Credit Suisse’s risky bond destruction flipped the market by $275 billion

(Bloomberg) — Among the biggest losers in the sale of Credit Suisse Group AG were investors in the firm’s riskiest bonds, known as AT1, worth $17 billion.

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These money managers must be eliminated, which could send the $275 billion bank financing market into a tailspin and European politicians in crisis mode threatened to backlash.

Lenders are frantically skimming the fine print for these so-called Tier 1 incremental securities to see if other countries’ authorities can repeat what the Swiss government did on Sunday: destroy them while saving $3.3 billion of value for equity investors. It doesn’t have to be a hierarchy, some bondholders insist.

“It just doesn’t make sense,” said Patrick Kaufmann, fixed income portfolio manager at Aquila Asset Management, which owns the bonds. “Shareholders should get zero” because “it’s quite clear that AT1 is older than stock.”

The CEO of a British bank was even more direct: The Swiss have killed this key funding sector for lenders, he said, asking not to be named because the situation is delicate. His comments underscore that the global financial community is on edge following the takeover of Credit Suisse by UBS, which followed the collapse of three US regional banks.

Prices for all AT1s will almost certainly drop on Monday. Some Barclays Plc traders predicted a drop of as much as 15 cents or more, according to people with knowledge of the matter.

It’s not that bonds shouldn’t have taken the hit from the Credit Suisse crash. In fact, that’s pretty much what they were created for when they were first conceived by European regulators in the aftermath of the global financial crisis, as a way to pass on losses to creditors when banks start to fail without resorting to taxpayer money.

However, by favoring equity investors over holders of the riskiest bank securities, this has left the bond community confused and uneasy about who comes first when it comes to the hierarchy of investor claims the next time a lender is in trouble.

With a lawsuit potentially brewing, traders at Goldman Sachs Group Inc. prepared to bid on claims against Credit Suisse’s riskiest bonds for investors betting they could eventually recover some value.

“Destroying AT1 holders while paying significant amounts to shareholders is contrary to every principle and settlement rule that has been agreed upon internationally since 2008,” said Jérôme Legrás, head of research at Axiom Alternative Investments, who said the firm owns AT1 bonds issued by credit. Swiss.

From the point of view of Swiss officials, he was able to get the securities written down because he needed to raise Credit Suisse’s capital and solve its liquidity problems. Bonds are usually sheared whenever government support is offered to a creditor facing solvency problems.

However, market participants say the move is likely to lead to a devastating revaluation of the entire industry. The market for new AT1 bonds is likely to freeze sharply, and the cost of risky bank financing risks jumping higher, traders said, given the regulators’ decision caught some lenders by surprise.

That would give bank treasurers less room to raise capital during times of market stress, as the Federal Reserve and five other central banks announced on Sunday a coordinated action to boost dollar liquidity.

“The AT1 market will be closed to new issuance for a while,” said Luke Hickmore, investment director at abrdn Plc, which owns a small number of Credit Suisse banknotes. “We will all be analyzing which securities in the AT1 space have a similar trigger for CS and which do not, which banks should issue AT1s and which should not.”

Even before the destruction, growing fears about the financial system had caused the average AT1 note to drop over the past two weeks, with the price quoted nearly 20% below face value – one of the steepest discounts ever.

“Poorly Designed”

AT1s were designed by regulators as an additional capital buffer between shareholders and bondholders. However, the legal framework has always been a subject of uncertainty and some controversy.

The policymakers’ latest move shows that “the structure has proven to be poorly designed and is likely to be phased out,” said Francesco Castelli, head of fixed income at Banor Capital.

The Swiss Financial Market Supervisory Authority’s decision is “probably legal,” he said, adding that Credit Suisse’s AT1 obligations would trade close to zero tomorrow. “Owners will only have some chance of reinstatement in court.” Castelli owns bonds issued by the bank but declined to say if he has a position in AT1.

However, the decision to wipe out the holders of these bonds was supported by John McClain, a portfolio manager at Brandywine Global Investment Management.

“This is absolutely the right decision to prevent moral hazard from penetrating this part of the market. These bonds were made for moments like the bonds of disaster.”

Counterparty risk

The acquisition by Credit Suisse comes after the failure of a number of regional US banks this month caused turmoil in the financial system. Bonds and shares of the Zurich lender plummeted, and counterparties to the transactions began to buy protection against a possible default.

The collapse of the bank would cause huge collateral damage to the Swiss financial industry and create a risk of contagion for UBS and other banks, Finance Minister Karin Keller-Sutter said at a news conference on Sunday.

“The failure of a global, systematically important bank would cause irreversible economic disruption in Switzerland and around the world,” she said.

Traders quickly made it clear they were a bit skeptical about the deal. UBS credit default swaps, derivatives often used to assess a borrower’s credit risk, have increased by at least 40 basis points to 215 basis points for five-year contracts, people with knowledge of the matter said. They asked not to be named, as the information is closed.

As part of the takeover, the Swiss central bank is offering CHF100 billion of liquidity assistance to UBS, with the government providing a CHF9 billion guarantee against potential losses on the assets it takes on. This came after Credit Suisse was deeply hurt by everything from the collapse of Archegos to the collapse of a number of funds it managed with Greensill Capital.

“Looking back is great,” Credit Suisse chairman Axel Lehmann said at a Sunday press conference. “We were overtaken by inherited situations, risks that materialized last year. We were influenced by a market model that no longer works in this environment.”

— Contributed by Stephen Arons, Paula Seligson, Reshmi Basu, Carmen Arroyo, Luca Casiraghi and Katherine Griffiths.

(Updates with Goldman preparing bids to sell AT1 debt in the ninth paragraph)

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