A financial crisis is somewhat like a particle accelerator: let banks collide hard enough and exotic phenomena become visible that only a small group of specialists knew existed.
For example, during the 2008 financial crisis collateralized debt obligations (CDOs), packages of loans that have been broken up into more or less risky tranches that have been traded separately, or repackaged, bundled and broken up again. Until no one knew what the risk for owners and investors was. Or the enormous ‘shadow banks’ outside the formal balance sheets of ordinary banks, which lived in the twilight zone of financial supervision.
Even now, due to the settlement of the bankruptcy of the Swiss bank Credit Suisse, a phenomenon is emerging that is only familiar to financial specialists: the coco. On Sunday it appeared that investors in Credit Suisse cocos lost 16 billion euros. And it was close to whether that would have contributed to even more mistrust and panic around banks.
Read also: Acquisition of Credit Suisse by UBS shows that regulators have no answer to the ‘too big to fail’ problem
Shareholders spared
Cocos were invented by the financial regulators as an answer to the previous financial crisis. The name ‘coco’ is an abbreviation of quota convertible: a loan to a bank that can be converted into shares of that bank if this bank gets into trouble. Essentially, a coco is equity capital, when it comes down to it. If that capital belongs to the hardest buffers, the Tier 1, of the bank, such a coco is called a Additional Tier 1or ‘AT1’.
Cocos are much riskier than a normal loan to a bank, because they are much sooner in the event of bankruptcy. Due to the greater risk, cocos have a high interest rate. And because interest rates have been so low in recent years, they were very popular: until this weekend there was just under 250 billion euros in cocos outstanding. Dutch banks also have them outstanding.
Great solution, it seems. Instead of a classic ‘bail out’ of a bank, where society pays for the losses, this is a ‘bail in’: first the investors have to bleed. According to the rules, in a bank rescue, first the shares of a bank become worthless, and only immediately after that the cocos are screwed.
But in Credit Suisse’s takeover plan, by its Swiss rival UBS last weekend, the Swiss bank’s AT1s turned out to be the first to be wiped out in one fell swoop, and the bank’s shareholders were actually spared a bit: they still got away with 3 billion euros.
This caused great confusion among investors on Monday morning: it turned out exactly the opposite of what they had expected. There was considerable unrest in that market of 250 billion in cocos. And: if things were to go the way they did in Switzerland, cocos should actually have given a much higher interest rate to make up for the much higher risk. Quite apart from the question of whether the coco itself would actually still be viable.
In the course of Monday, the supervisors of banks in the eurozone, the European Central Bank in the lead, therefore felt compelled to underline that the eurozone is not Switzerland, and that cocos in the eurozone are not the first to absorb the first blows.
Read also: Swiss bank UBS acquires Credit Suisse for $2 billion
Lawyers
That message brought some calm back to the coco market, and for the time being prevented panic selling that could cause even more mistrust in the health of banks. Although the value of cocos is now only 82 percent of every euro lent through the coco due to price falls.
Also helping was the decision by major central banks, including the ECB and the US Federal Reserve, to open so-called ‘swap lines’. Just like during the financial crisis of 2008 and the pandemic.
It means that they have access to each other’s currencies – especially dollars – at all times and can thus easily supply their commercial banks with extra money if needed, at least until the end of April. Already, across the border of the euro zone, lawyers in Switzerland are now sharpening their knives about the way in which the cocos were sacrificed there at Credit Suisse.