Credit Suisse AT1 Bonds Become Worthless: Finance's Chained Ships

AT1 Bonds Global financial markets really resemble the chained ships at the Battle of Red Cliffs. Once one catches fire, the entire fleet can quickly go up in flames. Every bank holding or issuing AT1 bonds immediately plunged. We have only just weathered the pandemic-insurance storm, and now a financial storm is stirring. ---- Roughly CHF 16 billion ($17.3 billion) of Credit Suisse bonds have become “wallpaper”—worthless. These are nicknamed CoCo bonds, also known as Additional Tier 1 (AT1) bonds. CoCo stands for contingent convertible bonds, also called CoCos. These instruments emerged after the European debt crisis. As the lowest-ranking bank debt, they can generate high yields in favorable conditions. But when a bank is in serious trouble, they are hit first, standing in the “front row of the tsunami.” The “evaporation” of Credit Suisse's AT1 debt will strengthen the merged bank's balance sheet, but may signal disaster for the broader CoCo market. What are these soon-to-be-worthless bonds? Why are they being written down entirely? How will markets be affected? Here is Bloomberg's Q&A. --- 1. What are CoCos (AT1 bonds)? They can essentially switch between debt and equity, helping banks strengthen capital to meet regulations designed to prevent failure. When capital falls below a specified level, the bonds can change status in an emergency. If the shortfall is large enough, CoCos can convert into equity—shares in the bank. In other circumstances, they are written down fully or partially. --- 2. Why were CoCos created? They form part of a debt-and-equity buffer intended to prevent taxpayers from having to pay when a bank collapses. Initially, CoCos were seen as providing a potentially larger capital cushion without forcing banks to issue new shares, which could raise concerns about excessive leverage. For regulators, CoCos provide a way to pull banks back from the brink without costing taxpayers or diluting existing shareholders. --- 4. Why were Credit Suisse's CoCos (AT1 bonds) completely written down? UBS agreed to acquire Credit Suisse in a government-brokered transaction intended to contain the confidence crisis and prevent a domino effect in global financial markets. Swiss regulator FINMA said extraordinary government support would trigger a “complete write-down” of Credit Suisse AT1 bonds to increase core capital. Put simply, banks must meet minimum requirements for the money and debt they hold—Minimum Required Eligible Liabilities (MREL)—to support an effective resolution if they collapse. If capital ratios fall below a predetermined level, CoCos are written down. --- 5. Had investors worried about a write-down? Yes. Credit Suisse CoCo prices swung sharply in the hours before the UBS deal was announced. Investors weighed two possibilities: regulators nationalizing part or all of Credit Suisse, potentially writing down its AT1 bonds, or a UBS takeover that might spare bondholders losses. Following government intervention to arrange the merger, the CoCos have now been fully written down rather than converted into shares. Investors had worried that so-called senior bail-in debt would mean AT1 was written down first, while higher-ranking debt issued by the holding company, Credit Suisse Group, would convert into bank shares. The group originally had about CHF 78 billion ($84 billion) in holding-company debt, including both types. Senior bail-in debt appeared several years after CoCos. In the event, the effect was not a “bailout,” but losses rather than rescue. --- 6. Why are some bondholders furious? In a normal write-down, shareholders should absorb losses before AT1 holders, as Credit Suisse told investors in a presentation earlier last week. Under the Swiss-government-brokered UBS acquisition, however, Credit Suisse shareholders are set to receive CHF 3 billion. Some AT1 holders reacted angrily because the transaction did not respect CoCos' higher ranking than shares in the capital structure. That is a major problem for a market expecting bondholders to be repaid before shareholders. --- 7. What is the impact on the broader CoCo market? A blow to the $275 billion AT1 market. The latest decision disregards the market convention that shareholders take losses first, followed by AT1 holders. It could deal a serious blow to the $275 billion AT1 market and raise concerns about other banks' CoCos. Making matters worse, this is the largest AT1 write-down ever, far exceeding the €1.35 billion write-down of Banco Popular SA bonds in Spain in 2017. That bank could not close a huge funding gap and was acquired by Santander to avoid collapse. Then, however, Banco Popular's shares were also written down when regulators forced losses on its CoCos. Credit Suisse's much larger write-down is bound to prompt the question: “Who is next?” Such enormous uncertainty could immediately affect comparable bank-bond prices. Recent banking turmoil in Europe and the United States has already pressured CoCo prices. AT1 trades at an average of just 82% of face value, among the largest discounts on record. https://money.udn.com/money/story/5599/7042989