You Gotta Fight for Your (Cap Stack) Right
Malt Liquidity 99
Just Click Agree
Generally, market practitioners tend to hand-wave terms and conditions in the same way we agree to the ones that pop up on iPhones occasionally, in that nobody reads them. Sometimes, this can lead to very odd outcomes, especially in the pre-2008 laissez-faire regulatory environment, which was essentially nonexistent. Take the case of U.S. Bank v. Ibanez, which essentially invalidated a foreclosure because some MBS issuers didn’t properly fill out paperwork that would have actually given them the title. Can you ever imagine this getting through the lawyers post-2008?
We’ve talked about legal edge before regarding Puerto Rican bonds and arrived at this statement:
A common misconception about legal edge is that it revolves around constructing creative, esoteric arguments designed to fit a thread through a tiny loophole, which ignores that the plain letter of the law and the intent with which it was created is generally enforceable. However, given the longer term nature of all these transactions — debt issuances are typically not products that resolve on a short time horizon — the potential for terms to be reinterpreted to be more favorable to one side or the other creates volatility that could be risk-efficient to trade amongst a swathe of products that already exist
Lost in the sauce of the SVB drama was another banking drama involving the Credit Suisse/UBS tie-up. We briefly looked at the circumstances that led to this merger
Turmoil begets more turmoil. Losses and scandals (and the occasional mysterious death) require constant restructuring and replacement of executives, who will all have different ideas on how to “recover” from the business, but the reputation loss is the real death sentence. Furthermore, how are they going to retain any remaining talent through their “bonus now pay later” structure in a bonus-driven industry? Admitting that business lines aren’t going well just shows even more incompetence which leads to more caution from potential clients which leads to even more business lines being shut down — it’s the death spiral. I don’t really see how Credit Suisse recovers without being absorbed by another institution at this point. As Agassi would say, “Image is Everything.”
but we didn’t look at the fallout of that merger — namely, what happens to the cap stack?
Remember that
…equity in stocks with severe debt issues shifts from trading in a normal delta one style — it doesn’t represent a stake in forward earnings, but rather it is closer to representing the probability that, when the company finally defaults and gets liquidated, shareholders recover some capital (remember that, ignoring complications like mezzanine debt and preferred shares, debt holders always get paid out before equity holders.)
Banks, as quasi-governmental institutions, don’t really ever file ch.11 — they generally are “coerced” into a merger/sale with another bank (or group of banks) by regulators, or taken into receivership as a buyer is sought. The terms of these “mergers” are more akin to hostage negotiations, and the payout structure looks similar to a bankruptcy. The acquiree’s equity gets wiped out and the acquirer absorbs the debt load “subject to terms and conditions”, but the core logic stays the same, in that debt holders > equity holders. Think of it like airplane boarding — senior debt first, all sorts of random types of debt in the following groups, and equity holders last. Let’s take a look at the saga involving a specific class of CS debt:
[Mar 19, 2023 ~ed.] Holders of $17bn of Credit Suisse bonds will have their investment wiped out following the bank’s takeover by UBS, in a surprise move that is expected to cause ructions in European debt markets when they open on Monday. As part of the historic deal between the banks, Swiss financial regulator Finma ordered that SFr16bn ($17bn) of Credit Suisse’s additional tier 1 (AT1) bonds, a relatively risky class of bank debt, will be written down to zero. Credit Suisse said it was informed of the decision by the regulator as it thrashed out the final details of its SFr3bn takeover by UBS, which was announced on Sunday evening after several days of intense negotiations.
Hm, alright, this doesn’t sound all that great, but let’s take a look at the AT1 terms:
TLDR: AT1 bonds are debt claims, but in the case of certain risk metrics falling below a certain level, these claims can be converted to equity or written off entirely. However, this can also happen if regulators deem it so (the “Viability Event”.) So, we’re in a viability event scenario as it stands: this shouldn’t be a shock to any AT1 investor, because it’s clearly outlined in the terms. The higher rate on AT1s relative to other bonds compensates for the scenario where the claims are written off, resulting in a payout prioritization that roughly looks like this:
But, in a shocking twist, this structure was violated:
[Mar 20, 2023 ~ed.] Credit Suisse bondholders were in uproar on Monday and the European Central Bank raised concerns after the rescue deal by rival UBS wiped out $17bn of the failed Swiss bank’s bonds, upending debt recovery norms and undermining financial market confidence. “In my eyes, this is against the law,” said Patrik Kauffmann, a fund manager at Aquila Asset Management, who invests in additional tier 1 (AT1) bank debt. He said it was “insane” that under the terms of UBS’s takeover of Credit Suisse, AT1 bondholders were set to receive nothing while shareholders would walk away with SFr3bn ($3.2bn)…
Davide Serra, founder and chief executive of Algebris Investments, said the move was a “policy mistake” by the Swiss authorities. “They changed the law and they have basically stolen $16bn of bonds”, he said…
Recall what I said above about how terms being reinterpreted creates volatility — here, all of the AT1 issues currently outstanding now have to incorporate the possibility that they might have a lower priority than equity. This is absurd! Naturally, AT1 prices plummeted
and other banking institutions hastily stated that they wouldn’t follow this precedent:
The European Central Bank and Bank of England were among the institutions that publicly said they would stick to the typical order of precedence and that equity holders should be wiped out first in any future bank failure.
Naturally, when there is a disagreement over terms in a contract, it ends up in court. Certainly this will take a while — after all, the FNMA lawsuit took just about a decade to resolve. But some interesting news has come out since these events:
[Mar 23, 2023 ~ed.] There’s a growing sense that Switzerland probably didn’t have a rock-solid legal foundation to wipe out Credit Suisse’s $16bn of AT1s — at least on a narrow interpretation on the bond documentation clauses. Not everyone agrees of course, but even the ECB, BoE EBA came out and pretty explicitly criticised it. That’s presumably why FINMA came out last week to stress that it also relied on an “emergency ordinance” passed by the Swiss government that weekend…
“On 19 March 2023, the Federal Council enacted the Emergency Ordinance on Additional Liquidity Assistance Loans and the Granting of Federal Default Guarantees for Liquidity Assistance Loans by the Swiss National Bank to Systemically Important Banks. The Ordinance also authorises FINMA to order the borrower and the financial group to write down Additional Tier 1 capital. Based on the contractual agreements and the Emergency Ordinance, FINMA instructed Credit Suisse to write down the AT1 bonds.”
There’s no clearer sign that regulators have probably overreached than by hastily pasting legislation “authorizing” such actions — a massive legal battle becomes imminent. All of a sudden, the entire class of AT1 bonds becomes an event trade, where the volatility reflects the sentiment towards the stability of the pre-existing structure of AT1’s prior to these events. Certainly, the ECB/etc statements helped buoy the market, and presumably some firms made a ton buying that dip,
but the legal questions obviously remain. Think back to the discussion of the FDIC essentially doing whatever it wanted, well beyond the intentions with which it was created — we have another debate over administrative overreach that has arisen, especially due to this curiously deleted paragraph from an older edition of one of these sources:
The lawsuit has been filed on behalf of the investors, and in a pretty insightful bit of progression, more information was demanded regarding the write-off itself:
[May 17, 2023 ~ed.] Investors representing at least $4.5bn of wiped-out Credit Suisse additional tier 1 bonds filed a lawsuit against Finma last month. The suit accuses Switzerland’s banking regulator of having acted unconstitutionally when it ordered the bank to cancel the $17bn of AT1 bonds as a part of its shotgun marriage to UBS two months ago. The aggrieved investors and their law firm Quinn Emanuel had to launch their challenge largely in the dark, as Finma had kept secret the wording of its decree ordering Credit Suisse to write down their investments. However, the judge overseeing the case, which was filed in the city of St Gallen in eastern Switzerland, ordered the financial regulator to hand over the decree last week, giving the AT1 bondholders a firmer foothold to contest the writedown.
In an effort to make this post less dense, I’m going to avoid the details of contractual discussion, and broaden the scope a bit.
These kind of decisions matter because they impact the liquidity of every instrument with similar terms, as I’ve talked about prior. Not only will all the other AT1 bonds reprice forward risk, but the demand might dry up if the terms are deemed too exploitable by potential traders. This affects accounting and other types of risk (such as duration and mark-to-market.) For example, does anyone want to buy orphan-able CDS as opposed to newer ones which don’t allow for such a circumvention of the CDS terms?
A core principle of the construction of the system of laws is that it only matters at the edges. Think about who enforces and propagates a system of laws — the role of a government is to damper the tail outcomes of a nation. Thus the system must contain an element that allows us to clearly define what the tails are. The more clarity, the better. These kind of financial contract disputes matter because it’s necessary to know how far administrative powers truly extend — it’s definitely standing in front of a steamroller to bring up these cases, because on some level administrative bodies really can do whatever they want, but every ruling gives insight into how much of the power of self-regulation has been usurped and continues the discussion of the consequences of regulatory overreach and overuse of emergency liquidity facilities.