Solve one problem; create another one.
While the news of UBS Group AG’s takeover of Credit Suisse brought an end to some worries that financial markets would go into Monday without some deal to rescue a bank regulators had called systemically important to the global financial system, the terms of the deal have already started to send shock waves through the bond and derivative markets.
The deal, which sees UBS buying its smaller Swiss competitor for $3.25 billion ($3 billion Swiss francs) does indeed end one part of the financial crisis. The price is less than half the 7.4 billion francs Credit Swiss was worth in Friday trading. (If you have a memory that stretches back 15 years or so, you’ll remember that the Swiss government had to step in to bail out UBS at taxpayer expense.)
But the deal involves a huge write-down in the AT1 bonds of Credit Suisse, wiping out about 16 billion Swiss francs ($17 billion) of this class of high-risk debt. And that’s where this deal gets tricky for the financial markets.
Additional Tier 1 (AT1) bonds. also known as contingent convertible bonds, or CoCos, were created after the Euro debt crisis as a way to bolster bank capital to meet requirements intended to prevent a bank failure that would require a taxpayer-funded bailout. AT1 bonds are the lowest rung of bank debt and investors in CoCos are intended to be among the first to feel pain when a bank gets into really, really bad trouble.
“Among the first” is critical here. In a normal writedown holders of equity shares get wiped out before holders of AT1 bonds. But because the UBS purchase required so much government support, it will trigger a complete write-down of the AT1 bones in order to increase core capital. Holders of the AT1 bonds are angry since they were counting on the traditional seniority of their CoCo bonds to equity shares. Under the terms of this deal, however, Credit Suisse shareholders are set to receive 3 billion francs. Sure, they’ll take a huge loss but the idea that they recover anything while holders of AT1 bonds get wiped out is likely to lead investors who hold AT1 bonds to rethink their holdings of the CoCos of other banks.
And maybe sell them.
Which could be a big deal. The market for AT1 bonds is big. BIG. How big? How about $275 billion big?
The Credit Suisse write-down is by far the biggest ever to hit this market, dwarfing the 1.35 billion euro loss when Spain’s Banco Popular was absorbed by Banco Santander in 2017.
And it’s not like the CoCo market hasn’t been a bit stressed lately with the average AT1 bond priced at just about 82% of face value. That’s one of the steepest discounts on record.
So what effect does all this have on what is increasingly a global banking crisis? It will sure make it harder for stressed banks to raise capital. In the immediate aftermath of the deal, some traders were saying that the AT1 market is now effectively closed for new fundraising. Not exactly what the global banking system needs at this point.
And you can expect traders to be looking to see what investors got hit hardest by the CoCo write-down. Another search will be underway to see what other banks have issued CoCos with terms that might lead to a write-down if the markets turn nastier. And there will be a lot of speculation about which national bank regulators would be likely to follow the Swiss lead and put equity holders ahead of this class of bondholders.
Oh, and the lawyers will be busy preparing suits to challenge the Swiss move. It’s probably legal, but hey, why not challenge?
All in all, the markets for risk capital just got more confusing and riskier with this deal.
