Why We Don’t Think Credit Suisse’s ‘Co-Cos’ Signal a Paradigm Shift

Editors’ Note: MarketMinder doesn’t make individual security recommendations. Any reference to specific securities herein is incidental to our higher-level discussion.

Here is the thing about bank crises: It isn’t necessarily the actual bank failures that pose economic risks. We have had enough banks fail during bull markets and economic expansions to prove there is nothing inherently, automatically bearish about them for broader markets. No, the real problems often arise when officials respond in inconsistent manners, making it difficult for investors to identify and price risks. And so we come to Credit Suisse, which was sold to UBS for centimes on the franc Sunday after flirting with failure for the umpteenth time last week. The manner in which regulators imposed losses on Credit Suisse’s investors seemingly caught a lot of folks off guard—giving equity investors some (small) compensation while wiping out holders of a particular kind of bank bond. Some fear this establishes a new and curious scenario across Europe, where equity investors outrank selected bondholders in the event of a failure. But we think there is good reason to believe the Credit Suisse situation isn’t a new blueprint for European banks, not least because Switzerland isn’t in the EU and Credit Suisse therefore wasn’t subject to the EU’s strict (on paper) bank resolution rules. However, the fear could impact banks’ funding costs in the near term, which could in turn slow lending and economic growth. More volatility wouldn’t surprise as markets price this in.

To explain all of this, we will have to go to some nerdy places and use finicky technical terms like “additional tier one capital” and “contingent-convertible” bonds. To help make this more digestible, we will abbreviate the former as “AT1” and the latter as “co-co.” We will also make this as simple and not-boring as possible—we will sprinkle some cheese on the broccoli, if you will. Ready? Off we go.

Credit Suisse is one of a few ginormous, long-suffering European banks that regulators have been trying to solve since 2007 – 2009’s global financial crisis. It is in a class called Globally Systemically Important Financial Institutions—aka G-SIFIs—whose sheer size or deep interconnectedness with the global financial system makes outright failure problematic economically in government officials’ opinions. Hence, despite many years of apparent mismanagement, regulators kept it afloat and bond investors—seemingly seeing the bank as too big to fail—continued capitalizing it. One big means of doing so? Co-co bonds, which the bank or regulators could convert to equity in order to shore up capital if need be. This is why they are classified as AT1 capital, which is one rung below Common Equity Tier 1 (CET1), the highest rank. AT1 assets have a strong potential to become equity capital in times of stress. This is well-known and written into the bond covenants, so it has long perplexed us that some considered them a low-risk investment. In the bank bond pecking order, they have the highest likelihood of going to zero, however low that raw probability is.

Last week, Credit Suisse released its delayed annual report, which contained some dismal results. This hit its already-battered stock price hard. Depositors, seeing this as a case of US regional banking problems going global, fled.^[i] The Swiss National Bank offered liquidity, but it couldn’t stem the outflows. Enter rival UBS, which purchased Credit Suisse Sunday in a deal most presume is a shotgun wedding arranged by regulators.

This is where the surprise kicks in. In the most recent instances of a big, solvent bank buying out a failing institution, the sale price was a token. HSBC bought Silicon Valley Bank’s UK subsidiary for £1 last weekend, for instance. When Spain’s Banco Santander bought the failed Banco Popular in 2017, it paid €1. But UBS paid 3 billion Swiss francs in stock, which will give Credit Suisse shareholders 1 UBS share for every 22.5 Credit Suisse shares they owned.^[ii] This wouldn’t be such a big deal, considering Credit Suisse hadn’t actually failed yet, but it happened after Credit Suisse wrote its co-co bonds down to zero, wiping out those creditors.

Typically, it doesn’t work this way. Longstanding practice is that shareholders take the first round of losses, with losses imposed on creditors only after common stockholders are wiped out. This makes sense in the real world. Shareholders own the business. When the business is no longer a business, its value goes to zero. But that business still owes people money, so its assets are sold and the proceeds used to pay off that debt. The order in which creditors get their money is determined by a pre-set pecking order, typically enshrined in bankruptcy law or—in banks’ case, bank resolution procedures set by regulators.

If Credit Suisse had failed outright with no buyer, you might reasonably expect it to go like this:

1. Bank fails.
2. Regulators divide bank in two—a “good bank” and a “bad bank.” The good bank contains everything that still works and makes money as intended. The bad bank contains everything that doesn’t work and is racking up losses.
3. Depositors and senior bondholders go with the good bank.
4. Junior bondholders and shareholders go with the bad bank. Shareholders get wiped out. Co-co bonds convert to equity, which is used to cover losses, and co-co bondholders get wiped out.
5. Regulators recapitalize the good bank, change the name, do some rebranding and eventually return it to the open market.
6. Regulators slowly sell the bad bank’s assets and use the proceeds to pay off remaining creditors, many of whom take a haircut.
7. People write long articles and books on what went wrong and how to fix the financial system.

That is the European blueprint. Whenever it has been tested, shareholders and co-co bondholders have been on the hook for losses. When Santander bought Banco Popular, both classes were wiped out.

So letting Credit Suisse’s shareholders avoid a total loss has caused some confusion. Like the Fed and US Treasury’s decision to guarantee all of Silicon Valley Bank and Signature Bank’s uninsured deposits, it is a change from established procedures. It seemingly changes the pecking order that determined how banks’ various debt instruments were priced. It makes investors wonder, is this now a thing that can happen at all European banks? Can bondholders take losses while shareholders don’t? Has precedent changed? These questions are currently rippling through European co-co bond markets.

Trying to predict how officials will act in the heat of the moment is always perilous. But we see some mitigating factors. One, again, Switzerland is a metaphorical island. It isn’t in the EU or eurozone, so its banks aren’t regulated by the ECB and aren’t part of the EU’s banking union. That means they aren’t subject to the EU’s bank resolution framework. In the wake of the move, reports noted the peculiarity of Swiss rules and that the bond prospectus outlined this risk.^[iii]

For the EU and eurozone, Swiss regulatory quirks don’t seem too relevant. A decade ago, in the wake of Cyprus’s bank crisis and sovereign bailout, the EU rewrote its bank rules in hopes of avoiding taxpayer-funded bailouts. In doing so, they formalized “bail-ins,” in which shareholders and bondholders take a certain percentage of losses when a bank fails. Only when enough creditors have been “bailed in” can a failing bank take state money to assist with its resolution process (i.e., Step 5 in the above hypothetical process). These rules create a very strict pecking order. Shareholders take the first losses, followed by junior or “subordinated” bondholders—which includes co-co bonds—and then senior bondholders. Next on the hook are uninsured deposits, starting with large corporations with deposits above €100,000, followed by small and midsized business and individual deposits above €100,000. These entities get “bailed in” until they have collectively covered at least 8% of the bank’s liabilities, at which point the bank can get a state capital infusion. If the bank seeks capital above 5% of liabilities, all creditors must be wiped out.

These rules are enshrined in EU law and mirrored in member-states’ laws and their central banks’ resolution processes. So on paper, presuming everyone goes by the book, it shouldn’t be possible for Credit Suisse’s shareholder-friendly resolution to become the blueprint. In time, as the dust settles, we think markets will likely reflect this. After all, this isn’t the first time European co-co bonds have responded negatively to bank failures in the region. Their yields spiked when Portuguese authorities botched the resolution of Banco Espírito Santo just before it crossed the finish line in late 2015. Initially, when BES failed in 2014, regulators followed the standard bail-in process, wiping out shareholders and junior bondholders. But when it came time to return the “good bank” to private hands, they flipped some senior institutional bondholders back to the “bad bank” while sparing retail investors from taking bond losses, violating “no creditor worse off” principles that mandate bondholders not be treated worse under resolution than they would have been in a typical insolvency procedure.

In other words, it was a case of regulators picking winners and losers, which caused European bank bond markets to have to reprice risk in a hurry. But the volatility was short-lived, and EU officials shored up the relevant loopholes in early 2018, which should reduce confusion surrounding the pecking order the next time an EU bank fails. These rules, if followed, should add clarity—an overall positive. That said, we do think officials’ behavior in the event of a failure is worth watching. Inconsistent actions by regulators, most notably the Fed and US Treasury, were a key cog in 2008’s financial crisis, in our view.

Beyond the regulatory response, the Credit Suisse saga could incentivize banks to reduce lending, especially if co-co debt becomes more expensive and difficult to issue for a while. Banks have used it above and beyond regulatory minimums in recent years to avoid diluting shareholders with equity capital raises. We doubt banks will have much appetite for raising equity capital now, as it would imply some weakness, perhaps scaring off depositors in this environment. Therefore, banks could very well decide to take less risk for the time being. Even if they don’t outright deleverage, they could reduce lending, which could slow economic growth. As in the US, it will take time for this to show in the data, making it an area to watch.

For now, though, the fear seems much greater than reality. Even if reality doesn’t go terribly well from here, anything shy of abject disaster probably qualifies as positive surprise. We will continue monitoring the situation, but currently, we don’t think recent banking issues present a fresh, lasting wallop for global markets.