Credit Suisse AT1 bonds: No free lunch in economics

23 Mar 2023 , 10:20 AM

Most Indian investors had their first brush with the downside risks of AT1 bonds during the Yes Bank crisis in early 2020. At that point, the RBI had negotiated a rescue package for Yes Bank, led by SBI and supported by other banks. However, there was one condition in the rescue deal; AT1 bonds of Rs8,000 crore will be fully written down to zero prior to the rescue plan. The legal battle over the repudiation of AT1 bonds in the Yes Bank case is still on as bondholders got nothing. Even, in the case of Credit Suisse, UBS had insisted that as part of the deal $17 billion of AT1 bonds will have to be written down to zero. Now that is nearly 17 times as large as the Yes Bank write-off and has stirred up a major controversy, with possible legal ramifications.

What exactly are AT1 bonds all about?

The AT1 bond or Additional Tier 1 bond is a recent invention permitted by the Bank for International Settlements (BIS), Basel, at the peak of the Global Financial Crisis in 2008. AT1 bonds have become quite popular in Europe for banks to raise risk capital and the size of AT1 bonds in Europe alone is worth $250 billion. Even India has its share of AT1 bonds issued by banks, but that is much smaller in size. Now, what is so unique about AT1 bonds? These AT1 bonds are technically perpetual bonds with no maturity. However, only strong banking institutions are allowed to issue AT1 bonds. These large banks, to maintain their brand value and reputation, would typically offer an exit option at the end of 5 years; either via redemption or conversion to equity.

Till now, it sounds well and good. AT1 bonds are Tier 1 bonds and can be classified as Tier 1 capital. So, this gives a direct boost to the Tier 1 capital adequacy of the bank; something so essential to keep the bank’s operations running. The AT1 bonds pay a much higher rate of interest. In fact, the rates are even higher than the rates paid by junk bonds, which is what makes them so uniquely attractive. Obviously, a big bank like UBS or Credit Suisse paying you more than junk bonds is a salivating proposition. But, now comes the real catch. In the event the equity getting depleted and for syndicating a proposed sale to a third party, the AT1 bonds can be written off fully. Investors in AT1 bonds get into these bonds, knowing fully well the risk involved. After all, as Milton Friedman had said many years ago, there is nothing like a free lunch in economics.

Why AT1 bonds were written down to zero for Credit Suisse?

Before we get into the actual AT1 bond repudiation of Credit Suisse, it would be useful to understand this case with a balance sheet analogy. Let us assume a banking unit with $100 of assets, $90 of liabilities and, therefore, $10 of equity. These liabilities have to paid when due and governments and central banks do not relish default on deposits by banks, so that is ruled out. The catch is that the assets that the bank creates with these deposits and loans are risky and valuations can be volatile. We are not only talking about asset depletion but also off-balance-sheet losses from derivatives positions. The problem here is that if the value of the assets depleted by 10% (quite normal) there is no equity left. It is in this context that the writing down of $17 billion of AT1 bonds must be understood.

In the case of Credit Suisse, as per the 2022 filings, it had SFR531 billion of assets, SFR486 billion in liabilities and the balance SFR 45 billion in shareholder equity. Equity is just about 8.47% of the assets so an 8.5% fall in asset value is good enough to make the shareholder equity worthless. Before the rescue act over the previous weekend, the stock of Credit Suisse was trading at SFR2.24 per share, which translates into a valuation of SFR9 billion or about 20% of the book value. Now, the assumption at this point is that the SFR531 billion of assets can recover at least that amount. But that is a specious assumption when the bank must be sitting on billions of dollars in bond losses due to rising interest rates. If that was factored in, the equity would be worthless and the only option would be for Credit Suisse to go bankrupt, with disastrous consequences for European markets and global markets.

Now we come to the reason for the AT1 bond write-down. By Friday, the stock price of Credit Suisse had fallen from SFR2.24 to SFR 1.86 implying an equity market value of SFR7.4 billion. Now the market value of Credit Suisse has gone down from 20% of shareholder equity to 16% of shareholder equity. For the SNB and the Swiss government there was little time left. They had to prevent bankruptcy, so it had to be a sale and it had to be UBS. The stock swap was eventually agreed at 1 share of UBS for every 22.48 shares of Credit Suisse held. That is about SFR0.76 per share or SFR3 billion in equity value. Earlier, UBS was willing to pay just SFR1 billion. The final figure of SFR3 billion is 3 times better. But to make it attractive and still leave something for equity investors, AT1 bonds had to be repudiated.

Buy why should equities have all the fun?

Not surprisingly, AT1 bond holders led by global fund managers like PIMCO, are up in arms against the decision. Their contention is that in any priority waterfall, equity come last. While AT1 bondholders fall below other bonds in priority, they must get priority over equity. The irony in the case of Credit Suisse is that equity investors are getting SFR3 billion worth of value, but AT1 bonds are getting just about nothing. Bond investors argued that this decision was ridiculous for a bank that still had a market value of $8 billion. However, AT1 bondholders are forgetting a basic point here. The priority waterfall would apply in the case of liquidation. In the case of a flash sale of the bank to another buyer, it is perfectly legitimate for the AT1 bonds to be written down, and that is the very idea of AT1 bonds.

Why did the government of Switzerland agree to such a deal. Remember, Credit Suisse has some powerful large shareholders like the Saudi National Bank and Qatar Investment Authority. They had already asked shareholders to vote against the SFR1 billion UBS offer. The latest offer of SFR3 billion looks like a face saver for everybody. In the process, the AT1 bonds are bearing the brunt, but that was the purpose of AT1 bonds; to provide a cushion in the event of a sale of the bank. If the shareholder vote failed, Credit Suisse would have folded up this week under a run on the deposits. That would have been disastrous for European and global markets. The price was, of course, paid by the AT1 bond holders. Also, employees hold lot of shares and you need them to come to work to run the bank.

AT1 bonds may have been introduced in 2008, but they existed for a long time as COCO bonds or contingent convertible bonds. The idea was to attract bond investors with higher yield and also provide a cushion to equity shareholders in a crisis. The legal battles may carry on for much longer; but what the Credit Suisse AT1 bond fiasco has done is to highlight the huge risks that AT1 bonds carry.