Buy-side trading desks say they are looking at the risk of contagion across financials, following the takeover of troubled Credit Suisse by UBS, for US$3.25 billion, with sources warning AT1 securities have just entered unknown territory.
The takeover has involved “extraordinary government support” with close coordination market regulator FINMA, the Swiss Confederation and the Swiss National Bank “triggering a complete write-down of the nominal value of all Alternative Tier 1 Capital (AT1) shares of Credit Suisse in the amount of around CHF 16 billion (US$17 billion),” according to FINMA.
AT1 shares are created when the issuer of AT1 bonds experiences a credit event, at which point the bonds are converted into equity or the value is wiped out. Writing off the value in this instance increases Credit Suisse’s core capital, but wipes out AT1 investments.
The Swiss treatment of AT1 seems unprecedented – the last time a bank’s AT1 capital was wiped out and it was taken over – Spain’s Banco Popolar in 2017 – so was the equity value.
This treatment of AT1s creates several questions. Firstly, as equity value remained in Credit Suisse, holders of AT1 paper may strike a legal challenge to having the value of their AT1 shares written down.
Secondly, holders of AT1 paper need to consider what happens if this scenario is repeated – and given the risk on contagion in financials that is possible – at other banks. If AT1 debt can be written off but common equity is made good, the value of AT1 debt could be severely affected. That is a market worth roughly US$270 billion.
This could be a major problem for other financials. AT1 securities are banks’ tier 1 capital as the name implies, and used to assess the bank’s capital ratio. A repricing could have a serious effect on bank stability.
As the CS/UBS takeover will result in a larger bank, for which the current regulations require higher capital buffers FINMA says it will grant “appropriate transitional periods” for these to be built up. If those buffers are expected to include AT1 securities, that might take longer than planned.
Another priority for buy-side trading desks is to assess how they are operationally exposed to Credit Suisse and to contagion-affected banks, both directly and indirectly. Prime brokerage and custody relationships with CS will be directly impacted and will complicate management of hedge funds and long-only funds.
Markets may suffer disruption where CS was a significant player as counterparties and infrastructure assess the effect of its acquisition by UBS. Depending on the reading of AT1 valuations after a busy weekend, bond traders are likely to see a Monday like no other.
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