‘Shotgun wedding’: What the UBS rescue of Credit Suisse means for global markets

The cut-price deal is expected to close this year and creates a banking behemoth with more than $5 trillion in total invested assets. The deal also includes support from the Swiss government, financial regulator FINMA, and the Swiss National Bank (SNB), which will offer a liquidity line of up to 100 billion Swiss francs, backed by a federal default guarantee. The government will offer a loss guarantee of up to 9 billion Swiss francs, with UBS assuming the first 5 billion of potential losses.

Shares of both UBS and Credit Suisse plunged on Monday morning, however.

Clarity at last?

Goldman Sachs said in a note late Sunday that the deal and associated liquidity and loss guarantees provided “clarity” and dampened tail risks. The U.S. bank has shifted back to an overweight allocation on European banks as a result.

“Of course, we are mindful that the situation among U.S. regional banks remains fluid. But as we discussed on Friday, we take comfort from the limited contagion from U.S. regional banks to larger money center banks, a trend we expect will persist,” the Wall Street giant’s credit strategists said.

Goldman also reiterated its favorable view on U.S. “money center” banks, a view echoed by Smead Capital Management’s CEO Cole Smead, who said interest rate rises from central banks help lenders “that don’t do stupid things in their assets.”

“Poor stock markets have caused investment banks to be the laggards, but commercial banks look good next to them,” he said via email, naming JPMorgan and Bank of America as stocks he particularly likes.

Smead also said investors could expect higher returns on assets from the new UBS-Credit Suisse entity, along with more consolidation in the European banking sector.

But bigger questions remain over the potential market impact of the deal. James Sym, head of equities at London-based investment manager River and Mercantile, told CNBC that the market was in “seek and destroy mode.”

“This solves what I think is probably an idiosyncratic problem at Credit Suisse, but I’m not sure it’s a firebreak big enough to stop the rot for the market,” he said Monday. Although he added that the rest of the European banking system is “much more robust” than it was.”

Since the Global Financial Crisis, the continent’s banks have built much larger capital buffers in order to withstand systemic risks.

Sym suggested that if European bank shares fall significantly as a result of the deal, he might “start to nibble” at some stocks, potentially even UBS.

“In the short term, the market is not going to like this deal for UBS, it’s not core to the strategy, but I think over the medium term it does potentially give them an edge to compete globally with the Americans and really puts them in an unassailable position domestically.”

Risks remain

While the deal could bring an end to doubts about the viability of Credit Suisse as a business, some analysts still believe the devil will be in the detail as the finer points are hashed out over the coming weeks and months.

“One issue is that the reported price of $3.25bn (CHF0.5 per share) equates to ~4% of book value, and about 10% of Credit Suisse’s market value at the start of the year,” said Neil Shearing, group chief economist at Capital Economics.

“This suggests that a substantial part of Credit Suisse’s $570bn assets may be either impaired or perceived as being at risk of becoming impaired. This could set in train renewed jitters about the health of banks.”

Shearing added that there may yet be risks to the deal “for legal or financial reasons, or if confidence in UBS is dented and it gets cold feet about the deal.”

“Only time will tell how this shotgun wedding is received,” he added.

The AT1 bond issue

As part of the deal, Swiss regulator FINMA announced the wipeout of 16 billion Swiss francs’ worth of Credit Suisse’s Additional Tier 1 (AT1) bonds, which some investors fear signals further spillover risk for global credit.

This was a major focal point for analysts assessing the potential ramifications on Monday morning.

“AT1 bonds were introduced in Europe after the global financial crisis to serve as shock absorbers when banks start to fail,” explained Charles-Henry Monchau, chief investment officer at Syz Bank.

“They are designed to impose permanent losses on bondholders or be converted into equity if a bank’s capital ratios fall below a predetermined level, effectively propping up its balance sheet and allowing it to stay in business. According to the Swiss bail-in regime, AT1 debt is above equity in the loss absorption waterfall.”

The entire AT1 tranche of bonds being written down to zero, Monchau suggested, is an “arresting development” given that unsecured bondholders usually rank higher than equity holders in the capital structure.

He argued that this raises questions about the real value of contingent convertible (CoCo) bonds and creates contagion risks.

“There is also a risk of spillover effect on global credit (although we note that senior secured bonds seem quite resilient including CS senior secured bonds which are jumping in price this morning),” he added.

Goldman highlighted that the write-down constitutes the largest loss ever inflicted on AT1 investors since the post-GFC birth of the asset class, and argued that although it preserves some shareholder value, the decision “greatly weakens the case to add risk.”

“Whether investors treat this decision as a one-off or whether they rethink the asymmetry of their risk-reward at times of elevated financial distress remains to be seen,” the bank’s credit strategists said.

“But in our view, it has become harder to assess the attractiveness of the current historically large spread pick-up provided by AT1 bonds vs. their HY (high-yield) corporate counterparts, which will likely constrain the appetite towards the AT1 asset class.”