Swiss parochialism backfires
Posted 24 March 2023
March continues to provide investors with the opposite of the ‘steady-as-she-goes’ environment of January and February. News this week of consumer price inflation in the UK rising again, the US Federal Reserve (Fed) and the Bank of England (BoE) raising rates again, despite the banking sector fall-out of the past two weeks, and banks in Europe still fighting loss of trust pressures, proved sufficient to have stock and bond markets continue their rollercoaster ride of late.
This came after the global banking sector turmoil calmed down at the beginning of the week, as Swiss authorities appeared to resolve their very own crisis around Credit Suisse, through a classic ‘shot-gun’ marriage with the remaining Swiss banking heavyweight UBS (more about the potential flaws of this later). It also helped that monetary authorities pledges of support appeared to recognise their share of responsibility for the banking sector pressures that have arisen. This time those burdens are not from reckless lending as in 2008/2009’s global financial crisis, but instead the value decline in their long-term fixed interest asset portfolios, much in the same way as some private investors had been shocked by losses in their own ultra-conservative government bond portfolios. As we know, this is collateral damage from central banks waging war against inflation through their steep rate hiking policies of the past 12 months.
For a few days, stock markets and bond yields recovered somewhat. Then, central bank sympathy seemed to wane, when, once again they raised interest rates, even if with dovish undertones. Fed chair Jay Powell acknowledged that the stresses on banks are likely to tighten financial conditions and thereby reduce inflation drivers far more effectively and rapidly than its own steep interest rise journey had achieved thus far and, as a result, the need for further rate rises may decline or even cease to exist. Given it was aggressive monetary tightening that had weakened banks’ capital base, the obstinance of the rate decision saw focus inevitably return to banks akin to Credit Suisse which were seen to have been similarly weakened by poor past management or with meaningful exposure to the ailing US office property sector. Germany’s Deutsche and Commerzbank came under renewed pressure, as well as some French and Italian banks.
In this context, the manner in which the Swiss authorities hammered out the conditions of the UBS takeover of Credit Suisse may well have been amplified the returning weakness. From our perspective, we started the week not with relief, but with an alarming bang. Our concern, shared by many other finance professionals, came from the manner of the Credit Suisse ‘rescue’, as it involved the explosive destruction of value for the holders of the bank’s Additional Tier 1 (AT1) bonds (also known as contingent convertible ‘CoCo’ bonds), while Credit Suisse equity shareholders were spared a similar fate. Organised by the Swiss Financial Market Supervisory Authority (FINMA), the Swiss National Bank (SNB) and UBS, this preferential treatment of equity over bond holders is without precedent and seemed to conspire by using the opaqueness of the specific legal wording of Credit Suisse’s AT1 bond prospectus.
It is true that the demise of Credit Suisse would have wiped out much of its Tier 1 capital anyway, which would have included the capital value of the AT1 bonds, but also its equity holders. When Spain’s Banco Popular Español was declared insolvent in 2017, holders of equity, AT1 bonds and Tier 2 subordinated debt all lost their capital. The bank was subsequently bought by Santander.
The principle is not that the AT1 bond holders should be protected from loss, it is that the risk-bearing seniority across the capital structure needs be upheld if the aim of the ‘shot-gun marriage’ is to re-establish trust in the sector. Common equity holders get to have all the upside as they are the last to get paid out of proceeds should a company (or bank) fail. Preference share holders have a priority claim over common shares on the company’s assets and earnings. European country regulators chose to have AT1 bonds rather than the US choice of preference shares.
The Swiss authorities denied what bond investors had good reason to believe would be the case. In the years following the global financial crisis, and after changes to capital structure rules, the authorities made no attempt to clarify the loose wordings for the AT1 bonds that Credit Suisse, UBS and other Swiss banks issued. As a result, those banks benefitted from a lower rate of interest on their bonds than would have been the case had bond holders known they would carry the same – or in this case more – risk than equity holders.
The European Central Bank, to its credit, issued a statement on Monday stating it would respect the market’s general understanding of bank capital structures. This likely helped calm markets, even as capital market experts fumed and became deeply concerned.
At this point, we should make clear we have no particular ‘skin in the game’ here. Our investment portfolios and funds have very minimal exposure directly to these issues, if any – and where we do, it is mostly through index tracker funds. The point is rather that instead of re-establishing trust among banking sector clients and investors, the Swiss authorities destabilised market structure, increased uncertainty, and decreased investor risk appetite, supposedly in the name of speed of action and financial stability. What is even more suspect is that they also chose between investor groups of differing (inter)nationality. According to Bloomberg, Credit Suisse’s non-Swiss equity holdings were about 87%, and for UBS about 64%. However, in both cases the AT1 issues are almost entirely owned by non-Swiss institutions.
The aftermath still reverberates around markets, and we predict that last weekend’s decisions have substantially eroded the Swiss banking sector’s international standing. Despite the ECB’s assurances over the treatment of AT1 bonds across the Eurozone, Deutsche Bank has come under increasing pressure through the week. And yet, as we said at the start, the western central banks raised rates over the past two weeks regardless, in the name of fighting inflation. Is the current disturbance enough for them to change tack?
We note that this month’s signals from the bond market, in the form of steep declines in shorter maturity bond yields, certainly imply they think exactly that. Moreover, reading between the lines, it seems the Fed and the BoE may also be alive to the possibility. The ‘dots plot’ charts of the expected future path of interest rates may not be liked by the members of the Federal Open Market Committee (FOMC), but it still contains their combined estimates of where they think rates will be in the future. Those dots have not moved perceptibly in the past three months, which means they are moving closer to the rate cuts embedded in their 2024 view. The language in that statement also signalled, in our view, a pause in rate rises now and a potential swift move to rate cuts.
Likewise, as we discuss below, the BoE was put in a difficult position by the inflation data for February. Governor Andrew Bailey’s call for corporate “price setters” to be restrained is, we think, clearly aimed at the supermarkets’ attempts to regain margin. He has not directly named-and-shamed them, but we could see stories in the media identifying the behaviour.
The aforementioned short rate expectations continue to fall substantially as markets expect the focus to shift decisively away from inflation and towards financial stability. However, markets may still be in an uncomfortable bind regarding employment data, which arrives next week. Jobs could still lag a downturn enough to remain strong, even when central banks become convinced they have done enough to contain the dreaded wage-price spiral.
The FOMC’s statement talked of long lags in the economy, as did Andrew Bailey. But both may have to tell us clearly that they are not so employment-data-dependent (as they told us for the last 12 months) if we are to think they will be responsive to a nascent credit crunch. If they do, the currently happy government bond bulls will be even more pleased, while yield-driven valuation pressures on equities should subside.