Prasad Gollakota was co-head of the global capital solutions group at UBS in the aftermath of the 2007-08 financial crisis. He was there at the beginning of the Additional Tier 1 securities market. Here he shares his view on the write-down of Credit Suisse’s AT1s by Swiss authorities. Spoiler: angry fund managers feeling hard done by don’t have a leg to stand on.
It has been fascinating to watch the uproar around the apparent breach of the so-called creditor hierarchy since the announcement of the writedown of Credit Suisse Group’s AT1 securities – and the talk of class action litigation that followed. It’s not new for investors to cry over spilt milk, but they can’t say they weren’t warned.
This topic is close to my heart, as I was involved in the early development of Additional Tier 1 securities and recall the conceptual discussions with regulators and policymakers, bank issuers, industry bodies and investors. I am keen to ensure past mistakes don’t repeat themselves.
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 Credit Suisse’s AT1s were written down to reinforce the traditional creditor hierarchy, but in those jurisdictions issuers of AT1s typically do not use a permanent writedown in distress structure.
I also note some investors have been exercised by the fact that the Swiss authorities chose to issue an emergency law confirming that the AT1s were to be written down in the context of the UBS takeover. But this does not deny the operation of the terms of AT1s. Their terms and Article 29 of 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 AT1s. It should not be viewed as an acknowledgment that the terms of the AT1s were ineffective and would not result in a writedown. This was confirmed as much by Finma's announcement on 23 March. As such, I will focus on the terms of the relevant AT1 securities.
Not black and white
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 writedown 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, ie, 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.
The terms relating to ranking on liquidation are a mirage as they create a psychological sense around a creditor hierarchy. However, as these 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 issues to focus on:
One, what happens to the principal value of the security in times of distress (the writedown)? Two, what qualifies as distress?
Let’s consider each of these in turn in the context of Credit Suisse’s AT1 Securities, using the 9.75% non-call 2027 (ISIN: US225401AX66) as an example.
Loss absorption
Writedown mechanism
Credit Suisse’s AT1 securities explicitly state they can be written down in full. Clause 7(b) of the documents governing the transaction states:
Following the occurrence of a writedown event, on the relevant writedown date:
(i) the full principal amount of each note will be written down to zero …
(ii) the holders will be deemed to have irrevocably waived their rights to, and will no longer have any rights against the Issuer with respect to, repayment of the aggregate principal amount of the notes …
and
(iv) the notes will be permanently cancelled.
The terms are crystal clear as to what happens in a writedown event. There is no reference to relativity with equity holders or conversion of such notes into equity. The inference being that if a writedown 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.
Breach of 7% CET1 and viability event
The first – call it automatic – limb for a writedown event is where Credit Suisse’s CET1 ratio breaches 7%. The alternative – malleable – limb of the writedown event, and of relevance here, is the viability event. Clause 7(a)(iii) states:
Viability event
As used in these conditions, a “viability event” means that either:
(A) the regulator has notified CSG that it has determined that a writedown of the Notes … is … an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or
(B) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the public sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and without which, in the determination of the regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.
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 SFr25bn of downside protection, including SFr9bn of protection on non-core assets bearing losses over SFr5bn 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 Credit Suisse, the government would have had to provide that support directly to Credit Suisse. Pursuant to the terms, Credit Suisse 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 happened here.
Non-viability and insolvency
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 Credit Suisse could have lasted. This principle is well-defined by the International Association of Deposit Insurers:
Non-viability refers to a situation before institutional Insolvency, and may also include circumstances in which: (i) regulatory capital or required liquidity falls below specified minimum levels; (ii) there is a serious impairment of the bank’s access to funding sources; (iii) the bank depends on official sector financial assistance to sustain operations or would be dependent in the absence of resolution; (iv) there is a significant deterioration in the value of the bank’s assets; (v) the bank is expected in the near future to be unable to pay liabilities as they fall due; (vi) the bank’s business plan is non-viable; and/or (vii) the bank is expected in the near future to be balance-sheet insolvent.
It’s clear Credit Suisse did meet this definition prior to the takeover, as it took extraordinary liquidity support from Finma prior to the writedown of the AT1 securities.
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 Credit Suisse. Viability asks whether the bank will last on its own, and solvency asks whether they can pay their debts.
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, while 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. 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 global financial crisis.
Risk factors couldn’t be clearer
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 the danger of writedown abundantly clear:
The likelihood of an occurrence of a writedown is material for the purpose of assessing an investment in the notes. The notes may be subject to a writedown and upon the occurrence of such an event holders will lose the entire amount of their investment in the notes …
The writedown may occur even if existing preference shares, participation certificates, if any, and ordinary shares of CSG remain outstanding.
The circumstances triggering a writedown are unpredictable. Future regulatory or accounting changes to the calculation of the CET1 amount and/or RWA amount may negatively affect the CET1 ratio and thus increase the risk of a contingency event, which will lead to a writedown, as a result of which holders will lose the entire amount of their investment in the notes.
The occurrence of a contingency event or viability event is inherently unpredictable and depends on a number of factors, many of which are outside of the Issuer’s control…
The occurrence of a viability event, and a writedown resulting therefrom, is subject to, inter alia, a subjective determination by the regulator as more particularly described below and in condition 7(a)(iii) (writedown—writedown event—viability event). As a result, the regulator may require and/or the federal government may take actions contributing to the occurrence of a writedown in circumstances that are beyond the control of CSG and with which CSG does not agree.
CSG is subject to the resolution regime under Swiss banking laws and regulations.
CSG is the Swiss parent company of a financial group, which means that under the Swiss Banking Act, Finma is able to exercise its broad statutory powers thereunder with respect to CSG, including its powers to order protective measures, institute restructuring proceeding… if there is justified concern that CSG … has serious liquidity problems ...
Additionally, holders of the Notes would have no right under Swiss law and in Swiss courts to reject, seek the suspension of, or to challenge the imposition of any such protective measures.
Resolution powers that may be exercised during restructuring proceedings with respect to CSG include the power to… (c) partially or fully convert into equity of CSG and/or writedown the obligations of CSG, including the Notes, if not already written down pursuant to their terms. Creditors, including Holders, will have no right to reject, or to seek the suspension of, any restructuring plan pursuant to which such resolution powers are exercised with respect to CSG.
In summary, across 30-plus pages of documentation, the risk factors state that the risk of a writedown is material and may subordinate holders to ordinary shareholders, and the trigger for this is unpredictable and is outside the control of Credit Suisse. 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 writedown. It could not be clearer.
This is consistent with the original understanding of securities with permanent writedown features. The regulator was aware and accepted that writedown 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 AT1s has the disadvantage of additional legal complexity in jurisdictions such as Switzerland.
Lessons to learn
Against the backdrop of a low-interest rate environment, investors naturally were hungry for yield. But Credit Suisse 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.
There are several lessons for investors:
- Read and understand the prospectus, including the risk factors which are not simply window dressing.
- Understand the context of the Basel III capital framework, and the inherent risks it introduced, particularly in the case of capital securities.
- Understand that the traditional creditor hierarchy may not be respected, and in such cases if the risk isn’t worth the reward, move on.
- Do not underestimate the power and desire of the banking regulator to restore market confidence in a crisis.
- Understand the relevant resolution legislation of the jurisdiction of the issuer, as it typically will allow wide-reaching powers to intervene in the contract between bondholders and a failing bank.
A 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 itself.
Gollakota is now chief content officer at the video finance learning platform Finance Unlocked