avatarWilliam Troyaux

Summary

UBS's takeover of Credit Suisse resulted in a significant loss for AT1 bondholders, who faced a $17 billion write-off, while UBS emerged as the sole winner with government support.

Abstract

In a high-stakes financial maneuver, UBS agreed to acquire Credit Suisse for 3.2 billion, a deal orchestrated to prevent a wider banking crisis. The transaction involved a controversial decision to write off 17 billion of Credit Suisse's Additional Tier 1 (AT1) bonds, leaving their holders as the primary financial casualties. This move, sanctioned by the Swiss regulator FINMA, was intended to absorb losses and stabilize the bank, utilizing the loss-absorbing feature of Contingent Convertible Bonds (CoCos), a post-2008 financial crisis instrument designed to bolster bank capital ratios. The write-off has raised questions about the future attractiveness of CoCos to investors and the ability of banks to issue them to raise AT1 capital. Notably, the typical repayment hierarchy, which prioritizes bondholders over shareholders in loss absorption, was reversed in this case, leading to criticism of the rescue's execution. Despite the turmoil, UBS stands to benefit from the acquisition, with financial support from the Swiss government and the Swiss National Bank, and plans to cut costs and solidify its market dominance in Switzerland.

Opinions

  • The Swiss Finance Minister, Karin Keller-Sutter, and economist Mohamed El-Erian, have differing views on whether the transaction constituted a bailout.
  • There is an opinion that the CoCos bonds issued by Credit Suisse fulfilled their intended purpose by absorbing losses, despite the significant financial hit to bondholders.
  • The decision to prioritize shareholders over AT1 bondholders in the loss-absorption process is seen as an error and a deviation from standard practice.
  • The rescue operation's handling may lead to increased investor caution and demand for higher returns on CoCos bonds in the future, potentially affecting European banks' ability to raise AT1 capital.
  • The author suggests that the only winner in this situation is UBS, which secured substantial financial support and stands to gain from cost reductions and market dominance post-acquisition.

AT1 bondholders: the major losers of the Credit Suisse takeover

Picture from Claudio Schwarz (unsplash.com)

“This is no bailout. This is a commercial solution because UBS is taking over Credit Suisse” Karin Keller-Sutter Swiss Finance Minister

“Yes, it was a bailout.” Mohamed El-Erian on Bloomberg Surveillance

On Sunday evening, UBS announced its $3.2 billion (3 billion Swiss francs) rescue plan to take over Credit Suisse.

Bail-in or Bail-out? This is a last-resort transaction characterized by both a bail-in from bond investors and shareholders and a bail-out from the Swiss National Bank and the Swiss government.

Bond investors or Additional Tier1 Bond Holders are the main losers of this rescue plan.

These investors lost their entire investment in the perpetual bonds issued by Credit Suisse, a $17 billion loss…

To be simple, in order to raise Additional Tier 1 (AT1), financial institutions are authorized to issue perpetual debt instruments such as Contingent Convertible Bonds (CoCos Bonds).

As the name implies, Contingent Convertible Bonds are convertible bonds with specific characteristics:

· On the one hand, banks use Contingent Convertible Bonds as a means of absorbing losses while raising AT1 capital in order to meet the capital requirements ratios of the Basel regulation;

· On the other hand, these bonds are risky to investors and characterized by a higher yield than traditional bonds.

CoCos bonds were created in Europe following the 2008 financial crisis to allow European financial institutions to easily raise capital to meet the Tier 1 regulatory ratio. CoCos bonds are debt instruments useful to undercapitalized financial institutions and limit the spread of a new systemic financial crisis by absorbing losses.

There are several options available to financial institutions with difficulties, such as Credit Suisse:

· Either the CoCos bonds issued by the bank are converted into shares (thus improving its capital ratio by removing the bond debt from the balance sheet) whose price and conversion methods (number of bonds against a share) are previously defined;

· Either the bank’s bond debt (CoCos bonds) is totally written off.

That’s what happened to Credit Suisse. FINMA (Swiss regulator) announced on Sunday evening the write-off of the $17 billion CoCos bonds issued by Credit Suisse.

That’s why CoCos bond yields are higher than traditional bonds. Investors purchase these bonds to collect higher yields, hoping they will one day be repaid by the issuer of the bond loan. However, if a financial institution is struggling, then the financial institution may suspend the payment of interest on the CoCos bonds and require a conversion to stock or write the debt down to zero.

The conversion into shares or the write-off of CoCos Bonds to absorb losses depends on one or more triggering events already planned as part of the CoCos bonds issuance. For example, a Tier 1 ratio that falls below a certain threshold can be identified as a trigger. Supervisory authorities may also require the conversion to stock or the wipe out of the bond debt.

To date, the CoCos bonds issued by Credit Suisse have fulfilled their role and their main objective of absorbing losses. They enabled Credit Suisse to eliminate $17 billion in debt by sacrificing bond investors who will never be repaid for their entire investment. This is the largest loss to CoCos bondholders since the inception of these instruments in Europe.

This loss to Credit Suisse bond investors is likely to call into question investors’ attractiveness and appetite for these risky instruments and, therefore, the ability of banks to raise AT1 capital through CoCos bonds. Future investors will potentially require much higher returns from other European banks to hedge the risk of non-repayment.

However, an error was made in this rescue operation, especially in repayment priorities.

The shareholders of Credit Suisse should have borne the bank’s losses first before the investors holding the CoCos bonds.

The repayment of shareholders is subject to the repayment of AT1 bondholders. In other words, investors holding CoCos Bonds must be repaid before shareholders. CET1 instruments are the first to absorb losses, then AT1 instruments. These elements were confirmed in the Single Resolution Board and ECB release: “Common equity instruments are the first ones to absorb losses, and only after their full use would AT1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB supervision in crisis interventions.”

In the context of the redemption of Credit Suisse by UBS, the reverse occurred. The holders of CoCos bonds first suffered all the losses of Credit Suisse, while the shareholders will receive 1 UBS share for each 22.48 Credit Suisse shares. At the same time, assessing a Swiss credit share of CHF 0.76, well below the closing price of CHF 1.86 on Friday.

The main losers of this transaction are undoubtedly investors in the perpetual bonds (AT1 bondholders) issued by Credit Suisse. Then, in a broader set, Credit Suisse employees (a buyout synonymous with job cuts) and its shareholders find themselves with a discount of 60% compared to the closing price of Friday, March 17.

The only winner of this transaction is UBS, which has managed to secure CHF 9 billion from the Swiss government and CHF 100 billion from the Swiss National Bank as liquidity support. In addition, UBS estimates that the new behemoth will reduce its annual costs by $8 billion by 2027. Finally, this transaction ensures, in Switzerland, a dominant position of UBS in the Retail and Corporate Banking sector.

These arrangements are the least bad compared to the nationalization or liquidation of Credit Suisse, provided that this crisis does not spread to this new banking behemoth.

That’s all for me today. In the coming months, I will continue to write articles on special order types and trading strategies used by High-Frequency Traders.

As I always say, do not hesitate to give me your feedback. That is the only way to improve my articles. I hope you enjoy the reading.

Let me end my article with a link to my book on High-Frequency Trading if you are interested:

https://amzn.eu/d/1XErUCl (in French)

https://amzn.eu/d/8B3XznD (in English)

My book in English and French version on Amazon

Article written by William Troyaux.

Finance
Credit Suisse
Stock Market
Banking
Economy
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