The One Thing We Should Learn From the Credit Suisse Debacle
In March of 2023, the global financial markets experienced a run on the banking systems, the likes of which had not been seen since 2008. This perhaps proves, once again, that there can be no real risk-free returns in the financial markets, no matter how much we delude ourselves! The final nail in the coffin of this episode of financial panic is probably the demise of Credit Suisse, a storied Swiss universal bank of some 167 years, bought over by its rival UBS for a paltry $3.3 bn. When Credit Suisse last raised equity capital from Saudi Arabia’s Saudi National Bank at the end of 2022 (at the end of a long decline in the value of the bank), it was worth $14 bn. So even the latest equity investors have lost some 75% of their investment.
But even those losses pale next to the 100% loss suffered by the holders of the Credit Suisse AT1 Bonds (AT1 being Additional Tier 1 Capital, as defined by the Basel Accords). The decision by the Swiss banking regulator to write down the value of these bonds triggered outrage in every corner of the financial world. Especially since investors in these bonds issued by Credit Suisse were assured that they were “bonds” and ranked above equity in liquidation or resolution. How is it possible that bond holders were wiped out while the equity holders still got to share in the paltry $3.3 bn offered by UBS for their shares? Surely this is against the order of the financial universe?
The one thing we should learn from the Credit Suisse debacle
And it is not just the bond investors who feel this way. Even banking regulators such as the Bank of England, the European Banking Authority and even the Monetary Authority of Singapore have issued statements to reaffirm the seniority of the AT1 bond to common equity. How outrageous that the Credit Suisse AT1 bondholders need to suffer a 100% loss! Or could there be grounds for this loss? What should we really learn from the Credit Suisse debacle?
What We Can Learn from the Credit Suisse AT1 Bonds Debacle
As individual investors, probably the biggest takeaway or learning we can have from this episode is that there may be hidden risks in any complex financial instrument. And a complex financial product issued by Credit Suisse probably compounds the risk, as they have a history of issuing investment products which have brought investors grief! Volatility Exchange Traded Notes (ETNs), oil ETNs, name it, and Credit Suisse probably has issued them before. Even if the smartest traders, financiers and mathematicians have put these things together, there are almost certainly unknown unknown risks lurking in them.
And while it may be tempting to dip our toes in these complex products, remember that for individual investors, it is really only the rare, select few who are able build significant wealth by dabbling in complex financial investments. A quick glance at the list of the ordinary people who have been able to accumulate enough wealth to retire on will show that the time tested ways for doing so are:
- Owning a profitable business
- Selling a promising business
- Earning a high income from employment, such as doctors, lawyers, professionals, bankers
- Investing in a ordinary stocks (for growth) and bonds (for risk management)
In none of these tried and tested ways for building wealth do complex financial investments play a part. And for good reason too, since the risks of newly created investments are rarely apparent until years later.
So if a financial advisor, wealth manager or relationship manager comes to you bearing an investment opportunity in a complex financial product, be sure to steer clear! Remember that the interests of these advisors is for their own remuneration firstly, and the interests of the issuing bank is for their own profit first and foremost. Your interests, the investor, will rank much lower down the pecking order! The commission and profitability of financial investments is generally higher the more complex it gets!
A Deeper Look at these AT1 Bonds
The fact that the issuing banks life Credit Suisse will put their own interests first and foremost when issuing complex investment products can be seen more clearly if we delve into the history of these AT1 bonds.
AT1 bonds were created back in the early 2010s after the Global Financial Crisis of 2008, when Leman Brothers collapsed, and nearly brought down the global financial markets with it. The frustrations of the general public with the bailouts of the global banks back in 2008 were quite clear:
- Why was it that banks could not use the capital they had, especially the Tier 2 Capital of their issued subordinate bonds to stave off bankruptcy and failure?
- Why was it that the management of these banks, who steered them into failure, were able to get away without any penalty or hit to their wealth?
How can AT1 bonds be used to save banks?
The answer to the first question, is of course, that that any form of debt, like subordinated bonds are still senior to equity capital, and cannot be tapped to save a bank from failure until the equity is wiped out. But this creates a dilemma about their use, since to wipe out the equity of a bank means that a bank must declare bankruptcy. And a bankrupt bank is of no use, since the assets of the bank will get frozen by the bankruptcy court and all the customers, counterparties, debt holders etc, are worse off, and the financial system can face a very real risk of collapse.
A bank declaring bankruptcy, like Lehman Brothers, is like pulling a leg off the stool of the financial system – the system simply cannot function! Which is why bank regulators need to intervene before the equity holders are wiped out, just like in the case of Silicon Valley Bank, which was closed by the bank regulators on Friday, and reopened under new ownership in Monday. A bankrupt bank is useless and bad news all around. And for AT1 bonds to be used like equity to help stave off a bank collapse, they really need to be written down before the equity holders are wiped out. It is a feature, not a flaw of the bonds!
How can bank management be made to bear the bank losses?
As for the second question, when banks began trying to design these AT1 bonds, some of them, like Credit Suisse, came up with the brilliant idea of issuing them to senior management as bonuses. Back then, these bonds could be converted to equity if the bank had losses of such magnitude as to require more equity. Which is where the name CoCos came from – Contingent Convertibles. By paying their management their bonuses in the good years in these CoCos, the value of the bonds and shares when converted in equity will fall in bad years, hence clawing back their bonuses to help save the bank. What a clever and satisfying idea! Karma is really a bitch, it appears!
But bank management were clearly not being paid bonuses in the billions, which is what the banks required their AT1 bond issuances to be. So there was a need to sell these AT1 bonds or CoCos to the investing public as well. Especially since the issued yields on these bonds were so much lower than raising new capital. Just look at what the banks in Singapore got away with in their AT1 bonds:
Issued Yields on Singapore Bank AT1 Bonds
Compared to issuing new equity capital at a required rate of return of at least 10%, issuing AT1 bonds made so much more sense to the bank. Note also that these AT1 bonds can be issued in 4 variants:
- Whether they are converted into equity, or written of
- Whether the trigger to convert or write down the bonds is exercised by the bank, or by the bank regulator
Clearly banks will prefer not to convert the AT1 bonds into equity, as it dilutes their existing shareholders. Also since no bank likes to annoy their AT1 bondholders by exercising the bonds, as they may need these investors for future capital raising, giving the regulator the power to exercise these bonds creates additional risk for the investor. And yet, the Credit Suisse AT1 bonds were the riskiest variants, i.e. where they are written off upon exercise by the regulator. Why? Self interest rules before investors’ interests once again!
Clearly, if yield hungry investors were willing to invest in the riskier variants of the AT1 bonds at low yields, the bank would be happy to issue them as much as they wanted, up to the regulatory limit. Which appears to be what happened everywhere, not just for Credit Suisse. And look where we ended up!
Were the Swiss justified in wiping out the Credit Suisse AT1 bondholders?
This may be a controversial view, but it appears that the Swiss did the right thing. As noted above, a dead or bankrupt bank is of no use to anyone, and so it needs to be saved before the equity holders get wiped out. And so the AT1 bondholders need to bear that loss. This is precisely the situation the AT1 bonds were designed for, so if anyone is at fault, it is Credit Suisse’s fault for not explaining it clearer to the bondholders. In reality, the AT1 bonds are more alike to insurance catastrophe bonds than the run-of-the-mill subordinate bonds. In the same way, catastrophe bonds get wiped out should the event in question (e.g. earthquake, hurricane etc) occur.
But what of all the statements from the bank regulators supporting the seniority of the AT1 bonds over equity? If you read them carefully, all of them reaffirm the seniority of the AT1 bonds in the event of bankruptcy or resolution, both of which mean the bank is dead beyond saving. Which these same regulators will never allow for a large systemically important bank under their watch, because it will take the financial system down with it. Which also means that if the ball were to be in their court, they would not hesitate to wipe out the AT1 bondholders as well!