A dozen years ago, I went to the London office of Credit Suisse for a tutorial about so-called “cocos” — or the contingent convertible bonds introduced after the 2008 financial crisis, in a bid to enable banks to absorb losses in a crisis.
The CS financiers duly presented a neat PowerPoint, complete with arrows and charts, which explained that cocos lay second from bottom in the capital structure. Thus if a bank went bust, its equity would be wiped out first, followed by the cocos, in order to protect senior creditors. In exchange for this risk, those bonds paid a high (ish) return to investors, reflecting the normal rules of financial capitalism.
No longer. As the dust settles (or, more accurately, floats in mid-air) from the Credit Suisse drama, many astonishing details about this weekend’s acquisition of the bank by UBS are tumbling out. But the most striking detail to my mind is the Swiss National Bank’s decision to let CS equity holders keep $3bn of value, but wipe out the $17bn in AT1s (or “additional tier one” bonds), which are a variant of cocos.
This has sparked unusual criticism from European regulators. It may still spark legal action from bondholders, which include pension funds, insurance companies and other wealthy investors. “In my eyes, this is against the law,” Patrik Kauffmann, a fund manager at Aquila Asset Management, told the FT.
And while it is unclear how any court might respond (SNB appears to think the move is permitted), the real issue is about something more fundamental than legal niceties: trust in capitalist logic. A key tenet of free market theory, as any economics student knows, is that it rests on clear-cut laws about property ownership. And one corollary is that companies or investment funds operate with predictable “waterfall” structures that define how the assets of an entity are paid out if it collapses. Hence those neat CS banker presentations.
But Sunday’s announcement has changed that waterfall structure. This, unsurprisingly, has caused the price of AT1 bonds issued by other banks to tumble. But it could also contribute to an insidious sense of investor doubt about the degree to which neutral laws will continue to underpin capital markets more widely.
It is hard to escape the suspicion that the Swiss authorities decided to make (modest) payments to the equity holders — but not to bond investors — because the former included a powerful Saudi shareholder (that Bern did not want to offend). The interests of CS employees might have also played a role. Protectionism, geopolitical self-interest and state intervention, in other words, seem to have over-ruled free-market principles.
And while a cynic might argue that this always happens in a banking crisis, what makes the CS saga doubly pernicious is that it comes amid uncertainty about the legal structures surrounding US finance too.
More specifically, a key issue hurting sentiment around America’s regional banks and the Silicon Valley Bank disaster is that no one currently knows for sure how far the Federal Deposit Insurance Corporation’s protection extends. Before last month, the FDIC mandate implied that protection was only given for the first $250,000 of deposits when institutions were not deemed to be systemically important (ie not monstrously large).
But when SVB and Signature failed, the protection was extended to all depositors. That could be invoked again if another bank wobbles: what the SVB saga has certainly shown is that it is ridiculous to define “systemic” purely by the size of an institution’s assets — panic can become systemically contagious even when small entities fail.
However, the Biden government has hitherto resisted extending FDIC insurance in a blanket manner, in spite of political pressure. Thus, it is not known how other institutions might be treated down the line. This creates the impression that capricious policies — rather than predictable capitalist principles — rule the day.
The net result, then, is that investors are in limbo land. They don’t know whether capital market laws will be a predictable pillar of faith for finance in the future, but they also don’t know whether US and European governments have the desire (or means) to stand behind all banks, and thus act as an alternative pillar of faith. No wonder fear abounds; moral hazard is rife, but in a deeply unpredictable manner.
Let us hope that governments can rectify this. If not, the scrambled CS solution may store up yet more long-term problems, even if it creates a sense of short-term reassurance. When “credit” — or “trust” in the Latin sense of the word — is shattered, it is painfully hard to restore; and not just at “Credit” Suisse.
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