Credit Suisse AT1 bond wipeout highlights dangers of holding banks' risky debt

The controversial write-down of Credit Suisse Group AG's bail-in-able capital instruments is causing investors to reassess their riskiness and is likely to impact their pricing and limit their appeal, according to market observers.

Credit analysts anticipate that as investors scrutinize the terms and conditions of Additional Tier 1 (AT1) notes, other European banks are likely to find it harder and costlier to place such instruments, which can be written down completely in the case of certain viability events. Swiss rules allowed authorities to wipe out CHF15.8 billion of Credit Suisse AT1 notes as part of a regulator-forced merger with UBS Group AG, while some shareholder equity was preserved, contravening the usual hierarchy of securities holder claims.

Although EU and UK regulators rushed to reassure credit holders in their own jurisdictions and distanced themselves from the Swiss case, confidence in the AT1 market has been shaken.

"The publicity surrounding the Credit Suisse case brings into focus the downside risks of holding AT1 notes," Sam Norris, a London-based special situations partner of law firm Ropes & Gray, said in an interview. Banks that need to issue such instruments in the future could potentially find fewer investors looking to buy, so AT1 issuance will likely become more difficult or expensive, Norris said.

Fine print

Swiss financial regulator FINMA said March 23 the Credit Suisse AT1 contracts allow for a complete write-down in a "viability event" when extraordinary government support is granted, even before the equity capital is completely used up.

One can argue investors should have been aware of the wipeout terms and conditions as they were in the Credit Suisse documentation, yet Swiss authorities "also changed the law over a weekend to make it a viability event," Joost Beaumont, head of bank research at ABN Amro, said in an interview.

On March 19, the Swiss Federal Council enacted an emergency ordinance enabling the central bank to grant Credit Suisse additional liquidity assistance loans and default guarantees. Prior to that, authorities amended the additional liquidity assistance ordinance so that FINMA would be authorized to order the write-down of AT1 debt in connection with the granting of central bank loans and guarantees.

This case will make investors rethink the risk and return attached to AT1 notes and will erode confidence in the instruments. Confidence is quick and easy to damage but hard and slow to repair, Beaumont said.

A vow by the EU and UK authorities to uphold the conventional credit- and shareholder-hierarchy gives some reassurance, but the Swiss case has cast doubt on whether authorities would make the same statements "when they need to rescue a bank overnight," Beaumont noted.

Credit Suisse AT1 holders, including some US investors, are also exploring legal action against the Swiss decision. This has the potential to lead to years of litigation, casting a shadow over the AT1 market.

UBS said the Credit Suisse AT1 write-down was a decision by FINMA, but did not comment further. A spokesperson for FINMA declined to comment beyond the regulator's official statement.

Market impact

Credit analysts at the leading rating agencies — S&P Global Ratings, Moody's and Fitch Ratings — also warned that AT1 issuance is likely to get harder and costlier following the Credit Suisse write-down.

"Jittery investors" will reassess their perceptions of risk for individual banks and instrument structures, S&P Global Ratings said in a March 21 report.

"Swiss actions highlight that AT1s are in the firing line for privatizing bank losses, which will sharpen technical scrutiny of existing hybrids' contractual terms, and may result in higher risk-adjusted pricing and lower issuance," Laura Kaster, senior director of North and South American financial Institutions at Fitch Ratings, said on LinkedIn.

"Investors will be much more focused on the write-down language in new issues. Unless future deals have this made clear, there will be a cost," Paul Summer, head of structured notes and financials trading at fixed income investment bank KNG Securities, told S&P Global Market Intelligence via email.

There is no issue with the instruments themselves, but it is up to the investment community to understand the risks, Sotiris Staikouras, senior lecturer in banking and finance at Bayes Business School, formerly known as Cass, said via email. Staikouras likened the bank AT1 notes to insurance industry catastrophe bonds — high-yield debt instruments designed to cover insurers' losses in the event of a natural disaster.

Even with reassurance from EU and UK regulators, the Swiss case "will likely lead to higher funding costs for these capital instruments globally because investors will likely demand additional risk premia, at least in the short-term," Moody's said in a March 21 report.

"AT1 bonds will probably experience a premium as an indication of the risk that investors undertake but this will be contained within reasonable bounds," Staikouras said. The market reaction is likely to be a short-term one, Staikouras said via email.