Hot CoCos: A Swiss Misfire
Unpacking how Crédit Suisse AT1 CoCo investors got Bern-ed by FINMA
Picture this, a sedate conference room in Bern filled with anodyne Swiss bureaucrats, shuffling through papers—mulling something serious.[1] Then one by one, “ja”, “oui,” “si,” “(fill in Romansch for yes).” It is decided, the Swiss Confederation has just declared war on Luxembourg. Wow, what a shock! Now notwithstanding the fact that this is almost certainly not how the Swiss constitutional order works—it would be quite a surprise to see the Swiss abandon one of their core things by abandoning nine millennia of neutrality. It would also be surprising to see the Swiss financial authorities and its central bank decide to embrace the philosophy of saying “yeah, f*ck ‘em” to a bunch of people who had loaned money to banks. Now, the first scenario would never happen, and I would have said the second never would either—until Sunday. I say until Sunday, as that is when FINMA, the Swiss Financial Market Supervisory Authority, revealed its plan to “save” Crédit Suisse by swapping out its shares for those in UBS on a basis that equates to 0.76CHF a share.[2] As part of that deal, FINMA said that this event would “trigger a complete write-down of the nominal value of all AT1 debt of Crédit Suisse in the amount of around CHF 16bn.[3]”
To put it plainly, the Swiss banking authorities decided to invert the normal hierarchy of claims and pay out equity holders[4] while telling bond holders that the cookie jar was empty and they would get rien, Nichts, niente, (insert Romansch for “nothing).” Of course these were not regular bonds—they were Additional Tier One Contingent Convertible bonds—or CoCos to their friends. In short, these hybrid instruments that gained popularity post GFC are designed to function as a shock absorber to the capital structure of financial institutions. When the gap between liabilities and assets gets to an uncomfortable place, which is to say equity gets too low, the CoCos convert from debt to equity. Hey presto your equity is now bigger. Critically, they can also be written down to zero. Everyone knows that AT1 CoCos are there to absorb losses which is why they are largely reserved for professionals and carry a significant premium to reflect their extreme risk. But at their core they are debt instruments until they are not and every understanding of what makes debt different from equity hinges on the principle that debt gets paid before equity. The CoCos did absorb losses here, and that is fair and to be expected. But, they did not convert; equity holders got paid out; CoCo investors got nothing. This raises some questions.[5]
Any distressed credit scenario is heavily reliant on legal issues, and I should be clear that I am not licensed to practice law at a federal or cantonal level in Switzerland.[6] Granted. I can however read in at least 1.5 languages. And a few points emerge from my research[7]. Before we get too far let me issue a further caveat—I don’t have access to the actual prospectus or debentures of these instruments and maybe they have language that allows these bonds to convert to the financial instrument equivalent of a joker card. However, I suspect that they do not. But the relevant law is easily available. Chapter 3, Articles 47 and 48 of l’Ordonnance de la FINMA sur l’insolvabilité bancaire spell out the normal hierarchy of debt and equity, that share capital must be completely reduced before debt converts to equity and that this is applies “en particulier” to CoCos.[8] The general Loi sur les banques is also pretty clear[9] that debt conversion or reduction is only possible if share capital has been written down entirely. There we have it in plain language. Seems suspect. I encourage you to read the full FT Alphaville piece—there is a twist at the end about how the Swiss did pass a law creating the mechanism for this write down—on Sunday, before FINMA released its plan. Cool. As an additional point aimed at the chorus of people saying “LOL losers, you should have read the prospectus before investing,” do you think the Swiss would have snuck in a little amendment to the law authorizing this approximately twelve minutes before they announced this? Seems unlikely, no?
Back to my first caveat—there might be a bunch of other legal issues going on that are beyond me and there may be a strong case for why this was all above-board, beyond a clearly ex post facto law. However at the very least these issues are in dispute—a bunch of CoCo investors will be filing suit. This will be settled eventually. But I can say with high certainty that the folks who invested in these instruments fully and reasonably expected to be treated as normal debt holders—albeit highly subordinated ones— until specific conditions were met. They are sophisticated investors who priced in the possibility that they could absorb losses—just not the losses of common shareholders. How did this happen?
We now turn to speculation. Do you think it is likely that a bunch of super serious Swiss Skoda enthusiasts sat down at the boardroom table and came up with a dubious scheme to wipe out institutional creditors in favour of common shareholders? I, for one, do not. Do I think that it is more likely that major institutional shareholders decided that they had the whip hand and insisted on this unorthodox solution to mitigate their own losses?[10] Yes, I very much do. Was this legal? We shall see. Was this just? Probably not. Will this have consequences? Oh, it very much will.
Bonds like these form a major component of the capital structure of a lot of European banks—there are more than $250bn of them on the market. There is one bank in particular that we could look at here that is especially fond of them—the Union Bank of Switzerland. Per Bloomberg, UBS has almost $13bn of them. They are not the biggest issuer—but they are among the most reliant on them as they measure up at 30% of the bank’s Tier One equity capital compared with about 21% and 13% for Société Générale and BNP Paribas respectively. You would think then, that UBS would be a bit more circumspect about taking part in a deal that fundamentally calls into question a source of funding on which they rely so heavily. Now, I assume the dust will settle on this relatively soon—the ECB and a whole alphabet soup of European financial authorities issued a joint statement saying “hold on, CoCos will not be absorbing equity losses too.” But as it stands, these bonds are tanking and tanking hard as markets cast scepticism over the entire asset class. Bloomberg data shows that average AT1 yields are now up from 7.8% in February to a whopping 15.3%. The average cost of equity for European banks is 13.4%. Let that sink in. Markets now view these fixed income securities which offer no upside beyond getting paid back as riskier than common equity. Did FINMA break this asset class? At least for the moment, yes.
As I suggested earlier, the dust will settle on this and I suspect that these bonds will climb back up and their yields will fall below the cost of equity as they should; however, I suspect their yields will not fully recover and banks will look elsewhere for cheap hybrid capital. Furthermore, I suspect that after some litigation even the CS CoCo holders will get something. Both of these represent decent money making opportunities which my imaginary global macro fund will be taking advantage of. But that will not change the fact that European banks will face materially higher costs of capital for the foreseeable future and given the shape of the global banking sector right now that is an additional headwind they could easily do without.
That’s broader European banking, but on the other hand I think the Swiss have inflicted significant damage to their reputation as solid and predictable banking partners by doing something so erratic and against character. Even more granularly, UBS has done itself a great deal of harm by almost explicitly telling its AT1 creditors that it is probably untrustworthy and has no compunction in using serpentine tactics to slither out of making good on its debts to them. To them, I offer this quote from the owner of Dairy Queen “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.” The reputation of the Swiss banking sector has been built over centuries and it will take more than this to completely destroy it—but actions like this are a good way to start.
[1] Maybe it is the seven members of the Federal Council, the weird super Swiss multitudinous executive? Who could know, their identities are unknown—unknown because of Swiss restraint, not equally Swiss secrecy.
[2] Approx. 76 centimes more than 0
[3] Record scratch
[4] Admittedly, at a pretty severe haircut
[5] Questions like “what?” “how?” “why?”
[6] Or, anywhere for that matter.
[7] Thanks in large part to FT Alphaville, without them I would have had to spend much more time crawling through legal French: https://www.ft.com/content/2e5ac49b-b055-4bd0-a9fd-8a41e19028b9
[8] les emprunts à conversion obligatoire sous certaines conditions, if you prefer
[9] As clear as the sapphire crystal of a Rolex. I promised myself that I could make only one watch joke and one chocolate joke. Please applaud my restraint, especially given that these things are called CoCos.
[10] Losses which, I might add, at least one investor instigated by loudly declaring CS to be in trouble and that they would be doing SFA to help.
