Credit Suisse Tier1 v Equity

[bruncher]

ps, just one example, but the Lloyds ECNs would have converted into ordinary shares if the CT1 ratio dropped below 5%. As it turned out, the real risk was with the capital disqualification event, which enabled them to be redeemed early!

Don't forget the other undisclosed undocumented risk that Lloyds would renege on the parri passu terms of their bonds, and treat bonds differently according to an arbitrary measure of how many bonds were in a particular holding - inventing the terms 'retail' and 'professional' and offering holders different terms.

[hiriskpaul]

ps, just one example, but the Lloyds ECNs would have converted into ordinary shares if the CT1 ratio dropped below 5%. As it turned out, the real risk was with the capital disqualification event, which enabled them to be redeemed early!

Don't forget the other undisclosed undocumented risk that Lloyds would renege on the parri passu terms of their bonds, and treat bonds differently according to an arbitrary measure of how many bonds were in a particular holding - inventing the terms 'retail' and 'professional' and offering holders different terms.

Yes I remember that. £200k nominal was it and you got a better offer? Retail could take advantage by selling in the market of course, with "professional" investors only too pleased to buy them up cheaply and tender for a risk-free return.

The CDE was disclosed of course, the problem was no-one could agree what constituted a CDE. Even Supreme Court judges could not agree!

[BondSquared]

There's a lot of AT1/Coco prospectus reading going on right now to identify those bonds with a viability clause a la CS ... my take on this is that all AT1s have a viability clause, explicity (CS) or implicitly (SVBUK). People tend to ignore that it was our own BoE/PRA which was first in triggering a full AT1 write-down based on a regulatory determination of lack of bank viability, a full week before SNB/Finma did the same - only that the BoE move was far more aggressive as no such trigger was in the AT1 docs, so the BoE instead used its statuatory power to write down the AT1s. Read all about it here:

https://www.svb.com/globalassets/uk-sit ... h-2023.pdf

The reason why this got lost in the discussion is probably due to the small size in question (GBP322mm SVBUK vs $17bn CS) and the fact that the SVB UK AT1 wasn't publicly held (I'm assuming it was entirely placed with its parent SVB in the US). In other words: regardless what the terms of the instrument in question says, whether converting into shares or just writing down, whether they have viability clauses or not, whether they are in effect economically subordinate to common equity or not - regulators are now viewing AT1s as fair game for a cheap bank recapitalisation. That's a very different approach to the one which the market wrongly assumed previously, viewing AT1s as legally and economically senior to commond equity and subject to mechanical triggers laid out in the documentation. Again, whether or not such documentation includes viability/resolution language or not makes little difference in the new world. Let's face it - when the s hits the fan, and the taxpayer has to step in (and is stepping in with force, giving explicitly/implicitly unlimited deposit insurance where it should be limited (US/Yellen), or a backstop to losses (SNB), any regulator will be tempted/pressured to apply the full force of its powers in an effort to protect the taxpayer, rather than geek out on securities documentation.

IMHV, the best use for AT1s has always been employee (bonus) compensation - again a point which is neglected in the discussion here, as CS has had a long-standing and quite innovative bonus component in (unlisted/private) AT1s, which is a great way of forcing "skin-in-the-game" for employees - if they share the upside (annual bonus) then force them to contribute to share the risk with capital instruments (shares/share options & AT1s). Full disclosure - the last ones of my CS bonus AT1s only vested/matured last year, but if they were still unvested and now written down then I would have nothing to complain about.

[ayshfm1]

It was being reported that the regulator was telling CS that UBS was going to emergency rescue it by Monday, last Wednesday, whilst telling the markets all was fine. The Saudi's were furious and refused to agree, hence the emergency legislation to shut the shareholders out of the decision making process.

They knowingly told lies and altered the rules as necessary, we can argue the circumstances were extenuating.

I think all central banks when faced with spending tax payers money are going to be duplicitous. No weight can be given to either the ECB or BoE statements, they'll bot do whatever is expedient at the time, IMHO AT1 is going to be wiped out by all of them at the first sign of trouble, which perhaps fulfils their design, however the coupons on this bog roll are going to need to compensate holders for the risk, which is in all probability is going to make them expensive debt. That said there is a lot of debt I wouldn't touch with a barge poll that has low coupons.

I also heard that many Asian investors bought this stuff with loans, pocketing the difference between the rate they could borrow at and what the coupon paid, they are facing margin calls now.

[Jwdool]

I think we need to be cautious about the future likely trajectory of AT1/ Cocos. When these notes first appeared in the form of ECNs back after the financial crisis - the rates that needed to be paid to convince holders to buy were all in double figures. There was a 16.5% Lloyds Bank note out there at some point. It doesn't take long for investors to forget the write-down catastrophe risk and I'd assume we won't see too much of an enhancement on yield above other Tier 1 (preference/ preferred) after too long. The fact is that CS/ SVB/ Signature were outliers. The vast majority of the banking system isn't under any particular risk - if anything many of them are too conservative and won't return very much by way of ROE. The building society sector is a good case of this, with some balance sheets now holding >30% CET1 - which shows you the degree of conservatism relative to pre 2008.

Ultimately if the crisis extends beyond here, I'd expect to see the Fed/ ECB and BoE support deposits beyond the normal FSCS (as they've done before). That would stabilise any "bank runs", and prevent a domino effect of crashing the financial sector. CS wasn't a Lehman Bros moment, principally because Lehman itself represented an institution that carried assets on their balance sheet which were worth considerably less than reported (as did much of the financial system at that time). CS had assets on book which will now be monetised by UBS. Overall, I'd suggest that UBS equity is now probably one of the best risk-weighted assets to hold - but other AT1 paper will be worth picking up because we are not going to see contagion.

Within the world of AT1 there will be some great bargains to be had. Legacy AT1 (as per the UBS note I mentioned this morning) are probably the best picks, given they are likely to be called at first call dates. Markets tend to overshoot - both on upside and downside. We've seen all manner of daft quasi-bubbles in the form of Tesla, FAANGMAN, ARKK equities priced at crazy multiples, not to mention cryto-assets. Similarly we will now see quality sold off. I'd suggest looking at cum-prefs in quality names (RSAB/ AV.A/B, GACA/B, NTEA) as well as PIBS across the building society sector. As rates come off later this year - a perpetual return of 7-7.5% will look very attractive as we see CPI break lower from June 2023.

[Newroad]

Hi Jwdool.

I substantively agree with you, but wouldn't want to hold any AT1's individually. If there were an Investment Trust or ETF spun up, to hold them in aggregate, I would think definitely worth a modest holding.

However, sort of the opposite has actually happened. In reaction to the zeitgeist, an ETF with the perceived safest US banks has been quickly created: "BIGB". It is by Roundhill and is equal weighted, IIRC, with the largest six US banks.

Maybe an IAT1 (iShares AT1's) needs to be spun up?

In the event there were mass wipe-outs of the instruments in such an ETF, I think we'd have a lot more to worry about ...

Regards, Newroad

[hiriskpaul]

I think we need to be cautious about the future likely trajectory of AT1/ Cocos. When these notes first appeared in the form of ECNs back after the financial crisis - the rates that needed to be paid to convince holders to buy were all in double figures. There was a 16.5% Lloyds Bank note out there at some point. It doesn't take long for investors to forget the write-down catastrophe risk and I'd assume we won't see too much of an enhancement on yield above other Tier 1 (preference/ preferred) after too long. The fact is that CS/ SVB/ Signature were outliers. The vast majority of the banking system isn't under any particular risk - if anything many of them are too conservative and won't return very much by way of ROE. The building society sector is a good case of this, with some balance sheets now holding >30% CET1 - which shows you the degree of conservatism relative to pre 2008.

The coupon on the various Lloyds ECNs did not reflect their yields at the time of issue. All of the ECNs came about from the replacement of older, non-convertible paper. For example I exchanged callable Lloyds prefs paying 6.0884% for an ECN paying 7.5884%. I am not aware of any ECNs with a coupon of 16.5%, but there was one with a coupon of 16.125%. That was issued in exchange for a BOS bond with a coupon of 13.625%. As far as I can recall, the ECNs never traded much above a yield of 10% until Lloyds threatened to reddem them early. As I mentioned earlier, the conversion trigger was at CT1<5%. I and many others were perfectly happy to hold the ECNs on yields below 10% because we thought the risk of conversion was very low and the risk of a CDE seemed even more remote.

[hiriskpaul]

The FT don't know why the T2 escaped being written down either. Best theory seems to be that it was forgotten!

https://www.ft.com/content/2489416d-013 ... b57b987d8d

[Gan020]

The FT don't know why the T2 escaped being written down either. Best theory seems to be that it was forgotten!

https://www.ft.com/content/2489416d-013 ... b57b987d8d

It is this that I think will form part of the legal case which is going to get very sticky for the Swiss central bank. Courts never like inconsistent treatment and it does suggest a not very thought out plan.

[Jwdool]

I'm not convinced there is a problem here. AT1 is clearly junior to T2, so if the regulator forms the view (which they apparently did), that only the T1 needed to be written off to get the UBS deal done, that was in their discretion. Allowing a residual equity val to go to equity is also legally fine, given the AT1 was "going concern" capital - which could be used for the exact purposes it was used for. I'm not seeing the problem here.

[hiriskpaul]

I'm not convinced there is a problem here. AT1 is clearly junior to T2, so if the regulator forms the view (which they apparently did), that only the T1 needed to be written off to get the UBS deal done, that was in their discretion. Allowing a residual equity val to go to equity is also legally fine, given the AT1 was "going concern" capital - which could be used for the exact purposes it was used for. I'm not seeing the problem here.

I guess the question is, does the regulator have discretion? The regulator determined that a Viability Event had occurred. Having made that determination, are they then at liberty to pick and choose which paper is affected? Which to bail-in and which not to? Without wading through the small print, it is not clear to me that they have that discretion. Absolutely something for lawyers to look at!

[Jwdool]

The full basis for the reasoning can be found on the link below. As for whether they had discretion - the answer is unequivocally yes. Once the regulator decided that the bank had fallen into a Viability Event (which it obviously had) but could continue in some form - the only question was how much "going concern" capital needed to be written off. The amount would then be written off (as determined by the regulator depending on the form of "going concern ex post) in accordance with the priority terms of the structure available to achieve that purpose. On this basis the "going concern" AT1 was sufficient, and they didn't need to touch the "going concern" T2. Admittedly the terms were a bit complicated and they differ from many other AT1 notes- which tend to convert into equity at a pre-determined rate. Nevertheless, the terms are not that tricky and in my view FINMA don't have anything to worry about. The debate about whether equity could retain value above AT1 is a red herring. The whole purposes of "going concern" AT1 notes were to allow the entity to continue - otherwise the entire thing would be "gone concern" capital. That legal structure is consistent with equity retaining some value after a Viability Event, but with the entity on-going in some form.

finma.ch/en/news/2023/03/20230323-mm-at1-kapitalinstrumente/#:~:text=The%20AT1%20instruments%20issued%20by,extraordinary%20government%20support%20is%20granted.

[hiriskpaul]

That link says that T2 was not written down, but it does not say why not or on what basis FINMA exercised their discretion.

[Jwdool]

It wasn't written down because it wasn't required on the view of the regulator. QED.

[BondSquared]

INterestingly, the CCA Contingent Capital Awards, which were employee bonuses designed to mirror AT1s, have not been triggered yet (at least not explicitly) - could again be a deliberate act by the regulator, or not.

[Gan020]

I have read the FINMA document and find myself struggling to form an opinion or at least an opinion that I hold much conviction about.

It seems the regulator has deemed that writing down the AT1's was necessary, but not the T2's. I am minded to agree the regulator has discretion but it seems to me the regulator should also provide justification and evidence for the decision and that is lacking.

Whilst the justifcation and evidence is lacking I am unable to form my firm opinion but conclude that the regulator has had the opportunity to provide more detail and hasn't done so. It is this part which is worrying. Some in the market are asking for clarification but it isn't forthcoming and whilst that's the case many will continue to question the decision.


It's my view that things happened very fast and the regulators had the weekend to sort this out, albeit I'm sure they had a plan in place for some time. The priority was saving the bank and it would not surprise me if the decision was made on the basis of time preference and that the plan to write off only the AT1's was not fully thought through especially since it appears by Sunday night there was only one party UBS willng to take on CS.

I suspect the regulator is comfortable with their decision even if in 5 years time the AT1 holders get something back. What was necessary was saving the bank and stopping the contagion.

[BondSquared]

Agree with the above analysis, the most likely explanation is that there was simply not enough time to come up with a coherent plan of regulatory action - which also means there could be amendments coming forth, even though that may add oil to fire.

My view is that there are some contractual elements (the specific viability clause in certain AT1s) and the use of statuatory power (again, the PRA triggered an SVB UK AT1 which lacked contractual viability language). The former is a fairly mechanistic determination - you can argue whether or not bank viability was endangered but it will be difficult to argue against the official expert arbiter of bank viability i.e. the financial regulator - while the latter is a principle enshrined not in specific t&cs but in current legislatiion (and much enhanced post-GFC), the use of which the market still needs to adapt to. Both are perfectly sensible instruments/processes, although on the latter one could think whether giving the state/authorities such wide-ranging unfettered discretion is appropriate or not - that's a political discussion, where the dividing lines are politics such as "nanny state", "free-market economy" etc; everyone will have a view one way or the other.

Away from the legalistic view and specific contractual language, triggering AT1s but not Tier2 conceptually makes sense; AT1 is "going concern" capital (bank remains viable and operating), while T2 is "gone concern" capital designed for post-failure creditor recovery, so meant to address very different scenarios.

[Gan020]

Sketch: Nutty shareholders provide comical end to Credit Suisse’s scandal-ridden history

https://www.cityam.com/sketch-nutty-shareholders-provide-comical-end-to-credit-suisses-scandal-ridden-history/

I enjoyed this article

[Gan020]

https://www.investmentweek.co.uk/news/4 ... -regulator?

Extract:
The complaint, seen by the Financial Times, accuses the regulator of having acted unconstitutionally, by failing to behave "proportionately" and "in good faith" when it ordered Credit Suisse to write down its riskiest bonds on 19 March.

Despite the publicly voiced complaints of bondholders, the appeal does not claim that FINMA operated outside the bounds of its legal authority or that the government's emergency ordinance was approved without proper authority.

According to the complaint, FINMA had a duty to decide "in good faith and in a non-arbitrary manner" in accordance with Articles 5 and 9 of the Swiss constitution, but alleged that it failed to do so.


The appeal also argues that Article 36, paragraph 3, which states that "any restrictions on fundamental rights must be proportionate" was violated. According to Swiss law, the right to property is a fundamental one.

[BondSquared]

emboldened by the SNS Reaal outcome: https://www.bloomberg.com/news/newslett ... uisse-at1s