Credit Suisse fallout: CoCo bondholders go loco

In their efforts to prevent contagion from the US regional banking crisis toppling Credit Suisse, the Swiss regulators have unwittingly spread contagion throughout the global financial banking system.

Other central banks – the European Central Bank, the Bank of England and the Canadian banking supervisor – all rushed to distance themselves from the decision by the Swiss financial regulator, Finma, to write down the value of Credit Suisse’s $US17.3 billion ($25.8 billion) of “additional tier one”, or AT1, bonds to zero.

Bondholders and shareholders aren’t happy with Credit Suisse’s “rescue” deal. Credit: Bloomberg

Those perpetual contingent convertible bonds, popularly known as CoCos, were a seemingly clever idea in response to the massive taxpayer-funded bank bailouts in Europe and the US during the 2008 financial crisis.

Bank regulators decided that banks needed to hold more total loss-absorbing capital – not just more equity, but debt that could be converted to equity in a crisis.

In Europe in particular, CoCos became popular as a form of “bail-in” capital that could be forcibly converted to equity if certain trigger events, generally related to capital adequacy ratios, occurred.

There’s an estimated $US275 billion of these CoCos on issue, with the bonds popular with investors searching for higher yields in what was, until relatively recently, an ultra-low-yield environment. Cheaper than equity and only redeemable at the issuer’s option, they have become a key element of banks’ total loss-absorbing capital, particularly in Europe.

In their hasty resolution of the liquidity crisis that enveloped Credit Suisse last week, and desperate to convince a reluctant UBS to acquire its domestic rival, the Swiss threw everything but the kitchen sink at the deal, offering the buyer $US100 billion of liquidity support, $US27 billion of cover for writedowns, litigation and restructuring costs, and a $US9.7 billion guarantee of any losses on non-core assets above $US5.4 billion.

They also decided to order the value of the $US17.3 billion of CoCo bonds to be written down to zero, even though shareholders are to be offered $US3.25 billion of equity in UBS. That upends the usual order of credit rankings, where bondholders rank ahead of shareholders.

Regulators were able to do that, it appears – there’s already a queue of investors and others lining up to litigate the issue – because the sale documents for Credit Suisse’s CoCo issues gave them the discretion to “zero” their value if it was deemed an essential requirement to prevent the bank from becoming insolvent, or if there had been extraordinary government support.

The Credit Suisse bonds gave Finma the explicit option of wiping out their value while maintaining some positive value for shareholders.

In most other jurisdictions, as Finma’s peers elsewhere in Europe, the UK and North America were quick to point out, total loss-absorbing capital would only be converted or written off after the common equity has been wiped out.

The way the ‘rescue’ of Credit Suisse was structured has deliberately blown up a lot of value, which is great for UBS and its shareholders, but an awful outcome for Credit Suisse’s investors.

Credit Suisse was suffering a liquidity crisis last week rather than a solvency issue. Its annual report, also issued last week, showed that at December 31 it had shareholder funds of almost $US50 billion and net tangible assets of about $US45 billion.

Until the weekend announcement of the terms of its rescue, its equity was valued by the sharemarket at about $US8 billion, and before the failure of several small US banks spread contagion, its market capitalisation was $US12 billion.

Thomas Jordan, the Swiss National Bank president, left, and Marlene Amstad, chairman of the Swiss Financial Market Supervisory Authority (FINMA), helped broker the deal that upset AT1 investors.Credit: Bloomberg

The Swiss regulators’ weekend deal with UBS therefore effectively created more than $US25 billion of extra equity value for UBS by evaporating the $US17.3 billion of liabilities, by zeroing the CoCos and valuing Credit Suisse’s equity at only $US3.25 billion. It is arguable that the Swiss have paid UBS handsomely to take Credit Suisse off their hands.

No wonder bondholders and shareholders – as the regulators’ actions have voided the requirement for a shareholder vote to approve the takeover – aren’t happy.

Indeed, the bondholders are livid that the Swiss have upended the natural order of creditors, even though it appears Credit Suisse had a significant buffer of common equity between them and a total loss.

Even a “bail-in,” or the forced conversion of their bonds to equity, would have offered a better outcome, and by switching $US17.3 billion of debt into $US17.2 billion of new equity would have been more in keeping with the role CoCos were intended to play in a crisis.

In Asia, where CoCos are popular with investors, the value of other additional tier-one bond issues was sold down heavily as investors reacted to the Swiss actions.

The scramble by other regulators to reassure their bondholders that they would never do what the Swiss did indicates they, too, are fearful of the implications for their markets and their banks.

In the near term, at least, the total losses experienced by Credit Suisse’s CoCo bondholders will shut down that market for bank issues and make investors nervous about all issues of AT1 bonds, regardless of regulators’ assurances.

Certainly, Swiss-based UBS – now certain to be even more intensely supervised and regulated by its home regulators – won’t be able to issue CoCos any time soon, and investors will pore over the detail in any future prospectus for any type of Swiss bank bond issue to see whether Finma has reserved the kinds of discretion that enabled it to decimate Credit Suisse investors.

Among Credit Suisse’s larger known CoCo holders are Pimco, reported to have more than $US800 million invested, Invesco ($US370 million) and BlackRock ($US113 million). They, and the hedge funds actively trading Credit Suisse’s debt last week with a conviction it had the capital to survive, have deep pockets to fund any litigation challenging Finma’s actions.

On the equity side, Credit Suisse’s biggest shareholder, with a 9.9 per cent stake, is Saudi National Bank. Saudi National has lost the best part of $US1 billion of the equity investment it made only last November as part of a capital raising designed to shore up Credit Suisse’s balance sheet. Qatar’s sovereign wealth fund also has a 6.8 per cent shareholding.

The way the “rescue” of Credit Suisse was structured has deliberately blown up a lot of value, which is great for UBS and its shareholders, but an awful outcome for Credit Suisse’s investors.

There was, at the point of their conception, a concern that CoCo’s and other AT1 securities might generate unintended consequences and could even ignite runs on banks, as, at the first signs of distress, investors scrambled to dump their holdings rather than expose themselves to a forced conversion into equity.

There were signs last week of that occurring, but there was also buying of CoCos by investors reassured by Credit Suisse’s capital position.

Now that the unthinkable has happened, there will be fewer buyers for what’s been demonstrated to be the highest-risk form of equity masquerading as debt with a better ranking - even if other regulators are essentially saying that Switzerland’s treatment of the bonds is unique. And those fewer buyers will dump their exposures at the first inkling of bank distress.

In an already nervous environment, that won’t enhance financial stability.

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