Sometimes the financial press is really good, but, sadly, sometimes it’s terrible. And it’s not really journalists’ fault; it’s the fault of the medium.
Take, for example, the difference between the AT1 issue at Credit Suisse (CS) and inflation. Inflation is a very simple concept—prices go up, and the rate of inflation is the measurement of how much inflation is going up by. Compared to capital structures and debenture covenants, that’s as easy as it gets.
Yet even then, misunderstands about inflation persist at an alarming rate. Many do not understand that lower inflation means prices increase at a lower rate rather than prices go down. Even more do not understand why a small bit of inflation is much better than stable prices, which is why price stability has not been a target for world economies in over a hundred years.
So if the press can’t educate the public on the subtleties of inflation, how can it even tackle debt subordination and triggered bond devaluations due to Tier 1 capital ratio MTM valuations? I mean, many people in finance don’t even understand what’s going on, how can you even start with the public?
Communicating about adult topics is hard. Science communication and science journalism is a serious field of study—how do you communicate science while being accurate and not sparking miscommunications? Some science journalists resort to lying to steer audiences in the “right” direction, as do some financial journalists. But for those who are trying to do an honest job, the job itself is daunting on so many levels.
So if journalists give up trying to explain CS’s AT1 bonds, I don’t blame them. That said, the story is actually quite simple if you know a bit about banking.
Fractional-reserve banking functions when regulators set rules for how much assets banks have to have to cover their liabilities (i.e., customer deposits). Those rules have evolved over time to make the banking system better, and that’s been mostly a success if we look throughout the history of banking in the west. But approving millions of people for loans that spur economic activity isn’t news; that’s just how things work, hence the flaws in the system get all the attention, driving people to assume the system is flawed beyond repair.
Financial incentives don’t encourage journalists to communicate otherwise, which is interesting because the CS story actually shows the system working quite well. CS has been a horror show for decades; that said, it was still doing fine according to the rules with a 14.1% common equity tier 1 capital ratio at the end of 2022, which is far above the 10% requirement.
However, UBS (UBS) bought CS at about $3 billion, meaning that UBS valued CS’s net book value after all equity and liabilities to be the $3 billion that it was instead of the $59 billion the market thought it was just days before.
Is that $56 billion worth zero? Possibly, possibly not. But at that moment when the transaction cleared, the new market value of CS’s own book was $3 billion, which implies that CS’s equity capital ratio had fallen well below the 10% limit and close to the rounding-error world.
This resulted in the triggering of some bonds issued by Credit Suisse called AT1 bonds, standing for additional tier-1 capital. Contingent convertibles, or cocos, are a wide range of bonds and stocks that have very complex rules, exceptions, and provisions. With AT1 bonds, the provision is that the bond issuer receives cash from the creditor in exchange for an interest payment until they come to term, at which point principal is given to the creditor. However, if CS’s tier-1 capital ratio went to less than 5%, these bonds would be nullified and worthless.
Usually, tier-1 capital ratios are disclosed in quarterly reports, and CS’s tier-1 capital ratio was fine in the last report. But in the last few days as markets repriced assets, suddenly it had a huge asset shortfall and the trigger to make AT1 bonds worthless was triggered.
The bondholders are crying foul for a couple of reasons. First, they are saying that equity is subordinated to debt and common shareholders are getting paid back. A lot of financial journalists are repeating this hollow and factually inaccurate argument. For one, not all debt is subordinate to all stocks in all situations; in general the capital structure works that way, but the provisions in bonds can make for that to not happen in some cases. This is very normal.
Second, and much more sympathetically, they are saying that the fall in the tier-1 ratio was not a real fall in the ratio. In February, CS saw $119 billion in outflows as sophisticated investors saw risks at the bank. This was a full month before the Silicon Valley bank and, while some journalists are trying to CS’s many, many legal and moral failings in the past, large organizations don’t withdraw billions of dollars because of a scandal a couple of banks did a few months ago in another country. This, some AT1 bondholder apologists say, is the smoking gun that this was a bank run-driven collapse and regulators should have come in to save CS instead of letting the tier-1 ratio fall too low.
Except, that is what they did. And while common shareholders are getting almost a dollar a share, that consolation prize (which is most likely there for optics) does not mean the AT1 bond covenants don’t apply.
If the covenants were written well enough to account for bank runs, AT1 bondholders will have a much stronger case and this zeroing out of value will be reversed in a court. If not, though, AT1 bondholders have learned a lesson.
