The Devil is in the Details

Many people are up in arms over the apparent subordination of bond holders to equity holders in the Credit Suisse takeover and arranged sale by the Swiss banking regulator. Holders of Credit Suisse Additional Tier 1 (AT1) bonds, aka Contingent Conversion ("CoCos"), get nothing while equity holders get paid something to sell to UBS. This is an inversion of the normal way of things. Equity holders should be wiped out before claimants start chomping off slices of debt.

My first reaction was "not again!" During the financial crisis some funds I managed owned Chrysler loans, which were supposed to be the senior securities in the capital structure. They explicitly had had precedence above "unsecured" claims on the company, including pension funds. In the bankruptcy process the Obama administration inverted the seniority so our claims were wiped out to support the pension fund. I mention Obama because he personally vilified the evil "hedge funds" for preying on the suffering retired auto workers. The retirees who invested in our mutual funds did not merit a thought from the administration.

This is not that. Bond holders did not get unfairly stiffed. They needed to read the fine print.

Remember the hierarchy for bank capital. "Core" Tier One includes common equity and retained earnings. "Additional" Tier One includes preferred stock and "high-trigger" Cocos. Tier Two includes subordinated debt and "low-trigger" CoCos. Tier 1 capital counts more toward capital requirements than Tier 2.

The basic idea of AT1 bonds is that they contribute their face amount to boosting a bank's capital when the bank gets in trouble. "Trouble" being defined as trigger point specified in the indenture. With most CoCos, the capital is boosted by converting the bonds into equity. Compare this to a typical bankruptcy where the equity is wiped out and the bondholders become the equity holders. AT1 bonds provide a method for this to happen without a formal bankruptcy or even a default by the more senior debt. This involuntary conversion feature (in essence a short put option) requires AT1 bonds to yield more than senior debt. Before this week, I confess this was about the extent of my knowledge of CoCo structure.

It turns out the trigger point isn't the only point of differentiation among AT1 bonds. There are also the loss absorption mechanisms, which can either be "conversion to equity" (CE) or "principal writedown" (PWD). CE AT1 bonds are converted to equity at some ratio when the trigger is hit. PWD bonds suffer a loss of principal upon the trigger, irrespective of what is happening with the equity. Here is what the prospectus for the Credit Suisse CoCos says: "Credit Suisse AT1 notes will be written down to zero when the bank’s capital falls below 7% of its risk-weighted assets (known as a contingency event) or when measures to boost its capital are deemed to be unfeasible or insufficient to prevent insolvency (known as a viability event).?"

Whether a CoCo is a CE or a PWD bond is a function of the regulatory domain. Switzerland provides for principal write downs, while in the EU and the UK the regulators stipulate that equity holders must bear the losses first. So it would seem that ALL Cocos issued by Swiss banks are of the PWD form. That would apply to UBS, which is taking over Credit Suisse, by the way. From my rocking chair on the porch I can't see if the market is now adding an additional haircut for PWD as opposed to CE CoCos, but it should.

My favorite trades are ones where the structural features of the securities bestow value that is abstracted from the fundamentals of the underlying company or collateral. I can then be more objective as an analyst. In 2008 buying the very risky equity tranche of sub-prime CDOs was a great hedge for shorting the not-recognized-as-risky senior tranches. "Covered" bank mortgage bonds issued by Washington Mutual were treated as nearly the same as senior bank bonds but rose in price when the bank failed taking the senior bonds with it. In both these cases understanding the structure allowed for very low risk trades to be constructed that would do fine in fair weather and pay off big in a storm. In the Credit Suisse case it seems that going long the equity against a short in the CoCos would have been a great idea. While I suspect a few hedge fund types thought of this trade, it would have to be very high conviction because shorting high-yielding bonds is very expensive.

It seems the holders of Credit Suisse CoCos, including Invesco and Pimco, are already lining up to sue, but they have an uphill battle because small print is pretty easy to read...now.

See here for a excellent primer on AT1 bonds: CoCos: a primer