(News Bulletin 247) – All European banks fell again on Monday. The takeover of Credit Suisse by UBS results in a reset of a certain type of bond, which raises fears for the whole sector.
If Switzerland thinks it has avoided the worst by pushing UBS to buy Credit Suisse, the market is not totally reassured about the banking system, far from it.
Bank securities are still suffering on Monday. In Paris, BNP Paribas drops 3.5% around 10 a.m. and Societe Generale also loses 4.5%. In Frankfurt, Deutsche Bank collapsed by 6.7%. As for Credit Suisse and UBS, they respectively lost 62% in and 11.9% in Zurich.
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For Credit Suisse the fall is not illogical given the impressive discount (nearly 60%) that UBS demanded to buy the sick bank from continental Europe. As for UBS, the stock’s decline can be explained by the short-term negative impacts of the operation, in particular the suspension of its share buyback program.
“The impact on earnings per share is still difficult to assess, but it should indeed be initially dilutive for UBS with the issuance of new shares (we calculate around 5%) and the consolidation of an entity (Credit Suisse) which is currently largely in deficit,” notes Jefferies.
Certainly, “the low price paid (3 billion Swiss francs) and the important safety net provided to UBS (with the guarantee of the government) are positive, while the strategy of UBS remains unchanged”, considers Jefferies. “However, UBS is exposed to significant execution risk, litigation risk, share buybacks are temporarily suspended (unclear for how long), UBS’s capital requirements will likely be reviewed at the upside, and management’s attention will be captured by this operation for many quarters, if not years,” the bank continued.
Fear on certain obligations
Beyond Credit Suisse and UBS, why are other banks falling? The reason seems to be slipped into the details of the transaction between the two Swiss establishments.
More precisely on the losses suffered by certain creditors of Credit Suisse, that is to say the holders of the group’s AT1 bonds, also called “CoCo bonds” for “contingent convertible bonds”. These debt securities are riskier than the usual ones because they automatically turn into shares if the bank’s capital ratio falls below a certain threshold.
“AT1 bonds were introduced in Europe after the global financial crisis to act as shock absorbers when banks began to fail. They are designed to impose permanent losses on bondholders or to be converted into equity if the ratios capital of a bank fall below a predetermined level, thus strengthening its balance sheet and allowing it to continue its activities”, explains Charles-Henry Monchau, director of investments of the Syz bank.
“Under the Swiss bailout regime, AT1 debt sits above equity in the loss absorption cascade,” he points out.
However, Finma, the Swiss market regulator, has decided that the exceptional support of the State, via guarantees for the operation, triggers a “complete amortization of the nominal value of all Credit Suisse AT1 loans for a volume of approximately 16 billion francs”. As Credit Suisse explained very well in its press release, this means that the value of these debt securities drops to zero.
“The market is worried about the nature of AT1s, which may explain the movement observed in banks today,” underlines Frédéric Rozier, manager at Mirabaud.
A questionable logic
This simply poses a risk to the entire debt market. Because the decision of the Swiss authorities quite simply calls into question a well-established hierarchy which wants creditors to be paid before shareholders, because they are supposed to bear less risk. This rule “would be called into question by the operation”, notes Frédéric Rozier.
“This is a surprising development, given that even holders of unsecured bonds generally rank higher than equity holders in the capital structure,” agrees Charles-Henry Monchau.
“So the fact that equity holders get ‘something’ and CoCo bondholders get ‘nothing’ raises serious questions about the real value of CoCo bonds,” he continues.
“This creates contagion risks on CoCos (…) There is also a risk of a contagion effect on global credit (although we note that the senior covered bonds seem quite resilient, including the covered bonds of first rank of Credit Suisse whose price jumped this morning)”, concludes Charles Henry Monchau.
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