- On March 19, Credit Suisse and UBS announced together that they had reached an agreement on a merger whereby UBS would acquire 100% equity of Credit Suisse in an all-share transaction with a purchase price of CHF 0.76 per share, for a total consideration of CHF 3 billion (approximately USD 3.2 billion).
- Upon completion of the acquisition, Credit Suisse shareholders will receive shares of UBS (22.48 shares of Credit Suisse for 1 share of UBS). Based on the market capitalization of UBS last Friday (CHF 5.6 billion), the new shares issued by UBS will represent 5% of the total shares outstanding post-transaction, which the expected dilution should be small.
- Existing shares of Credit Suisse will not be diluted because it does not issue any new shares in this transaction. Based on the closing price of Credit Suisse last Friday (CHF 1.86), shareholders will suffer an unrealized loss of approximately 60%.
- On the other hand, Credit Suisse also announced that its Additional Tier 1 (AT1) capital of approximately CHF 16 billion will be written off to zero, in accordance with the instructions from Swiss Financial Market Supervisory Authority (FINMA). In other words, all holders of Credit Suisse's AT1 perpetual bonds will face a loss of 100%.
- As we mentioned before, AT1 bonds contain the risk of loss absorption. When the capital adequacy ratio of the issuing bank drops below a certain level (mechanical), or when the regulatory authority makes a judgement that the bank is unable to continue its operation (discretionary), it will reach the trigger point and bondholders will need to bear a loss in their investments. This time, the principal write-down of Credit Suisse’s AT1 bonds is a discretionary trigger based on the decision of local regulator.
- AT1 bonds are inherently riskier as the primary intention of the issuance is to provide addition layer of protection to issuer. Therefore, it is anticipated that a principal write-down would be triggered when the bank is in trouble. However, what is worth discussing in this deal is the priority of loss absorption between the stocks and the bonds.
- By definition, common stock is Common Equity Tier 1 (CET1) capital, while the perpetual bond subjects to principal write-down is Additional Tier 1 (AT1) capital. Both of them should help the bank to absorb losses, and common stock should have a lower seniority than AT1 bonds when it comes to liquidation. As a result, many investors believe that the value of existing shares should be diluted or simply reduced to almost zero before the AT1 bonds start to absorb losses.
- However, the two instruments have different ways to absorb losses. CET1 capital (common stocks and retained earnings) is reduced on an ongoing basis as the bank incurs losses, while AT1 bond is subject to a direct principal write-down when it deems necessary. From regulatory context, AT1 bonds only rank higher in seniority than common stocks in the event of a bankruptcy liquidation. Therefore, it does not mean that the bank must issue additional shares or force the shareholders to take on all the losses before triggering the loss absorption of the bonds.
- Majority of AT1 bonds issued by banks have fallen sharply as a result of Credit Suisse’s AT1 bondholders suffering much bigger losses than shareholders, which the market finds it difficult to understand the rationales behind the regulator’s decision. If the AT1 bondholders are chosen to be the ‘scapegoat’ simply because of the fact that the loss absorption feature is clearly stated in the bond terms, investors may be more skeptical on these AT1 bonds, and even the T2 and other senior bonds that are subject to loss absorption (TLAC-eligible), as there is no guarantee that the regulators will not set fire on these bonds next time.
- Another discussion point in this case is about the effectiveness of mechanical trigger. Credit Suisse's CET1 capital adequacy ratio was 14.1% at the end of last year, which was significantly higher than the mechanical trigger threshold of 7%. Since then, Credit Suisse never disclosed any latest capital adequacy ratio, but the regulator has already decided to write-down all the AT1 bonds with the discretionary trigger. If we also consider the fact that the deal was forced through by the regulator at a 40% discount to Credit Suisse's share price on last Friday, it is likely that the market will think the regulator is too overpowered.
- At this point, the regulator's actions clearly reflected that they would do anything to prevent the large banks from collapsing, and they will even make quick decisions to write down the bonds. This seems to deliver a message that the mechanical trigger framework for AT1 bonds is useless, and the regulator can freely utilize the loss-absorbing discretionary trigger if other banks also fall into trouble in future, making bondholders suffer.
- It is important to note that the terms of subordinated bonds such as AT1 and T2 are more complicated, and the key concern is that there are not many precedents for reference in terms of loss absorption triggering. Investors may face a high degree of uncertainty because each country may have different approach to handle the situation.
- It may be better for investors who are interested in bank bonds to consider the senior bonds, which some of them are still eligible for loss absorption, but should have a lower risk because they absorb losses the same way as AT1 and T2 bonds and therefore should have a relatively higher seniority.
Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds positions in CS 5.625% Perpetual Corp (SGD) and UBS 5.875% Perpetual Corp (SGD), and the analyst who produced this report holds a NIL position in the abovementioned securities.
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