23rd March 2023
The uproar around the breach of the so-called creditor hierarchy has been fascinating to watch since the announcement of the write-down of Credit Suisse Group’s (CSG’s) AT1 securities. As have discussions around potential class action litigation. It’s not new for investors to cry over spilled milk. In this instance, however, they had plenty of warnings. This topic is close to my heart, principally, as I was involved in the early development of the market in those securities and recall the conceptual discussions with regulators and policymakers, bank issuers, industry bodies, and investors. I am also keen to ensure past mistakes don’t repeat themselves.
The Swiss authorities came out with an emergency law announcing the CSG AT1 securities were to be written down in the context of the UBS takeover, however, this does not deny the operation of the terms of AT1 securities. The AT1 securities terms and Article 29 of the FINMA’s Regulation about Own Funds are clear. Having sat at the table on several messy bailouts, standard operating procedure is belts and braces. This is how the emergency law should be viewed in the context of the AT1 securities. It should not be viewed as an acknowledgment that the terms of the relevant securities were ineffective to result in a write-down. This was confirmed as much by FINMA’s announcement on 23 March 2023. As such, below, I will focus on the terms of the relevant AT1 securities.
The notion that holding a bond makes the bondholder a creditor is inaccurate. That is simply the form of the instrument. At its essence, a creditor is one who has rights to enforce against the borrower in the event of non-payment at predetermined dates. This is simply not the case with AT1 securities; there is no predetermined legally enforceable entitlement to receive a coupon or repayment of principal at a fixed point in time. In this way, they are more akin to equity. I note some regulators have come out since this event to reinforce a creditor hierarchy, but in those jurisdictions the bank issuers of AT1 typically do not use permanent write-down in distress.
For those unfamiliar with capital securities post the GFC, all AT1 capital securities feature what’s referred to as “going concern principal loss absorption’. These are essentially contingent features which allow securities to morph from being akin to subordinated debt to being akin to equity, in times of distress, with certain write-down features if specific events are triggered. The ‘times of distress’ are both hard coded and malleable. The latter point is key to the situation that transpired at Credit Suisse. The principal point to highlight is that capital securities, and most acutely AT1 securities, have a ‘living’ function, and while the terms in the prospectus explain how it functions in some instances, to assume the terms are black and white and static is naive. The operation of the security changes depending on the viability of the bank, i.e. the health of the bank and the regulator’s stance in times of distress should be incorporated into investors’ expectation of how the security functions.
A second point to note is that whilst the terms create liquidation preference ahead of ordinary shareholders, this is somewhat of a mirage. Whilst they create a psychological comfort blanket around a creditor hierarchy, as the securities are ongoing loss absorbing instruments, they'll have been triggered well before liquidation ever kicks in.
To understand how loss absorption works for any particular deal, there are two clauses to focus on:
i. What happens to the principal value of the security, in times of ‘distress’?
ii. What qualifies as distress, for the purposes of the security?
Let’s consider each of these in turn in the context of CSG’s AT1 Securities, using the 9.75% non-call 2027 (ISIN: US225401AX66) as an example.
CSG’s AT1 securities explicitly state they can be written down in full. Clause 7(b) states:Following the occurrence of a Write-down Event, on the relevant Write-down Date:
The terms are crystal clear as to what happens in a ‘Write-down Event’. There is no reference to relativity with equity holders or conversion of such notes into equity. The inference being that if a Write-down Event happens and the securities are written down to zero, the holders position relative to equity holders is unclear, and there is certainly no commitment to preserve creditor hierarchy.
The first, call it automatic limb for a write-down event, is where CSG’s CET1 ratio breaches 7%. The second, malleable limb of the Write-down Event, and of relevance here, is the Viability Event. Clause 7(a)(iii) states:
In offerings outside of Switzerland, some AT1 instruments only have an automated capital based trigger event, and then rely on the resolution framework to support the capital base. In Switzerland, however, the viability event is embedded within the terms, and its intent is clear.
What is unclear here is which of the limbs of the Viability Event was triggered by the Regulator. The announcement by UBS that the Swiss authorities provided CHF 25bn of downside protection, including CHF 9bn of protection on non-core assets bearing losses over CHF 5bn clearly shows extraordinary support from the public sector. The fact that this support was provided to UBS should not make a difference – after all, the counterfactual is that if UBS did not buy CSG, the government would have needed to have provided that support directly to CSG. Pursuant to the terms, CSG has to notify holders of a writedown, but where it is the result of an intervention by relevant authorities, such authorities need to pronounce this first. This seems to be what’s happened here.
To be clear, non-viability is intended to occur prior to any sort of insolvency or event of default, so the test is not how many more days they could have lasted. This is well-defined by the International Association of Deposit Insurers:
It’s clear CSG did meet this definition prior to the takeover, as CSG took extraordinary liquidity support from FINMA prior to the write-down of the AT1 securities. This is consistent with Article 29 of the FINMA’s Regulation about Own Funds.
There has also been some confusion about solvency being equal to viability. Viability is about the ability to operate viably and independently without any form of extraordinary state support, whereas solvency is merely the ability to pay debts as they fall due. So, one can be non-viable at one point, and still be solvent at that point, which may have been the case for CSG. Viability asks will the bank last on its own, and solvency asks can they pay their debts at this point.
It is also important to note that in bank rescues, time is of the essence, and the key is to restore market stability – this is highlighted well by the announcement by the Swiss authorities. Moreover, whilst the concept of liquidity and capital are clearly distinct topics in ordinary circumstances when there is a crisis of confidence in an institution, both liquidity and capital inextricably merge into one bucket of inadequate confidence. When a liquidity crisis exists, and counterparties are unwilling to provide emergency liquidity, the principal source of liquidity for such a bank is to sell assets, and such a situation may be a fire-sale below fair market prices. Such a fire-sale results in a capital problem. So, to restore either liquidity or capital, both need to be restored, and not because the accountants had it wrong, but rather because the market demands it. The market will demand belts and braces, and a clean bill of health. This was most evident in the GFC.
Going back to the uproar from investors about being written-down; in addition to the terms which make it clear there is no respect given to a traditional creditor hierarchy, the risk factors make this abundantly clear:
In summary, across 30+ pages the risk factors state that the risk of a write-down is material and may subordinate holders to ordinary shareholders, and the trigger for this is unpredictable and is outside the control of CSG. They reinforce that under the Swiss Banking Act, FINMA has broad powers to execute resolution powers, outside the scope of the terms of the securities, including permanent write-down. It could not be clearer.
This is consistent with the original understanding of securities with permanent write-down features. The regulator was aware and accepted that write-down instruments would in various circumstances (in particular when re-establishing the going-concern capitalisation of a bank) be beneficial to the shareholders. So conceptually, this appears to have been acceptable for regulators, as conversion of AT1 has the disadvantage of additional legal complexity in jurisdictions such as Switzerland.
Against the backdrop of a low-interest rate environment, investors naturally were hungry for yield. But CSG was plagued by many crises in recent years (including the default of Archegos Capital Management and the collapse of Greensill Capital), none of which had fully been resolved.
Several learnings for investors:
Final point: the key lesson we took from the last financial crisis was that the “old style” of subordinated debt and hybrid equity was not practically available to absorb losses or provide any kind of systemic protection before the point of non-viability. The best we could do at the time was to conduct liability management exercises and restructurings to generate core equity capital. The “new-style” of hybrid equity has been specifically structured to address this weakness, and ensure history does not repeat.
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