How the Credit Suisse rescue deal creates a headache

The Credit Suisse fire was supposed to have been put over the weekend, courtesy of a hastily arranged rescue by rival UBS.

UBS is paying £2.5bn, with a big assist from the Swiss authorities in the form of liquidity in case the waters get choppy again.

Perennially crisis-racked Credit Suisse is too big to fail and money was heading for the exits at a rate that put the frighteners on regulators and just about everyone else.

Two problems with the deal. First up, nobody bothered asking UBS shareholders what they think about it. The rescue deal was stitched up between UBS bosses, Credit Suisse and the Swiss authorities over the weekend.

The second, bigger one, is that holders of Credit Suisse AT1 or CoCo bonds are getting wiped out, which has created a problem across Europe.

CoCos were created after the financial crisis as a means of providing banks with extra capital in the event of a fresh squall (such as the current one).

If a bank’s financial strength falls below a certain level, they either get converted into shares or they’re wiped out, depending on the bond. This makes them risky to hold so they generally offer very generous rates.

But they are still bonds and bonds are supposed to have priority over shares in the event of things going wrong. Senior debt at the top has first call on any assets all the way down to AT1s and then shares at the bottom, with various forms of debt sitting in between.

The Swiss deal upends that order. Credit Suisse shareholders get a little something out of this deal; its CoCo holders get nada. Zip. Not even a few shabby shares for their trouble.

One assumes the Swiss are confident of their legal grounds for doing this.

However, it has created a panic among holders of CoCos across the board who are left wondering what they’re holding onto.

This is a big market, roughly $250bn, and it is a key part of post-crisis architecture. The Swiss deal has created a big problem for watchdogs because it threatens to blow a hole in that architecture.

European watchdogs and the Bank of England hurriedly issued statements, implicitly or explicitly criticising the Swiss move while stressing that “it couldn’t happen here”.

The Bank, for example, made a pointed reference to the rescue of Silicon Valley Bank UK by HSBC, which it brokered in a more traditional fashion.

There’s a political fuss brewing in Switzerland. Europe’s stock markets, meanwhile, opened to a sea of red in the banking sector, with UBS leading the charge down.

Fortunately, that didn’t last. The interventions, and the reassurances over CoCo bonds and how they would be treated elsewhere, calmed frayed nerves somewhat.

As for UBS, the biggest clunker early on, it was soon in positive territory as investors started to wake up to the fact that this looks like a rather good deal for the bank.

It has purchased an asset – albeit a severely distressed one – for a knock-down price that it wouldn’t have been able to get anywhere near in a more normal situation.

UBS still has to manage a lot of risk, not least from trying to integrate two businesses that were bitter rivals until last Friday. But the payoff down the line could be considerable.

Part of managing that risk will inevitably result in job losses. The City of London is bracing itself for a bloodletting. UBS is most interested in Credit Suisse’s retail and commercial banking operations and especially its wealth management arm, a business UBS has long been focused on. Credit Suisse’s investment bank? Not so much. It faces a gigantic set of shears. The word “downsizing” is going to be heard a lot.

This deal was hurried and it does rather bring to mind that old proverb, “act in haste, repent at leisure”. But it puts the sector’s problem child to bed, so banking watchdogs will still be thankful.

It certainly didn’t hurt that Wall Street enjoyed a positive start to the week with major US banks posting modest gains. The troubled smaller player, First Republic was, however, a notable exception. This storm has yet to blow itself out.