We didn’t expect the leopards to eat OUR faces, say AT1 bondholders

“They’ve changed the law and they have basically stolen $16bn of bonds,” Davide Serra, founder and CEO of Algebris Investments, told investors on a call this morning. “This has been a big policy mistake, [and] they will regret it. [ . . . ] Switzerland will be the new pariah in this [loss-absorbing bond market]. They asked for it, they will have it.”

The above is not unrepresentative of the market’s response to Swiss regulators ignoring Finance 101 and putting shareholders ahead of bondholders. Wiping out CS’s Sfr16bn of Additional Tier 1 capital is the trade Swiss authorities have demanded for offering exceptional help — but it’s inconsistent with UBS management’s Sfr3bn valuation of CS equity.

It’s the largest loss ever inflicted to AT1 investors since the birth of the asset class. The fear, as measured by Invesco’s AT1 Capital Bond ETF, is that it changes the rules for everyone:

Regulators elsewhere are trying to undo the damage. The European Banking Authority, The Single Resolution Board and the ECB Banking Supervision committee said in a joint statement that:

The resolution framework implementing in the European Union the reforms recommended by the Financial Stability Board after the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses

In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One 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 banking supervision in crisis interventions

Additional Tier 1 is and will remain an important component of the capital structure of European banks

Goldman Sachs had been telling clients on Friday that AT1 bonds were too cheap relative to high-yielders. FINMA’s action “greatly weakens” the argument, it said this morning.

Whether investors treat this decision as a one-off or whether they rethink the asymmetry of their risk-reward at times of elevated financial distress remains to be seen. But in our view, it has become harder to assess the attractiveness of the current historically large spread pick-up provided by AT1 bonds vs. their HY corporate counterparts, which will likely constrain the appetite towards the AT1 asset class.

The worry now is that AT1 issuance will become more expensive. Charts on exposure and refinancing requirements via Barclays:

All that needs a couple of qualifiers, the first of which is that it’s Switzerland. Constitutional priorities are often a bit weird. Analyst Andrew Lim of Societe Generale says the wiping out of AT1s is a product of “a peculiar Swiss Finish” and argues that “confidence in such instruments will not be affected in the long term.”

Second, CS was insolvent irrespective of the Sfr3bn take-under sop from UBS to famously irritable retail investors. It’s political, not equitable. Applying subordination to a token gesture would have been correct but hardly proportionate.

Or, as DoubleLine Capital’s Jeffrey Gundlach puts it:

Bloomberg reports the gunslingers who foolishly kept holding Credit Suisse’s bail-in bonds are angry they are being wiped out. Seriously? Put on your big boy pants and look in the mirror. That’s where the “blame” lies. Learn how to manage risk!

— Jeffrey Gundlach (@TruthGundlach) March 20, 2023

Thirdly, CS and UBS are outliers in the CoCo marketplace. Most AT1 debt is more protected from total wipeout. Here’s Barclays to explain the “viability event” clause:

From reading the CS AT1 document and the FINMA statement, we think FINMA is using the “Viability Event” as described below in CS AT1 documentation in order to trigger permanent writedown of AT1s:

A “Viability Event” will occur if either… or (ii) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG receives an irrevocable commitment of extraordinary support from the public sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and without which, in the determination of FINMA, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business. 

While the AT1s were discounting a significant probability of writedown as evidence by price levels on Friday 17 March, the full and permanent writedown of AT1s, despite shareholders receiving ~CHF3bn of compensation for the merger, is a surprise to us and, we believe, to the wider investor community.

While we believe it was broadly acknowledged that there were inherent risks in banks’ AT1 structures such that losses could be higher than shareholders, the full writedown of CS AT1s is likely to be a significant negative event for the AT1 investor base. 

While the writedown of the AT1 could have been the correct interpretation of the AT1 prospectus (only a legal judgement would be able to confirm that), we think the step by FINMA is likely to have been surprising given Swiss authorities perceived more friendly stance towards AT1s (eg, dividend stopper language, allowing banks to call significantly non-economic AT1s). 

… and what it means for the rest:

We think the full writedown on CS AT1s is likely to have a significant impact on the broader AT1 market, with investors re-evaluating unfavourably the risks of AT1s relative to both the senior and junior parts of the capital structure.

We would highlight that we are not aware of any other major non-Swiss banks issuing permanent writedown AT1 instruments (we identify SANUK 6.75% as an exception), and while other regulators do have “mandatory writedown and conversion powers” in addition to bail-in powers, our initial analysis suggests that UK and EU regulators are required to maintain subordination hierarchy while using those powers. We would acknowledge that at this point, we have only done a relatively quick scrutiny of the relevant BRRD/SRMR and UK Banking Act.

Despite our initial favourable perspective as above, we would expect significantly negative reaction in the broader AT1 market on the back of these developments.

One potential positive catalyst could be if the EU and UK regulators confirm that similar action (AT1 loss absorption alongside significant equity recovery) would not be possible (or extremely remote) under EU and UK law.

While we remain unsure about the impact on the CS T2 CoCo, we would also expect T2 spreads to generically underperform as investors question the overall creditor hierarchy of bank capital.

Meanwhile, last word to Davide Serra of Algebris, whose views on national pariahs seem to be complex and contextually subjective:

“UBS has done the deal of a lifetime,” he told clients. “UBS equity is probably one of the best longs over the next three-four years. It is a no brainer and we will be adding to our UBS equity position.”

Further reading:
— Credit Suisse AT1s vaporised (FTAV)