Can a bond that now not exists set off a default?

That is the quasi-metaphysical query dealing with the panel of consultants who’ve to find out whether or not Credit score Suisse’s credit-default swap contracts pays out. Name it Schrödinger’s swap.

Whereas most out there had assumed that Switzerland’s resolution to vapourise $17bn of Credit score Suisse’s Further Tier 1 bonds wouldn’t set off the financial institution’s CDS (for causes we’ll get into under), a few US hedge funds have wagered that just about everybody has missed essential quirks within the by-product contracts that would result in a payout.

Bloomberg revealed final week that FourSixThree Capital and Diameter Capital Companions have loaded up on Credit score Suisse CDS aiming to revenue from a ruling that the swaps have in truth been triggered. On Thursday, a query was lodged with the Determinations Committee — the omnipotent panel of market representatives who make often-controversial rulings on whether or not credit-default swaps pay out — asking whether or not a so-called credit score occasion has occurred at Credit score Suisse (CDS aficionados may have famous that the query went in just some days shy of the 60-day deadline after the AT1 bonds have been written down). 

The rationale behind why these funds are betting on a payout just isn’t but public, nevertheless. Bar some clues within the phrasing of the query submitted to the DC and the supporting paperwork hooked up, the broader world is none the wiser as to why two refined hedge funds imagine a lot of the market has missed a seismic occasion on the earth of CDS.

In a bid to fill this void, FT Alphaville has spoken to a number of gamers with information of the commerce with a view to set out as clearly as potential the thorny argument in favour of a CS CDS payout.

We will’t promise that the reason might be simple. However you realize you’re in for a wild trip when the supporting supplies embody paperwork as esoteric as a bond prospectus from the 12 months 2000 and a greater than a century outdated New York courtroom judgment.

Tiers for fears

Earlier than we get into the nitty gritty of the argument in favour of a set off, it’s first price explaining why nearly all of CDS merchants had assumed there could be no payout on the Credit score Suisse swaps.

CDS contracts written in opposition to financial institution bonds have two primary courses: senior and subordinated, referencing the debt on the prime and backside of the capital construction, respectively.

You may naturally assume that when Swiss authorities worn out $17bn of Credit score Suisse’s deeply subordinated AT1 bonds, as a situation of the financial institution’s shotgun wedding ceremony to UBS, it will set off payouts on the latter set of contracts.

Certainly, the Worldwide Swap and Derivatives Affiliation overhauled the usual CDS contract definitions in 2014 to incorporate a brand new “governmental intervention credit score occasion” to cowl precisely this type of eventuality (one of many causes for the overhaul was a fiasco surrounding the CDS of Dutch financial institution SNS Reaal the earlier 12 months, the place swap holders acquired no payout even after the federal government zeroed its subordinated bonds).

The issue is that financial institution capital buildings are somewhat extra sophisticated than simply being cut up into “senior” and “subordinated” bonds. There are a number of tiers of debt. And for the needs of subordinated CDS, it’s the Tier 2 bonds that matter.

It’s because AT1 bonds, which banks solely first began issuing round a decade in the past, have quite a lot of structural options that make them incompatible with CDS. For instance, their perpetual maturities (which imply they by no means must be repaid) conflict with the requirement in normal CDS contracts that the related bonds have a most maturity of 30 years.

This distinction didn’t matter the primary time that AT1 bonds have been written down in Europe — within the case of Banco Widespread in 2017 — as a result of regulators zeroed the Spanish financial institution’s Tier 2 bonds in tandem. This led to a full payout for individuals who had purchased CDS safety on Banco Widespread’s subordinated bonds.

Within the case of Credit score Suisse, nevertheless, Swiss authorities left its Tier 2 bonds fully unscathed (somewhat miraculously, on condition that the Tier 2 debt had an extremely related writedown clause to the Swiss financial institution’s AT1 bonds). 

With the Tier 2 bonds unimpaired, it appeared logical that there could be no payout on Credit score Suisse’s subordinated CDS contracts.

Or so that you may need thought.

Y2K bug

The primary trace that each one won’t be because it appears comes from the truth that among the many supporting paperwork on this week’s query to the DC is the providing round for a £250mn subordinated bond that Credit score Suisse’s US subsidiary issued within the 12 months 2000.

College students of banking M&A historical past could also be to find that these bonds have been issued to fund the acquisition of US funding financial institution Donaldson, Lufkin & Jenrette, again when an expansionary Credit score Suisse First Boston was attempting to make deeper inroads into the US junk bond market:

Crucially, nevertheless, this bond matured again in 2020. How can debt that now not exists have any bearing on Credit score Suisse’s CDS contracts within the right here and now?

The reply lies in one of many many ways in which financial institution capital buildings have change into much more advanced as the results of the worldwide regulatory framework launched following the 2008 monetary disaster.

On prime of the usual capital necessities, globally vital banks additionally must have a certain quantity of bonds that may be simply written down in a disaster, not-so-catchily generally known as “complete loss-absorbing capability”. To replenish these buckets, banks started issuing a brand new tier of bonds that ranked between senior and Tier 2.

Within the EU, banks largely opted for so-called contractual subordination, the place bonds are issued from the identical entity and their contracts specify totally different orders of precedence. Fairly than giving them the extra logical title Tier 3 bonds, bankers christened this new class of debt with the somewhat oxymoronic moniker “senior non-preferred”.

Within the UK and Switzerland, nevertheless, banks as a substitute adopted structural subordination, the place bonds are issued out of various entities to find out their order of precedence. Whereas conventional senior bonds have been issued from the principle banking entity, the brand new bonds have been issued out of a holding firm. The 2 courses of debt turned colloquially generally known as “OpCo senior” and “HoldCo senior” respectively.

The shift created much more complexity for European financial institution CDS, with totally different contracts rising to reference the differing methods the 2 tiers of senior debt have been issued throughout the continent.

It signifies that for Swiss CDS, the excellence between bonds on the HoldCo and the OpCo issues. And Credit score Suisse’s subordinated CDS references Credit score Suisse Group AG (the HoldCo) not Credit score Suisse AG (the OpCo).

You’d in all probability anticipate that the related bond for this contract (the “reference obligation” in CDS parlance) to be the Credit score Suisse Tier 2 bond that escaped a writedown in March. And but that bond’s providing memorandum makes clear that this bond is an obligation of Credit score Suisse AG, not Credit score Suisse Group AG:

At this stage it is sensible to show to the “Normal Reference Obligation record” maintained by IHS Markit to get a definitive reply on the contract’s related bond. And lo and behold, it lists the £250mn bond issued in 2000 that matured in 2020:

A fast examine of the bond’s prospectus reveals that in distinction to the Tier 2 bond, it was assured by the identical entity that the subordinated CDS references, Credit score Suisse Group:

Whereas it might sound deeply bizarre for CDS to reference a bond that now not exists, ISDA’s normal CDS definitions do permit for this risk, with the idea of a “prior reference obligation” for conditions the place no reference obligation is excellent.

So, extremely, it might nicely be the bond we have to look most intently at in figuring out whether or not there was a CDS default.

Unwritten rating?

Up to now, so unusual.

However you might be forgiven for nonetheless questioning what relevance this legacy bond has to Credit score Suisse’s AT1 wipeout. In spite of everything, it goes with out saying {that a} bond that was repaid almost three years in the past was not written down as a part of the UBS merger.

The following clue lies in the truth that the DC has not solely been requested to rule on whether or not a governmental intervention credit score occasion has occurred at Credit score Suisse Group. The query submitted to the panel has a supplementary question:

“The Eligible Market Participant who submitted the query famous that with a view to decide the DC Query the EMEA DC would want to find out whether or not the AT1 bonds have been Not Subordinated to the Reference Obligation or the Prior Reference Obligation and asks the EMEA DC to think about this level in reference to the DC Query.”

That is related as a result of it isn’t solely a default on the particular “reference obligation” that results in a CDS payout. The swaps also needs to be triggered if the borrower defaults on debt that ranks on the similar stage or increased (or, to make use of CDS parlance, debt that’s “not subordinated to the reference obligation”).

If the AT1 bonds that have been zeroed have been deemed to rank pari passu with the £250mn subordinated bond that matured in 2020, which may be sufficient to set off the swaps.

On the floor, this doesn’t look like the case. The type of legacy financial institution capital that Credit score Suisse issued within the 12 months 2000 was colloquially generally known as “decrease tier 2”. Within the order of precedence that makes up a financial institution’s capital construction, it follows that “tier 1” ranks behind “tier 2”.

And but, within the 2020 maturity bond’s phrases and circumstances there isn’t any reference to it being “tier 2” debt. The bond’s phrases solely set out that they’re generic “subordinated obligations”. Unsurprisingly, there isn’t any reference to the bond’s rating in relation to AT1 debt, on condition that these securities didn’t but exist when the bonds have been issued in 2000.

The hedge funds which might be wagering on a payout are betting on the truth that, whereas market contributors usually perceive that the subordinated bond issued in 2000 ranked forward of the AT1s, there’s not something making that specific within the paperwork related to a CDS resolution.

On this logic, there’s an amusing echo of the talk between Credit score Suisse’s AT1 holders arguing that their debt was generally understood to rank forward of the financial institution’s widespread fairness (which paradoxically was not zeroed within the merger and acquired $3bn) and sceptical observers telling them that this was by no means truly enshrined within the paperwork.

The ultimate piece of the puzzle is a New York courtroom resolution from 1918, which FT Alphaville understands has been submitted to the DC as a part of a belt and braces method to proving that perpetual bonds are nonetheless legally thought-about debt (the ruling offers with a “perpetual debenture” issued in 1901, a type of early twentieth century model of an AT1 bond).

Senior second

Let’s think about for the sake of argument that this gambit works. The DC agrees that there has certainly been a governmental intervention credit score occasion in respect to Credit score Suisse Group’s subordinated CDS. What then?

CDS contracts don’t all pay out the identical quantity when they’re triggered. In most situations, an public sale of the related bonds is held to find out what the loss to bondholders has been and to compensate them accordingly (for instance, an public sale that valued the bonds at 25 cents on the greenback would result in a 75 cent payout on the CDS).

Provided that the subordinated bond Credit score Suisse issued in 2000 has already been repaid and its different bonds which might be eligible for a CDS public sale weren’t impaired within the UBS merger, you may assume there’s little reward in retailer for these betting on a shock CDS default.

That is the place the hedge funds betting on a payout are banking on the sharp strikes increased in rates of interest over the previous 12 months coming to their assist, nevertheless.

Credit score Suisse Group has a bond excellent that’s buying and selling at round 65 cents on the greenback, purely as a perform of the dramatic change in underlying charges because it was issued on the finish of 2021 (the bond in query has a skimpy 0.625 per cent coupon and a decade-long 2033 maturity, making it notably delicate to rate of interest adjustments).

Whereas this is without doubt one of the so-called “HoldCo senior” bonds we mentioned earlier, CDS contracts explicitly permit for bonds which might be extra senior than the reference obligation to be submitted into an public sale. Within the occasion that Credit score Suisse’s subordinated CDS is deemed to have triggered, the hedge funds stand to bag a tidy 35 cent pay out.

That’s good in idea however…

That’s the commerce as FT Alphaville understands it. Primarily, these two funds assume the anomaly over the rating of a lifeless bond is sufficient to flip the AT1 wipeout right into a CDS payout.

The large query stays: will it work?

¯_(ツ)_/¯

The logic behind all of it might at instances appear counterintuitive and faintly ridiculous, however then CDS choices are ceaselessly counterintuitive and faintly ridiculous. The members of the DC are usually not speculated to rule on how market contributors supposed the contracts to behave, however on their strict authorized definitions, unintended quirks and all.

The DC accepted the query late on Friday and can maintain their first dialogue on the matter later as we speak, so the panel actually thinks it’s on the very least worthy of debate.

It is usually price noting that there are critical gamers concerned. FourSixThree and Diameter are each distressed debt specialists whose principals have intensive expertise buying and selling CDS. They’ve additionally enlisted a heavyweight regulation agency in Kramer Levin to assist of their trigger.

One factor that does strike us, nevertheless, is that there are a number of steps that the DC must associate with for a payout to happen. This implies the commerce has a number of factors of failure.

For instance, whereas the 4 corners of the 2000 classic bond’s providing memorandum don’t include a sign that it’s a Tier 2 bond that ranks forward of the AT1, the order of hierarchy will be present in different publicly accessible paperwork. This doc Credit score Suisse issued in 2019 explicitly states that the 2000 bond has a “Tier 2” rating, whereas additionally stating the AT1 bonds’ “place in subordination hierarchy in liquidation” is behind the Tier 2.

If the DC doesn’t agree with the notion that the AT1 bonds are “not subordinate” to the “prior reference obligation”, then the entire commerce falls aside. Athanassios Diplas, one of many architects of the trendy CDS public sale, has tweeted that this might be an “uphill battle”:

A query has been submitted to the DC asking to substantiate that the CS AT1 bonds weren’t subordinated to the RefOb of the CS CDS contracts.
Don’t see how that may be potential given the character of the AT1s.
Appears like uphill battle.
PS I can not entry a few of their hooked up docs https://t.co/JbPW18HXrt

— Athanassios Diplas (@AthanaDiplas) Might 11, 2023

Regardless of the final result although, one factor is for sure: the commerce is delightfully bizarre and enjoyable.

And FT Alphaville is strongly in favour of bizarre and enjoyable trades, whether or not or not they’re finally profitable.

Additional studying:
— Who killed Credit score Suisse? (FTAV)
— Watch out for Greek classes for AT1 bondholders (FTAV)
— Why financial institution capital has an issue (FTAV, 2017)