Perspective on Risk - March 20, 2023 (quick explainer on CS, CB Swap Lines, and AT1s)
Europeans Are Whining; Foam on the Runway; Debt Can be Subordinated to Equity
Can’t catch a break. Whenever I want to stop writing on this there are things where I think I can help explain what’s going on.
The Europeans Are Whining That The US Caused The CS Failure
Don’t buy it. Correlation is not causation. As we’ve shown in the past, none of their investors were willing to put up any more capital, and the sales price indicates a substantial hole in CS’s balance sheet.
Credit Suisse has been a problem for at least a decade. Here is a nice rundown from Bloomberg: How Scandal and Mistrust Ended Credit Suisse’s 166-Year Run
Before the global financial crisis — which Credit Suisse survived without a bailout, unlike many of its peers — the Swiss lender had more than $1 trillion in assets, but after years of decay, they’ve dwindled to about $580 billion, roughly half of UBS’s.
We’ve watched the bank lurch from scandal to scandal for so long that it’s hard to recall all of them at this point.
Leadership, or lack there of, are at the core of the CS demise
Factbox: Credit Suisse's scandals - spies, lies and money laundering (Reuters). Even I had never heard of the Mozambique tuna fraud.
Credit Suisse pleaded guilty to defrauding investors over an $850 million loan to Mozambique meant to pay for a tuna fishing fleet and is paying U.S. and British regulators $475 million to settle the case under a deal announced in October.
About $200 million of the loan went in kickbacks to Credit Suisse bankers and Mozambican government officials. The bank was aware of a huge shortfall between the funds raised and the value of boats bought but failed to disclose this to investors when the loan was restructured in 2016, the regulators said.
Credit Suisse also arranged a loan that was kept secret from the International Monetary Fund (IMF). When Mozambique admitted to $1.4 billion in undisclosed loans the IMF pulled its support, sending the southern African country's economy into a tailspin.
Foam on the Runway
Tim Geithner’s famous phrase, internalized by many of us.
That’s all this notice about swap lines actually is. Central banks want each country to take care of their own financial system. This means the Swiss need to take care of the CS issue. The Fed doesn’t want counterparty exposure to CS, but will take it to the Swiss National Bank. So when CS needs dollars, it can go to the SNB rather than the Fed.
Yes, Debt Can be Subordinated to Equity
Following the 2008 GFC, a couple of streams converged. Many people wanted higher overall capital levels, bankers resisted a bit because they wanted to earn an adequate ROE, and researchers loved the market discipline and signaling effects of debt.
So Contingent Convertibles (CoCos) were born and codified into law. More frequently these days the are referred to as Alternative Tier 1 (AT1), which just means they get to count as Tier 1 regulatory capital.
Now in PRINCIPLE this loss absorbing AT1 debt should be senior to equity in liquidation. But that is not per se the case when the lawyers, regulators and investment bankers get involved.
Here is the hierarchy of loss absorbing capital. CET is ‘core equity’ - equity that counts for regulatory purposes, and ‘equity capital’ is the amount above requirements.
So what happened here is the AT1 was triggered resulting in a complete writedown of $17 billion.
SRB, EBA and ECB Banking Supervision statement
Credit Suisse AT1s vaporised (FT)
Clearly the Swiss regulators looked at the instruments and felt confident that they have the legal backing to vaporise the AT1s. The standard threshold is when Common Equity Tier 1 falls below 7 per cent, but we think they can often be triggered at a national regulator’s discretion — basically when they reckon a bank is “non-viable”.
I expect we will see AT1 reprice; we may see firms have substantial difficulty issuing AT1 for some time. I have no idea who owns the AT1 and how concentrated the ownership is - possible vector of contagion transmission.