UBS needs to act swiftly
Zurich, we have a problem. The Swiss government, the central bank and market regulator Finma have obliterated $17bn of AT1 debt in orchestrating the rescue of Credit Suisse, while allowing shareholders to collect a small but not insignificant payoff.
That has created a huge capital problem for newly enlarged UBS Group that the banking behemoth needs to address swiftly. The upshot of the wipeout is a pending set of lawsuits and investors demanding to be paid a premium over other European yields to hold Swiss CoCos (convertible bonds).
Swiss AT1 bond terms were already harsher than those in other jurisdictions by typically including a complete writedown clause, whereas debt elsewhere in Europe is restricted to partial or temporary writedowns, or conversion to equity. This has big implications for UBS — new owner of Credit Suisse — and its $12bn of junior AT1 bonds.
Finma explained its unexpected decision to wipe out Credit Suisse’s bonds on Thursday after bondholders were left aghast at their losses in the takeover. The regulator said the move was justified by the terms of the bonds themselves, in combination with an emergency law passed by the Federal Council in Switzerland to enact a special liquidity line for Credit Suisse. Lawyers, start your engines.
The Swiss authorities wanted to zero the bonds to ensure that the takeover would happen, Credit Suisse could continue to function smoothly and Swiss and internal markets would be protected. All the contractual terms that allow the bonds to be written off ultimately reference Credit Suisse’s capital adequacy, according to analysts and investors. That was a problem because the bank’s capital adequacy was fine all the way through the rescue — it was deposit flight and other liquidity issues that threatened to kill it.
The Swiss solution was to enact a law that created a new kind of liquidity facility which included government guarantees on the borrowing. The law contained a single line allowing AT1s to be wiped out if the facility was used; because it enlisted federal guarantees, it also triggered contractual language in the bonds related to “extraordinary government support”. Credit Suisse bondholders were caught in a legal pincer movement that Finma says justifies the wipeout; the courts will end up having to decide whether that works.
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For UBS, this creates a big problem. After buying Credit Suisse, it will find itself with too much of certain types of capital and not enough of others. It clearly recognises it has a looming investor image problem, offering to buy back €2.75bn of senior bonds it issued only earlier in March. A lot has happened in recent weeks, but it is incredibly unusual for — what is on paper — a much more valuable entity to wind back the clock and allow investors a free exit.
Banks are not charitable institutions. The new UBS no longer needs that much senior debt. Similarly, it probably has a core Tier 1 equity ratio of at least 17%, at the top end of global banks. That is reinforced by all the extra liquidity and loss protections put in by the Swiss central bank to square away its Credit Suisse problem.
The biggest headache for UBS is what it does with its own $12bn of AT1 debt, which is trading at yields north of 15% compared with less than 12% for the broader Bloomberg European CoCos index. After swallowing Credit Suisse, it will ironically have a lack of the riskiest type of AT1 bail-in capital. It plans to shrink the combined balance sheet, but bank analysts estimate UBS could need as much as $10bn more AT1s — just when the legitimacy of that asset class has been brought into question broadly, and the Swiss version of it especially.
The first thing UBS should do is change the terms of its existing bonds to bring them closer to European standards. It can use a consent solicitation to ask existing bondholders to allow the alteration. Removing the permanent writedown clause, to be replaced by a more standard conversion to equity in the event of its capital ratio dipping below a certain hurdle, is a no-brainer.
Normally this exercise involves a modest sweetener — a small payment to bondholders — but virtually all holders should be ecstatic that this onerous clause that threatens to make their securities worthless one day might be excised.
It would remove most of the Swiss yield premium/price discount at a stroke. But while that might reduce the stigma of its existing debt, it will not solve the bigger issue — how UBS will persuade investors to buy a flavour of debt that has proven to be at the risk of regulatory arbitrage in a financial jurisdiction that is perceived to have played fast and loose with bondholders’ rights.
THE FIRST THING UBS MUST DO IS CHANGE THE TERMS OF EXISTING BONDS TO BRING THEM CLOSER TO EUROPEAN STANDARDS