To The Moon

UBS agreed to buy its embattled rivalCredit Suissefor 3 billion Swiss francs ($3.2 billion) Sunday, about less than half of Friday's closing price of $8.4 billion for Credit Suisse.with Swiss regulators playing a key part in the deal as governments looked to stem a contagion threatening the global banking system.

In order to preserve Credit Suisse and execute a successful takeover, Switzerland changed the law to allow both parties to bypass shareholder approval.Thus, as long as the board approved the sale, shareholders cannot question the sale price or the terms of the sale, resulting in shareholders who attempted to hold their shares on Friday losing half their stock equity.

As an initial offer, UBS offered only $1 billion for Credit Suisse, which slowed down negotiations for a short time. However, the offer eventually rose to $3.3 billion to close the deal, despite the fact that $17 billion of Credit Suisse AT1 bonds were wiped out for nothing.

According to reuters news, Credit Suisse said 16 billion Swiss francs ($17.24 billion) of its Additional Tier 1 debt will be written down to zero on the orders of the Swiss regulator as part of its rescue merger with UBS(UBSG.S), angering bondholders on Sunday.

It means AT1 bondholders appear to be left with nothing while shareholders, who sit below bonds in the priority ladder for repayment in a bankruptcy process, will receive $3.23 billion under the UBS deal.

Engineered in the wake of the global financial crisis, AT1 bonds are a form of junior debt that counts towards banks' regulatory capital. They were designed as a way to transfer risks to investors and away from taxpayers if a bank gets into trouble.The bonds can be converted into equity or written down when a lender's capital buffers are eroded beyond a certain threshold.

Bonds generally have a higher priority than stocks, which means that shareholders are generally the first to incur a loss before bonds take the hit.However, in this transaction, the AT1 bonds were the first to be zeroed out.These bonds are known as CoCos bonds, a special type of convertible bond that changes from debt to stock under certain conditions.

At this point, however, the bank needs to meet minimum requirements for own funds and eligible liabilities, often calledMREL, tosupport an effective resolution in the event of a failure. CoCos can be written down if the lender's capital ratios fall below a predetermined level, but this direct write-down to zero, while still allowing shareholders' equity to remain close to 50%, is surprising.

Over the weekend, these $1 denomination bonds were extremely volatile, closing Friday at 35 cents.When the $1 billion offer was rejected, these $1 denomination bonds were trading at 20 cents.It was still considered valuable by traders despite the failure of the acquisition and forced nationalization.

When the deal was struck,the bonds traded rapidly soaring to 50-70c, a threefold jump. Some traders thought the bonds could be paid off at $1or around50c after conversion.Once the details of the deal were revealed and these AT1s were completely sacrificed, the price droppedto0.(The chart below does not show the special deals on Saturday andSunday)

The institutions that still hold these bonds are furious, arguing that this decision is contrary to market practice and may even be illegal.They argue that shareholders should be hit first to lose before AT1 bonds face losses, and that making such a provision, resulting in bonds going to zero before the stock, could prove to be a huge blow to the $275 billion AT1 market, and raise serious doubts about the prospects of other lenders to CoCo.

Credit Suisse has 13 outstanding AT1 (Coco) bonds, about 20% of its debt, the largest of which is about $2 billion and could have been redeemed as soon as July, the data show.

Credit Suisse still claimed to investors that the stock would take the hit first, despite concerns about the safety of AT1 bonds, causing AT1 prices to fall to just 35C just one week ago.As a result of the results, AT1 is all but lost, but the stock still retains several percent of its value, which will inevitably cause some investors to become enraged.

In the next few days, it is likely that the Federal Reserve will stop raising interest rates or raise rates by only 25 basis points to stabilize the financial market first.After that, inflation and financial stability will likely require monetary easing and rate increases in tandem.Thus, capital markets will not continue to bear the costs, but the real economy may continue to bear them.

$UBS Group AG(UBS)$ $Credit Suisse Group AG(CS)$