Discover more from Without Warning
Credit Suisse's AT1s & Bank Capital in a Crisis
The AT1 jig may be up
The saga over the $17 billion of Credit Suisse’s Additional Tier 1 [capital] bonds that got wiped out, while shareholders walked away with not nothing, seems set to continue for a while. The market expected that shareholders would be wiped out before AT1 holders—who might still then emerge as the new equity holders. These instruments are intended to be “going concern” bail-in instruments. They were to be written off in the event CS’s capital ratio dipped below 7%. That they were to be written off instead of converted into equity was semi-unique (see picture), which seems to have also contributed to spooking the market:
AT1s can can also be triggered at regulators’ discretion — at the “point of non-viability.” Credit Suisse’s AT1s included a clause that a “viability event” might be triggered by unusual government assistance. That Swiss authorities used this explanation to zero out the AT1s as part of this deal was perceived poorly in the market as a general violation of the hierarchy of claims in a capital structure. The market for AT1s sold off, in some cases becoming more expensive than equity. Here’s Bloomberg on the Tuesday after:
Major European banks’ cost of equity capital now averages 13.4%, based on data compiled by Bloomberg. That’s lower than the average yield across AT1 bonds, which jumped to 15.3% after the Credit Suisse wipeout.
AT1s’ Evil Genius
Now, on the one-hand: there’s always been doubt about these structures. While it’s nice for a bank to not wonder in the middle of a crisis where it’s going to get some life-saving capital, regulators triggering a bail-in via the AT1s risks exacerbating a balance sheet run. Moreover, while raising bank capital during a crisis is the hardest thing to do, much of the effectiveness often comes from the signaling value of the *voluntary* aspect of a successful capital raise. E.g., “Buffett Invests in Goldman,” etc.
Yet, there’s some elegance to this writedown structure at first approximation. Instead of shareholders being wiped out and AT1 bondholders becoming the new owners of the firm, shareholders stay in their position. AT1 “going concern” bondholders—i.e. ones that can be bailed in without shareholders being wiped out—essentially bought a bond and also sold a put option on left-tail risk to the shareholders (and got compensated for it via the coupons).1 Keeping key shareholders — which also often substantially include bank employees — alive as shareholders can be hugely advantageous.
The Shareholder Value of…the Shareholders
Relationships with external shareholders are often deep and even personal—and can be essential for supporting management’s vision. Reporting suggests that Credit Suisse’s (particularly Michael Klein’s) relationships with Middle East investors were crucial in even giving the firm a chance at raising fresh capital and commencing a restructuring. Zeroing them out and turning PIMCO, et al. into the firm’s new shareholders doesn’t exactly paint a picture of market stability: “Hi, nice to meet you, please trust me to restructure this multibillion dollar firm.” Oh and, “I know you’re a bond fund, but please don’t sell and cut your losses. Hold onto some equity shares that are getting constant media attention for tanking and will thus cost you tons of time with customers.” And again, a bank in crisis wants to show off a well-known investor voluntarily putting up capital, not well-known funds dumping shares because they involuntarily put up capital.
It’s also a good thing for a bank clinging to its survival to not suddenly zero out the stakes of its employees. Bank capital is only useful to the extent a bank—that is, its employees—knows how to use it. Banks that were trigger-happy in laying off fixed income traders during the subprime crisis often then found themselves in over their heads trying to manage these books—and thus dragging for longer than necessary. Meanwhile, the traders would get hired back later to help or go make a billion dollars in a hedge fund that would give them some capital—because they knew the market and where all the bodies were buried.
Indeed, bleeding key employees over recent months is a key reason the market continued to view Credit Suisse as undercapitalized, despite:
That being said, even in this deal being characterized as too nice to shareholders, they got just $0.83 a share. It’s not clear how much employee goodwill an extra 82 cents per share will really engender amongst the newly christened UBS employees. By all accounts, Bear Stearns employees didn’t exactly love their new JP Morgan overlords for bestowing upon them even $10 per Bear share. (This was down from a high of over $170, a closing price of north of $30 bucks on its final pre-deal trading day, but renegotiated after an initial deal at $2/share.)
Bank Capital Is Hard
Bank capital can help prevent financial crises, but is a scarce resource. And, because of the macro need to economize on bank capital (a 100%-equity funded “bank” has no deposits, no repos, etc.—i.e., it does not provide us with our basic financial needs), the banking sector always looks like it should have had a higher capital wall once a crisis climbs over it. Fighting a financial crisis is an exercise in sourcing capital you can stuff into the banking sector’s balance sheet(s) without losing too much franchise value.
Solving this problem by using sleight of hand to get fixed income investors to actually buy equity may have just gotten a lot harder. That trick might only work once. And it’s not clear their money would be any good here anyways: ex ante capital should maybe just be actual capital, and ex post capital is less valuable when it’s conscripted.
Subscribe below to receive new notes directly. Without Warning will always be free.
This also helps the government solve its problem of wanting the firm to survive (i.e., maintain a material, positive market value) but also wanting to limit moral hazard. If you assume that GSIB AT1s are as good as Treasurys outside of a systemic crisis, you can imagine that instead of requiring AT1s, the government issues moral hazard bonds (hawked by Uncle Sam?). They’d be priced like a Treasury plus the compensation for selling a put option on systemic risk. And the government would pay those bondholders back like Treasury holders in all but a financial crisis. What moral hazard?