Among the biggest losers in the shotgun sale of Credit Suisse Group AG are investors in the firm's riskiest bonds, known as AT1s, worth $17 billion.
These money managers are set to be wiped out - potentially sending that $275 billion market for bank funding into a tailspin, while threatening blowback for European policy makers in crisis-fighting mode.
Creditors are frantically poring through the fine print for these so-called additional tier 1 securities to understand if authorities in other countries could repeat what the Swiss government did on Sunday: Wiping them out while preserving $3.3 billion of value for equity investors. That's not supposed to be the pecking order, some holders in the bonds insist.
"This just makes no sense," said Patrik Kauffmann, a fixed-income portfolio manager at Aquila Asset Management, who holds the notes. "Shareholders should get zero" because "it's crystal clear that AT1s are senior to stocks."
One UK bank CEO put it even more bluntly: The Swiss have killed this key corner of funding for lenders, he said, asking not to be named because the situation is sensitive. His comments underscore how the global financial community is on edge after the UBS takeover of Credit Suisse, which came on the heels of the collapse of three regional US banks.
Prices on all AT1s will almost certainly drop on Monday. Some traders at Barclays Plc have predicted declines of as much as 15 cents or more, according to people with knowledge of the matter.
It's not that the bonds weren't supposed to take some of the blow from the Credit Suisse collapse. In fact, that's in large part what they were created to do when they were first conceived by European regulators in the aftermath of the global financial crisis, as a way to impose losses on creditors when banks start to fail without resorting to taxpayer money.
Yet, by privileging equity investors over holders of the riskiest bank securities, it's left the bond community confused and rattled about who ranks first when it comes to the hierarchy of investor claims the next time a lender is in trouble.
With litigation potentially brewing, Goldman Sachs Group Inc. traders were preparing to take bids on claims against Credit Suisse's riskiest bonds for investors betting they can ultimately recover some value.
"Wiping out AT1 holders while paying substantial amounts to shareholders goes against all the resolution principles and rules that were agreed internationally after 2008," according to Jérme Legras, head of research at Axiom Alternative Investments, who said the firm owns AT1 bonds issued by Credit Suisse.
From the perspective of Swiss officials, it was able to force a write-off of the securities because it needed to boost Credit Suisse's capital and resolve its liquidity problems. The bonds typically face a haircut whenever government support is offered to a lender facing solvency problems.
Yet market participants say the move will likely lead to a disruptive industry-wide repricing. The market for new AT1 bonds will likely go into deep freeze and the cost of risky bank funding risks jumping higher given the regulatory decision caught some creditors off-guard, say traders.
That would give bank treasurers fewer options to raise capital at a time of market stress, with the Federal Reserve and five other central banks announcing coordinated action on Sunday to boost dollar liquidity.
"The AT1 market will be shut now for new issuance for a while," said Luke Hickmore, investment director at abrdn Plc, who holds a small number of the Credit Suisse notes. "We will all be parsing which securities in AT1 space have a similar trigger to CS's and which don't, which banks need to issue AT1s and which don't."
Even before the wipeout, rising worries about the financial system caused the average AT1 note to tumble over the last two weeks, with pricing indicated at almost 20% below face value - one of the steepest discounts on record.
'Poorly Designed'
AT1s were dreamt up by regulators to act as an additional buffer of capital between shareholders and bondholders. Yet the legal framework has always been subject to uncertainty and some controversy.
The latest move by policy makers shows that the "structure has proved to be poorly designed and will be probably phased out," said Francesco Castelli, head of fixed income at Banor Capital.
The decision by the Swiss Financial Market Supervisory Authority is "probably legal," he said, adding he expects Credit Suisse's AT1 obligations to trade at close to zero tomorrow. "Holders will only have some recovery chance in court." Castelli owns bonds issued by the bank but declined to say if he has a position in the AT1s.
Still, the decision to wipe out the holders of those bonds gets support from John McClain, portfolio manager at Brandywine Global Investment Management.
"It's absolutely the right thing to do to prevent moral hazard from creeping into that part of the market. Those bonds were created for moments like this - similar to catastrophe bonds."
Counterparty Risk
The acquisition of Credit Suisse comes after the failure of a number of US regional banks this month sent concerns rippling through the financial system. The Zurich-based lender's bonds and shares plunged and counterparties on trades began buying protection against a possible default.
A collapse of the bank would have caused huge collateral damage to the Swiss financial industry, and a risk of contagion for UBS and other banks, the country's finance minister Karin Keller-Sutter said at a press conference on Sunday.
"The bankruptcy of a global systematically important bank would have caused irreparable economic turmoil in Switzerland and throughout the world," she said.
Traders quickly made clear they had some skepticism about the deal. UBS's credit default swaps, derivatives often used to gauge a borrower's credit risk, widened by at least 40 basis points to 215 bps for five-year contracts, according to people with knowledge of the matter. They asked not to be named as the information is private.
As part of the takeover, the Swiss central bank is offering a 100 billion-franc liquidity assistance to UBS and the government is granting a 9 billion-franc guarantee for potential losses from assets it is taking on. That comes after Credit Suisse was left deeply wounded by everything from the blowup of Archegos to the collapse of a suite of funds it ran with Greensill Capital.
"Hindsight is wonderful," Credit Suisse Chairman Axel Lehmann said at Sunday's press conference. "We were overtaken by legacy situations, by risks that materialized last year. We were affected by a market model that no longer works in this environment."
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