 or AT1 bonds.
This type of bond is held as a form of subordinated debt investment with a relative level of risk. The latter explains why their yield capacity is considerably high, allowing these products to be among the favorites of institutional investors.
It should not be lost sight of the fact that these are exactly the same as contingent convertibles (CoCo). This name derives from the fact that they can be converted into equity or redeemed. In other words, that their value can be brought to zero under certain scenarios and circumstances. This is precisely what happened with the merger of the two Swiss banks.
The purchase agreement included zeroing out Credit Suisse’s CoCos, which was endorsed by the regulatory institution, FINMA. The result of this was the disappearance of a Swiss franc equivalent of $17 billion. But the negative balance goes far beyond that.
The AT1 bond crisis
The collapse of the capital of investors holding Credit Suisse AT1 bonds is not an internal phenomenon of the institution. It transcends its borders, since this form of investment exists with almost identical characteristics in other banks in Europe and the United States. As a result, billions could flow out of this form of investment, further damaging the battered banking sector.
It is important to note that the market for such bonds panicked this week, particularly in Europe. In addition, regulators in the EU (to which Switzerland does not belong) are distancing themselves from FINMA. They are trying to keep investors calm and avoid a massive debt sell-off, which could have serious consequences.
CoCo bonds were born in 2008 in the aftermath of the financial crisis of that year. At the time, regulators were doing their utmost to ward off the risks that were threatening taxpayers. At the same time, the aim was to increase banks’ capital so that they would not collapse again during future crises.
At that time, regulators in Europe established frameworks that demarcated the boundaries of all investments in banks. In that sense, they sought to create a balance between assets from equity investments, AT1 bonds and other debts.
But in the current case of Credit Suisse, the steps taken in the merger agreement were out of the book. That was noticeable in the fact that shareholders would receive loss-limiting support, but CoCo debt holders would not.
The bank Goldman Sachs called this move “unusual” and considered it a situation of subordination of bondholders to shareholders.
Why are AT1 bonds so attractive?
This type of debt issued by banks enjoys great popularity among institutional investors thanks to its yield. As the books dictate, it is an investment where risk is offset by returns. Although the very nature of these bonds implies that they can be written down to zero, cases have been rare since their inception.
One of the most talked-about precedents for automatic AT1 liquidation dates back to 2017 with Spain’s Banco Popular during its sale to Santander.
With the current precedent set by Credit Suisse, investors are starting to notice how dangerous AT1s can be. As such, this scenario would change the view on these investments forever and the level of confidence in them would inevitably drop. To get an idea of how well these investments performed, it should be noted that some of them offered a yield of up to 10%.
The investment was considered one of the most profitable and the risks were embodied only in theories and unlikely assumptions. The problem for bondholders is that these assumptions were precisely the ones that came true. Until a few weeks ago, there was no better safe haven than the debt of a bank of this size, even side by side with Treasury bonds.
With the current reality it is clear that no one is safe, which generates a climate of concern that could end badly. In other words, investors could turn their capital into assets other than AT1 bonds, which would increase the banks’ liquidity crisis. The fact of having lost everything can only be equated with the fall of some cryptocurrencies such as Terra’s LUNA and UST almost a year ago.
From this Credit Suisse wreck no one came out of it well. For example, the bank’s board had to liquidate it at a price 60% below the bank’s value during Friday’s close (two days before the sale). Shareholders received just 0.76 francs in UBS shares for each Credit Suisse share, valued at 1.86 francs. However, this does not compare to the situation for bondholders.
The reaction of CoCo debt holders
As might be expected, investors in this type of asset were not going to stand by and watch passively as they lost $17 billion. Consequently, as soon as the move to zero AT1s became known, the reaction of debt holders began. Although erasing the value of these bonds is a possibility, it applies under certain conditions, as mentioned at the beginning.
In the Credit Suisse case, redemption would occur in the event of bankruptcy. However, this was not the case, judging by the purchase and sale agreement announced by the authorities and the directors of the two banks involved. Under that argument, AT1 investors announced the possibility of taking legal action against the institution and the regulators. Thus, since the bank did not fail, its bonds should have remained.
According to the CNBC portal, a famous law firm in San Francisco, United States, would have begun this task as of Monday. Specifically, it would be Quinn Emanuel Urquhart & Sullivan, which was in the process of teaming up with a “multi-jurisdictional team of lawyers from Switzerland, the United States and the United Kingdom”. They would work closely with investors in Credit Suisse’s AT1 bonds.
By acting in the way they did, regulators would have targeted a particular asset and created risk across an entire international market, they argue. Some bondholders consulted in the same media say they are ready to join the possible lawsuit.
An important aspect of this issue concerns the Swiss National Bank’s backing of UBS in the event of lawsuits or fines arising from the deal. That backing would amount to approximately $9 billion, while AT1 bondholders lost close to $17 billion.
EU financial authorities came out swinging
In a desperate attempt to calm investors in this particular asset class, European authorities were quick to speak out. In a recent statement they recalled that Switzerland and its regulatory authorities are not part of the EU. Therefore, the measure announced by FINMA has nothing to do with those that the Eurozone would take in a similar case.
The communiqué was signed jointly by the ECB’s Banking Supervisory Authority, the Single Resolution Board (SRB) and the European Banking Authority (EBA). In it they were emphatic:
“In particular, common equity instruments are the first to absorb losses, and only after full utilization would it be necessary to write down additional Tier 1 capital.”
With this, European financial policymakers implied that Swiss regulators acted backwards. For them, the backstop should have focused on AT1 bondholders over shareholders:
“That approach has been consistently applied in previous cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions. Additional Tier 1 capital is, and will remain, an important component of the capital structure of European banks.”
One of the injured parties, David Benamou, a bondholder and executive at the firm Axiom Alternative Investment, said that this move by FINMA was no accident. For the investor, the weight of the shareholders motivated the regulators to give preference to them instead of the AT1 bondholders. “It is the only logical explanation,” he told CNBC. Major shareholders include Saudi National Bank, with 9.9% of the shares, and Qatar Investment Authority with 6.8%.
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