Credit Suisse AT1 Securities: The Uproar of Intended Consequences

The Swiss authorities came out with an emergency law announcing the CSG AT1 securities were to be written down in the context of the UBS takeover, however, this does not deny the operation of the terms of AT1 securities. The AT1 securities terms and Article 29 of the FINMA’s Regulation about Own Funds are clear. Having sat at the table on several messy bailouts, standard operating procedure is belts and braces. This is how the emergency law should be viewed in the context of the AT1 securities. It should not be viewed as an acknowledgment that the terms of the relevant securities were ineffective to result in a write-down. This was confirmed as much by FINMA’s announcement on 23 March 2023. As such, below, I will focus on the terms of the relevant AT1 securities.

AT1 status as a ‘creditor’

The notion that holding a bond makes the bondholder a creditor is inaccurate. That is simply the form of the instrument. At its essence, a creditor is one who has rights to enforce against the borrower in the event of non-payment at predetermined dates. This is simply not the case with AT1 securities; there is no predetermined legally enforceable entitlement to receive a coupon or repayment of principal at a fixed point in time. In this way, they are more akin to equity. I note some regulators have come out since this event to reinforce a creditor hierarchy, but in those jurisdictions the bank issuers of AT1 typically do not use permanent write-down in distress.

Recap on AT1 securities

For those unfamiliar with capital securities post the GFC, all AT1 capital securities feature what’s referred to as “going concern principal loss absorption’. These are essentially contingent features which allow securities to morph from being akin to subordinated debt to being akin to equity, in times of distress, with certain write-down features if specific events are triggered. The ‘times of distress’ are both hard coded and malleable. The latter point is key to the situation that transpired at Credit Suisse. The principal point to highlight is that capital securities, and most acutely AT1 securities, have a ‘living’ function, and while the terms in the prospectus explain how it functions in some instances, to assume the terms are black and white and static is naive. The operation of the security changes depending on the viability of the bank, i.e. the health of the bank and the regulator’s stance in times of distress should be incorporated into investors’ expectation of how the security functions.

A second point to note is that whilst the terms create liquidation preference ahead of ordinary shareholders, this is somewhat of a mirage. Whilst they create a psychological comfort blanket around a creditor hierarchy, as the securities are ongoing loss absorbing instruments, they'll have been triggered well before liquidation ever kicks in.

Loss absorption features in CSG AT1 Securities

To understand how loss absorption works for any particular deal, there are two clauses to focus on:

i. What happens to the principal value of the security, in times of ‘distress’?

ii. What qualifies as distress, for the purposes of the security?

Let’s consider each of these in turn in the context of CSG’s AT1 Securities, using the 9.75% non-call 2027 (ISIN: US225401AX66) as an example.

i. Write-down mechanism

CSG’s AT1 securities explicitly state they can be written down in full. Clause 7(b) states:

Following the occurrence of a Write-down Event, on the relevant Write-down Date:

i. the full principal amount of each Note will be written down to zero…;
ii. the Holders will be deemed to have irrevocably waived their rights to, and will no longer have any rights against the Issuer with respect to, repayment of the aggregate principal amount of the Notes…;
...
iv. the Notes will be permanently cancelled.

The terms are crystal clear as to what happens in a ‘Write-down Event’. There is no reference to relativity with equity holders or conversion of such notes into equity. The inference being that if a Write-down Event happens and the securities are written down to zero, the holders position relative to equity holders is unclear, and there is certainly no commitment to preserve creditor hierarchy.

ii. Breach of 7% CET1 and Viability Event

The first, call it automatic limb for a write-down event, is where CSG’s CET1 ratio breaches 7%. The second, malleable limb of the Write-down Event, and of relevance here, is the Viability Event. Clause 7(a)(iii) states:

Viability Event

As used in these Conditions, a “Viability Event” means that either:

1. the Regulator has notified CSG that it has determined that a write-down of the Notes … is … an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or
2. customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the Public Sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and without which, in the determination of the Regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.

In offerings outside of Switzerland, some AT1 instruments only have an automated capital based trigger event, and then rely on the resolution framework to support the capital base. In Switzerland, however, the viability event is embedded within the terms, and its intent is clear.

What is unclear here is which of the limbs of the Viability Event was triggered by the Regulator. The announcement by UBS that the Swiss authorities provided CHF 25bn of downside protection, including CHF 9bn of protection on non-core assets bearing losses over CHF 5bn clearly shows extraordinary support from the public sector. The fact that this support was provided to UBS should not make a difference – after all, the counterfactual is that if UBS did not buy CSG, the government would have needed to have provided that support directly to CSG. Pursuant to the terms, CSG has to notify holders of a writedown, but where it is the result of an intervention by relevant authorities, such authorities need to pronounce this first. This seems to be what’s happened here.

Non-viability, insolvency & solvency

To be clear, non-viability is intended to occur prior to any sort of insolvency or event of default, so the test is not how many more days they could have lasted. This is well-defined by the International Association of Deposit Insurers:

a situation before institutional Insolvency, and may also include circumstances in which: (i) regulatory capital or required liquidity falls below specified minimum levels; (ii) there is a serious impairment of the Bank’s access to Funding sources; (iii) the Bank depends on official sector financial assistance to sustain operations or would be dependent in the absence of Resolution; (iv) there is a significant deterioration in the value of the Bank’s assets; (v) the Bank is expected in the near future to be unable to pay liabilities as they fall due; (vi) the Bank’s business plan is non-viable; and/or (vii) the Bank is expected in the near future to be balance-sheet insolvent.

It’s clear CSG did meet this definition prior to the takeover, as CSG took extraordinary liquidity support from FINMA prior to the write-down of the AT1 securities. This is consistent with Article 29 of the FINMA’s Regulation about Own Funds.

There has also been some confusion about solvency being equal to viability. Viability is about the ability to operate viably and independently without any form of extraordinary state support, whereas solvency is merely the ability to pay debts as they fall due. So, one can be non-viable at one point, and still be solvent at that point, which may have been the case for CSG. Viability asks will the bank last on its own, and solvency asks can they pay their debts at this point.

It is also important to note that in bank rescues, time is of the essence, and the key is to restore market stability – this is highlighted well by the announcement by the Swiss authorities. Moreover, whilst the concept of liquidity and capital are clearly distinct topics in ordinary circumstances when there is a crisis of confidence in an institution, both liquidity and capital inextricably merge into one bucket of inadequate confidence. When a liquidity crisis exists, and counterparties are unwilling to provide emergency liquidity, the principal source of liquidity for such a bank is to sell assets, and such a situation may be a fire-sale below fair market prices. Such a fire-sale results in a capital problem. So, to restore either liquidity or capital, both need to be restored, and not because the accountants had it wrong, but rather because the market demands it. The market will demand belts and braces, and a clean bill of health. This was most evident in the GFC.

Risk factors which couldn’t be clearer

Going back to the uproar from investors about being written-down; in addition to the terms which make it clear there is no respect given to a traditional creditor hierarchy, the risk factors make this abundantly clear:

The likelihood of an occurrence of a Write-down is material for the purpose of assessing an investment in the Notes. The Notes may be subject to a Write-down and upon the occurrence of such an event holders will lose the entire amount of their investment in the Notes.

….
The Write-down may occur even if existing preference shares, participation certificates, if any, and ordinary shares of CSG remain outstanding.

The circumstances triggering a Write-down are unpredictable. Future regulatory or accounting changes to the calculation of the CET1 Amount and/or RWA Amount may negatively affect the CET1 Ratio and thus increase the risk of a Contingency Event, which will lead to a Write-down, as a result of which holders will lose the entire amount of their investment in the Notes.

The occurrence of a Contingency Event or Viability Event is inherently unpredictable and depends on a number of factors, many of which are outside of the Issuer’s control.
…

The occurrence of a Viability Event, and a Write-down resulting therefrom, is subject to, inter alia, a subjective determination by the Regulator as more particularly described below and in Condition 7(a)(iii) (Write-down—Write-down Event—Viability Event). As a result, the Regulator may require and/or the federal government may take actions contributing to the occurrence of a Write-down in circumstances that are beyond the control of CSG and with which CSG does not agree.

CSG is subject to the resolution regime under Swiss banking laws and regulations.

CSG is the Swiss parent company of a financial group, which means that under the Swiss Banking Act, FINMA is able to exercise its broad statutory powers thereunder with respect to CSG, including its powers to order protective measures, institute restructuring proceeding… if there is justified concern that CSG … has serious liquidity problems.
…
Additionally, holders of the Notes would have no right under Swiss law and in Swiss courts to reject, seek the suspension of, or to challenge the imposition of any such protective measures.
Resolution powers that may be exercised during restructuring proceedings with respect to CSG include the power to… (c) partially or fully convert into equity of CSG and/or write-down the obligations of CSG, including the Notes, if not already written-down pursuant to their terms. Creditors, including Holders, will have no right to reject, or to seek the suspension of, any restructuring plan pursuant to which such resolution powers are exercised with respect to CSG.

In summary, across 30+ pages the risk factors state that the risk of a write-down is material and may subordinate holders to ordinary shareholders, and the trigger for this is unpredictable and is outside the control of CSG. They reinforce that under the Swiss Banking Act, FINMA has broad powers to execute resolution powers, outside the scope of the terms of the securities, including permanent write-down. It could not be clearer.

This is consistent with the original understanding of securities with permanent write-down features. The regulator was aware and accepted that write-down instruments would in various circumstances (in particular when re-establishing the going-concern capitalisation of a bank) be beneficial to the shareholders. So conceptually, this appears to have been acceptable for regulators, as conversion of AT1 has the disadvantage of additional legal complexity in jurisdictions such as Switzerland.

Learnings

Against the backdrop of a low-interest rate environment, investors naturally were hungry for yield. But CSG was plagued by many crises in recent years (including the default of Archegos Capital Management and the collapse of Greensill Capital), none of which had fully been resolved.

Several learnings for investors:

• Read and understand the prospectus, including the risk factors which are not simply window dressing.
• Understand the context of the Basel III capital framework, and the inherent risks it introduced, particularly in the case of capital securities.
• Understand that the traditional creditor hierarchy may not be respected, and in such cases if the risk isn’t worth the reward, move on.
• Do not underestimate the power and desire of the banking regulator to restore market confidence in a crisis.
• Understand the relevant resolution legislation of the jurisdiction of the issuer, as they typically will allow wide reaching powers to intervene in the contract between bondholders and a failing bank.
• An investor cannot assume that instruments issued from different jurisdictions and at a different time over the last few years will have the same risk profile: they won’t.

Final point: the key lesson we took from the last financial crisis was that the “old style” of subordinated debt and hybrid equity was not practically available to absorb losses or provide any kind of systemic protection before the point of non-viability. The best we could do at the time was to conduct liability management exercises and restructurings to generate core equity capital. The “new-style” of hybrid equity has been specifically structured to address this weakness, and ensure history does not repeat.