Like clockwork, every few weeks for the last decade one of our clients would forward an email recommendation from a private bank on the newest subordinated AT1 (also known as Contingent Convertibles – CoCos) new issue. With this frequent issuance, it’s little wonder that the size of this new ‘hybrid’ instrument created in the aftermath of the 2008 Great Financial Crisis ballooned to over 250 billion US dollars.
My answer was always the same: “Don’t buy it. You’re not getting paid for the risk.” Why would you ever invest in a security whose sole reason for existence is to provide a source of bank equity in times of crisis at investors’ expense, especially since by their nature banks tend to fail in a financial crisis? And all this risk for a two per cent pickup in yield? Why is anyone surprised that some investors lost their investment the first time CoCos were stress-tested?

Now that the Credit Suisse AT1 investors were wiped out overnight, some are complaining about being ranked junior to equity holders. The common equity investors in Credit Suisse aren’t exactly a happy bunch, as investors are left with massive losses of over -90%, not materially different from the fate of the AT1 investors.
Yet the language was clearly stated in all the documentation and the marketing presentations that Credit Suisse did when pitching investors for the AT1s they issued. While I have yet to meet an individual investor who ever read an investment prospectus, it is inexcusable for a professional investor not to have known the underlying risks.
Credit Suisse’s AT1 bonds stated that ‘in the situation of a write-down event, the full principal amount will be written down to zero, holders will have irrevocably waived their right to the repayment of the notes, and the notes will be permanently cancelled.’ It doesn’t get any clearer than that.
For years bank analysts bemoaned the 0% interest rates we’ve seen for 15 years, citing that banks need higher interest rates to make money. Unfortunately some tend to also blow up when interest rates move up sharply. With all the introspection that the regulators are doing, as they do after every banking crisis, there is simply no way to regulate this risk.
The global systemically important banks (G-SIB) are fragile. Total G-SIB balance sheet assets are $64 trillion, but are supported by only $4.4 trillion of balance sheet equity, giving a ratio of assets to equity of 14.4 times.
This risk is not evenly spread around the world . Eurozone’s seven G-SIBs average 19.7 times, Japan’s three G-SIBs at 23 times and at the lower end of the scale there are the USA’s eight G-SIBs averaging 11.4 times and China’s four banks at 12.0 times.
If 15 years of zero interest rates caused all these problems in the US and Europe, imagine the potential hidden bombs in Japan’s financial system, which has endured 30 years of zero rates, where the banks have the highest leverage? Again, why would anyone invest into AT1s when the express purpose of these instruments is to provide banks cheap financing to shore up their balance sheet during the next banking crisis, at the expense of investors?
While I am of the opinion that Switzerland’s decision to wipe out AT1 holders at the expense of common shareholders sounded the death knell for AT1s, some are taking the opposite view saying that the sell-off now makes AT1s attractive. While there are some more distressed CoCos that approach double digit yields, I fail to see how an average of three to four per cent additional yield compensates investors for the risk of a total permanent loss in the next banking crisis. One of my colleagues put it well: “you’d have to be CoConuts to buy CoCos.”
All this discussion on whether AT1s are now a buy however misses the real point. The first question I get when people find out what I do is ask me what they should buy now. A much better question would be to ask where the biggest risks are. Within a well-diversified portfolio, avoid the big risks that cause permanent loss and the upside will take care of itself. This is what I’d like to devote the
rest of this article on, the seismic shifts we are seeing in the world which will become the big risks for the future.
For decades Switzerland has been seen as a haven of legal certainty for investors. In the Credit Suisse bailout, both shareholder rights and corporate seniority have been overridden. CS could have made the determination that capital ratios were triggered and then force a writedown. Instead because of the urgency involved, at the insistence of the Swiss regulators, it skipped the trigger. The takeover was done over a weekend by skipping a shareholder vote, and surely lawsuits will follow.
The rule of law and protection of individual rights was supposed to be sacrosanct in Western economies. It was the reason why the West attracted capital from all around the world, especially from countries that were seen to not possess the same levels of investor protection.
However Western democracies have been systemically undermining these advantages, with the most flagrant events all happening in the last year, not just in financial markets but in politics as well.
Recently President Macron sought to increase the retirement age from 62 to 64, but the motion faced last minute dissention among its National Assembly members. Rather than face a political loss, the government rammed the measure through without a vote using a procedural trick offered by article 49.3 of France’s constitution.
On top of the dissention within the French government, this was a deeply unpopular decision with French voters, and citizens protested on the street. Bypassing the vote has been used multiple times in the past after the loophole was added in a 1958 constitution rewrite to keep the government working during times of gridlock. It’s one thing to use this to pass a budget, quite another to push through major reform that is opposed by most French people. The motion passed without parliamentary majority.
The skipping of the shareholder vote in the Credit Suisse forced takeover/bailout may well be the straw that breaks the camel’s back of the cozy relationship of the last eighty years, where countries with a trade surplus (primarily China and the Middle East) recycled them into Western financial markets, primarily the US, perpetuating US hegemony and the dollar’s status as the global reserve currency. Middle East countries supplied large amounts of capital to Western banks during the 2008 financial crisis, as China created significant amounts of stimulus. Six months ago the Saudi National Bank bought a 9.9% stake in Credit Suisse and ended up suffering losses of over -80% during the forced takeover, without being offered a say in the matter. Would the Swiss government have acted differently if the investor was not Saudi Arabia, but Germany? You can be sure that in the next financial crisis there will be much less, if any, capital from the Middle East available to bailout the Western banks.
In Western democracies individual rights have become subordinated to the greater good. Is this so different from China’s common prosperity drive?

The weaponization of the US dollar against Russia will hasten this shift of global money flows away from Western economies, resulting in the end of many aspects of finance that have persisted for all our lives.
Investors can continue to debate whether AT1 bonds should be invested in or not. They may be better served in thinking about the bigger picture where the real risks are, the direction that the world is heading in:

• Wars are inflationary, and the current Russia Ukraine war has no end in sight, since both Russia and Ukraine view this as an existential fight. A nuclear power fighting an existential war should not be taken lightly. Worse still the situation could become a global conflict, with the announcement that North Korea will send troops to help Russia. The aftermath of large wars leads to loss in value of financial assets and currencies (for everyone involved in the short term, and for the losing country in the long term), and favours investment in hard assets.
• The weaponization of the US dollar has set in process the end of global dollar hegemony.
  What happens when the capital surplus countries stop recycling their surplus into western assets?
•  The collapse of Credit Suisse challenges the key foundations of the attractiveness of investments in the Western world: the rule of law and protection of individual property rights. The next banking crisis will require a completely different solution which regulators are not yet prepared for.
•  The days of easy money are over. Investors who have never seen the impact of high interest rates are in for a shock. They should study the history of inflationary decades.