Troubled bank Credit Suisse will be acquired by Swiss rival UBS, a move engineered by the Swiss government in an effort to quell concerns of a financial crisis. While the takeover offered a momentary reprieve for bank industry observers, one aspect of the deal was, on its face, confounding: The Swiss government said that some $17 billion worth of Credit Suisse bonds would get marked down to zero, meaning their holders would lose all of their investment.
But these were not ordinary bonds. Designed in the wake of the 2008 financial crisis, these were issued precisely to give banks like Credit Suisse a financial cushion in the event of a severe setback. But holders of the bonds - regarded as extremely risky investments - were still angry about winding up with nothing, while Credit Suisse shareholders received shares in UBS.
Here's what we know about the "CoCo" bonds and what their evaporation may mean for the banking sector.
What are CoCo bonds?
CoCo stands for "contingent convertible" bonds. They were designed in the wake of the 2008 financial crisis to help banks raise capital and also maintain capital in a crisis. They're also referred to as AT1 bonds, and they are not issued by U.S. banks.
How do CoCos work?
Ordinary corporate bonds act as IOUs, delivering periodic payments called "yields," as well as the original investment returned at the end of the bond's term. Bonds help companies raise money, and they remain in debt to the bondholders unless the bond issuer collapses and defaults, which means big trouble for investors and - if the company is big enough - taxpayers, who may ultimately fund a bailout.
After the 2008 financial crisis, European banks were required to maintain a certain level of high-quality capital. One way they were allowed to do that was through contingent convertible bonds, which could be converted to stock - or completely downgraded to zero - if the bank ran into serious trouble.
Those bonds pay higher yields, but with greater risk for their holders because if the bank's business sharply declines, the institution can erase its CoCo bond debt. The bondholders, meanwhile, would either receive shares in bank's declining stock - or not get paid at all, as in the case of Credit Suisse. The mechanism is sometimes referred to as a "bail-in" because the bondholders end up losing, and not taxpayers.
"That's sort of the beauty of it," said Steven Kelly, a senior research associate at the Yale of School of Management who studies financial crises.
What happened with Credit Suisse's CoCo bonds - and did $17 billion really disappear?
As part of the takeover by UBS, the Swiss Financial Market Supervisory Authority, or FINMA, said that the government intervention "will trigger a complete write-down of the nominal value of all AT1 debt of Credit Suisse" in the amount of around $17 billion.
That means holders of the AT1 bonds probably saw their money vanish. Credit Suisse, now owned by UBS, now has $17 billion in debt off its books, which allowed the bank "an increase in core capital," as FINMA put it.
So the $17 billion didn't actually disappear, Kelly said. Rather, he said, that value was "transferred" to the institution and its shareholders.
Why are bondholders angry?
Ordinarily, holders of debt - such as bonds - rank higher than shareholders on the hierarchy of claims, Kelly said. So holders of the CoCo bonds are angry that they lost everything while shareholders were rewarded with UBS shares and are still in the game. Some bondholders are weighing legal action, Reuters reported.
The Swiss government's move should not have been a shock, Elisabeth Rudman, global head of financial institutions at DBRS Morningstar, told CNBC's "Squawk Box Europe" on Monday.
"AT1s are there to absorb losses, so it's not a surprise," she said. "They've done what they were supposed to do."
Can this affect markets?
The downgrade is the largest that has ever happened with CoCo bonds, and Kelly said it prompted people who trade CoCo bonds to "wake up to how these things function" - which is how they're supposed to function, he said. The total value of the CoCo bond market is estimated around $250 billion, Kelly said.
Richard Herring, a professor of international banking at the University of Pennsylvania's Wharton School, said the market for CoCo bonds probably will be "beaten down," making it harder for banks to sell new offerings of them "for some time to come."
But it probably won't have much impact beyond the CoCo market specifically, Herring said.
"These bonds are generally held by institutions that have well-diversified portfolios and so the losses are unlikely to have large spillover effects," Herring said.
At the end of February, funds managed by Lazard Asset Management, Nuveen and GAM Investments had large holdings in the Credit Suisse CoCo bonds, according to Morningstar Direct.
One of Lazard's funds, Capital Fi SRI, had a nearly $114 million exposure to the bonds, equivalent to 7.4 percent of its portfolio, Morningstar estimated. Among U.S. institutional investors, Nuveen's Preferred Securities & Income Fund, held more than $187 million in Credit Suisse CoCo bonds, an estimated 3.5 percent of the fund's portfolio, according to the report, which a Morningstar spokesperson said conveyed rough calculations. Nuveen declined to comment.
But if the downgrade in Credit Suisse's CoCo bonds more broadly shakes confidence in people holding other kinds of bank debt, such as depositors, "that can spark a run and a little more contagion that we're seeing," Kelly said. "And that would make life difficult for banks."
WASHINGTON POST