A close Suisse shave

Craig Coben is a former senior investment banker at Bank of America, where he served most recently as co-head of global capital markets for the Asia-Pacific region.

Yesterday Credit Suisse announced that its shareholders subscribed to 98.2 per cent of its rights issue. That’s an impressive level of take-up, but it was nail-biting suspense until the end.

The CS share price fell so much during the rights issue period that late last week it looked like the underwriters might end up owning a significant chunk of the Swiss bank’s stock. This would have been a nasty shock to everyone involved, including the market.

In the end, the shares rebounded and the rights issue completed successfully. But the close shave has exposed some unresolved and perhaps unresolvable issues that arise when investment banks underwrite capital-raises for companies.

Launched as part of a SFr4bn capital increase and organisational overhaul, Credit Suisse’s SFr2.24bn rights issue should have been smooth sailing. For one thing, the new shares were being offered at SFr2.52 per share, a meaty 32 per cent discount to the dilution-adjusted price (aka “theoretical ex-rights price” or TERP).

Moreover, CS was able to assemble a massive syndicate of 19 banks to underwrite the fundraise at SFr2.52. The rights issue was also accompanied by a SFr1.76bn share placement to investors, mostly the Saudi National Bank, with a further commitment from those investors to exercise their rights to buy shares.

So this capital increase had the building blocks for success: (1) a deep discount to ensure that shareholders exercise the rights to buy shares, (2) a Justice League-strength underwriting syndicate, and (3) the presence of a cornerstone investor.

Yet the rights issue caused some sweaty palms. Battered by client outflows and a profit warning, Credit Suisse shares tumbled from the late October announcement. On 1st December the shares skidded to SFr2.667, meaning the discount to buy shares in the rights issue had contracted from 32 per cent to just 5.5 per cent. That’s waaaay too close for comfort.

The vast majority of rights issues are anticlimaxes. As long as the shares stay well above the subscription price, shareholders have every incentive to exercise the right and buy shares at a discount. And since the underwriting banks aren’t actually selling shares, there is none of the stress or uncertainty of collecting orders and building a book of investor demand, as there is in an IPO or share placement.

What matters is that the share price does not get too close to the underwritten price. It can drift or drop a bit, but not crumble or crater. A 32 per cent discount is a big cushion, and such a sizeable discount is why some investors disparage the fees that banks earn for underwriting as “money for old rope”: the underwriters are pocketing a fee for taking on the very remote risk of being stuck with shares.

Yet rights issue underwriting has two features that can turn money for old rope into a noose around the neck of underwriters.

First, it exemplifies what Nassim Taleb and others call “picking up pennies in front of a steamroller.” The underwriters collect fees of around 2 per cent, but in the extraordinarily unlikely event that the share price collapses, they could be left with a big position in a stock they don’t want to hold.

The “pennies in front of a steamroller” situation typically arises when a party writes (sells) a low-value derivative, such as a deeply out-of-the-money option or a credit default swap. That party collects the premium, and there is little chance of the option ever being exercised or the CDS being triggered. But in the extreme case it is exercised, the party can find itself nursing big losses.

To be clear, the underwriters did not enter into an actual derivative contract with Credit Suisse. There was no ISDA documentation, and the exposure never sat in a derivatives book. But by underwriting at the deep discount, the banks sold Credit Suisse the functional equivalent of a short-expiry, deeply out-of-the-money put. If shareholders hadn’t bought shares in the rights issue, then CS could have “put” shares to the underwriters at SFr2.52 per share.

Thus the underwriting has the substance, but not the form, of a derivative option. And the size of that de facto derivative is enormous as a percentage of market capitalisation or trading volume. There is no way to buy an equivalent out-of-the-money put in such size in the regular trading market. And no market counterparty would ever write one, either.

A second, albeit related problem, is that there is virtually no way to hedge the underwriting of Credit Suisse shares either. When writing an option, most market players hedge their positions. But here it’s practically impossible.

For one thing, shorting CS shares is likely prohibited in the underwriting agreement and in any case would be self-defeating as a hedge, as you would be pushing the share price down — it would be akin to an animal eating its own tail to feed itself.

For another, shorting a basket of other peer stocks will create mismatches (known as “basis risk”): in the middle of a major corporate event, Credit Suisse shares had their own dynamic, and they could not be expected to closely correlate to UBS or other European banking shares.

Buying Credit Suisse credit default swaps would also have been difficult as a hedge, given the illiquidity and idiosyncrasies of that market, and it may have been barred in the underwriting agreement anyway.

The underwriters of a rights issue can hedge against a market crash via index options, but not a stock-specific one. An index hedge here might have generated significant losses, because the broader market rallied hard from the time of the deal’s announcement.

So when shares get perilously close to the subscription price, what can the underwriters do to manage their risk?

Not much. You can stare at the terminal screen to will the shares higher, but if Uri Geller couldn’t stop Brexit with his telepathy, an investment banker won’t have more sway even if they are doing God’s work. More practically, you can lob in communication advice to management, but at such a late stage it’s usually like screaming in a wind tunnel.

Fortunately, a sharp rally in Credit Suisse came in the nick of time, lifting the share price above SFr3 last Friday after chair Axel Lehmann said that outflows had stopped. This good news was followed by weekend media reports about possible investments by the Saudi Crown Prince and Bob Diamond’s Atlas Merchant Capital into its First Boston investment bank spin-off. As FT Alphaville wrote: “Timing’s pretty convenient.”

But you can’t always count on such deux ex machina to save the day. It is extremely rare, but rights issues can leave underwriters stuck with an outsized rump of stock. The cumulative underwriting losses on July’s €2bn rights issue for Italian oilfield services firm Saipem may have exceeded €100mn.

In the end, the underwriters will have made money on the Credit Suisse rights issue. But the close shave is a reminder that rights issues expose underwriters to equity risk that is both unhedgeable and many times larger than their reward.