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By Nicholas Lord
Hybrid securities, which combine elements of debt and equity, surged in popularity in the years running up to the economic meltdown, as credit rating agencies offered them favorable treatment when evaluating an issuer's balance sheet. But as with most untested securities instruments, many didn't exactly perform like the credit raters expected when faced with extreme stress.
For that reason, Moody's Investors Service has issued new proposals for rating hybrid securities and is seeking comment on them. The document was released in New York at the end of last week.
The credit rating agency had previously considered such securities more equity-like to the extent that banks and other issuers would skip coupon payments that were due if necessary. But because banks wanted to maintain their reputations for meeting such coupon payments, many hesitated to skip them during the crisis, even though regulators wanted losses to be absorbed by the hybrid instruments so that capital could be preserved.
"We have learned that it generally took outside factors to prompt issuers to use the loss-absorbing features of hybrids and skip payments on them," said Moody's Senior Vice President Barbara Havlicek. "In certain cases, the breach of triggers resulted in the same outcome. We have also learned that some features effectively become loss absorbing only when the issuer faced a general default, and hence the instruments are in fact only a step away from debt in the capital structure."
The proposals would lead to certain changes in the ratios that Moody's uses to determine ratings – especially the debt to total capitalization ratios. That could change the ratings themselves.
Moody's notes that under its new approach to rating hybrids, it will ask three questions:
i. Does the hybrid absorb losses in advance of a broad, company wide default?
ii. Does the hybrid only absorb losses when a broad company-wide default is imminent?
iii. Is the hybrid likely to be part of the capital structure when needed to absorb losses?
Depending on the answers to these questions, Moody's could treat hybrids without strong mandatory coupon skip triggers more like debt than equity, and downgrade them by one notch. That might not seem like much. But for CFOs of companies that have issued these types of instruments, the implication that hybrids will be treated more like debt than equity is inescapable.
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