Roman Octavio Paz <pazromanoctavio@gmail.

com>

Money Stuff: UBS Got Credit Suisse for Almost Nothing

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Matt Levine <noreply@mail.bloombergview.com> 20 de marzo de 2023, 15:03

Para: pazromanoctavio@gmail.com

Credit Suisse
It is sometimes useful to think that the shareholders of a bank are not its owners; they are
just renting it from its creditors. Schematically, a bank borrows a bunch of money from
depositors and other creditors and uses the money to make loans and buy securities and do
other risky investments. If the investments end up being worth more than the deposits, the
shareholders keep what’s left. If the investments end up being worth less than the deposits
then, uh, that’s bad. Then the shareholders don’t own the bank anymore, for one thing, but
that’s really the least of your problems. The real problem is that the depositors can’t lose
money; the banking system relies on bank deposits being usable as money. “Banks are
speculative investment funds grafted on top of critical infrastructure,” Matt Klein wrote last
week. The liabilities (deposits, etc.) are the critical infrastructure; the assets (loans,
securities) are the speculative investment fund. The bank is a machine for turning safe
deposits into risky investments. If the investments end up being worth less than the
deposits, then regulators and central banks step in and there is some sort of rushed rescue
to make sure that the depositors still get paid.

One important consequence of this is that the equity of the bank — the shareholders’
ownership stake — is just a tiny sliver resting on top of an enormous iceberg of liabilities. In
a good profitable conservative bank, there might be $100 of assets, $90 of liabilities and
thus $10 of equity. The liabilities are certain and knowable, things like deposits that really
need to be paid back at 100 cents on the dollar.[1] The assets are risky and variable, and
their valuation is a bit of a guess: They include securities with volatile market prices, weird
derivatives that are hard to value, and business loans with uncertain probabilities of being
paid back. The bank applies some accounting conventions and makes some guesses and
comes up with a value of $100 for its assets, but there is a range of uncertainty around that
number.

And because the equity is only like 10% of the assets, if the asset valuation is off by 10%,
then there is no more equity, and that’s bad. The value of the bank’s equity
is extremely sensitive to the value of its assets, because the bank is so leveraged. I wrote
once that “a bank is a collection of reasonable guesses about valuation. It is a purely
statistical process. There is no objective reality. At best, there is a probability distribution, a
reason to reject the null hypothesis with some level of confidence.” If the bank reports $100
of assets and $90 of liabilities, then probably its assets are worth more than its liabilities, but
you can’t really be sure. There is a cloud of probabilities, and $100 is in that cloud, but so
are other numbers. Some of the other numbers are bad.

And most of the time the bank bops along like this, in its cloud of probabilities. But
occasionally a thing will happen to collapse the probabilities and force it to find a real
number. Occasionally a bank will have to, in effect, sell all its assets over a weekend. Often
the thing that causes this is bad: a bank run, a loss of confidence, an emergency. When this
happens, the assets will probably sell at a discount. If the discount is more than about 10%
— more than the equity cushion — then the shareholders get nothing. If you are in the sort
of emergency that requires you to sell all of your assets over a weekend, it is arguably a
little surprising to do better than a 10% discount.

Credit Suisse Group AG filed its 2022 annual report last week. It reported about 531 billion
Swiss francs of assets and about CHF 486 billion of liabilities, leaving about CHF 45 billion
of shareholders’ equity (about 8.5% of assets). When it filed the report last week, its stock
was trading at about CHF 2.24 per share, for a total market value of the stock of about CHF
9 billion (about $9.7 billion).

One way to put this is that the market thought the stock was worth 20% of its book value.[2]
But another, more useful way to put it is that the market thought that the assets were worth
93.2% of their book value: Credit Suisse’s CHF 486 billion of liabilities were real enough, so
if the market priced the equity at CHF 9 billion then that implicitly meant that it valued the
assets at about CHF 495 billion. The market thought that the reported asset value was off
by 6.8%. But if the reported asset value was instead off by 8.5%, the stock would be
worthless. The cushion was very very thin.

It kept getting thinner. Last Friday, the stock closed at CHF 1.86 per share, for a market
value of CHF 7.4 billion. And over the weekend, Swiss authorities forced through a merger
of Credit Suisse and UBS Group AG. Here is UBS’s statement on the deal:

UBS Chairman Colm Kelleher said: “This acquisition is attractive for UBS
shareholders but, let us be clear, as far as Credit Suisse is concerned, this is
an emergency rescue.”

And Credit Suisse’s:

Axel P. Lehmann, Chairman of the Board of Directors of Credit Suisse said:

“Given recent extraordinary and unprecedented circumstances, the
announced merger represents the best available outcome. This has been an
extremely challenging time for Credit Suisse and while the team has worked
tirelessly to address many significant legacy issues and execute on its new
strategy, we are forced to reach a solution today that provides a durable
outcome.”

In deals like this, it is customary for the shareholders of the selling bank to get something,
not so much because their shares are worth much but because it is technically a voluntary
deal, a merger between a willing buyer and a willing seller, and it is hard for the board of
directors of the selling company to say to their shareholders “hey we negotiated the best
possible price for you, which is zero.” This is only technically true, though, and you can tell
from Lehmann’s statement that Credit Suisse was not exactly a willing seller. It was barely
even involved in the deal: “[Credit Suisse Chief Executive Officer Ulrich] Koerner and the
rest of the Credit Suisse management team were marginalized as emergency weekend
talks — led by Swiss National Bank President Thomas Jordan — to sell the group to UBS
gathered pace,” reports Bloomberg.

But there is a payment, in stock, of one UBS share for every 22.48 Credit Suisse shares.
UBS closed on Friday at CHF 17.11 per share, making the deal worth about CHF 0.76 per
Credit Suisse share, or about CHF 3 billion total, down about 60% from Friday’s close. I
have previously described the customary payment for equity in deals like this as “a Snickers
bar,” and given that benchmark Credit Suisse drove a surprisingly hard bargain. Bloomberg
again:

When the terms of the initial UBS offer — which valued its rival at just 1 billion
francs — landed on Sunday morning, the Credit Suisse managers were
outraged. The price tag was seen as derisory for a bank that had a market
cap of $8 billion at the close on Friday. Shareholders would be wiped out,
managers argued.

Saudi National Bank — the Swiss bank’s largest shareholder — urged Credit
Suisse to reject the offer. Calls went out from Credit Suisse to various
institutions, including Deutsche Bank AG, in a last-ditch attempt to find an
alternative. But the complexity and timeframe meant there were no takers. A
full sale to UBS was the only option. That triggered a final round of back-and-
forth which lifted the price to 0.76 francs per share. That's 99% lower than
Credit Suisse's peak share price.

You can, on the internet, find various expressions of astonishment that a bank as old and
important as Credit Suisse turned out to be worth only $3 billion.[3] But this is, I think, the
wrong way to look at it. Credit Suisse is not worth $3 billion; it is worth half a trillion dollars,
more or less.[4] It's just that virtually all of that value — more than 99% of it — belongs to its
creditors. UBS will take over Credit Suisse’s hundreds of billions of assets and use them to
pay Credit Suisse’s hundreds of billions of liabilities, and there's the tiniest sliver — about $3
billion — left for its shareholders. That $3 billion is pretty much rounding error on the value
of Credit Suisse; it could just as well have been $5 billion, or $1 billion, or a Toblerone bar.
The value and mechanics of this deal don’t depend that much on the price for the equity, as
you can tell by the fact that UBS tripled that price in the course of a few hours.

It really could just as well have been zero, but it is polite to give the shareholders something,
a little consolation prize on their way out the door. The dynamics are:

1. You want shareholders to get something so that the board of Credit Suisse can feel
okay about agreeing to the deal, rather than making trouble and trying to hold out for
something better.
2. You want shareholders to get something so that they don’t make legal trouble, trying
to find some legal way to block the deal. (My Bloomberg Opinion colleague Shuli Ren
writes: “Regulators might have just given Credit Suisse’s equity owners some
sweeteners so they don’t go to court and overturn the merger.”)
3. You want shareholders to get something so that they are more willing to support the
combined bank, and the banking system generally, after the merger. If you make
Saudi National Bank and other big holders feel like they have been taken care of,
even a little bit — even with 90% losses — they might be a bit more willing to buy
bank shares in the future, and it does feel like banks are going to be selling a lot of
shares in the future.
 4. You want shareholders to get something because the employees often own a lot of
shares, and you need them to keep coming to work, and zeroing them is bad for
morale. Not that a 90% haircut isn’t, but 100% is worse.

Similarly, it is normally a requirement in mergers for the selling shareholders to get to vote
on the deal: They own the company, after all, and it can’t be bought from them without their
permission. But in a distressed bank merger it is silly to pretend that the shareholders own
the company, and nobody did. “Pursuant to the emergency ordinance which is being issued
by the Swiss Federal Council,” says Credit Suisse, “the merger can be implemented without
approval of the shareholders.”

The upshot of this for UBS is not that it paid CHF 3 billion to buy its historic competitor. The
upshot of this is that it has assumed hundreds of billions of francs of liabilities, and taken on
a bunch of assets that are probably worth more than that, but it’s hard to tell over a
weekend, or ever really. Fortunately it got a discount:

[UBS CEO] Ralph Hamers … and his team will have plenty to work through as
they consider which businesses and people to keep, alter or jettison. But he’ll
have 56 billion francs of so-called badwill to help cover any writedowns, as
well as 9 billion francs of guarantees from the Swiss government to take on
certain losses. And the firm can access a huge liquidity line from the central
bank.

The badwill is the difference between the price that UBS paid for the assets and their book
value. In Credit Suisse’s accounting, it had CHF 531 billion of assets as of Dec. 31; UBS
effectively bought them for CHF 473 billion.[5] If Credit Suisse’s valuation was too high by
10%, then UBS still makes out okay.

Of course banks aren’t allowed to operate with too thin a sliver of equity, and UBS will have
to make sure that its capital ratios are high enough to support the new much larger bank.
After the deal, “the bank remains capitalized well above its target of 13%,” UBS announced,
while Swiss regulators announced that “the takeover will result in a larger bank, for which
the current regulations require higher capital buffers,” but they “will grant appropriate
transitional periods for these to be built up.” Now UBS owns Credit Suisse; it would like to
be able to hang onto it.
AT1s
After the 2008 financial crisis, European banks issued a lot of what are called “additional tier
1 capital securities,” or “contingent convertibles,” or AT1s or CoCos. The way an AT1 works
is like this:

1. It is a bond, has a fixed face amount, and pays regular interest.

2. It is perpetual — the bank never has to pay it back — but the bank can pay it back
after five years, and generally does.
3. If the bank’s common equity tier 1 capital ratio — a measure of its regulatory capital
— ffalls below 7%, then the AT1 is written down to zero: It never needs to be paid
back; it just goes away completely.

This — a “7% trigger permanent write-down AT1” — is not the only way for an AT1 to work,
though it is the way that Credit Suisse’s AT1s worked. Some AT1s have different triggers.
Some AT1s convert into common stock when the trigger is hit, instead of being written down
to zero; others are temporarily written down (they stop paying interest) when the trigger is
hit, but can bounce back if the equity recovers. (Here is a 2013 primer on CoCos from the
Bank for International Settlements.)

These securities are, basically, a trick. To investors, they seem like bonds: They pay
interest, get paid back in five years, feel pretty safe. To regulators, they seem like equity: If
the bank runs into trouble, it can raise capital by zeroing the AT1s. If investors think they are
bonds and regulators think they are equity, somebody is wrong. The investors are wrong.

In particular, investors seem to think that AT1s are senior to equity, and that the common
stock needs to go to zero before the AT1s suffer any losses. But this is not quite right. You
can tell because the whole point of the AT1s is that they go to zero if the common equity tier
1 capital ratio falls below 7%. Like, imagine a bank:

It has $1 billion of assets (also $1 billion of regulatory risk-weighted assets).[6]

It has $100 million of common equity (also $100 million of regulatory common equity
tier 1 capital).
It has a 10% CET1 capital ratio.
It also has $50 million of AT1s with a 7% write-down trigger, and $850 million of more
senior liabilities.

This bank runs into trouble and the value of its assets falls to $950 million. What happens?
Well, under the very straightforward terms of the AT1s — not some weird fine print in the
back of the prospectus, but right in the name “7% CET1 trigger write-down AT1” — this is
what happens:

It has $950 million of assets and $50 million of common equity, for a CET1 ratio of
5.3%.
This is below 7%, so the AT1s are triggered and written down to zero.
Now it has $950 million of assets, $850 million of liabilities, and thus $100 million of
shareholders’ equity.
Now it has a CET1 ratio of 10.5%: The writedown of the AT1s has restored the
bank’s equity capital ratios.

This, again, is very explicitly the whole thing that the AT1 is supposed to do, this is its main
function, this is the AT1 working exactly as advertised. But notice that in this simple example
the bank has $950 million of assets, $850 million of liabilities and $100 million of
shareholders’ equity. This means that the common stock still has value. The common
shareholders still own shares worth $100 million, even as the AT1s are now permanently
worth zero.

The AT1s are junior to the common stock. Not all the time, and there are scenarios (instant
descent into bankruptcy) where the AT1s get paid ahead of the common. But the most basic
function of the AT1 is to go to zero while the bank is a going concern with positive equity
value, meaning that its function is to go to zero before the common stock does.

Credit Suisse has issued a bunch of AT1s over the years; as of last week it had about CHF
16 billion outstanding. Here is a prospectus for one of them, a $2 billion US dollar 7.5% AT1
issued in 2018. “7.500 per cent. Perpetual Tier 1 Contingent Write-down Capital Notes,”
they are called.

In UBS’s deal to buy Credit Suisse, shareholders are getting something (about CHF 3 billion
worth of Credit Suisse shares) and Credit Suisse’s AT1 holders are getting nothing: The
Credit Suisse AT1 securities are getting zeroed. This is not, to be clear, exactly because
Credit Suisse’s CET1 capital fell below 7%; instead, there is a separate clause of the AT1s
allowing them to be zeroed if the bank’s regulator decides that zeroing them is “an essential
requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material
part of its debts as they fall due.”[7] Plus, in a situation like this, the banking regulators get
to do a certain amount of ad hoc stuff, and they do. (They got rid of the shareholder vote on
the deal!) Zeroing the AT1s while preserving a little value for the common does seem to
have been done in an ad hoc way; my point is just that it follows very logically from the
terms and function of the AT1s.

People are very angry about this. Bloomberg News reports:

The clauses that led to the bonds being marked to zero aren’t common. Only
the AT1 bonds of Credit Suisse and UBS Group AG have language in their
terms that allows for a permanent write-down and most other banks in Europe
and the UK have more protections, according to Jeroen Julius, a credit
analyst at Bloomberg Intelligence. ...

“This just makes no sense,” said Patrik Kauffmann, a fixed-income portfolio

manager at Aquila Asset Management, who holds Credit Suisse CoCos.
“Shareholders should get zero” because “it’s crystal clear that AT1s are senior
to stocks.”

The Financial Times adds:

“In my eyes, this is against the law,” said Patrik Kauffman, 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). “We’ve never seen this before. I don’t
think this would be allowed to happen again.”

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 in a widely attended
call on Monday morning.

I’m sorry but I do not understand this position! The point of this AT1 is that if the bank has
too little equity (but not zero!), the AT1 gets zeroed to rebuild equity! That's why Credit
Suisse issued it, it’s why regulators wanted it, and it would be weird not to use it here.

Oh, fine, I understand the position a little. The position is “bonds are senior to stock.” The
AT1s are bonds, so people bought them expecting them to get paid ahead of the stock in
every scenario. They ignored the fact that it was crystal clear from the terms of the AT1
contract and even from the name that there were scenarios where the stock would have
value and the AT1s would get zeroed, because they had the simple heuristic that bonds are
always senior to stock.

That's the trick! The trick of the AT1s — the reason that banks and regulators like them — is
that they are equity, and they say they are equity, and they are totally clear and transparent
about how they work, but investors assume that they are bonds. You go to investors and
say “would you like to buy a bond that goes to zero before the common stock does” and the
investors say “sure I’d love to buy a bond, that could never go to zero before the common
stock does,” and the bank benefits from the misunderstanding.[8]
We talked about CoCos a few years ago due to a different misunderstanding. CoCos
generally are perpetual — they never need to be paid back — but the bank is allowed to
repay them after, usually, five years (the “first call date”). It is customary for banks to repay
CoCos at the first call date (because they are like bonds), but it is not required, and in fact
bank regulators go around saying that banks shouldn’t make too much of a habit of repaying
them. “A bank must not do anything which creates an expectation that the call will be
exercised,” say the rules, because the regulators do not want CoCos to be too bond-like.

And so one day four years ago Banco Santander SA did not call its AT1s after five years,
and the market freaked out. “Santander’s decision is raising questions about whether
investors will start souring on AT1s across the board,” said the Wall Street Journal at the
time, “which could force European banks to rethink a key way in which they have cushioned
themselves against potentially catastrophic losses since the global financial crisis.” I was
unmoved. I wrote:

If the regulators think that AT1s are equity and the investors think that they’re
debt, someone is wrong, and much better for the investors to be wrong!

Since then I have become very convinced that regulators know how AT1s work, and that
investors don’t, and that this is good.

Anyway there are once again threats that this is the end of the AT1 market, that no one will
ever buy these securities again, etc., threats that are familiar from the Santander situation
four years ago. Bloomberg:

Market participants say the move will likely lead to a disruptive industry-wide
repricing. The market for new AT1 bonds will likely go into deep freeze and the
cost of risky bank funding risks jumping higher given the regulatory decision
caught some creditors off-guard, say traders.

That would give bank treasurers fewer options to raise capital at a time of
market stress, with the Federal Reserve and five other central banks
announcing coordinated action on Sunday to boost dollar liquidity.

And my Bloomberg Opinion colleague Marcus Ashworth:

The entire banking sector will end up paying for Credit Suisse's myriad
transgressions one way or another. The repercussions of the Swiss takeover
structure may close off access to CoCos for all but the strongest banks — the
definition of which will come under ever-closer scrutiny.

To be fair, most AT1s outside of Switzerland don’t work like this — they tend not to be
permanent write-down AT1s — and so it is not clear why the Credit Suisse writedown
should affect the prices of other AT1s:

European regulators are rushing to reassure investors that shareholders

should face losses before bondholders after the takeover of Credit Suisse
Group AG wiped the bank’s Additional Tier 1 debt.

The clauses that led to the bonds being marked to zero aren’t common. Only
the AT1 bonds of Credit Suisse and UBS Group AG have language in their
terms that allows for a permanent write-down and most other banks in Europe
and the UK have more protections, according to Jeroen Julius, a credit
analyst at Bloomberg Intelligence.
It is just possible that the explanation is that AT1 investors don’t read the terms of their
securities? Anyway European Union and UK banking authorities put out statements saying
in effect that they would never do what the Swiss authorities did here, and that (in the Bank
of England’s words) “AT1 instruments rank ahead of CET1 and behind T2 in the hierarchy.
Holders of such instruments should expect to be exposed to losses in resolution or
insolvency in the order of their positions in this hierarchy.” If you read that very closely, it
does not quite say that AT1 instruments can’t be written off in a shotgun merger over the
weekend that preserves some value for the equity (not “resolution or insolvency”!), but I
guess there’s no reason to read it too closely.

Sadly, Bitcoin
A key idea in derivatives is no-arbitrage pricing. Let’s say that the price of some metal is
$100 today, and you think it will be $300 in three months. What should be the price of a
futures contract on that metal with delivery in three months? The wrong answer is $300.
Let’s say you bid $300 for that contract. I will sell you that contract. I will buy the metal for
$100 today. I will put it in my garage. In three months, I will deliver the metal to you, and you
will pay me $300. I have made $200 of free money.

I mean, not free, I had to use some space in my garage. In practice the futures price will
differ from the spot price for various reasons (interest rates, storage costs, etc.). But none of
those reasons, generally, are “I think the price will be higher in the future.” If you think the
price will be higher in the future, you can buy it now, and wait.

Similarly the price of Bitcoin for delivery in three months is not exactly the same as the price
of Bitcoin for delivery today, again for reasons of leverage and interest and contract
mechanics and storage costs.[9] The CME Bitcoin June 2023 futures contract price was
about $28,575 at 10 a.m. today, whereas spot Bitcoin was about $27,975. You can, and
people do, buy Bitcoin and sell futures and pocket the $600ish difference to pay for storing
Bitcoin for three months. But this has nothing to do with where you think Bitcoin will be in
three months; this is just no-arbitrage pricing.

What if you are extremely confident that the price of Bitcoin will be $1 million in three
months? Here are some trades you should not do:

Pay $1 million to buy a Bitcoin today, since it’ll be worth $1 million in three months.
Pay $1 million for a futures contract to buy a Bitcoin in three months, since that’s
where the price will be when the contract settles.
Absolutely any variant on this trade that involves you paying $1 million for a Bitcoin.

Here are some trades you could rationally do[10]:

Pay $1 million to buy 35 Bitcoins today.

Enter into futures contracts to buy 35 Bitcoins for $1 million in three months.

I just cannot emphasize enough how much better it is to buy 35 Bitcoins for $1 million than
to buy one Bitcoin for $1 million. It is 35 times better. There is absolutely no state of the
world where paying $1 million for a Bitcoin today is better for you than paying $1 million for
35 Bitcoins today. “I am confident that Bitcoin will go to $1 million”: Fine, great, buy 35 of
them. “I am confident it will go to $10 million”: Still, buy 35. “I am confident that the US dollar
will be worthless in 90 days and the only value left will be in Bitcoin”: Okay but then you’ll be
much happier with 35 Bitcoin.