There were no surprise events… CDS did exactly what it said on the tin

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

The bailout of Credit Suisse yet again proves the value and integrity of CDS

Good tabloid headlines rely on the obverse of normal expectations and, over the years, Credit Suisse has furnished a deep seam. Banks are meant to be risk-averse, and of unimpeachable character and integrity. Credit Suisse, however, serviced autocrats and kleptocrats of all stripes, human rights abusers, bent businessmen and cocaine kingpins; its staff shared kickbacks with fraudulent functionaries from fishy tuna bonds; it skirted sanctions and abetted tax-dodgers; and it engaged in espionage on its own executives.

Credit default swaps (CDS) have also enjoyed their share of headlines: remember Warren Buffett’s “financial weapons of mass destruction” or the “manufactured” credit events cooked up to manipulate profits from their misuse? Surely the combination of the two would offer rich pickings for the red-top headline writers?

It got off to a promising start. Two hedge funds allegedly lawyered up and went long CDS in the hope of persuading Isda’s Determinations Committee (DC) that a credit event had occurred as a result of governmental intervention. For this to work, they needed a wheeze of Daedalian complexity. They had somehow to rope in tier-2 debt, since the AT1s that were torched as part of the UBS takeover were perpetual and, therefore, ineligible under standard CDS contracts, which stipulate a maximum bond maturity of 30 years.

While most of Credit Suisse’s tier-2 is issued by Credit Suisse AG, the subordinated CDS contract references Credit Suisse Group AG, the Standard Reference Obligation (SRO) for which is a £250m sterling issue that matured in 2020. So the DC would have to deem a credit event to have occurred on a matured bond, which, while slightly bizarre, is not in and of itself an obstacle.

This is not the event you are looking for

However, the event (governmental intervention) affected the AT1s, not the SRO. For the governmental intervention in the AT1s to cause a credit event at the SRO, they would have to rank pari passu. On the Bloomberg description page for the SRO, it quite clearly states that the SRO bonds are “Lower Tier-2 Capital. Basel III Tier 2 Capital.” Conversely, Bloomberg tags the AT1s as “Bail-in Basel III Additional Tier 1.” Language in AT1 issues states that they rank junior to all priority creditors and senior only to shareholders and other claims that the issuer deemed to rank junior to them. The DC agreed that the SRO was a priority creditor to the AT1s, so no credit event had taken place.

The second attempt tried a variant of the bankruptcy angle (which would have affected not merely subordinated but also senior CDS). The question targeted Section 4.2 (b) and (h) of the 2014 Definitions, the former of which would trigger a credit event if the reference entity “admits in writing in a judicial, regulatory or administrative proceeding or filing its inability generally to pay its debts as they come due…” (my italics). ((h) is something of a mop-up clause extending the conditions of Section 4.2 to other analogous events that happen under any jurisdiction).

Failure to meet the criteria

Unfortunately, much of the evidence adduced in support of the question fell short of the strict criteria italicised above. Interviews with the Swiss finance minister in the Neue Zürcher Zeitung don’t meet the cut; nor does a speech from the chair. The Ordinance on Additional Liquidity Assistance Loans might acknowledge that a borrower has “exhausted the funding sources that can be accessed with its own means”, but this is a general statement rather than one specific to Credit Suisse, and the ensuing loans in any case ensure business continuity.

The Swiss Federal Council’s granting of bankruptcy privilege rights to enable it to guarantee liquidity during the UBS takeover did not come from the reference entity and, again, far from admitting a failure to pay, ensured that Credit Suisse could continue to pay.

And an admission in an earnings release that failure to consummate the merger with UBS could jeopardise Credit Suisse’s going-concern status is not, itself, an admission of failure to pay. The DC determined that no bankruptcy credit event had taken place.

Credit Suisse was bailed out through a state-orchestrated merger, in which contingent capital was bailed in. There were no surprise events that led to CDS being triggered; this was wholly in line with market expectations. Nor were CDS market participants wrong-footed by devious schemes. In short, the story here is that there is no story.

CDS did exactly what it said on the tin, proving again its worth and integrity both as a hedging instrument and a vehicle for expressing credit risk. The only people bitten were its critics (and maybe some clever hedge funds).

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Global credit funds & CLO's

June 2023 | Issue 255

Published in London & New York.