Lessons from the Credit Suisse wipe-out

One of the biggest traders in Europe, an Aussie based in London, wryly asks: “Mate, when will it stop – we are investing through plagues, wars, inflation shocks, equity and crypto collapses, record rate rises, house price plunges, high-yield defaults, and now bank runs?”

Although there are many lessons to be garnered from recent events, an important one is the myth of blind diversification. A common trick is to build a portfolio comprising thousands of bonds and assume it signals safety. Yet, the largest holders of Silicon Valley Bank and Credit Suisse securities were the most fancied fund managers on earth, including some Australian institutions.

Locally, investors are learning that the search for yield is a reach for risk.

In 2020, we had the Virgin Airlines insolvency, wiping out investors in widely held Virgin bonds. Now, Aussies have suffered enormous losses in high-yielding Credit Suisse and Silicon Valley Bank securities.

Blind diversification can be very dangerous. Concentrating on the safest global firms is, by way of contrast, a source of strength.

We were warning clients to get out of Credit Suisse in February 2021, and we short-sold their bonds last year. And we’ve avoided European hybrids like the plague precisely because the inherently fragile European Union is a source of never-ending risk that is difficult to manage.

In 2011 and 2012, we had Grexit I, then Grexit II in 2015, fears of a collapse of Deutsche Bank in 2016, Brexit ructions, ongoing Italian fiscal and political dramas, the Russian-Ukraine war, and now the fire-sale of Credit Suisse to UBS.

While Credit Suisse was a basket case, there was nothing that warranted its sudden sale. This was an engineered speculative attack. And it will probably end up being one of the greatest banking deals ever for UBS.

For 3 billion Swiss francs, UBS picks up a retail bank worth 10 billion Swiss francs plus a private bank valued even higher. It further gets a total of 150 billion Swiss francs in cheap loans from the Swiss central bank plus a government guarantee over 9 billion Swiss francs in losses on Credit Suisse’s assets (after UBS bears the first 5 billion Swiss francs).

UBS will now be the monopoly too-big-to-fail bank in Switzerland and the No. 1 supplier of private banking services globally. If it was government-guaranteed before the Credit Suisse saga, it has rolled-gold public backing today.

Sadly, the fate of Credit Suisse’s shareholders and hybrid investors is not as promising. The equity investors lost 89 per cent of their capital based on trading levels 12 months ago and the hybrid investors were wiped out. Significantly, Credit Suisse’s depositors, and senior and Tier 2 bondholders, were fully protected: they have not lost a single cent.

The Credit Suisse hybrids, which were rated junk or “B” by S&P, were radically different to Aussie bank/insurer hybrids in many respects (major bank hybrids are rated an investment-grade “BBB-“). First, they did not convert into equity, or bank shares, in a “non-viability” (blow-up) event, as Aussie hybrids automatically do. Instead, they had to be written off.

Second, the Credit Suisse write-down had to be 100 per cent: the securities did not allow for a partial write-down. In the case of Aussie hybrids, they are only converted into stock, diluting shareholders to the extent the bank needs additional equity.

Third, most Credit Suisse hybrids had to be wiped out at an equity capital ratio trigger of 7 per cent, which is much higher than the 5.125 per cent equity threshold at which Aussie hybrids convert into shares. The current average major bank equity ratio is about 12 per cent. In the case of CBA, it would have to suffer unprecedented losses of $31.5 billion (and not raise compensating equity in the process), for its equity ratio to fall to 5.125 per cent.

If UBS was government-guaranteed before the Credit Suisse saga, it has rolled-gold public backing today.

In its regular stress-testing, the Australian Prudential Regulation Authority runs a scenario where Aussie house prices fall 30 per cent, commercial property values decline by 40 per cent, the jobless rate jumps from 3.5 per cent to more than 13 per cent, and GDP contracts by 15 per cent. In this extraordinarily severe recession, Australian banks’ equity ratios decline to 6.6 per cent, notably above the 5.125 per cent threshold at which hybrids convert into shares.

A final important difference is the sacrosanct capital structure “hierarchy”, the protection of which is an essential feature of the global Basel 3 banking regulations, the framework of the Australian Prudential Regulation Authority (APRA), the Corporations Act and Australian common law, and is embedded explicitly into Aussie hybrid prospectuses.

In short, this means shareholders need to bear losses first. The Swiss bizarrely inverted the capital structure hierarchy: Credit Suisse shareholders recovered modest value and hybrid investors lost everything.

This has led to widespread condemnation from global regulators, including the European Union, the Bank of England and others, which have confirmed that in their jurisdictions shareholders would lose 100 per cent of their investments before higher-ranking creditors suffered losses.

APRA’s regulations state that bank shares must be “the most subordinated claim in liquidation of the issuer” and “take the first and proportionately greatest share of any losses as they occur”. They further declare that after equity suffers losses, hybrids must be converted into equity before any Tier 2 bonds are at risk.

Aussie hybrid prospectuses expressly state that they cannot be converted into shares until equity first bears losses. And the issuers pre-arrange all approvals for equity conversion before a hybrid is launched to ensure the process cannot be perturbed.

Australia’s banks are widely regarded as among the safest globally, and APRA is considered the toughest regulator on the planet. Under Wayne Byres’ impressive leadership, APRA forced the big banks to massively de-lever and raise $150 billion of extra equity buffers to comply with the “unquestionably strong capital” recommendation of the 2014 Financial System Inquiry (I helped co-author the original terms of reference for this inquiry.)

Banks were also compelled to dump their riskier offshore exposures and non-core business lines, such as investment banking, financial advice, funds management and insurance. New APRA chairman John Lonsdale, who developed the “unquestionably strong” concept, looks like he will be an equally tough successor to Byres.

APRA is not, however, perfect. The regulator can sometimes get buried in the weeds and lose sight of strategic financial stability considerations. In 2017, this column outlined a scenario identical to the Credit Suisse events that was possible with a small number of hybrid securities that APRA had approved.

The two I focused on were issued by the insurer Genworth and ME Bank. Both had previously issued securities that converted into equity in a non-viability scenario. But because shareholders subsequently decided they wanted to avoid being diluted by higher-ranking hybrids/bonds converting into equity, they replaced the old instruments with new ones that did not convert into equity and went straight to write-down.

“The far-reaching dysfunction associated with this should be obvious,” this column argued in 2017. “At a time of stress, Genworth shareholders have an incentive to reduce their debts. So they will be potentially motivated to encourage APRA to declare non-viability to wipe out the debt in what is a direct transfer of wealth from debt to equity. Genworth adopted this structure precisely because its US parent, which owns 51 per cent of the business, did not want to be diluted in a non-viability event.”

The Bank for International Settlements, which is the global regulator of regulators, has arrived at similar conclusions. In a 2017 paper, it found that hybrids that don’t convert into equity and go straight to write-off “are, in effect, junior to equity in distress states and, therefore, particularly attractive to shareholders”.

“A [hybrid] that converts into equity disciplines risk-taking by shareholders because conversion may dilute existing equity holders’ claims,” the BIS wrote. “In contrast, risk-taking is rewarded at the conversion margin when [hybrids] absorb losses via a write-down.”

The BIS further found that equity-converting hybrids reduced a bank’s cost of capital much more than hybrids that only go to write-off precisely because the former are perceived to discipline equity-owning executives more effectively.

Given the above, it is not surprising that the Aussie hybrid market has been extraordinarily resilient – the index has lost only 0.9 per cent since the Credit Suisse write-down. In all previous shocks, Aussie bank hybrids have had much lower volatility and losses than bank shares, as should be expected.

We sold about $1.1 billion of Aussie hybrids over the past year when credit spreads were much tighter (less attractive), switching up the capital stack into bank bonds. Spreads have since lifted about 80 basis points. The current average five-year hybrid issued by a major bank offers a franked running yield of about 6.7 per cent annually, which is oddly superior to the franked dividend yield on CBA shares.

These days, banks offer new hybrid issues only to wholesale rather than retail investors (unless they get explicit advice from a financial planner recommending a purchase). Excessive regulation means it is easier to buy a start-up tech stock issued on the ASX than it is to acquire a BBB- rated CBA hybrid that has one-third the volatility of CBA shares.

Bizarrely, Aussie regulators have always made it harder for mum and dad investors to buy safer bonds than speculative equities sitting lower down the capital structure.

First published in the AFR.