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HYBRID CAPITAL SECURITIES: A DEFINITIVE GUIDE FOR ISSUERS AND INVESTORSBY STEVE SAHARA WITH ANNABEL DAWS-CHEW, Calyon, London

HYBRID CAPITAL SECURITIES: A DEFINITIVE GUIDE FOR ISSUERS AND INVESTORSBY STEVE SAHARA WITH ANNABEL DAWS-CHEW, Calyon London

About the contributorsSteve SaharaSteve embarked on his investment banking career in 1991 at Merrill Lynch and hassuccessfully worked in a senior role managing the global hybrid capital and preferredstock structuring efforts for leading firms such as Morgan Stanley, Lehman Brothers, ABNAMRO and now Calyon, where he is Managing Director and Global Head of Hybrid CapitalStructuring. Steve has contributed greatly to the continued growth and innovation of thisdynamic and lucrative market segment which saw explosive growth among Europeancorporate issuers in 2005. Steve has an MBA from the University of Chicago, a BSCCommerce and MAcc from DePaul University and is a CPA.

Annabel Daws-ChewAnnabel is an integral part of the Hybrid Capital Structuring team at Calyon, bringing oversix years of experience in debt capital markets including credit analysis and debtorigination for UK, German, and Benelux clients across corporate and financial sectors.Annabel gained a BSc honours degree in Financial Economics from Liverpool University.

© Thomson Financial 2007The contents of this publication, either in whole or in part, may not be reproduced, storedin a data retrieval system or transmitted in any form or by any means, electronic,mechanical, photocopying, recording or otherwise without written permission of thepublishers. Action will be taken against companies or individual persons who ignore thiswarning. The information set forth herein has been obtained from sources which webelieve to be reliable, but is not guaranteed. This publication is provided with theunderstanding that the author and publisher shall have no liability for any errors,inaccuracies or omissions of this publication and, by this publication, the author andpublisher are not engaged in rendering consulting advice or other professional advice tothe recipient with regard to any specific matter. In the event that consulting or otherexpert assistance is required with regard to any specific matter, the services of qualifiedprofessionals should be sought.

DisclaimerThe information in this publication is not to be construed as a solicitation or an offer tobuy or sell any investment or security and has no regard to the specific investmentobjectives, financial situation or particular needs of any reader. It is not intended toprovide legal, tax, accounting or other advice and readers should obtain specificprofessional advice from legal, tax, accounting or other appropriate professional advisersbefore embarking on any course of action. While the information in this publication hasbeen compiled or obtained from sources believed to be reliable, no guarantee,representation or warranty, express or implied, is made as to its currency, accuracy,completeness or correctness. This publication contains information from third parties.Neither Calyon nor the Publisher has independently verified the accuracy of such thirdparty information and shall not be responsible or liable, directly or indirectly, for anydamage or loss caused or alleged to be caused by or in connection with the use of orreliance on this information. This publication is in the nature of a summary and readersshould refer to source material (including where relevant offering circulars or informationmemoranda) for further or more detailed information. Opinions, estimates and indicativeprices in this publication are subject to change without notice and are provided in goodfaith without legal responsibility. Neither Calyon nor the publisher is under any obligationto update this information. Past performance is not necessarily a guide to futureperformance. The price, value of or income from any of the financial products or servicesmentioned in this publication can fall as well as rise and investors may make losses.Neither Calyon nor the Publisher acts in a fiduciary capacity and assumes that readershave sufficient knowledge, experience and professional advice to make their ownevaluation of the merits and risks of the information in this publication and that readersare not relying on Calyon or the Publisher for information, advice or recommendations ofany sort. This publication does not purport to identify all the risks or other considerations(direct or indirect) which might be material to the reader in respect of the informationherein. Under no circumstance shall Calyon or the Publisher be responsible or liable,directly or indirectly, for any damage or loss caused or alleged to be caused by or inconnection with the use of or reliance on the information in this publication.

First published 2007 by Thomson Financial Group, Aldgate House, 33 Aldgate High Street,London EC3N 1DL, UK

Typeset by: Claire Taylor and Nicola O’Hara

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CONTENTS

Chapter 0101 Hybrid capital marketoverviewWhat are hybrid capitalsecurities?

The preferred stock paradigmSome bank regulatory history

The Basel Capital AccordRating agency impactAccounting, legal and tax

considerationsWho are the issuers?

Issuance trendsThe corporate hybrid

market has shown dramaticgrowth and structural innovation

Diversity and globalisationprevalent in geographicalissuance trendsWho are the investors?Evolution – historical milestonesand outlook

Chapter 02: 09 The market for hybridcapital securitiesIntroductionHybrid market size, growth andstructureInvestor markets

The European investor marketBank Tier 1 sectorInsurance hybrid sectorCorporate hybrid sector

The US investor market Bank Tier 1 sectorInsurance hybrid sectorCorporate hybrid sector

The Asia-Pacific investormarket

Bank Tier 1 sectorInsurance hybrid sectorCorporate hybrid sector

RPB versus institutional investormarketsIssuer regionsConclusion

Chapter 03: 31 Why issue hybrid capitalsecurities? IntroductionThe rationale for issuanceWho issues hybrid capitalsecurities?Drivers for issuing hybrid capitalsecurities

MichelinLindeSuedzucker, Vattenfall and

DONGHenkelPorscheGlencoreCEMEX

Interview with Vattenfall

Interview with INGConclusion

Chapter 04: 47 Investor overview IntroductionInvestors in hybrid securities

Institutional investorsAsset managersPension fundsInsurance companiesHedge fundsBanks

Retail private bank marketKey global investor trends

Profile of select UK investorsProfile of select German

investorsProfile of select French

investorsProfile of select US investorsMarkets to watch

JapanCanadaAustralia/New ZealandMiddle East – market for

domestic placementInvestor dynamics andmotivation to buy hybrids

Hybrids versus senior debtwith similar credit quality

Stronger credit quality Liquid markets Strength of new issue

performance in the secondarymarkets

Market volatilityDedicated hybrid fundsHedging

Investor risk factorsStructural conservatismObserving the secondarymarket yield of hybrid capitalsecurities

Observing spreadrelationships for bank capital

Spread observations forcorporate hybrid securities

‘Sample skew’ in averagerating quality of Basket C versusBasket D population

Isolate sector championsIsolate outliersMultiples and spreads

Institutional True Perpetual andstep-up Tier 1 distinctions

Reducing the cost of issuanceusing a coupon floor

Analysis and rationaleInterview with SGAM

Chapter 05: 73 Structuring hybridcapital securities Introduction

Background issues

Structuring frameworkTechnical foundations

Regulatory capital General characteristics of

bank capital (based on BISguidelines)

Tier 1 hybrid instrumentsTier 2 hybrid instrumentsTier 3 capital

LegalTax

SPV hybrids Typical SPV structure

Summary rating agencyguidelines

How to achieve a Moody’s‘Basket C’ or ‘Basket D’

Basket CBasket D

Practical considerations Addressing investor non-

payment riskPayment deferral conditionsDeferred payment

resolutionAddressing investor extension

riskAddressing investor event risk

Change of control clause(COC)

Issuer protections Accounting guidelinesRating agency approaches tohybrid capital

Moody’s approachMarket precedent and

application of the Moody’smethodologyMandatory deferralReplacement language

Standard & Poor’s approachFitch’s approach Rating agency evolution

promotes increasing marketsophisticationInterview with FitchEligible capital for insurancecompaniesIntroductionThe current regulationCapital buffer to be required inthe Solvency II frameworkEligible elements in theSolvency II framework

Tier 1 or core capital Tier 2 or supplementary

capital Insurance Tier 3 capital LimitationsFSA position in the UKCapital resources for insurers

Chapter 06: 115 Structuralconsiderations – focus onselect countries

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IntroductionUKUK termsheets

L&G Tier 1 debut packs apunch

L&G's sparkling debutBarclays shows human sideFIG hybrids get a new lookRexam's hybrid paves way for

UK corporatesIrelandIreland termsheets

Anglo Irish spreads wings New issues defy secondary

wideningFrance

The French ‘TSS’ structure forhybrid securities

Some historyOperating subsidiary Tier 1Evolution

More recent French bankcapital developments

Commission Bancaire sets amaximum limit of 25% onhybrid capitalFrance termsheets

AXA calms Tier 1 nervesFrench firstVinci against the oddsHybrid volatility

GermanyBank Tier 1 issued via an SPVTier 1 issued via a Stille

Einlage and German GmbHTier 1 via a Stille Einlage and

Jersey Limited PartnershipGerman termsheets

Munich Re debutsAllianz takes the plungeCommerz advances on two

frontsSiemens sees record demand

Some German tax influences onhybrid structures

OverviewSome important German

hybrid capital characteristicsMaturity Payment discretion/

obligation Participation in profits Participation in liquidation

Obtaining a tax rulingWithholding tax

considerationsSwitzerlandSwitzerland termsheets

Overwhelming demand forSwiss Re

Credit Suisse gets Tier 1 indollarsSpain

The Preferentes structure Spain termsheets

Tweak for BBVAFenosa prefers retail

ItalyCurrent innovative Tier 1

structuring opportunitiesHybrid structuring in Italy

Italy termsheetsSmooth operator GeneraliTwin-sets in fashionItalian jobLottomatica picks right

number Recent developments

Italy hybrid capital limitincreases to 20% of total capital

Two key issuesUSAUS termsheets

AIG tests marketEurope FIG WrapCVS rings up year’s largest

Chapter 07: 163 The future of the hybridmarketIntroduction Growing the investor baseExpansion of the issuer pool Tax, accounting, rating agencyand regulatory Conclusion

Appendix 01:167 Tax deductible equityand other hybrids in the US– a brief history and currentdevelopments

Early attempts to createdeductible equity

Revenue Ruling 85-119MIPS, etc.Treasury department and

legislative responsesRegulatory developments

Current tax developmentsTax treatment of new (and

old) equity-like featuresMandatory deferralReplacement covenantsLonger maturitiesScheduled maturitiesInterest caps

Current structuresEnhanced trust preferred -

CENTs, etc.WITS and HITS

Hybrids issued by foreignissuers in the US

217 Appendix 02

List of Tables and Figures

Table 1.1: The preferred stockparadigmTable 2.1: European investormarket hybrid capital volumes,2005–H1 2007 (€m)

Table 2.2: European investormarket bank Tier 1 supply –select issues by size, 2006–H12007Table 2.3: European investormarket insurance hybrid supply– select issues by size, 2006–H12007 Table 2.4: European investormarket corporate hybrid supply– select issues by size, 2006–H12007Table 2.5: US investor markethybrid capital volumes,2005–H1 2007 (US$m)Table 2.6: US investor marketbank Tier 1 hybrid supply –select issues by size, 2006–H12007 Table 2.7: US investor marketinsurance hybrid supply – selectissues by size, 2006–H1 2007Table 2.8: US investor marketcorporate hybrid supply – selectissues by size, 2006–H1 2007Table 2.9: Asia-Pacific investormarket hybrid capital volumes,2005–H1 2007 (US$m)Table 2.10: Asia-Pacific investormarket bank Tier 1 hybridsupply – select issues by size,2006–H1 2007Table 2.11: Asia-Pacific investormarket insurance hybrid supply– select issues by size, 2006–H12007Table 2.12: Asia-Pacific investormarket corporate hybrid supply– select issues by size, 2006–H12007Table 2.13: Global hybridmarket supply, by issuer sector,2006–H1 2007 (€, %)

Table 3.1: A selection of majorhybrid capital deals

Table 4.1: Select UK investorprofileTable 4.2: Select UK investorsTable 4.3: Select Germaninvestor profileTable 4.4: Select GermaninvestorsTable 4.5: Select Frenchinvestor profileTable 4.6: Select FrenchinvestorsTable 4.7: Select US investorfeedbackTable 4.8: Select US investorsTable 4.9: Hybrid capital –considering equity featuresTable 4.10: Select dual-tranchetransactions, 2006Table 4.11: Risk dynamics –investor perspective

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Table 4.12: Example ofstructural conservatism Table 4.13: Spread analysis –bank capitalTable 4.14: Corporate hybridspreads – CDS multiples andrating agency equity creditTable 4.15: Example of step vs.non-step premiums

Table 5.1: Hybrid securities –summary primary foundationsTable 5.2: Notching for hybridsecuritiesTable 5.3: Development of the‘meaningful’ mandatory deferraltrigger, 2004–06Table 5.4: Classification ofhybrid securities for financialservices companiesTable 5.5: Fitch debt-to-equitycontinuumTable 5.6: Summary - corporatehybrid transactionsTable 5.7: Tier characteristicsdefined in Solvency llTable 5.8: Elements eligible forthe guarantee fundTable 5.9: Additional elementseligible for the ASM

Table 6.1: UK termsheetsTable 6.2: Ireland termsheetsTable 6.3: France – total Tier 1capital breakdownTable 6.4: France termsheetsTable 6.5: Germany termsheetsTable 6.6: SwitzerlandtermsheetsTable 6.7: Spain termsheetsTable 6.8: Italy termsheetsTable 6.9: US termsheets

Table 7.1: Select new entrantsto the hybrid capital market

Figure 1.1: Sectoral differencesin the rationale for hybridissuanceFigure 1.2: Growth of nextgeneration European hybridissuance, 2003 to date (€m)Figure 1.3: Institutional hybridinvestors – illustrative globalbreakdown (%)

Figure 2.1: Global hybridsupply, by market, 2002–H12007 (US$m)Figure 2.2: Global hybridsupply, by investor market,2006–H1 2007 (%)Figure 2.3: Global hybridsupply, by issuer sector,2006–H1 2007 (%)

Figure 2.4: European investormarket hybrid supply, by issuerregion, 2006–H1 2007 (%) Figure 2.5: European investormarket hybrid supply, bycurrency, 2006–H1 2007 (%) Figure 2.6: European investormarket hybrid supply, by sector,2006–H1 2007 (%) Figure 2.7: European investormarket bank Tier 1 supply, byissuer region, 2006–H1 2007 (%)Figure 2.8: European investormarket bank Tier 1 supply, bycurrency, 2006–H1 2007 (%)Figure 2.9: European investormarket insurance hybrid supply,by issuer region, 2006–H1 2007 (%)Figure 2.10: European investormarket insurance hybrid supply,by currency, 2006–H1 2007 (%)Figure 2.11: European investormarket corporate hybrid supply,by issuer region, 2006–H1 2007 (%)Figure 2.12: European investormarket corporate hybrid supply,by currency, 2006–H1 2007 (%)Figure 2.13: US investormarket hybrid supply, by issuerregion, 2006–H1 2007 (%)Figure 2.14: US investormarket hybrid supply, by sector,2006–H1 2007 (%)Figure 2.15: US investormarket bank Tier 1 supply, by issuer region, 2006–H1 2007(%)Figure 2.16: US investormarket bank Tier 1 supply, bycurrency, 2006–H1 2007 (%)Figure 2.17: US investormarket insurance hybrid supply,by issuer region, 2006–H1 2007(%)Figure 2.18: US investormarket corporate hybrid supply,by issuer region, 2006–H1 2007 (%)Figure 2.19: Asia-Pacificinvestor market hybrid supply,by issuer region, 2006–H1 2007 (%)Figure 2.20: Asia-Pacificinvestor market hybrid supply,by currency, 2006–H1 2007 (%)Figure 2.21: Asia-Pacificinvestor market hybrid supply,by sector, 2006–H1 2007 (%)Figure 2.22: Asia-Pacificinvestor market bank Tier 1supply, by issuer region,2006–H1 2007 (%)Figure 2.23: Asia-Pacific

investor market bank Tier 1supply, by currency, 2006–H12007 (%)Figure 2.24: Asia-Pacificinvestor market insurancehybrid supply, by issuer region,2006–H1 2007 (%)Figure 2.25: Asia-Pacificinvestor market insurancehybrid supply, by currency,2006–H1 2007 (%)Figure 2.26: Asia-Pacificinvestor market corporatehybrid supply, by issuer region,2006–H1 2007 (%)Figure 2.27: Asia-Pacificinvestor market corporatehybrid supply, by currency,2006–H1 2007 (%)Figure 2.28: European investormarket supply, 2006–H1 2007 (%)Figure 2.29: US investormarket supply, 2006–H1 2007 (%)Figure 2.30: Asia-Pacificinvestor market supply,2006–H1 2007 (%)

Figure 3.1: The cost ofcommon equity (expectedmarket return), by country (%)Figure 3.2: WACC calculation –common equity vs. hybrid debt(%)Figure 3.3: Evaluating equityalternatives - hybrid is low costequityFigure 3.4: Issuer motivationsFigure 3.5: Issuance rationalefor select corporate issuers

Figure 4.1: Illustrative investordistribution for an institutionalglobal hybrid transaction (%)Figure 4.2: Illustrative investordistribution (Perp nc 10structure) (%)Figure 4.3: Exampledistribution for a Euro-denominated hybrid capitalissue, by region (%)Figure 4.4: Exampledistribution for a Euro-denominated hybrid capitalissue, by region (%)Figure 4.5: Exampledistribution for a Euro-denominated hybrid capitalissue, by region (%)Figure 4.6: Exampledistribution for a US$-denominated hybrid capitalissue, by region (%)Figure 4.7: Corporate hybridspread performance, 2006 to

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dateFigure 4.8: Hybrid performancevs. other asset classes, Apr 2006to dateFigure 4.9: Unrated/low-ratedissuers targeting the hybridmarket, 2006–07Figure 4.10: Spread differentialanalysis, by ratingFigure 4.11: True Perpetual vs.step-up hybrid securities,Jan–Sep 2007

Figure 5.1: Primary technicalfoundations for structuring ahybrid security Figure 5.2: Preferred stock

paradigmFigure 5.3: Hybrid Tier 1structuring considerationsFigure 5.4: Simple SPVstructure Figure 5.5: Hybrid example 1 –interest payment mechanicsFigure 5.6: Hybrid example 2 –interest payment mechanicsFigure 5.7: Hybrid example 3 –interest payment mechanicsFigure 5.8: Hybrid example 3 –optional early redemptionmechanicsFigure 5.9: New hybridtransaction – time andresponsibility schedule

Figure 5.10: Global hybrid Tier1 capital originsFigure 5.11: Available solvencymargin: Solvency l minimumsolvency levelFigure 5.12: Capital limitations

Figure 6.1: German Tier 1 SPVstructureFigure 6.2: German StilleEinlage structureFigure 6.3: German StilleEinlage structure with Jersey LPFigure 6.4: Italian hybrid Tier 1structure via a US trustFigure 6.5: Italian hybrid Tier 1structure via an EU SPV

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ACSM Alternative coupon satisfaction mechanismACT Advance Corporation TaxARPS Adjustable rate preferred securitiesASM Available solvency marginBIS Bank for International SettlementsCAGR Compound annual growth rateCAPM Capital asset pricing modelCDO Collateralised debt obligationCDS Credit default swapCEIOPS Committee of European Insurance and Occupational Pensions SupervisorsCMS Constant maturity swapCOC Change of controlDRD Dividends received deductionECR Enhanced capital requirementFASB Financial Accounting Standards Board GAAP Generally accepted accounting principlesICA Individual capital assessmentICG Individual capital guidanceIFRS International financial reporting standardsLBO Leveraged buy-outLBRL Legally binding replacement languageLLC Limited liability companyM&A Mergers and acquisitionsMAPS Market auction preferred stockMCR Minimum capital requirementMPD Mandatory payment deferralNAIC National Association of Insurance CommissionersP&L Profit and lossPCDS Preferred credit default swapPIK Payment-in-kindRCC Replacement capital covenantRCI Reserve capital instrumentsREIT Real estate investment trustRMM Required minimum marginROE Return on equityRSM Required solvency marginRWA Risk-weighted assetsSCR Solvency capital requirementSEC Securities and Exchange CommissionSPV Special purpose vehicleTAC Total adjusted capitalTSS Titres super-subordonnésWACC Weighted average cost of capital

GLOSSARY

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01CHAPTER

What are hybrid capital securities?The term ‘hybrid’ is often referred to in a wider context and can be applied to a number ofvarying situations – with the term often applied when discussing the breeding of plants oranimals of different varieties or races. However, the basis remains the same and a hybrid at themost basic level can be said to derive from two component entities which are dissimilar.

Evaluating the complex and arcane hybrid capital security market is best achieved by beginningwith a framework of analysis from which to operate. One useful framework is the ‘preferredstock paradigm’, which compares a hybrid security directly with the classic preferred stockstructure.

The preferred stock paradigmHybrid capital securities can be thought of as ‘synthetic preferred stock’. This framework is mostuseful in establishing the equity characteristics that regulators, rating agencies and other marketconstituents may use as a benchmark to measure the merits of a hybrid as a common stocksubstitute to strengthen the balance sheet and provide financial flexibility.

Where possible, the terms of classic preferred may be altered to reduce the desired equity charac-teristics just enough to produce a hybrid security that achieves tax deductibility whilemaintaining the desired regulatory and/or rating agency benefits. Alternatively, one could startwith simple senior debt and ‘layer on’ the desired equity features and ‘strip away’ the typicalsenior investor protections to achieve the same result. People seem to ‘get’ the preferred stockmetaphor more readily. In practice, hybrids include preferred, subordinated bonds and variouscombinations which may utilise special purpose vehicles (SPVs) to deliver the intended issuerbenefits and investor protections.

Before hybrid Tier 1 capital for banks took off in 1998 and the first corporate hybrids in 1993,classic preferred stock was used to obtain the many benefits of a quasi-equity mezzanine layer ofcapital that would be cheaper than common stock. Although there are different types of preferredstock or preference shares, for purposes of evaluating hybrids a classical preferred stock formatcan be observed. The hybrid securities which are now issued by most major industry sectors areusually debt instruments that are therefore tax efficient (deductible) and emulate classicpreferred stock but retain their ultimate debt ‘essence’. In some jurisdictions specific laws enablehybrid security issuance (Spain, France, Germany, for example).

Preferred securities exhibit elements of debt and elements of equity. Residing at the meetingpoint of debt and equity the various types of preferred securities that exist such as market auctionpreferred securities (MAPS), or adjustable rate preferred securities (ARPS) and fixed rateperpetuals (FRP) were historically rooted in financial engineering where neither pure debt norpure common equity was adequate to strike the desired balance of risk allocation, sharingreward/returns, control via voting rights etc.

HYBRID CAPITAL MARKET OVERVIEW

1

Table 1.1: The preferred stock paradigm

Source: Compiled by CALYON

Preferred stock Paradigm

Perpetual

Discretionary non-cumulativepayments

Deeply subordinated and senioronly to common

The term hybrid is increasingly stretched – sometimes including classic preferred stock, which isstill issued by banks when they have reached the regulatory limit on ‘innovative’ hybrid Tier 1but have capacity for more low-cost quasi-equity for regulatory capital purposes. Some types ofpreferred securities also had/have tax benefits associated with them such as the UK ACT (AdvanceCorporation Tax) preference shares, US DRD (Dividends Received Deduction) preferred stock, andQDI (Qualified Dividend Income) eligible securities. The issuer could pay a lower dividend rate onsuch securities since the investor enjoyed a higher tax-adjusted return on their dividendsreceived. So while most modern hybrid securities seek tax efficiency primarily via a tax deductionon the payments, it is historically consistent that quasi-equity securities may also provide theissuers with lower cost due to tax benefits.

Some bank regulatory historyBanks and other regulated financial institutions are required to maintain prudent levels of capitalto keep them solvent, even in the event that they suffer losses on their asset portfolios. Asummary of the major bank capital guideline – the Basel Accord – provides some insight into therole of bank regulatory capital requirements in motivating banks to issue lower cost preferredstock (and later hybrid Tier 1) for part of their regulatory capital requirements.

The Basel Capital Accord1988 – In 1988, the Basel Capital Accord was constructed by the Basel Committee organisation ofcentral banks for the G10 countries to effect a uniform level of capital adequacy requirements.The Accord was introduced to create regulatory capital requirements in line with the particularrisks that bank portfolios could bear and to incentivise holding lower risk assets or more riskcapital. Additionally, the Accord was meant to rationalise eligible capital definitions across thejurisdictions of the member countries to foster fair competition.

It was in fact the 1988 Basel Capital Accord which introduced to the industry the notion of tieredcapital, with Tier 1 representing core capital and Tier 2 representing supplementary capitalrespectively.

Tier 1 is defined in the 1988 Basel Capital Accord in the following terms:

0 Common stock and perpetual non-cumulative preferred stock, preference shares;

0 Reserves (through appropriations of retained earnings or other surplus);

0 Less than wholly-owned minority interests in operating subsidiary equity where there are consolidated accounts.

1998 – The evolution of the Basel Capital Accord1, was progressive in its allowance of ‘innovation’with regard to capital instruments. The Basel Committee press release in October 1998 stated thatsuch hybrid innovations in bank capital securities including non-operating SPV instrumentswould be allowed if they met the new guidelines and were subject to a limitation rule, whereby anon-common equity Tier 1 instrument feature with a step-up and call which may incentredemption of the security is capped at 15% of a bank’s Tier 1 capital. Step-ups were limited to thehigher of 100bp or 50% of the Libor equivalent spread at issue. The Committee allowed nationalregulators to endorse new criteria for financial instruments which would qualify as Tier 1 capitalwithout too large a reliance on such instruments to meet capital ratio requirements.

The acceptance of hybrid Tier 1 capital was an improvement in the approach by the Committeefrom the 1988 Accord. That was a direct result of industry globalisation and a response to variousdisparities between national regulators where some jurisdictions were benefiting from fiscaland/or other benefits which other jurisdictions did not allow.

In line with the 1998 guidelines, hybrid Tier 1 was required to exhibit the following characteristics:

0 Issued and fully paid up (to the bank);

0 Non-cumulative payments at the bank/regulator discretion;

0 Support going-concern status (loss absorption);

0 Subordinate to deposits, creditors, senior debt, other subordinated debt (Tier 2 capital);

1 Press release: ‘Instruments eligible for inclusion in Tier 1 capital’, 27th October 1998

CHAPTER01ifrintelligence reports/Hybrid Capital Securities: a definitive guide for issuers and investors

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These guidelines shaped hybrid capital over the past decade and help us understand thestructures of many outstanding bank capital instruments. Many of these instruments will beeligible for redemption in 2008 and beyond. Work on Basel II, Solvency II and IFRS will no doubtcontinue to refine the landscape of capital securities in the coming years.

The impact of these guidelines on structuring hybrid structures is further detailed in Chapters 5and 6. Further information can also be sourced on the Bank of International Settlements (BIS)website www.bis.org, CEBS at www.c-ebs.org, FSA at www.fsa.gov.uk, and the Fed at www.federal-reserve.gov

Rating agency impactThe rating agencies have always been a key constituent when considering the issuance ofpreferred-type securities since there has always been a desire to gain maximum ratings benefitfrom any preferred in the capital structure. The release of the Moody’s Toolkit in 2005 made itclear how to structure hybrid securities to gain the optimal mix of equity credit considering thepre-tax and post-tax cost of hybrids and classic preferred. The Moody’s Toolkit2 also provides auseful framework that is analogous to the preferred stock paradigm basic concepts, but isdeveloped into a more complete methodology. The three primary drivers to obtain a high level ofequity credit from the rating agencies as stated by Moody’s are:

1 – No Maturity (permanence);2 – No Ongoing Payments;3 – Loss Absorption.

These criteria dovetail with the bank regulatory guidelines and preferred stock paradigmframework in distinguishing the equity essence of a security. The extensive works by the threemajor agencies should be studied in their entirety to fully appreciate the depth of their thinkingon hybrids from both issuer and investor perspectives.

Regulated bank entities had sufficient motivation to issue low-cost hybrid capital securities. Theclarification of the rating agency evolution toward increased equity credit for hybrids wasanalogous stimulus for the insurance and corporate sectors (as shown in Figure 1.1). The rationalefor corporate issuers is covered in summary later in this section and in detail in Chapter 3.

The published works by the rating agencies also did a tremendous amount of good for promotingthe hybrid security asset class among investors since all the investors could access the same publi-cations and evaluate the different perspectives of Moody’s, Standard & Poor’s (S&P) and Fitch.While the publications were aimed at the potential hybrid issuers in terms of how to achievecorporate finance objectives and support their ratings, the lucid discussion of which equityfeatures could enhance financial flexibility was instructive to investors considering hybridinvestments. Rating agencies also sought to signal various amounts of hypothetical investor riskby ‘notching’ the ratings of the hybrid securities down from the plain vanilla senior ratings. Anissuer with senior debt rated BBB might have a hybrid rated BB+, for example, to signal hybridequity feature risks such as subordination and optional payments.

Rating agencies also referenced historical data on the payment performance and loss statistics onpreferred securities (again a proxy for the new hybrids). By providing an unbiased and thoroughframework for evaluating hybrid equity securities the three rating agencies helped issuers andinvestors come to understand the essentials of hybrid securities in a very short period of time sothat a critical mass of corporate issuance occurred and a ‘new’ asset class was born.

Accounting, legal and tax considerationsIn the early days of the Basel guidelines, accounting took on a more significant role than is doesnow. The US was the first nation to experience massive issuance of tax-efficient Tier 1 capital byadapting the then current corporate hybrid structure to a format suitable to the US bankregulators. At that time, ‘minority interest’ equity accounting treatment was accomplished via awholly-owned SPV bank subsidiary issuing preferred securities that would consolidate with thebank and meet the requirements of bank capital in the US. Minority interest satisfied Basel andFederal Reserve (FED) guidelines so it was supportive to the regulatory lobbying for the adoptionof hybrid Tier 1 to note that the accountants record Hybrid Tier 1 as ‘equity’ via minority interest.Financial Accounting Standards Board (FASB) changes no longer provide SPV minority interest,but US regulators no longer care about this cosmetic aspect.

2 Refinement to Moody’s Tool kit: Evolutionary, not revolutionary!’ (February 2005)


3

Many variations of this SPV capital theme were used globally (and still are) to provide globalbanks with various versions of hybrid Tier 1 capital. This is discussed further in Chapters 5 and 6.The adoption of international financial reporting standards (IFRS) has had sweeping impact onthe hybrid security market. Many companies found that they lost accounting equity treatment forsecurities that counted as equity under their prior generally accepted accounting principles(GAAP) systems. Another major implication is that ‘equity’ securities do not allow for theapplication of IFRS hedge accounting and can result in more profit and loss (P&L) volatility thanthey would have under GAAP.

For these reasons some structuring efforts have been applied to modify hybrid structures to berecorded as debt for accounting purposes so that hedge accounting can be applied and P&Lvolatility limited. More recently there have been securities issued into the ‘hybrid market’ whichhave few of the capital or rating agency equity features but are designed only to achieveaccounting equity on the balance sheet. So again the hybrid definition evolves to meet anotherset of issuers’ objectives.

The fact that the US led the first wave of explosive growth in hybrid corporate and Tier 1 bankcapital issuance in the 1990s had an impact on the early developments of the structures globally.Since the US had a well defined legal classification of preferred stock and the tax regulations fordeductible debt conflict significantly with the characteristics of regulatory capital there were veryclever but somewhat awkward SPV/REIT (real estate investment trust) structures that emerged toreconcile the conflicting perspectives. Key problems were the inability of perpetual and/or fullynon-cumulative instruments to qualify as deductible debt for US tax purposes. Use of the SPVhelped overcome these issues (as discussed in Chapters 5 and 6) but in many European jurisdic-tions there has been a migration to direct issues as the need for SPV issuance is diminished, and inresponse to a general sense of displeasure with SPV issuance (particularly from tax havens) on thepart of some European regulators.

Who are the issuers?Regulated financial institutions such as banks and insurance companies are the key issuers ofhybrids, but the explosive growth in corporate hybrid issuance has grabbed significant attentionin the financial press. The key issuer rationale for the three main issuer groups – banks, insuranceand corporates – is summarised below and also covered in greater detail in Chapter 3.

Issuance trends M&A is one of the key drivers for recent global hybrid issuance growth, particularly in theinsurance sector, which increased by 60% to €15.9bn (equiv.). By contrast, while issuance frombanks continues to account for the majority of overall supply, contributing to 69% of the totalvolume of the market, bank issuance growth in recent years has been relatively stable andconsistent.


4

Figure 1.1: Sectoral differences in the rationale for hybrid issuance


Banks

Regulatory tier 1 capital

Ratings

Structures are getting more debt- like as regulators/rating agencies allow ACSM features

Insurance

Regulatory tier 1 capital

Ratings

CorporatesAccounting

Ratings

Regulated Unregulated

Usuallynon

cumulative

Depends - someissues have both

Mostlynon-cash

cumulative

The corporate hybrid market has shown dramatic growth and structural innovationRecent years have seen corporate hybrid structures become increasingly used to fund M&A,increase return on equity (ROE) and reduce weighted average cost of capital (WACC) with low-costquasi-equity. The corporate sector saw significant activity from German blue chips such asSiemens, Porsche and Linde, which further stimulated interest in corporate hybrid strategies in2006. This followed the explosion of corporate issuance seen in 2005 (see Figure 1.2), when ratingagencies first clarified their newly evolved methodologies and the hybrid securities were deemedmore beneficial to corporate and financial issuers alike.

Diversity and globalisation prevalent in geographical issuance trendsIssuance from the US, Asia and Europe continues to dominate but several new growth areas are emerging.

In the European investor market, French, German and UK financial issuers dominate, accountingfor half of recent supply. Germany also continues to lead issuance in the European corporatesector, including the largest corporate deal (Siemens), inaugural Sterling corporate hybrid deal(Linde), and some of the most interesting and structurally innovative transactions to date. Thisdominance in the European investor market is, however, lessening, driven by stronger supplyfrom other European countries, renewed flows from Asia-Pacific and also new and developing ju-risdictions such as Kazakhstan, India and Korea. US financial institution issuers also tapped intothe European investor market with Euro and/or Sterling-denominated transactions. The CEMEXUS dollar dual-tranche issue found European diversification and was partly distributed toinvestors in Europe and Asia.

The US investor market has also grown in recent years. The majority of supply continues to bedriven by US-domiciled financial institution and corporate issuers. However, the US investormarket is also finding greater international appeal and providing low-cost diversification andmarket capacity for many European issuers. This has been most noticeable for the largerEuropean banks (particularly from the UK), but also for some of the European insurance issuers(for example Axa, Swiss Re). Asia-Pacific financial institutions have also been active, with Japanesebanks issuing infrequently but in large size, and LatAm issuers have also tapped into demand inthis market.

In the Asian investor market, Japanese issuers contributed to a significant level of the overallhybrid supply. Japanese retailer Aeon also broke new ground and issued the first corporate hybridsold into Japan’s domestic market. However European and US issuers (most notably the largerbanks and insurers) are becoming an increasing presence, diversifying and tapping into retail andinstitutional investor demand in the region.

New and developing hybrid investor markets such as Canada and Australia were also tapped andshould provide increasing opportunities for issuers going forward.


5

Cumulative issuance volume (€m)

18,000

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

2003

2004

2005

2006

2007

Rating Agency Publications

Figure 1.2: Growth of next generation European hybrid issuance, 2003 - 2007 (€m)


Who are the investors?Investors have been attracted to hybrids in a quest for yield in a low rate, tight spreadenvironment where the credit profiles have been improving, companies had been de-leveragingand the economic outlook was positive. As structural conservatism adds investor-friendly featuresto corporate hybrids the universe of eligible issuers expands and more investors enter the assetclass globally for exposure.

The continued growth and evolution of the global hybrid market has seen issuers tap intoincreasing demand from institutional, retail and private bank (RPB) investors.

Institutional hybrid investors (as summarised in Figure 1.3) are comprised primarily of assetmanagers, banks, hedge funds, insurance and pension funds, and these investors have increasingly utilised the hybrid market as a method to maximise returns.

These investors have become more familiar with assessing the structural risks of hybridsecurities, and one of the key motivations for many investors has been the spread/yield pick-upversus senior debt with a similar credit quality. Spread multiples or differentials are now utilisedby many institutional investors as a method for assessing the relative value and pick-up ininvesting in the hybrid versus the senior security.

RPB investors (pure retail ‘mom-and-pop’ investors and high net worth individuals targetedthrough private bank networks) have also become increasingly active and benefited from theyield pick-up of hybrid securities. They have also provided important investor diversification to anumber of issuers who are more active in the institutional investor market. This investor base isof particular significance in the US, European and Asian markets and has facilitated hybrid trans-actions from both domestic and overseas issuers in recent years.

Evolution – historical milestones and outlookDiversity is a prevalent theme as the hybrid market follows the path of globalisation – more typesof issuer are active in hybrids and more countries are entering the market as home to either thehybrid issuers, the hybrid investors or both.

The hybrid capital securities market has recently experienced record new issue volumes. BankTier 1 supply provides the greatest amount of new issue volume, although the insurance andcorporate sectors were a key driver for recent growth and structural innovation following ratingagency stimulus. Corporate and insurance issuance was largely driven by M&A-related funding requirements and characterised by jumbo multi-tranche, multi-currency transactions in theglobal hybrid market.

As more investor markets develop globally, hybrids also offer a source of funding diversification –particularly important for issuers seeking historically large total amounts of cash. The ability tochoose from different instruments and investor bases including common equity, converts,hybrids and senior debt in the European, US and Asian markets and tapping investors in the RPBand institutional sectors has been a key component of the contemporary acquisition war chest.


6

Asset manager

Banks

Insurance

Pension fund

Hedge fund

35%

20%15%

10%

20%

Figure 1.3: Institutional hybrid investors – illustrative global breakdown (%)


The milestones of the 1990s, including the first generation of corporate hybrids and the adoptionof hybrid Tier 1 capital for banks, are now being challenged in significance as the next generationof hybrid structures have stimulated the next wave of issuance from corporates and expanded thepool of marketable issuers to include more sectors and countries than ever before.

The rating agencies have been the key catalyst for the recent hybrid structural enhancements, butthis would not have been as possible without the extremely constructive market conditionswhich compressed the pricing of ‘risky’ structural features that provide equity credit.

Structures have become more conservative to attract more investor types and allow for morediverse credit profiles to tap the hybrid market (low rated and unrated issuers). The market hasseen a ’new renaissance’ of hybrid capital structuring, and massive M&A funding needs have beenwell supported by evolutionary developments in the sector. M&A also provided the purpose to thehybrid product for many corporate issuers that do not need regulatory capital.

The current period is now reminiscent of the 1990s, when banks around the world were rapidlyinnovating country specific variants of tax-efficient capital and issuance volumes surged. Investorswere attracted by yield, but wary of structural nuances and the potential for ‘embedded risk’within the emerging hybrid asset class. Over time, structural details faded from significance, asgreater outstanding issuance volumes and liquidity led to understanding, commoditisation andmarket efficiency.

The structural innovation rate of change may vary and the new issue volumes will rise and fallwith the business cycle but the continued use of hybrid capital securities in the capital structuresof sophisticated issuers seems as certain as ‘perpetual change’.


7

02CHAPTER

IntroductionHybrid capital issuance in the global debt markets has been at its most dynamic in recent years,exhibiting expansion, innovation, diversity and the emergence of several new growth areas. Anumber of factors have led to the recent explosion of issuance. One of the most influential eventsin the market occurred in 2005 when the lead rating agencies gave clarification to their method-ologies for assessing hybrid capital securities. This opened the hybrid markets to a number of newsectors and issuers and the market has been building on this momentum ever since. Organicgrowth and M&A activity have, however, remained the primary drivers for market supply,although more and more issuers look to further adapt hybrids for their own unique objectives.Issuer aspirations have been supported by strong market conditions, which have attracted newinvestors to hybrids and also a greater diversity of issuer credits.

Investor markets around the world are becoming deeper and more established. Institutional, retailand private bank investors have all played a key role in the market expansion. While in many casesdomestic investors provide the backbone to the market, issuers are increasingly looking outsidetheir local investor base, tapping into new investor markets and achieving diversification. Withinthe global hybrid markets, bank issuers raising Tier 1 regulatory capital continue to contribute themajority of supply seen in the market today. Insurance and corporate hybrid volumes have,however, seen significant growth in recent years and increased volumes look set to become a keytrend of the sector in years to come. As the market further opens, smaller mid-cap issuers have alsobeen able to access this important source of capital funding. This has led to the increasingappearance of transactions below a typical benchmark size, and has also paved the way for issuerswith low or no credit ratings, as global investors become increasingly educated about the structureof hybrid securities and issuers from emerging regions.

This chapter provides an overview of the global hybrid markets and some of the developmentswhich have driven rapid growth and expansion in recent years. A summary is given of the keytrends of the market, from both an investor market and issuer region perspective. Issuermotivation is further analysed in Chapter 3, and the investor base for hybrid securities isdiscussed in detail in Chapter 4. Looking forward, demand for these innovative securities,continuing product development and increased issuer focus on balance sheet management are allexpected to result in the continued innovation and growth of the market going forward, bothfrom a supply and demand perspective.

Hybrid market size, growth and structureLooking back, the last five years have been a growth period for the global hybrid capital markets.In 2005, the market saw a significant boost of issuance as supply increased by 80% to over US$80bn.Then in 2006 the global hybrid markets saw further expansion, reaching over US$120bn by theyear-end (a 45% increase from 2005). 2007 has already seen significant activity, with H1 volumes ofover US$80bn already surpassing 2005 year-end volumes, as shown in Figure 2.1.

The growth rate in recent years has also been significant, averaging 42% for the period 2002–06.The insurance and corporate sectors have led this expansion (with 2002–06 growth rates of 100%and 47% respectively).

THE MARKET FOR HYBRID CAPITALSECURITIES

9

So the global hybrid markets have experienced significant change in recent years, not only interms of size but also structure. A number of factors shaped the development of the market overthis period and have led this sector to be of such significance in the market today:

0 Rating agency methodology clarification – One of the defining moments for the market was when the lead rating agencies gave significant clarification and improvement in equity credit to their hybrid methodologies. This resulted in an explosion of supply, particularly from the more rating agency focused corporate and insurance sector issuers. Global hybrid markets have subsequently continued their rapid growth and expansion, with volumes hitting record levels in 2006;

0 M&A activity – The increase in M&A activity has had a strong impact on this growth level in recent years. As funding requirements for some issuers (particularly via these M&A-related financings) have increased, this has in turn led to larger ‘jumbo’ deals and multi-tranche deals as issuers have looked to tap multiple investor markets to achieve funding requirements while at the same time optimising pricing;

0 Multi-tranche transactions – These have also become more prevalent and have proven a popular route for larger funding needs. The search for investor diversification, coupled with larger funding requirements for many issuers, has resulted in the launch of an increasing number of large multi-tranche transactions in the hybrid capital market and hybrids in new currency markets. This targeting of different maturities and currencies has enabled issuers to attract different investor bases into the same deal, which was particularly relevant for the larger funding exercises now seen in the market. These multi-tranche transactions have been multi-currency (targeting different investor bases), and maturity (targeting different investor types), or have had varying structures (for example, step-up and true perpetual, or subordinated and Tier 1);

0 Expansion of the market to include new issuer regions and investor markets – Hybrid supply from new issuer regions has grown significantly in recent years. Issuers from these new regions (select LatAm, Eastern European, Asian countries) are now a more frequent occurrence in the market and provide investors with diversification away from the more frequent hybrid supply seen from US and Western European issuers. Investor markets are also expanding away from the traditional US and European investor bases, broadening the overall demand for hybrid securities, and also offering issuers a greater number of hybrid investors to tap into.

Global hybrid supply at present is sold primarily into three distinct investor markets – the US,Europe and Asia. Figure 2.2 highlights the comparative size of each of these investor markets.

Approximately 48% of total global hybrid supply is sold into the US investor market. The majorityof this supply comes from domestic issuance from US-domiciled institutions; however, a significantvolume (over 20%) comes from cross-border issuance from Europe, with most of the remaining supplycoming from Asia.


10

Volume (US$ equiv. m)

140,000

120,000

100,000

80,000

60,000

40,000

20,000

02004 2006 H1 2007200520032002

Corporate hybridInsurance hybridBank T1

Figure 2.1: Global hybrid supply, by issuer sector, 2002–H1 2007 (US$m)


The European investor market is also significant in size, absorbing approximately 42% of totalglobal hybrid volumes, and is the main focus of many of the cross-border flows seen in the markettoday.

Approximately 10% of total global hybrid volumes are sold into the Asia-Pacific investor market,with supply primarily from Asian and Australian banks, and also European institutions targetingthe region for diversification purposes.

The global market can also be discussed in the context of issuer sector. Figure 2.3 splits the hybridmarket into three distinct groups – bank Tier 1, insurance hybrid and corporate hybrid:

0 Bank Tier 1 – This sector is the most dominant, contributing to approximately 69% of the total global supply of hybrid securities. Tier 1 capital issuance from regulated financial institutions has reached record volumes in recent years, with the leading international banks returning frequently and tapping multiple markets to benefit from a diverse and developing hybrid investor base. This issuance has been driven primarily by M&A and the growth of banks’ risk-weighted assets as the majority of banks have been fully capitalised up to hybrid limits. The continued dominance of the bank Tier 1 sector has also been supported by increased supply from issuers in new jurisdictions where regulatory capital guidelines are either being clarified or established for the first time;

0 Insurance hybrid – This sector contributes approximately 21% of the total global supply of hybrid securities. Insurance hybrid supply has become a growing presence in recent years, which can be attributed to both regulatory and rating agency developments, with the growth in M&A activity also playing a key role. This has resulted in often-significant financing needs within the sector, resulting in many of the transactions structured as large €1bn+ multi-tranche multi-currency transactions, as issuers have sought to maximise diversification and achieve tight pricing;

0 Corporate hybrid – While hybrid capital has traditionally been a financing vehicle for regulated financial institutions, changes to the treatment of hybrids by the rating agencies has increased the attractiveness of the product to the corporate sector. As a result, corporate hybrid supply today contributes approximately 10% of the total volume of global hybrid securities. This supply has often been intermittent, and much less frequent than for bank and insurance issuers, with some months seeing a slew of supply. This has in the past been strongly correlated to execution conditions and timing. The provision of low cost equity remains a key driver for the majority of corporate hybrid transactions. Corporate hybrid structures have also become increasingly used as a cost-effective financial tool to reduce the weighted cost of capital and de-leverage. This, together with the development of rating agency hybrid methodologies (which is discussed in Chapter 5) has resulted in the explosion of global corporate hybrid supply seen in recent years.


11

Europe

US

Asia-Pacific

42%

48%

10%

Figure 2.2: Global hybrid supply, by investor market, 2006–H1 2007 (%)


Investor marketsFrom the perspective of investor markets, hybrid market supply can be split into three groups, ashas already been highlighted – Europe, the US and Asia-Pacific.

The European investor marketTable 2.1 provides a summary of hybrid capital supply into the European investor market in 2006and H1 2007. The European investor market grew to over €42bn equivalent in size in 2006.Average deal sizes have also increased to €486m, and this has risen again in 2007, increasing by7% to approximately €517m. The largest single-tranche transaction during H1 2007 was a €1.5bninsurance hybrid transaction from Munich-Re, issued in June 2007. The largest deal of 2006 alsocame from the insurance sector – a €1.275bn insurance hybrid transaction from Generali, issuedin June 2006.

The shape of the European investor market for hybrid securities can be seen in Figure 2.4, andanalysed by the region of the issuer. European-domiciled issuers account for approximately 86% ofsupply into the European investor market, with French, German and UK issuers the most active(these three jurisdictions dominate, contributing to half of all supply in the European investormarket). The majority of these transactions have been from banks and insurance companies withlarge capital requirements, which has required them to issue on multiple occasions and withvarying structures, currencies and target investor bases.

The dominant presence of France, Germany and the UK is, however, beginning to lessen. Thisshift in the market has been driven partly by stronger supply from some of the other Europeanissuer regions such as Italy (10%), Netherlands (6%) and Iberia (5%), which in total account for 34%of European market volumes. Supply from Central and Eastern Europe is also expected to becomean increasing presence going forward, which will further add diversity to the European investormarket.


12

Bank tier 1

Insurance hybrid

Corporate hybrid

69%

21%

10%

Figure 2.3: Global hybrid supply, by issuer sector, 2006–H1 2007 (%)


Table 2.1: European investor market hybrid capital volumes, 2005–H1 2007 (€m)

European investormarketsize2006 2007 H1

Total issuance (€ equiv. m) 42,746 21,185No. deals 88 41No. multi-tranche currencydeals 8 4Largest size (€ equiv. m) 1,275 1,500Average size (€ equiv. m) 486 517


Supply from non-European issuer regions into the European investor market has also becomemore established, with the most significant volumes seen from the US (6%) and Japan (5%), with in-ternational banks again dominating. New and developing issuer regions in Asia-Pacific and LatAmaccount for a relatively low proportion of supply into the European investor market, althoughbank capital supply from many of these jurisdictions has already been seen in Tier 2 format,which will likely pave the way for more Tier 1 supply in the future, and Mexican issuer Cemex hasrecently opened the European investor market for LatAm corporate hybrid issuance.

From a currency perspective, European investor market hybrid supply remains focused on eitherEuros or Sterling, as highlighted in Figure 2.5.

Euros continue to be the key currency to be issued into the European investor market, accountingfor almost 60% of the total supply.

Sterling hybrid issuance has grown rapidly in recent years and now accounts for just over 40% oftotal hybrid volume. The key growth area here has been increased volumes from non-UK issuerregions, primarily from the continent (65% of total sterling hybrid volumes). These continentalissuers have targeted the currency as a diversification play away from Euros, with the proximityof the investor base often making this the first choice from a marketing (and often documenta-tion) perspective. Non-European issuer regions in Asia-Pacific and the US have also tapped intothis deep and mature investor market (7% of total sterling hybrid supply), with transactions oftenpart of a larger dual tranche Euro-Sterling financing.


13

17%

15%

1%United Kingdom

Switzerland

Scandinavia

Other

Mexico

Japan

Italy

Ireland

2%

8%

20%

5%4%

10%

5%

1%1%

4%1%

6%

Iberia

Germany

France

Benelux

Austria

Australia

United States

Figure 2.4: European investor market hybrid supply, by issuer region,

2006–H1 2007 (%)


Euros

Sterling

US$

57%

42%

1%

Figure 2.5: European investor market hybrid supply, by currency, 2006–H1 2007 (%)


Bank Tier 1 sectorBank Tier 1 accounts for approximately 57% of supply into the European hybrid investor market.Figures 2.7 and 2.8 and Table 2.2 analyse the split of this supply by issuer region and currency, andalso highlight some of the largest bank Tier 1 transactions to be issued in the European investormarket in 2006 and H1 2007.

Bank Tier 1 supply into the European market consists primarily of transactions from theEuropean banks (85%) tapping into their natural investor market, one which has in recent yearsestablished itself as a deep and sophisticated investor base able to absorb hybrid supply fromrepeat and frequent issuers. Japanese banks have been quite active, contributing to 9% of supply(e.g. MUFG, Mizuho, SMFG). US banks have been less active (5%), with bank Tier 1 issuance stillremaining low relative to Tier 2 supply.

Many of the larger banks have also successfully repeat issued in the European investor market.These transactions have targeted both multiple investor bases such as institutional and retailprivate bank (RPB) (e.g. Lehman, Helaba), structures such as step-up, true-perpetual (e.g. BPVN)and currencies such as Euros, Sterling, US Dollars (e.g. Commerzbank, BNP Paribas, MUFG). CréditAgricole has also been one such issuer, targeting both Sterling and Euros, and also institutionaland RPB investor bases in Europe and Asia in recent years.

Smaller European banks have also been active in numbers, although deal sizes have on averagetended to be smaller. Some of these institutions have also been progressive in their approach,either in issuing a non-step structure or in the targeting of the RPB investor base.

Over 50% of this supply is denominated in Euros. Sterling has contributed to 45% of bank Tier 1supply and continues to be used by continental and non-European issuers looking to access theUK institutional investor base (62% of Sterling bank Tier 1 supply is from non-UK banks).


14

Bank tier 1

Insurance hybrid

Corporate hybrid

57%

31%

12%

Figure 2.6: European investor market hybrid supply, by sector, 2006–H1 2007 (%)



15

13%

7%

5%Benelux

France

Germany

Ireland

Italy

Japan

20%

8%

4% 9%2%

8%

15%

3%

Other

Scandinavia

Spain

United Kingdom

United States

Austria

6%

Figure 2.7: European investor market bank Tier 1 supply, by issuer region,

2006–H1 2007 (%)


Euros

Sterling

US$

54%45%

1%

Figure 2.8: European investor market bank Tier 1 supply, by currency,

2006–H1 2007 (%)


Table 2.2: European investor market bank Tier 1 supply – select issues by size,2006–H1 2007

Issuer Size Sizecountry Issuer Issue date Currency (m) (€ equiv. m) Coupon First call date Maturity

Germany CommerzbankCapital Funding Trust I 15 Mar2006 € 1,000 1,000 5.012 12 Apr2016 PGermany CommerzbankCapital Funding Trust II 15 Mar2006 £ 800 1,162 5.905 12 Apr2018 PFrance BNPParibas SA 04 Apr2006 € 750 750 4.730 12 Apr2016 PFrance BNPParibas SA 05 Apr2006 £ 450 645 5.945 19 Apr2016 PNetherlands ABN AMRO BankNV 24 Feb 2006 € 1,000 1,000 4.310 10 Mar2016 PGermany HT1 Funding GmbH 21 Jul 2006 € 1,000 1,000 6.352 30 Jun 2017 PIreland SaphirFinance plc 17 Aug 2006 £ 600 891 6.369 25 Aug 2015 PJapan MUFG Capital Finance IVLtd 12 Jan 2007 £ 550 823 6.299 25 Jan 2017 PFrance Credit Logement 01 Mar2006 € 800 800 4.604 16 Mar2011 PJapan MUFG Capital Finance II Ltd 10 Mar2006 € 750 750 4.850 25 Jul 2016 PFrance BNPParibas SA 29 Mar2007 € 750 750 5.019 13 Apr2017 PUnited Kingdom HBOSCapital Funding No 3 LP 16 May2006 € 750 750 4.939 23 May2016 P

Source: Compiled by CALYON P=Perpetual

Insurance hybrid sectorInsurance sector supply accounts for approximately 31% of the European investor market. Figures2.9 and 2.10 and Table 2.3 analyse the split of this supply by issuer region and currency, and alsohighlight some of the largest insurance hybrid transactions to be issued in the European investormarket in 2006 and H1 2007.

European insurance companies account for approximately 86% of this supply, with France (21%)and Italy (24%) the most active regions (Axa and Generali were noticeably active). US insurersaccounted for 12% of supply into the European investor market, with AIG particularly active. Themajority of insurance sector transactions sold into the European investor market have beenheavily focused on M&A-driven deals e.g. Axa, Generali, Allianz and Munich Re (which issued thelargest single tranche transaction of 2007 – €1.5bn – in June). Many transactions have also takenthe form of large multi-tranche financings to enable larger funding requirements to be met(European issuers such as Generali and Axa, and US insurer AIG all issued in dual-currency Euro-Sterling format). Supply from non-European/non-US insurance sector issuers was limited (2%).

Approximately 54% of supply has been in Euros, with European insurance companies contribut-ing to the majority of the volume (90%). Approximately 45% of insurance sector supply has beenSterling-denominated. Supply in this currency has been from a more geographically diverse set ofissuers, with 25% from UK insurance companies, 58% from continental insurance companies, 12%from the US and 5% from Australia.


16

Italy

Netherlands

14%

21%Switzerland

24%

UK

US

Australia

4%

11%

12%

2%

12%

France

Germany

Figure 2.9: European investor market insurance hybrid supply, by issuer region,

2006–H1 2007 (%)


€

£

54%45%US$

1%

Figure 2.10: European investor market insurance hybrid supply, by currency,

2006–H1


Corporate hybrid sectorApproximately 12% of European market issuance is derived from corporate hybrid transactions.Figures 2.11 and 2.12 and Table 2.4 analyse the split of this supply by issuer region and currency,and also highlight some of the largest corporate hybrid transactions to be issued in the Europeaninvestor market in 2006 and H1 2007.

Western European issuers, as expected, dominate corporate supply into the European investormarket (over 90% of total volumes), with the larger blue chip companies embracing hybrids as amainstream corporate financing tool to reduce WACC with low-cost quasi-equity.

German corporates continue to lead, contributing over 50% of total volumes. This incorporatesthe largest corporate hybrid deal in the European investor market, from Siemens (a €900m/£750mdual-tranche deal issued in September 2006), a dual-tranche £/€ issue from Linde issued in July2006, and also more recently a number of smaller sized deals (circa €100–250m) from lower ratedand non-rated issuers.

Other regions such as France (8%), Italy (10%) Austria (6%) and Belgium (6%) have also been active,including more recently the UK (10%), with Rexam the first UK-domiciled corporate to issue inhybrid format (€750m, issued in June 2007). Mexico contributed to 9% of supply, with Cemexissuing €730m in May 2007. This deal offered investor diversification for the issuer, which hadpreviously targeted the US investor market with two dollar-denominated hybrid transactions.

Over 80% of corporate hybrid volumes in the European investor market have been Euro-denominated, driven by strong supply from European issuer regions targeting their domesticcurrency, and also all the recent supply seen from non-European issuer regions. Europeancorporate hybrid issuers have also issued in Sterling (19%) to diversify and tap into the UK institu-tional investor base. German corporates Linde and Siemens have both been active in thiscurrency, with Linde the first corporate to issue a Sterling hybrid in July 2006. It is also interestingto note that a single-tranche Sterling corporate hybrid has yet to be seen, with both the Linde andSiemens deals part of larger dual-tranche Euro-Sterling financings.


17

Table 2.3: European investor market insurance hybrid supply – select issues by size, 2006–H1 2007

Size SizeIssuercountry Issuer Issue date Currency (m) (€ equiv. m) Coupon First call date Maturity

Italy Generali Finance BV 07 Jun 2006 € 1,275 1,275 5.317 16 Jun 2016 PerpetualItaly Generali Finance BV 07 Jun 2006 £ 700 1,021 6.214 16 Jun 2016 PerpetualItaly Generali Finance BV 07 Jun 2006 £ 350 510 6.269 16 Jun 2016 PerpetualUnited States American International 08 Mar2007 € 1,000 1,000 4.875 15 Mar2017 15 Mar2067

Group Inc - AIGUnited States American International 08 Mar2007 £ 750 1,103 5.750 15 Mar2017 15 Mar2067

Group Inc - AIGGermany Munich Re 05 Jun 2007 € 1,500 1,500 5.767 12 Jun 2017 PerpetualFrance CNPAssurances SA 12 Dec2006 € 1,250 1,250 4.750 22 Dec2016 PerpetualItaly Assicurazioni Generali SpA 30 Jan 2007 € 1,250 1,250 5.479 08 Feb 2017 PerpetualItaly Assicurazioni Generali SpA 30 Jan 2007 £ 495 750 6.416 08 Feb 2022 PerpetualNetherlands ELM BV(Swiss Re) 04 May2006 € 1,000 1,000 5.252 25 May2016 PerpetualFrance AXASA 29 Jun 2006 € 1,000 1,000 5.777 06 Jul 2016 PerpetualUnited Kingdom Legal & General Group plc 19 Apr2007 £ 600 884 6.385 02 May2017 PerpetualNetherlands ING Groep NV 01 Mar2006 £ 600 882 5.140 17 Mar2016 Perpetual


The US investor market The US hybrid investor market has experienced surging levels of issuance in recent years.Investors have given strong support to new hybrid transactions, which has ensured recordissuance sizes and minimal new issue premiums in the process. A summary is given in Table 2.5.

US investor market hybrid issuance in 2006 was particularly strong, totalling almost US$45bn.This volume was particularly impressive given the NAIC shock which chilled the market in thefirst half. 2007 has also been a particularly noticeable year for hybrid supply into the US investormarket, with H1 2007 volumes reaching US$51bn from 80 deals – already surpassing those seenin the US investor market for the entire year in 2006. The largest deal of 2006 came fromWachovia, which issued a US$2.5bn single-tranche trust preferred issue in January. 2007 also sawthe bank Tier 1 sector provide the largest transaction, a US$1.75bn Tier 1 issue from Goldman


18

Germany

Italy51%

10%Mexico

9%

10%

6%

8%

6%

UK

Austria

Belgium

France

Figure 2.11: European investor market corporate hybrid supply, by issuer region,

2006–H1 2007 (%)


€

£

81%

19%

Figure 2.12: European investor market corporate hybrid supply, by currency,

2006–H1 2007 (%)


Table 2.4: European investor market corporate hybrid supply – select issues by size, 2006–H1 2007


Germany Siemens Financieringsmaatschappij NV 08 Sep 2006 € 900 900 5.250 14 Sep 2016 14 Sep 2066Germany Siemens Financieringsmaatschappij NV 08 Sep 2006 £ 750 1,115 6.125 14 Sep 2016 14 Sep 2066Germany Linde Finance BV 07 Jul 2006 € 700 700 7.375 14 Jul 2016 14 Jul 2066Germany Linde Finance BV 07 Jul 2006 £ 250 362 8.125 14 Jul 2016 14 Jul 2066Italy Lottomatica SpA 10 May2006 € 750 750 8.250 31 Mar2016 31 Mar2066United Kingdom Rexam plc 20 Jun 2007 € 750 750 6.750 29 Jun 2017 29 June 2067Mexico C10-EUR Capital Ltd (Cemex) 03 May2007 € 730 730 6.277 30 Jun 2017 PerpetualFrance Vinci SA 07 Feb 2006 € 500 500 6.250 13 Nov2015 PerpetualBelgium SolvayFinance BV 23 May2006 € 500 500 6.375 02 Jun 2016 02 Jun 2104Austria WienerbergerAG 25 Jan 2007 € 500 500 6.500 09 Feb 2017 Perpetual


Sachs in May. Multi-tranche transactions have become increasingly used by both banks andinsurers to target different investor bases and increase funding sizes (either in fixed-floating ordual-maturity format).

As highlighted in Figure 2.13, hybrid supply into the US investor market continues to be drivenprimarily by US-domiciled institutions (both financial and corporate), accounting for approxi-mately 55% of total issuance volumes. Non-US domiciled issuers have also been active in thismarket, tapping into strong execution conditions and achieving additional diversification.Approximately 6% of this supply has come from issuers in Asia-Pacific; however, the majority ofnon-US supply has come from the European issuer regions, driven by Tier 1 capital raisingexercises from the larger European banks and insurers looking to diversify away from Euros.


19

Table 2.5: US investor market hybrid capital volumes, 2005–H1 2007 (US$m)

USinvestormarketsize2006 2007 H1

Total issuance (US$ equiv. m) 44,903 51,650No. deals 60 80No. multi-tranche currencydeals 2 7Largest size (US$ equiv. m) 2,500 1,750Average size (US$ equiv. m) 748 646


US

UK

67%

5% Switzerland

6%

8%

2% 3%

1% 2%

4%

Other European countries

Mexico

Ireland

Germany

France

Asia

Other countries

2%

Figure 2.13: US investor market hybrid supply, by issuer region, 2006–H1 2007 (%)


Bank tier 1

Insurance hybrid

76%

9%

15%

Corporate hybrid

Figure 2.14: US investor market hybrid supply, by sector, 2006–H1 2007 (%)


Bank Tier 1 sectorBank Tier 1 supply accounts for approximately 76% of the total US investor market. Figures 2.15and 2.16 and Table 2.6 analyse the split of this supply by issuer region and currency, and alsohighlight some of the largest bank Tier 1 transactions to be issued in the US investor market in2006 and H1 2007.

Almost two-thirds of this supply is derived from US-domiciled banks. These banks have been ableto issue into the domestic market for the majority of their Tier 1 financings, with the depth ofdemand for these strong-branded names ensuring the market is deep enough to fund all theircapital requirements.

The European banks (e.g. Crédit Agricole, Deutsche Bank, Bank of Ireland, Santander), contributeto 24% of bank Tier 1 into the US investor market. The UK region has been the most active intapping into this investor base, with Barclays, RBS, HBOS, Standard Chartered and Lloyds TSB allissuing in 2006–H1 2007. Bank Tier 1 European supply into the US investor base often differs instructure, with both step-ups and true perpetuals (Lloyds TSB, Standard Chartered, HBOS, BNPParibas) utilised. BBVA also recently issued a bank Tier 1 deal, with a coupon floor after the firstcall date.

LatAm and Asia-Pacific issuers have also intermittently tapped into the US investor market (e.g.BBVA Bancomer, Woori Bank). Japanese banks contributed to 5% of supply, with the large banksissuing into the US investor market infrequently but in large size (the average transaction size hasbeen approximately US$2bn). Canada is another North American market to watch.

Almost 100% of bank Tier 1 volumes in the US investor market were US$-denominated. One suchnon-US$ transaction was last year’s C$400m Tier 1 deal from Crédit Agricole, the first hybridstructure to be issued into the C$ institutional investor market.


20

US

UK

63%

3%

Switzerland

4%

10%

2%

8%

5%2%

3%

Spain

Others

Japan

Ireland

Germany

France

Figure 2.15: US investor market bank Tier 1 supply, by issuer region, 2006–H1 2007 (%)


US$

C$

99.5%

0.5%

Figure 2.16: US investor market bank Tier 1 supply, by currency, 2006–H1 2007 (%)


Insurance hybrid sectorInsurance hybrid supply accounts for approximately 20% of the US investor market. Figure 2.17analyses the split of this supply by issuer region, and Table 2.7 highlights some of the largestinsurance hybrid transactions to be issued in the US investor market in 2006 and H1 2007.

US insurers account for approximately 62% of this supply. European issuer regions such as France(10%) and Switzerland (16%) have also been active, with large European insurers such as Swiss Re,Axa and Zurich FS all issuing (both Axa and Zurich FS issued in dual-tranche step-up/true perpformat and Swiss Re issued in US$ as part of a dual currency Euro-Dollar financing). TheBermudan reinsurance sector has also played a significant role, contributing to approximately 8%of hybrid supply into the US investor market.


21

Table 2.6: US investor market bank Tier 1 hybrid supply – select issues by size,2006–H1 2007

Issuer Size Sizecountry Issuer Issue date Currency (m) ($ equiv. m) Coupon First call date Maturity

US Wachovia Capital Trust III 25 Jan 2006 US$ 2,500 2,500 5.8 15 Mar2011 PerpetualJapan MUFG Capital Finance I Ltd 10 Mar2006 US$ 2,300 2,300 6.346 25 Jul 2016 PerpetualUS JPMorgan Chase Capital XXII 26 Jan 2007 US$ 1,000 1,000 6.45 - 02 Feb 2037US JPMorgan Chase Capital XXI 26 Jan 2007 US$ 850 850 FRN 02 Feb 2012 02 Feb 2037US Goldman Sachs Capital II 08 May2007 US$ 1,750 1,750 5.793 01 Jun 2012 PerpetualJapan SMFG Preferred Capital USD 1 Ltd 13 Dec2006 US$ 1,650 1,650 6.078 25 Jan 2017 PerpetualUS BACCapital Trust XIII 12 Feb 2007 US$ 700 700 FRN 15 Mar2012 15 Mar2043US BACCapital Trust XIV 12 Feb 2007 US$ 850 850 5.48 15 Mar2012 15 Mar2043US Citigroup Capital XVI 15 Nov2006 US$ 1,500 1,500 6.45 31 Dec2011 31 Dec2066US Merrill Lynch & Co Inc 15 Mar2007 US$ 1,500 1,500 5.85 24 May2012 PerpetualUS Lehman Brothers Holdings Capital Trust VII 8-May-07 US$ 1,000 1,000 5.857 31 May2012 PerpetualUS Lehman Brothers Holdings Capital Trust VIII 8-May-07 US$ 500 500 FRN 31 May2012 Perpetual


US

Switzerland

62%16%

Netherlands

8%

France

Bermuda

4%

10%

Figure 2.17: US investor market insurance hybrid supply, by issuer region,

2006–H1 2007 (%)


Corporate hybrid sectorCorporate hybrid supply is the smallest sector, contributing to approximately 10% of total hybridvolumes into the US investor market. Figure 2.18 analyses the split of this supply by issuer region,and Table 2.8 highlights some of the largest corporate hybrid transactions to be issued in the USinvestor market in 2006 and H1 2007.

Supply from US-domiciled corporate issuers remains dominant (75%). Non-US issuers accountedfor 25% of the volume, with Cemex the most active of these issuers (both in terms of the numberof deals – three – and volume issued – US$2bn). The first of these deals from Cemex representedthe first issue from a LatAm corporate in hybrid format, which achieved 85% placement withinthe US investor market, but also a significant 10% into the European investor market and 5% intoLatAm. Cross-border supply from European corporates into the US investor market has yet to beestablished, and is set to be an area of growth for those corporate hybrid issuers with repeatborrowing requirements who also want to diversify away from the European investor markets.


22

Table 2.7: US investor market insurance hybrid supply – select issues by size, 2006–H1 2007

Size SizeIssuercountry Issuer Issue date Currency (m)($ equiv. m)Coupon First call date Maturity

US ZFSFinance (USA) Trust I 03 May2007 US$ 1,000 1,000 6.500 09 May2017 9 May2037US ZFSFinance (USA) Trust I 03 May2007 US$ 500 500 5.875 09 May2012 9 May2032France AXASA 04 Dec2006 US$ 750 750 6.379 14 Dec2036 PerpetualFrance AXASA 04 Dec2006 US$ 750 750 6.463 14 Dec2018 PerpetualUS MetLife Inc 14 Dec2006 US$ 1,250 1,250 6.400 15 Dec2036 15 Dec2036US XLCapital Ltd 12 Mar2007 US$ 1,000 1,000 6.500 15 Apr2017 PerpetualUS American International Group Inc - AIG 06 Mar2007 US$ 1,000 1,000 6.250 15 Mar2037 15 Mar2087US Travelers Companies Inc 05 Mar2007 US$ 1,000 1,000 6.250 15 Mar2017 15 Mar2037US Progressive Corp 18 Jun 2007 US$ 1,000 1,000 6.700 15 Jun 2017 15 June 2037US ING Groep NV 06 Jun 2007 US$ 1,000 1,000 6.375 15 Jun 2012 PerpetualSwitzerland Swiss Re GB plc 04 May2006 US$ 750 750 6.854 25 May2016 PerpetualUS American International Group Inc - AIG 31 May2007 US$ 750 750 6.450 15 Jun 2012 15 June 2047


US

Mexico

75%

25%

Figure 2.18: US investor market corporate hybrid supply, by issuer region,

2006–H1 2007 (%)


The Asia-Pacific investor market

The most significant supply into the Asia-Pacific investor market has been from Japan, which hascontributed to approximately 44% of recent hybrid supply in the region (highlighted in Figure2.19). This has comprised primarily of Tier 1 capital deals from the Japanese banks issuing in US$and JPY format into both the institutional and RPB investor bases.

Other Asia-Pacific issuer regions have accounted for 29% of recent Asia-Pacific market supply.These jurisdictions are becoming an increasingly important segment of the Asia-Pacific investormarket as regulatory frameworks evolve and new banks access the market. One example is India(now 5% of the Asia-Pacific hybrid investor market), which has had a growing presence followingclarification of bank capital adequacy guidelines, making it clearer for the Indian banks to tapinto the institutional debt markets to raise tax-efficient Tier 1 capital.

European issuers account for 24% of the Asia-Pacific investor market. Many of these transactionsare targeted towards the Asia-Pacific RPB market (the RPB investor base is discussed in greaterdetail in Chapter 4), which remains a popular method of diversification for both Europeanfinancial institutions (for example, NIBC Bank, CNCEP) and corporates (Glencore, Porsche).


23

Table 2.8: US investor market corporate hybrid supply – select issues by size, 2006–H1 2007

Size SizeIssuercountry Issuer Issue date Currency (m) ($ equiv. m) Coupon First call date Maturity

United States CVSCaremarkCorp 22 May2007 US$ 1,000 1,000 6.302 01 Jun 2037 01 Jun 2037Mexico C5 Capital Ltd 11 Dec2006 US$ 350 350 6.196 31 Dec2011 PerpetualMexico C10 Capital Ltd 11 Dec2006 US$ 900 900 6.722 31 Dec2016 PerpetualMexico C8 Capital Ltd 06 Feb 2007 US$ 750 750 6.640 31 Dec2014 PerpetualUnited States Enterprise Products Operating LP 21 May2007 US$ 700 700 7.034 15 Jan 2018 15 Jan 2068United States Comcast Corp 03 May2007 US$ 575 575 6.625 15 May2012 15 May2056United States USB RealtyCorp 18 Dec2006 US$ 500 500 6.091 15 Jan 2012 PerpetualUnited States PublicStorage Inc 04 Jan 2007 US$ 500 500 6.625 09 Jan 2012 PerpetualUnited States PPLCapital Funding Inc 16 Mar2007 US$ 500 500 6.700 30 Mar2017 30 Mar2067


Table 2.9: Asia-Pacific investor market hybrid capital volumes, 2005–H1 2007 (US$m)

Asian investormarketsize2006 2007 H1

Total issuance (US$ equiv. m) 14,568 5,333No. deals 30 13No. multi-tranche currencydeals 2 1Largest size (US$ equiv. m) 3,488 1,000Average size (US$ equiv. m) 486 410


Figure 2.20 highlights hybrid supply into the Asia-Pacific investor market, split by currency.Approximately 57% of supply into the Asia-Pacific investor market is denominated in US$.However a significant component (approximately 32%) of supply is also denominated in JPY,driven by continued capital issuance from the international Japanese banks such as Mizuho,Fukui and MUFG, and this currency continues to facilitate Tier 1 transactions of significant size (for example Mizuho). Other currencies comprise a smaller component of the investormarket (11%), driven by domestic currency bank Tier 1 supply from issuer regions such as Indiaand Malaysia.

The sector split for hybrid supply into the Asia-Pacific investor market is highlighted in Figure 2.21.


24

Japan

India

44%

7%

Germany

5%

France

Australia

US

UK

Thailand

Switzerland

South Korea

Philippines

Netherlands

Malaysia

6%

8%

9%

3%

2%

7% 2% 1% 4%

2%

Figure 2.19: Asia-Pacific investor market hybrid supply, by issuer region,

2006–H1 2007 (%)


US$

¥

57%

32%

Other

11%

Figure 2.20: Asia-Pacific investor market hybrid supply, by currency, 2006–H1 2007 (%)


Bank tier 1

Corporate hybrid

81%

10%

Insurance hybrid

9%

Figure 2.21: Asia-Pacific investor market hybrid supply, by sector, 2006–H1 2007 (%)


Bank Tier 1 sectorBank Tier 1 supply accounts for over 80% of total supply into the Asia-Pacific investor market.Figures 2.22 and 2.23 and Table 2.10 analyse the split of this supply by issuer region and currency,and also highlight some of the largest bank Tier 1 transactions to be issued in the Asia-Pacificinvestor market in 2006 and H1 2007.

Japanese banks account for over 50% of bank Tier 1 issuance into the Asia-Pacific investor market,with deals from this issuer region typically in single-tranche format, and utilising both US$ (28%)and JPY (72%). The Asia-Pacific investor market has provided opportunities for these banks to fundin large size (Mizuho and Mitsubishi UFJ both issued US$1bn+ equivalent deals) and for repeatissues (Mizuho and Shinsei).

Approximately 30% of bank Tier 1 supply comes from other Asia-Pacific banks in issuer regionssuch as Australia, Thailand, Malaysia, the Philippines and South Korea, with deals denominatedeither in US$ or the domestic currency.

The remaining supply comes from bank Tier 1 issuance from European issuers (14%), with USbanks relatively inactive, contributing to 3% of total volumes.


25

Japan

India

59%

5%

France

7%

Australia

US

UK

Thailand

Switzerland

South Korea

Philippines

Netherlands

Malaysia

6%

5%

3%

2%

3%

8%2%

1% 5%

Figure 2.22: Asia-Pacific investor market bank Tier 1 supply, by issuer region,

2006–H1 2007 (%)


US$

¥

59%

38%

Other

3%

Figure 2.23: Asia-Pacific investor market bank Tier 1 supply, by currency, 2006–H1 2007

(%)


Insurance hybrid sectorInsurance sector issuance into Asia remains undeveloped at present, but looks set to become agrowth area for the future as large insurance companies look to repeat issue in the market anddiversify into new investor bases. Figures 2.24 and 2.25 and Table 2.11 analyse the split of thissupply by issuer region and currency, and also highlight some of the largest insurance hybridtransactions to be issued in the Asia-Pacific investor market in 2006 and H1 2007.


26

Table 2.10: Asia-Pacific investor market bank Tier 1 hybrid supply – select issues by size, 2006–H1 2007


Japan Mizuho Capital Investment (JPY) 1 Ltd 22 Dec2006 ¥ 400,000 4,744 2.960 Jun 2016 PerpetualJapan MUFG Capital Finance III Ltd 10 Mar2006 ¥ 120,000 1,586 2.680 25 Jul 2016 PerpetualSouth Korea Woori Bank 25 Apr2007 US$ 1,000 1,000 6.208 02 May2017 2 May2037Japan Shinsei BankLtd 16 Feb 2006 US$ 775 775 6.418 20 Jul 2016 PerpetualJapan Shinsei BankLtd 14 Mar2006 US$ 700 700 7.160 25 Jul 2016 PerpetualJapan Mizuho Capital Investment (USD) 1 Ltd 09 Mar2006 US$ 600 600 6.686 30 Jun 2016 PerpetualJapan STB Preferred Capital 3 (Cayman) Ltd 23 Feb 2007 ¥ 50,000 589 2.830 25 Jul 2017 PerpetualIndia State Bankof India 08 Feb 2007 US$ 400 400 6.439 15 May2017 PerpetualUnited Kingdom Aberdeen Asset Management plc 11 May2007 US$ 400 400 7.900 29 May2012 PerpetualFrance BNPParibas SA 16 May2007 US$ 600 600 6.500 06 Jun 2012 PerpetualUS Lehman Brothers UKCapital 15 May2007 US$ 500 500 6.900 01 Jun 2012 Perpetual

Funding VLP


Switzerland

France

35%31%

Australia

34%

Figure 2.24: Asia-Pacific investor market insurance hybrid supply, by issuer region,

2006–H1 2007 (%)


US$

A$

69%

31%

Figure 2.25: Asia-Pacific investor market insurance hybrid supply, by currency,

2006–H1 2007 (%)


Corporate hybrid sectorCorporate hybrid issuance in Asia is also a new area for development. Figures 2.26 and 2.27 andTable 2.12 analyse the split of this supply by issuer region and currency, and also highlight someof the largest corporate hybrid transactions to be issued in the Asia-Pacific investor market in2006 and H1 2007. Most recently, Japan saw the first corporate hybrid transaction fromsupermarket chain Aeon, which was placed domestically within the institutional investor base.


27

Table 2.11: Asia-Pacific investor market insurance hybrid supply – select issues by size, 2006–H1 2007


Switzerland ELM BV(Swiss Re) 20 Apr2007 A$ 300 253 7.635 25 May2017 PerpetualSwitzerland ELM BV(Swiss Re) 20 Apr2007 A$ 450 379 FRN 25 May2017 PerpetualAustralia QBE Capital Funding LP 25 Apr2007 US$ 550 550 6.750 02 May2017 PerpetualFrance AXASA 11 Oct 2006 A$ 300 253 7.500 26 Oct 2016 PerpetualFrance AXASA 11 Oct 2006 A$ 300 253 FRN 26 Oct 2016 PerpetualFrance AXASA 27 Oct 2006 A$ 150 126 7.500 26 Oct 2016 Perpetual


Germany

Australia

59%

15%

Japan26%

Figure 2.26: Asia-Pacific investor market corporate hybrid supply, by issuer region,

2006–H1 2007 (%)


US$

A$

59%

15%

¥26%

Figure 2.27: Asia-Pacific investor market corporate hybrid supply, by currency,

2006–H1 2007 (%)


RPB versus institutional investor marketsThe investor base for hybrid securities can be split into two groups: institutional investors (assetmanagers, pension funds, insurance companies, hedge funds, banks) and retail private bank (pureretail ‘mom-and-pop’ and private banks). This is further discussed in chapter 4.


28

Table 2.12: Asia-Pacific investor market corporate hybrid supply – select issues by size, 2006–H1 2007


Germany Porsche International Financing plc 19 Jan 2006 US$ 1,000 1,000 7.20 01 Feb 2011 PerpetualAustralia Woolworths Ltd 10 May2006 A$ 600 506 FRN 15 Sep 2011 PerpetualJapan Aeon Co Ltd 20 Sep 2006 ¥ 26,500 312 FRN 29 Sep 2011 29 Sep 2056Japan Aeon Co Ltd 20 Sep 2006 ¥ 4,500 53 3.25 29 Sep 2011 29 Sep 2056


Institutional

Retail private bank

88%

12%

Figure 2.28: European investor market supply, 2006–H1 2007 (%)


Institutional

Retail private bank

59%

41%

Figure 2.29: US investor market supply, 2006–H1 2007 (%)


Issuer regions

ConclusionSo what can be expected for the shape of the hybrid market going forward?

Hybrid issuance can be expected to continue to grow, with straight refinancing requirements andrisk-weighted asset (RWA) growth anchoring expected issuance volumes. Revisions to regulatoryguidelines for financial institutions could also lead to marginally greater issuance, and newregulatory guidelines established in emerging and new jurisdictions will be key areas of growthfor these markets running forward. M&A-driven issuance will also continue to be a major variablegoing forward.

Cross-border issuance, one of the key trends of the hybrid markets in recent years, looks set tocontinue to expand, which will also support the issuance of multi-tranche multi-currency transac-tions as issuers benefit from targeting multiple investor bases.

New markets will continue to be established and it can be expected that more ‘firsts’ from new jurisdictions. The Middle East, Latin America and Asia are likely to be the key players, particularlyin bank capital where regulatory frameworks are becoming increasingly transparent and interna-tional investors gain diversification for an attractive spread.

The drive for innovation, balance sheet optimisation and evolution of the rating agencies’methods have increased the sophistication of market participants. The product is becoming in-creasingly complex, as new issuers and rating agency revisions lead to some new structuralnuances with certain product features.

We expect even more and better opportunities in 2007, as new markets open and an ever broaderrange of issuers benefit from hybrid security equity features. This is the exciting and challengingaspect of hybrids – they defy limiting definitions and are adaptable to evolving objectives.


29

Institutional

Retail private bank

78%

22%

Figure 2.30: Asia-Pacific investor market supply, 2006–H1 2007 (%)


Table 2.13: Global hybrid market supply, by issuer sector, 2006–H1 2007 (€, %)

% splitby investormarketUS European Asian

Issuer jurisdiction Volume (€. equiv) % investormarket investormarket investormarket Total

US 55,947 37 92 7 1 100Europe 74,071 49 21 74 5 100Asia-Pacific 19,332 13 22 22 56 100Other 2,979 2 73 27 0 100Total 152,329 100 – – – –


03CHAPTER

IntroductionHybrids are low cost equity! The growth and evolution of hybrid securities is due to the many‘equity benefits’ that hybrid securities provide. The bottom line is: if you need equity – hybrids aretypically the lowest cost form of equity or quasi-capital. A clear illustration of the benefits is viathe weighted average cost of capital (WACC) calculation, as will be demonstrated.

The Bank for International Settlements (BIS) bank capital guidelines have played a key role in thebeginnings of the asset class now called hybrid capital securities. The need for prescribedamounts of capital to support risky assets drives the behaviour of financial institutions that are byfar the most active issuer group for hybrid capital securities. Preferred stock (also calledpreference shares) are an example of the lower cost alternatives to common equity for meetingbank Tier 1 capital requirements. Hybrids are an evolution of preferred stock – engineered to bemore investor friendly and tax efficient for the issuer. Other forms of more debt-like subordinatedsecurities are permissible to form Tier 2 and Tier 3 capital. Since the late 1990s billions of hybridcapital securities were issued by banks to satisfy their regulatory capital requirements. Asinsurance companies also look to meet capital requirements under the developing solvency rules(which are converging with the bank capital rules) they too have turned to hybrid capitalsecurities. Hybrid capital securities provide the most cost-effective way to raise regulatory capitalfor banks and insurance companies.

A key catalyst to recent hybrid new issue volume growth was the publication of hybrid securityequity credit guidelines from all of the major rating agencies (Moody’s, S&P, Fitch). Theseguidelines made it clear that rating agencies view the financial flexibility and equity-like charac-teristics of hybrid securities very favourably when conducting their financial analysis of theissuer’s balance sheet and key financial ratios such as debt/equity leverage ratios. As hybridsprovide these benefits they strengthen the capital structure of the issuer and provide support forthe ratings at their current level. Issuing a hybrid capital security instead of senior debt is a low-cost way to complete a debt financing in a ‘leverage light’ fashion because the hybrid adds someequity to the issuer’s balance sheet in the rating agency ratio calculations but costs the issuer farless than issuing common stock. Although these benefits were often pursued via hybrid issuanceprior to the publication of the guidelines, the black and white prescription for equity credit in theguidelines gave potential issuers a greater belief in the rating agency conviction toward the valueof hybrids in the capital structure.

The rating agency publications coincided with an explosion in debt-financed M&A activity and theuse of hybrid capital securities in M&A was a key feature of many of the major deals that werecompleted. In addition issuers used hybrids for accounting equity, currency hedging, and pensionliability funding. The list of possible issuer rationales continues to grow and in some cases hasnothing to do with the original catalysts of regulatory capital or rating agency equity. Logicallythe types of issuers have gone beyond regulated financial institutions to include corporate issuersfrom a variety of sectors such as utilities, manufacturing, REITS, gaming, travel/leisure, energyand consumer products.

The rationale for issuanceHybrids are low-cost equity from a WACC perspective. The academic framework of the capitalasset pricing model (CAPM) can be borrowed to demonstrate how hybrids can be a smart way toreduce the WACC and increase ROE which should add value to the common shareholdersinvested in the hybrid issuer. In this example it is assumed that a hypothetical issuer rated in theBBB level needed to raise funds and a hybrid is evaluated compared to a combination package ofpart senior debt and part common stock. Using the Moody’s terminology of Basket C (50% equity)and Basket D (75% equity) Figure 3.2 shows the added value and cost savings (calculated in basispoints) provided by using a hybrid capital security instead of the debt/equity combo package.

WHY ISSUE HYBRID CAPITAL SECURITIES?

31

When comparing the gross fixed annual cost of the hypothetical hybrid security to a debt/equitycombo package it is clear that both the Basket C and Basket D scenario produce a significant costbenefit (approximately 120 to 230bp) for the hybrid issuer.

What is even more compelling is the after-tax comparison, where the hybrid payments arestructured to achieve tax deductibility and savings of 242bp and 390bp respectively are achievedby issuing the hybrid instead of the debt/equity combo.

In this hypothetical example where it was assumed that a hybrid annual cost of about 6.5%(average cost between Basket C and Basket D) and an after-tax cost of about 4.5% it should be clearthat this also compares favourably to the current common dividend yield of some issuers. Whenthe current and future higher common dividends and their dilutive impact are considered thefixed hybrid cost looks very good indeed.


32

Europe USA United Kingdom

Risk premium : 6.94Risk free rate : 4.39Market return : 11.33









Japan Hong Kong Canada

Denmark Sweden Australia

Expected market returns range between 9-12%

Figure 3.1: The cost of common equity (expected market return), by country (%)

Source: Bloomberg L.P.

Figure 3.2: WACC calculation – common equity vs. hybrid debt (%)

Hypothetical assumptions (all numbers illustrative only)1 - Senior Spread of +75bp over Mid-Swap giving a cost of 10yr Debt of 4.92% before tax2 - Corporate Tax Rate of 30%3 - Cost of Equity (Refer to Cost of Common Equity Figure 3.1)4 - Hybrid Costs are based on Corporate Hybrid secondary trading levels which are subject to change5 - Methodology used: Capital Asset Pricing ModelSource: Compiled by CALYON

Equity

10-yr senior debt

Cost before tax (%)

10.25

4.92

Cost after tax (%)

10.25

3.44

-242bp

-390bp75% Equity + 25% 10-yr senior debt

100% Hybrid (basket D)

8.917

6.63

8.548

4.65

50% Equity + 50% 10-yr senior debt

100% Hybrid (basket C)

7.585

6.310

6.845

4.42

For issuers that expect the market value of their common equity shares to continue to increaseover the forecast future period (such as issuers engaged in share buybacks) it is much cheaper toissue the fixed cost non-dilutive hybrid now and retain all the upside of the common stock for thecurrent common shareholders (the hybrid inflicts no new share issue dilution). For the samereason the issue of a fixed cost hybrid will most often be less expensive than a convertible orequity-linked security if the potential dilution of the convert is taken into account as shown inFigure 3.3 for an issuer with average or greater forecast annual growth (expressed as theCompound Annual Growth Rate – CAGR).

Recent hybrid security issuance has also been stimulated by clarity in the published methodolo-gies used by the three major rating agencies on the overall impact of hybrid capital in capitalstructure and on the issuers’ senior debt ratings. This has allowed both issuers and investors tomake better informed assessments of the risks and benefits involved.

The increased dialogue with investors and financial engineers is leading to product evolution andenhancements that will bring the hybrid security benefits to an ever larger population ofinvestors and issuers globally. Since the latest methodologies in use by the rating agencies cangive a high level of equity credit for specific instruments there is fresh stimulus for corporateissuers and financial institutions that value the ratings support. In general the motivations forissuance across sectors can be summarised as in Figure 3.4. Banks are predominantly focused onthe regulatory aspects but the ratings benefits are taking on increased import. Insurancecompanies also focus on the regulatory capital aspects of hybrid securities but have shown a morerapid adoption of the ratings methods that should ensure high rating agency equity credit. Forunregulated corporate issuers the benefits are predominantly ratings driven but can sometimesbe driven by a desire to book accounting equity either alone or in addition to ratings agencyequity. The accounting equity motivation has even been exhibited by not-rated corporates wherethere is zero concern for the rating agency perspective. Given the strong market conditions andthe attractive pricing of hybrid securities, some issuers just view the addition of hybrid capital as acheap long-term funding and/or a way to diversify the investor base.


33

Cost of equity %

-5

Common equity

-4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

CAGR

-5

0

5

10

15

20

Convertible Sec.

Hybrid Capital Sec.

Figure 3.3: Evaluating equity alternatives - hybrid is low cost equity


Figure 3.4: Issuer motivations


InsuranceBanks

Regulatory Tier 1Capital

Regulatory Tier 1Capital

Ratings

Ratings

Corporates

Ratings

Accounting

Who issues hybrid capital securities?Recently, the hybrid capital securities market experienced record new issue volumes. The markethas seen a ‘new renaissance’ of hybrid capital structuring, and insurance companies' fundingneeds have been well supported by structural developments in the sector. With bank Tier 1supply remaining stable, the insurance sector was a key driver for growth, fuelled largely byM&A-related funding requirements and characterised by jumbo multi-tranche multi-currencytransactions in the global hybrid market.

Hybrid capital securities remain the most efficient way to optimise the capital structure, and themarket’s focus has led to continued evolution beyond a static definition along the debt-equitycontinuum. Hybrid securities can be compared to classical preferred stock and this ‘preferredstock paradigm’ serves a basis for defining quasi-equity. With the terms of classic preferred stocktweaked to reduce the equity characteristics just enough to enhance tax efficiency whilemaintaining regulatory and/or rating agency benefits, hybrid capital securities can be consideredas ‘synthetic preferred stock’ or equity-rich deeply subordinated debt capital. This approachprovides a useful framework for evaluating this growing fixed income asset class.

The current period is now reminiscent of the mid-1990s, when banks were rapidly innovatingcountry-specific variants of tax-efficient capital and issuance volumes surged. Investors wereattracted by yield, but wary of structural nuances and the potential for ‘embedded risk’ within theemerging hybrid asset class. Over time, structural details faded from significance, as greateroutstanding issuance volumes and liquidity led to understanding, commoditisation and perhaps adegree of complacency.

The major issuers therefore include:

0 Regulated financial institutions:- Bank Tier I regulatory capital;- Insurance Tier I equivalent regulatory capital;

0 Corporate hybrid (rating agency or accounting equity, quasi-capital).

Banks – The banks led the dynamic global development of hybrids (cheap regulatory Tier 1capital) and early investors took comfort from generally high credit quality, the importance ofmarket liquidity/reputation, and assumed regulatory support for major banks. The ‘belief’ is thatgenerally major banks will make payments, will call at the first call date and if failing, the banksconsidered ‘too big to fail’ will be bailed out or supported and smaller banks may be merged bythe national regulator for the sake of the overall financial system. History supports this for themajority of banks and bank capital securities are often more ‘equity-like’ than other sectors.

Most banks around the world have typically been obliged by their national banking regulators tomaintain a certain amount of equity capital to support their business risks. This regulatory capitalserves as a protection for depositors and creditors against unexpected losses as these can beabsorbed by the capital, thereby cushioning the claims of depositors or the repayment of debt.Capital security features also provide financial institutions with flexibility.

The global hybrid funding opportunity is one of the major themes set to continue in the capitalmarkets. Hybrid issuance via multi-tranche, multi-currency transactions in markets around theworld has allowed for increased product capacity, which has helped to facilitate very large M&Afunding requirements. New and developing markets have also been targeted by issuers todiversify the investor base and maintain overall price tension.

Insurance companies – Hybrids have been used by insurance companies for both capital andrating agency equity in the past. They have been issuing hybrid capital in anticipation of theconvergence of bank capital regulation under Basel II with the insurance capital regulation underSolvency II and also to support the strategically important credit ratings of the issuer. The benefitsof hybrid issuance are heightened in an M&A scenario.

On the Insurance side one such issuer was Axa, which successfully raised €3.8bn equivalent ofTier 1 capital in 2006 – the largest annual hybrid funding exercise from a European insurer at thattime. This was achieved via a number of multi-tranche transactions worldwide – the proceeds ofwhich were to be used to refinance the €7.9bn acquisition of Winterthur from Credit Suisse. Thefirst transaction in June comprised three tranches, a £500m Perp nc 10, £350m Perp nc 20 and€1bn Perp nc 10.


34

Axa also achieved further diversification and successfully tapped ‘new world’ hybrid marketsincluding the Australian dollar market (the first to issue an Australian dollar Tier 1 Basket Dsecurity), followed by a dual-tranche long duration US dollar transaction in December.

Clarification of the Italian fiscal and regulatory classification of hybrid Tier 1 securities paved theway for the first insurance sector hybrid Tier 1 deal from Italy, with Generali issuing €2.8bnequivalent in June. Generali also benefited from the three-pronged approach, pricing a Euro-Sterling array comprising three tranches, a €1.275bn perpetual nc 10, £700m perp nc 10 and£350m perp nc 20.

Further cross-border issuance was also seen from Swiss Re, which tapped the US dollar market viaa dual-tranche Euro–US dollar issue in May. This was in spite of the NAIC chill in the US market atthe time. This followed the reassessment of the Lehman ECAPS issue and other US dollar hybridsecurities by the NAIC, which had a profound effect on the market in the second quarter, causingwider Tier 1 US dollar spreads and severe but temporary limitations to US market access (see theNAIC website: www.naic.org).

For insurance companies the business risks differ from banks, the credit quality is on averagelower than major banks, there is less historical data, regulation is less developed and marketliquidity is less essential. Investors require increased structural protection in insurance hybrids,given the relatively higher business risks of insurance companies and less regulatory oversight.The issuers have complied to reduce hybrid issue costs and optimise the equity benefits. Germaninsurers were among early hybrid pioneers and some of the quirks of the German tax code shaped the development of the current insurance hybrids as discussed in the structuring sectionof this publication.

Non-regulated corporate/industrial companies – These hybrid issuers are usually seeking ratingagency or accounting equity at a lower cost than common stock or equity-linked issuance. Ingeneral, non-dilutive hybrid capital securities are the cheapest form of equity capital forcompanies that are regulated, or fast growing, or have an average or higher equity cost. Corporatehybrid issuers exhibit the least systemic support (unregulated, lower liquidity/reputation motives,perhaps less market sophistication/financial dexterity). Therefore more heterogeneous featuresand a faster reversion back towards the certainty of traditional debt in structuring corporatehybrids can be observed– particularly where rating agency equity is not a key driver.

Figure 3.5 gives an overview of some of the corporate issuers and an indication of what their issuancerationale may be in deciding to issue hybrid securities. Some issuers have multiple overlapping rationales.


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Figure 3.5: Issuance rationale for select corporate issuers


SOLVAY

LOTTOMATICA

TUI

VINCI

REXAM

WIENERBERGER

M&G

VOESTALPINE

PFLEIDERER

EUROGATE

HENKEL

CEMEX

OTTO

VATTENFALL

CASINO

DONG

MICHELIN

GLENCORE

SUEDZUCKER

BAYER

UNION FENOSA

THOMSON

LINDE

PORSCHE

IVG

CLAAS

EUROFINS SCIENTIFIC

BEHR

SIEMENS

M&ANon dilutive

capitalPension

obligations

Foreign Currency Hedging

Strengthening capital structure(including debt refinancing)

Drivers for issuing hybrid capital securitiesHybrids can help support a number of strategic initiatives, including but not limited to thefollowing:

0 Raise regulatory capital;0 Strengthen rating agency credit metrics;0 Finance M&A activity; 0 Balance sheet optimisation;0 Reduce WACC, increase ROE;0 Enable common equity buyback; 0 Make special dividend payments;0 Refinance pension or other liabilities.

There are also opportunistic reasons to issue hybrids, including:

0 Attractive pricing;0 Permanent funding;0 Tapping new investor base.

In sum, financial flexibility is a key benefit to ‘equity’ and hybrids are very low-cost equity.

Below, some of the landmark corporate hybrid deals are discussed to give some insight into thecommercial rationalisation for their issuance. Among the pioneering issuers were Linde andMichelin, which helped develop the market well ahead of the release of the Moody’s Toolkit andsubsequent rating agency publications.

MichelinA landmark deal in European hybrid capital was Michelin's subordinated offering launched in2003. The 30-year nc 10 structure proved popular with investors at issue and it pre-dated therelease of clarifying comments from the rating agencies on how to get more equity credit.Michelin Finance, the issuing entity, was rated Baa1/BBB+, so the notched subordinated bond wasrated Baa3/BBB-. The hybrid security strategy, allowed Michelin to increase its long-term capitalbase without diluting its common equity share capital and dilution was something the majorshareholders (the Michelin family) wanted to avoid. This is a common theme among family-owned businesses.

LindeGerman industrial gas and engineering group Linde issued hybrid securities to refinance seniordebt via its finance arm, Linde Finance, which issued €400m in perpetual nc 10 subordinatedbonds. Linde’s deal was considered the first undated Euro-denominated subordinated offering bya European corporate targeted to the European institutional market, and opened up a newmarket in hybrid capital for the non-financial corporate universe. By using the proceeds torefinance senior debt, Linde will be able to strengthen its capital base and demonstrate itscommitment to its credit ratings.

The surge of corporate issuance which heralded the ‘next generation’ of corporate hybridsincluded Südzucker, Vattenfall and DONG. These well known and high-quality issuers providedlarge, liquid institutionally targeted ‘benchmark’ hybrid transactions within a short span of time– commanding the attention of investors and the financial media for an emerging new asset class.Among these deals the variety of terms within the structures demonstrated the diversity offeatures that could differentiate quasi-equity hybrids in accordance with the new rating agencyguidelines while allowing for differences in national legal and tax regimes. Linde later issued thefirst Sterling corporate hybrid.

Südzucker, Vattenfall and DONGGerman sugar manufacturer Südzucker priced its €500m perpetual nc 10 and the Swedish state-owned utility Vattenfall opted for a similar structure for its €1bn deal. Vattenfall managed togenerate a higher level of equity treatment from S&P with 60% equity credit and Basket Dtreatment (75% equity) from Moody's. Südzucker also achieved Basket D treatment with Moody'sbut was assigned 50% equity from S&P. All issuers looking at the hybrid security market areattracted by the more generous ratings treatment now assigned to such structures and for state-owned entities – for which issuing equity is more difficult – the hybrid security structure offers anew solution for generating equity credit.


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“Due to the government ownership structure, we have restricted access to equity capital and wesaw this as an interesting alternative. We have been working on the transaction for 10–11 weeks,but did not make the decision to launch a transaction until this week, when we had the feedbackfrom the roadshow. Vattenfall has been looking at the hybrid capital market for quite some time,but has previously disregarded it since volumes obtainable were not meaningful within thecontext of our balance sheet and the ratings agencies were less clear on their treatment of suchtransactions," said Anders Lidefelt, treasurer of Vattenfall at the time in discussion with IFR.

Danish state-owned utility Dansk Olie Og Naturgas (DONG) generated more than €3bn of demand forits €1.1bn hybrid. The choice of a 1,000 year maturity rather than perpetual reflects the differing taxrequirements across jurisdictions, making a Danish perpetual less efficient from a tax perspective.

"We viewed the hybrid as a way of raising equity capital for an issuer with limited access to equity.The decision came from some recent M&A activity where we had the option of paying in sharesand by selling the hybrid we were able to exceed our equity requirements," said MortenBuchgreitz, head of treasury and risk management at DONG in discussion with IFR.

Although the DONG transaction follows the basic structure seen for the two earlier transactions,there are some structural differences, with the DONG hybrid achieving a slightly lower levelequity treatment with Moody's (50% or Basket C). The issuer chose a more bond-like structure thatdid not have the mandatory deferral mechanism and was quasi-cumulative. While the Moody’sBasket C equity credit is lower, the investor pricing was more attractive for DONG and required alower premium to the senior bonds than a Basket D would have. "We were initially looking at 75%equity treatment, but chose 50% as a trade-off between the equity credit we could achieve and theprice we had to pay," said Buchgreitz.

"The hybrid product has applicability for a broad range of sectors and is a long-overdue developmentfor European corporates. We are currently in a sweet spot where it makes sense for a lot of issuersand is probably cheaper now than it might be in the future," said Steve Sahara at the time of the deal.

HenkelGerman consumer products company Henkel issued a €1.3bn 99-year nc 10 hybrid to fund itspension liabilities. The Fortune Global 500 company used the hybrid security proceeds toestablish a contractual trust arrangement (CTA) for the benefit of the employees owed a pension.The pension trust will provide for investment to meet pension obligations when they come due.Henkel used the hybrid very effectively to fund the employee pension liability, thereby furtherenhancing employee morale and meeting socially important commitments. The paymentflexibility of the Henkel hybrid considered in the overall capital structure was far more ratingsfriendly than if the pension liability were to be funded with senior debt issuance and the hybridprovided a far lower cost than an issuance of common equity. If Henkel were to suffer financialdistress the hybrid can absorb losses and allow for cash conservation. Senior debt would not dothis and nor would the employee pension liabilities. So replacing the inflexible pension liabilitywith the more flexible hybrid should be a real positive factor for the issuer’s credit profile. Asmore companies come under pressure to address large and growing unfunded employee pensionschemes the Henkel example may provide an alternative for many other issuers to consider.

PorscheGerman car manufacturer Porsche issued a US$1bn perpetual nc five hybrid sub-debt. The strongname recognition overcame the lack of a credit rating. The structure includes optional deferral ofpayments if no common equity dividend is paid, and deferred coupons are cumulative. The dollar-denominated hybrid generated global demand driven by Asian RPB investors who have tradition-ally purchased subordinated bonds from the global banking sector. For Porsche, the transactionprovides a currency hedge against US dollar receivables. Despite the subordinated, cumulativestructure, the hybrid achieves full equity accounting treatment under IFRS because of thepayment discretion provided. Porsche’s hybrid was a market leader ahead of the now increasingnumber of corporates that are using hybrids to benefit from an accounting perspective.


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GlencoreLike Porsche, Glencore also visited the Asian RPB markets with a US$700m perpetual nc fivesenior issue. The bonds were also placed primarily with Asian and Swiss Private Banks. Sincethere is no ratings benefit intended or accounting equity credit assigned, the issuance rationalecomes down the fact that Glencore is a privately held company that has not tapped capitalmarkets to raise common equity capital. Although there is no equity credit assigned to the paperfrom an accounting standpoint, as a perpetual security, Glencore obtains low-cost, long-termquasi-capital with no incentive for calling the issue at the call date after the first five years.Furthermore, the hybrid security is non-dilutive allowing the common equity owners to retain allupside and voting control in the privately held company.

CEMEXCEMEX, the Mexican cement company, issued a US$1.25bn hybrid security in 2006. The uniquedual-tranche (US$900m perp nc 10 and US$350m perp nc 5) transaction was driven by themotivation to hedge FX exposure from some Asia business units with an equity-like instrumentissued in dollars and euros, and to gain accounting equity treatment. CEMEX was not specificallyseeking to improve the capital structure of the company, nor to upgrade its existing rating.CEMEX followed up its successful hybrid debut with another issue in May 2007, this time tappingthe Euro market for a €730m hybrid perp nc 10 transaction.


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Interview

The following Q&A interview is with Johan Gyllenhoff, President of Vattenfall Treasury AB and Group Treasurerfor the Vattenfall Group. Based on 2006 figures, Vattenfall is the fourth largest generator of electricity and thelargest generator of heat in Europe. The company both produces and delivers electricity throughout Europe,and provides a wide range of additional energy solutions and services, in addition to add-on services such astelecoms.

Vattenfall is also a pioneer in the European debt markets, achieving significant success with their €1bn hybridissue, one of the first corporate hybrid transactions to be issued after the rating agencies gave clarification totheir guidelines in 2005.

This interview provides an interesting insight into the main drivers for issuing hybrid securities, and alsohighlights the subsequent benefits achieved from such a transaction.

What have been the main drivers of your decision to issue hybrids? As Vattenfall is a government-owned company its access to capital through issuing new equity is more limitedthan for its listed peers and competitors. Therefore, seeking a substitute instrument geared to the ratingagencies that would provide us with significant equity credit is very interesting, especially as we have a verystrong management commitment to a single A rating. In general, you can say that hybrids work well forcompanies that operate in a stable and profitable business and also want to grow and take market sharethrough acquisitions, which is the case for Vattenfall.

How has the issuance of hybrids delivered the intended benefits or failed to do so? The issue of the hybrid security immediately lowered our average cost of capital and at the same time gave usgreater financial flexibility, i.e. improved our capital base. An alternative for us could of course have been tocreate the same base for growth by ‘sitting and waiting’ for operating cash flow to accumulate. That wouldhave taken us about one-and-a-half years, so effectively we bought ourselves ‘time’.

What advice, tips, or warning would you give a first-time hybrid issuer? Our experience is that you have to have many dialogues open at the same time in order to explain, convinceand/or educate your different stakeholders. One important party that is not mentioned in your question is theauditors. You need them ‘on the boat’ too. But the key is of course to educate and convince your Board ofDirectors and have a close dialogue with the rating agencies.

How might the new imposition of legally binding replacement language from S&P have impacted yourevaluation of issuing hybrids, if that requirement had existed at the time of your initial analysis of thehybrid opportunity?That is difficult to say. I believe we would have issued, but it would probably have looked different, as we have difficulties in accepting a legally binding replacement language.


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In general, does the perception of frequent shifting of rating agency requirements decrease the attrac-tiveness of hybrids as a corporate finance tool?In general, yes, but I guess that is something we will have to live with to at least some extent. The reason for thisprobably lies in the very nature of this mezzanine product and the problem of ‘pleasing many masters’, i.e.rating agencies, issuers, investors, tax authorities, auditors etc.

What changes, if any, would you like to see in future hybrids? Less change.

Interview

The following Q&A interview is with Johannes D. Wolvius, Head of Corporate Treasury at ING Group. INGGroup is a global financial services company, providing a wide array of banking, insurance and assetmanagement services in over 50 countries. Based on market capitalisation, ING is one of the 20 largestfinancial institutions worldwide, ranked in the top 10 in Europe and the number one financial servicescompany in Benelux.

ING is a frequent and prominent issuer in the global hybrid markets. Most recently in September 2007, INGlaunched a US$1.5bn hybrid capital transaction which was a notable success from both from a size andpricing perspective.

1) Can you describe the ING hybrid capital budgeting process you undertake each year to determinethe amount of hybrid capital you might raise in the next year (asset growth, business changes, hybridredemptions, etc)?On a yearly basis in December we draw up next year's funding plan, which is directly derived from ING'sMedium Term Plan for the next three years. With the funding plan we try to make sure that by the end ofeach year, ING's hybrid capacity is fully used to optimise our capital structure. We try to co-ordinate all capital markets activities for the Group and this plan is then used throughout the year and updated on aquarterly basis, taking into account factors such as our growth rate, the potential for acquisitions and thestate of the market.

Although we have quite a stringent plan set up at beginning of the year, we have a flexible approach andadjust it according to market circumstances and also time it well – throughout the year – if spreads are goodat the start of the year, we try to do more at that point and vice versa.

2) Can you tell us about the ING project you undertook to start with a ‘clean piece of paper’ and structuredyour own capital security? What were the benefits and/or challenges of this unique approach?Hybrid capital structuring has almost become an industry in itself. There has been a race among investmentbanks, rating agencies and regulators to include more and more features which adds to the complexity but, inour view, does not always improve the instrument. It is our responsibility and decision to stay the AA ratedcompany that we are. From our perspective hybrid capital should be about maximising financial flexibility. Wethink that it is not desirable to build future behaviour into hybrid capital through features such asreplacement covenants, certain mandatory deferral triggers or caps.

Earlier in the year, we conducted an independent review of our hybrid capital in order to maximise thefinancial flexibility that these instruments provide, make the instruments more equity-like from ourperspective, simplify the terms and conditions used and align the structures that we use in the European andUS markets. Two law firms (one international and one Dutch) were hired and we had extensive discussions onhow each of the features would work out in stress scenarios. Based on this, some adjustments to thestructures were made and we achieved our objectives. While we believe that we have optimised our structureto help us overcome any form of financial distress, from a Moody's perspective we are still only getting a 'B'qualification, which we see as a curious outcome of their methodology.

ConclusionMarket forces have conspired to create the perfect conditions for a boom in hybrid capitalsecurity supply and innovation. Investors’ quest for yield and issuers’ need to fund asset growthwhile also increasing ROE have produced a period of significant growth in hybrid issuanceworldwide. Regulators have become increasingly comfortable with the expanded use of hybridcapital given the robust nature of structures now possible in most international jurisdictions.

Amidst this positive backdrop, however, credit should be given to the major rating agencies thathave invested significant time to develop their own thinking around the essence of equity andhow it can be practically distilled within a security class that is also fiscally beneficial to issuersand marketable to fixed income investors. They have provided numerous educating publicationsand support to this growing market. Looking back over the history of hybrid capital gestation, anever changing and improving asset class can be observed, and looking forward that evolutionlooks set to continue from this rampantly fertile period.


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3) ING is an example of a bank/insurance issuer that successfully balances the dual requirements oftwo regulatory constituents simultaneously. Can you highlight the way you approach this complextask (any difficulty in reconciling regimes etc)?

Our main objective is to make sure that ING Groep NV, ING Bank NV and ING Verzekeringen NV are capitalisedaccording to the AA standard independent of each other. We have one issuing entity for our hybrid tier 1 transac-tions – the top holding company ING Groep NV – in order to achieve the maximum flexibility in the deploymentof the capital. In this way it can be assured that all terms and conditions of our hybrid capital are well aligned.Hybrid tier 1 raised by ING Groep NV is on-lent to either ING Bank NV or ING Verzekeringen NV where it can beused to support the business. This is done on the same conditions as it was placed in the market.

In terms of how we optimise the structure while reconciling the requirements of both sets of rules for banksand insurers, we have so far focused mainly on the guidelines for Bank Tier 1 Capital which are very specific,and have then applied this for insurance capital purposes. We primarily manage our business according to ourown economic capital models and then try to achieve ensure that rating agency credit and the rating agencyassessment of capitalisation follow suit.

4) You expressed a desire to "keep your hybrid capital simple" and have also chosen not to pursue thecomplexities of the high equity rating agency ‘baskets’. We have also seen this choice from highlyrated Banks that issue ‘pure Tier 1’ only. However many large insurance groups including otherBenelux bank/insurers have gone for Basket C and Basket D hybrid structures - what are the keydrivers of ING's decision?We are concerned about basket treatment and, in principle, we would be inclined to strive for a higher basket.But in order to achieve that, rating agencies require us to add features which we think would limit ourfinancial flexibility. For example, in the case of mandatory deferral and replacement capital covenants thereare instances when it would limit our ability to deal with financial distress. We would only change our hybridterms if it would result in a structural improvement. Our strategy is to be consistent and transparent towardsour hybrid capital holders; not to change our hybrids according to the flavour of the day.

5) What is your thinking about the hardening of S&P's new requirement for legally bindingreplacement language for unregulated step up hybrids?ING values its AA rating and aims to maintain that rating because we think it's important for our clients andother counterparts. From that perspective, we think that the rating agencies should not be overly focused onthe permanence of our capital. If we were to choose to reduce our overall capitalisation, there are many moreways to do this such as entering into large acquisitions or share buybacks. In this context, we are unsure as towhy the rating agencies feel so strongly about replacement language when we have always had the flexibilityto utilise our own capital.


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Table 3.1: A selection of major hybrid capital deals

Issue date Issue FirstIssuer (year) Currency size (m) Coupon call date Maturity

AAuussttrraalliiaaANZCapital Trust I 2003 US$ 750 5.3600 Dec-13 PerpetualANZCapital Trust I 2003 US$ 350 4.4840 Jan-10 PerpetualANZCapital Trust III 2004 € 500 FRN Dec-14 PerpetualCBA Capital Trust 2 2006 US$ 700 6.0240 Mar-16 PerpetualMacquarie Capital Funding LP 2004 £ 350 6.1770 Apr-20 PerpetualNational Capital Instruments (Euro) LLC2 2006 € 400 FRN Sep-16 PerpetualNational Capital Trust I 2003 £ 400 5.6200 Dec-18 PerpetualNational Capital Trust II 2005 US$ 800 5.4860 Mar-15 PerpetualQBE Capital Funding LP 2006 £ 300 6.8570 Jul-16 PerpetualQBE Capital Funding LP 2007 US$ 550 6.7970 Jun-17 PerpetualWestpacCapital Trust III 2003 US$ 750 5.8190 Sep-13 PerpetualWoolworths Ltd 2006 A$ 600 FRN Sep-11 Perpetual

AAuussttrriiaaErste Capital Finance (Jersey) Tier1 PC 2006 € 400 5.2940 Sep-16 PerpetualErste Finance (Jersey) 4 Ltd 2004 € 275 FRN Mar-09 PerpetualErste Finance (Jersey) 6 Ltd 2005 € 200 5.2500 Sep-10 PerpetualErste Finance (Jersey) Ltd 1999 € 100 6.6250 Feb-04 PerpetualHypo Alpe-Adria (Jersey) II Ltd 2004 € 130 6.5000 Oct-11 PerpetualKommunalkredit Austria AG 2006 € 150 5.4500 May-36 PerpetualOesterreichische Volksbanken AG 2004 € 250 6.0000 Sep-11 PerpetualRZB Finance (Jersey) II Ltd 2004 € 200 6.0000 Jun-09 PerpetualRZB Finance (Jersey) II Ltd 2003 € 100 5.8950 Jul-13 PerpetualRZB Finance (Jersey) Ltd 2006 € 500 5.1690 May-16 PerpetualWienerbergerAG 2007 € 500 6.5000 Feb-17 Perpetual

BBeellggiiuummDexia Funding Luxembourg SA 2006 € 500 4.8920 Nov-16 PerpetualFortis BankSA/NV 2001 € 1,000 6.5000 Sep-11 PerpetualFortis BankSA/NV 2004 € 1,000 4.6250 Oct-14 PerpetualFortis Hybrid Financing 2006 € 500 5.1250 Jun-16 PerpetualSolvayFinance BV 2006 € 500 6.3750 Jun-16 Jun-2104

DDeennmmaarrkkDanske BankA/S 2004 US$ 750 5.9140 Jun-14 PerpetualDanske BankA/S 2007 € 600 4.8780 May-17 PerpetualDONG A/S (Danish Oil & Natural Gas) 2005 € 1,100 5.5000 Jun-15 PerpetualNykredit 2004 € 500 4.9010 Sep-14 Perpetual

FFrraanncceeAXASA 2006 € 1,000 5.7770 Jul-16 PerpetualAXASA 2006 £ 500 6.6666 Jul-16 PerpetualAXASA 2006 £ 350 6.6862 Jul-26 PerpetualAXASA 2006 US$ 750 6.3790 Dec-36 PerpetualAXASA 2006 US$ 750 6.4630 Dec-18 PerpetualBanque Federative du Credit Mutuel 2004 € 750 6.0000 Dec-14 PerpetualBanque Federative du Credit Mutuel 2005 € 600 4.4710 Oct-15 PerpetualBNPParibas Capital Trust 2000 US$ 500 9.0030 Oct-10 PerpetualBNPParibas Capital Trust III 2001 € 500 6.6250 Oct-11 PerpetualBNPParibas Capital Trust IV 2002 € 660 6.3420 Jan-12 PerpetualBNPParibas Capital Trust V 2002 US$ 650 7.2000 Jun-07 PerpetualBNPParibas Capital Trust VI 2003 € 700 5.8680 Jan-13 PerpetualBNPParibas SA 2005 US$ 1,350 5.1860 Jun-15 PerpetualBNPParibas SA 2005 € 1,000 4.8750 Oct-11 PerpetualBNPParibas SA 2006 € 750 4.7300 Apr-16 PerpetualBNPParibas SA 2006 £ 450 5.9450 Apr-16 PerpetualBNPParibas SA 2007 € 750 5.0190 Mar-17 PerpetualBNPParibas SA 2007 US$ 1,100 7.1950 Jun-37 PerpetualCA Preferred Funding Trust 2003 US$ 1,500 7.0000 Jan-09 PerpetualCA Preferred Funding Trust III 2003 € 550 6.0000 Jul-09 Perpetual


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Table 3.1: A selection of major hybrid capital deals (continued)


Caisse Nationale des Caisses d'Epargne 2003 € 800 5.2500 Jul-14 Perpetualet de Prevoyance - CNCEPCaisse Nationale des Caisses d'Epargne 2004 € 700 4.6250 Jul-15 Perpetualet de Prevoyance - CNCEPCasino Guichard-Perrachon SA 2005 € 500 7.5000 Jan-10 PerpetualCLCapital Trust I 2002 € 750 7.0470 Apr-12 PerpetualCNPAssurances SA 2006 € 1,250 4.7500 Dec-16 PerpetualCompagnie Generale des Etablissements Michelin 2003 € 500 6.3750 Dec-13 03 Dec2033Credit Agricole SA 2005 € 600 6.0000 Feb-10 PerpetualCredit Agricole SA 2005 € 600 4.1300 Nov-15 PerpetualCredit Agricole SA 2006 £ 500 5.1360 Feb-16 PerpetualCredit Logement 2006 € 800 4.6040 Mar-11 PerpetualSG Capital Trust I 2000 € 500 7.8750 Feb-10 PerpetualSG Capital Trust III 2003 € 650 5.4190 Nov-13 PerpetualSociete Generale 2005 € 1,000 4.1960 Jan-15 PerpetualSociete Generale 2007 US$ 1,100 5.9220 Apr-17 PerpetualThomson SA 2005 € 500 5.7500 Sep-15 PerpetualVinci SA 2006 € 500 6.2500 Nov-15 Perpetual

GGeerrmmaannyyAllianzFinance BV 2005 € 1,400 4.3750 Feb-17 PerpetualAllianzFinance II BV 2006 € 800 5.3750 Mar-11 PerpetualBayerAG 2005 € 1,300 5.0000 Jul-15 29 Jul 2105BayernLB Capital Trust I 2007 US$ 850 6.2032 May-17 PerpetualCommerzbankCapital Funding Trust I 2006 € 1,000 5.0120 Apr-16 PerpetualCommerzbankCapital Funding Trust II 2006 £ 800 5.9050 Apr-18 PerpetualDepfa Funding IVLP 2007 € 500 5.0290 Mar-17 PerpetualDeutsche BankCapital Finance Trust VII 2006 US$ 800 5.6280 Jan-16 PerpetualDeutsche BankCapital Funding Trust I 1999 US$ 650 7.8720 Jun-09 PerpetualDeutsche BankCapital Funding Trust IV 2003 € 1,000 5.3300 Sep-13 PerpetualDeutsche BankCapital Funding Trust VI 2005 € 900 6.0000 Jan-10 PerpetualDeutsche PostbankFunding Trust II 2004 € 500 6.0000 Dec-09 PerpetualDeutsche PostbankFunding Trust IV 2007 € 500 5.9830 Jul-17 PerpetualEurohypo Capital Funding Trust I 2003 € 600 6.4450 May-13 PerpetualFuerstenberg Capital GmbH II 2005 € 550 5.6250 Jun-11 PerpetualHenkel KGaA 2005 € 1,300 5.3750 Nov-15 Nov-2104HT1 Funding GmbH 2006 € 1,000 6.3520 Jun-17 PerpetualHVB Funding Trust VIII 2002 € 600 7.0550 Mar-12 PerpetualLandesbankSchleswig-Holstein 2002 € 500 7.4075 Jun-14 PerpetualGirozentrale - LB KielLinde Finance BV 2006 € 700 7.3750 Jul-16 Jul-66MuenchenerRueckversicherungsgesellschaft 2007 € 1,500 5.7670 Jun-17 PerpetualAG - Munich ReOtto Finance Luxembourg A.G. 2005 € 150 6.5000 Aug-12 PerpetualPorsche International Financing plc 2006 US$ 1,000 7.2000 Feb-11 PerpetualSiemens Financieringsmaatschappij NV 2006 € 900 5.2500 Sep-16 Sep-66Siemens Financieringsmaatschappij NV 2006 £ 750 6.1250 Sep-16 Sep-66Suedzucker International Finance BV 2005 € 700 5.2500 Jun-15 PerpetualTUIAG 2005 € 300 8.6250 Jan-13 Perpetual

GGrreeeecceeAlpha Group JerseyLtd 2005 € 600 6.0000 Feb-15 PerpetualEFG FiduciaryCertificates 2004 € 325 6.5000 Apr-10 PerpetualEFG FiduciaryCertificates 2004 € 75 6.5000 Apr-10 PerpetualEFG Hellas Funding Ltd 2005 € 200 6.7500 Mar-10 PerpetualEFG Hellas Funding Ltd 2005 € 400 4.5650 Nov-15 PerpetualEFG Hellas Funding Ltd 2005 € 150 6.0000 Jan-11 PerpetualEFG Hellas Funding Ltd 2005 € 50 6.0000 Jan-11 PerpetualNational Bankof Greece Funding Ltd 2003 € 350 FRN Jul-13 PerpetualNational Bankof Greece Funding Ltd 2004 € 350 6.2500 Nov-14 PerpetualNational Bankof Greece Funding Ltd 2004 US$ 180 6.7500 Nov-14 PerpetualNational Bankof Greece Funding Ltd 2005 € 230 6.0000 Feb-15 Perpetual


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National Bankof Greece Funding Ltd 2006 £ 375 6.2889 Nov-16 PerpetualPiraeus Group Finance plc 2004 € 200 FRN Oct-14 Perpetual

IIrreellaannddAIB UK2 LP 2006 € 500 5.1420 Jun-16 PerpetualAllied Irish Banks plc 2001 € 500 7.5000 Feb-11 PerpetualAnglo Irish Asset Finance 2002 £ 160 7.6250 Jul-27 PerpetualAnglo Irish Capital (2) UKLP 2006 € 600 5.2190 Sep-16 PerpetualAnglo Irish Capital Funding Ltd 2004 € 600 6.0000 Sep-10 PerpetualAnglo Irish Capital Funding Ltd 2004 € 600 6.0000 Sep-10 PerpetualBankof Ireland UKHoldings plc 2001 € 600 7.4000 Mar-11 PerpetualBankof Ireland UKHoldings plc 2003 £ 350 6.2500 Mar-23 PerpetualBOI Capital Funding (No 1) LP 2005 € 600 6.2500 Mar-10 PerpetualBOI Capital Funding (No 2) LP 2006 US$ 800 5.5710 Feb-16 PerpetualBOI Capital Funding (No 3) LP 2006 US$ 400 6.1070 Feb-16 PerpetualBOI Capital Funding (No 4) LP 2006 £ 500 6.4295 Apr-17 PerpetualChess Capital Securities plc 2005 € 125 4.8300 Jul-15 PerpetualLambayCapital Securities plc 2005 £ 300 6.2500 Jun-15 PerpetualSaphirFinance plc 2006 £ 600 6.3690 Aug-15 Perpetual

IIttaallyyAssicurazioni Generali SpA 2007 € 1,250 5.4790 Feb-17 PerpetualAssicurazioni Generali SpA 2007 £ 495 6.4160 Feb-22 PerpetualBanca Popolare di Lodi InvestorTrust III 2005 € 500 6.7420 Jun-15 PerpetualGenerali Finance BV 2006 € 1,275 5.3170 Jun-16 PerpetualGenerali Finance BV 2006 £ 700 6.2140 Jun-16 PerpetualGenerali Finance BV 2006 £ 350 6.2690 Jun-16 PerpetualIntesaBci Capital B 2001 € 500 6.9880 Jul-11 PerpetualLottomatica SpA 2006 € 750 8.2500 Mar-16 Mar-66San Paolo IMI Capital Trust I 2000 € 1,000 8.1260 Nov-10 PerpetualUniCredito Italiano Capital Trust 1 2000 € 540 8.0480 Oct-10 PerpetualUniCredito Italiano Capital Trust 2 2000 US$ 450 9.2000 Oct-10 PerpetualUnicredito Italiano Capital Trust 3 2005 € 750 4.0280 Oct-15 Perpetual

JJaappaannKUBCPreferred Capital Cayman Ltd 2007 ¥ 12,500 3.4600 Jul-12 PerpetualMizuho Capital Investment (€) 1 Ltd 2006 € 500 5.0200 Jun-11 PerpetualMizuho Capital Investment (US$) 1 Ltd 2006 US$ 600 6.6860 Jun-16 PerpetualMTFG Capital Finance Ltd 2005 ¥ 165,000 2.5200 Jan-11 PerpetualMUFG Capital Finance I Ltd 2006 US$ 2,300 6.3460 Jul-16 PerpetualMUFG Capital Finance II Ltd 2006 € 750 4.8500 Jul-16 PerpetualMUFG Capital Finance III Ltd 2006 ¥ 120,000 2.6800 Jul-16 PerpetualMUFG Capital Finance IVLtd 2007 € 500 5.2710 Jan-17 PerpetualMUFG Capital Finance IVLtd 2007 £ 550 6.2990 Jan-17 PerpetualResona Preferred Global Securities (Cayman) Ltd 2005 US$ 1,150 7.1910 Jul-15 PerpetualShinsei BankLtd 2006 US$ 775 6.4180 Jul-16 PerpetualShinsei BankLtd 2006 US$ 700 7.1600 Jul-16 PerpetualSMFG Preferred Capital £ 1 Ltd 2006 £ 500 6.1640 Jan-17 PerpetualSMFG Preferred Capital US$ 1 Ltd 2006 US$ 1,650 6.0780 Jan-17 Perpetual(Sumitomo Mitsui)STB Preferred Capital 3 (Cayman) Ltd 2007 ¥ 50,000 2.8300 Jul-17 Perpetual

LLuuxxeemmbboouurrggBanque Internationale a Luxembourg SA 2001 € 225 6.8210 Jul-11 PerpetualBanque Internationale a Luxembourg SA 2001 € 275 6.8750 Jul-06 Perpetual

NNeetthheerrllaannddssABN AMRO BankNV 2006 € 1,000 4.3100 Mar-16 PerpetualABN AMRO Capital Funding Trust II 1999 US$ 1,250 7.1250 Apr-04 PerpetualABN AMRO Capital Funding Trust V 2003 US$ 1,250 5.9000 Jul-08 PerpetualABN AMRO Capital Funding Trust VII 2004 US$ 1,800 6.0800 Feb-09 PerpetualAEGON NV 2005 US$ 925 6.3750 Jun-15 Perpetual


44



ELM BV(Swiss Re) 2006 € 1,000 5.2520 May-16 PerpetualEureko BV 2006 € 600 6.0000 Nov-12 PerpetualING Capital Funding Trust III 2000 US$ 1,500 8.4390 Dec-10 PerpetualING Groep NV 2002 US$ 1,000 7.2000 Dec-07 PerpetualING Groep NV 2003 € 750 FRN Sep-13 PerpetualING Groep NV 2004 € 1,000 FRN Jun-14 PerpetualING Groep NV 2005 € 500 4.1760 Jun-15 PerpetualING Groep NV 2005 US$ 700 6.1250 Jan-11 PerpetualING Groep NV 2005 US$ 700 6.1250 Jan-11 PerpetualING Groep NV 2005 US$ 1,000 5.7750 Dec-15 PerpetualING Groep NV 2006 £ 600 5.1400 Mar-16 PerpetualING Groep NV 2007 US$ 1,500 7.3750 Oct-12 PerpetualRabobankCapital Funding Trust I 1999 € 650 7.0000 Dec-04 PerpetualRabobankCapital Funding Trust II 2003 US$ 1,750 5.2600 Dec-13 PerpetualRabobankCapital Funding Trust III 2004 US$ 1,500 5.2540 Oct-16 PerpetualRabobankCapital Funding Trust IV 2004 £ 350 5.5560 Dec-19 Perpetual

NNoorrwwaayyDnB NOR BankASA 2007 £ 350 6.0116 Mar-17 Perpetual

PPoorrttuuggaallBanif Finance Ltd 2004 € 75 FRN Dec-14 PerpetualBCPFinance Co 2004 € 500 5.5430 Jun-14 PerpetualBCPFinance Co 2005 € 500 4.2390 Oct-15 PerpetualBESFinance Ltd 2004 € 150 5.5800 Jul-14 PerpetualBESFinance Ltd 2003 € 450 5.5800 Jul-14 PerpetualBPI Capital Finance Ltd 2003 € 250 FRN Aug-13 PerpetualCaixa Geral de Depositos Finance 2004 € 250 FRN Jun-14 PerpetualCaixa Geral Finance Ltd (Cayman) 2005 € 350 FRN Sep-15 PerpetualESFG International Ltd 2007 € 400 5.7530 Jun-17 PerpetualTotta & Acores Financing Ltd 2005 € 300 4.1200 Jun-15 Perpetual

SSppaaiinnBanco de Sabadell SA 2006 € 500 5.2340 Sep-16 PerpetualBBVAInternational Preferred SA Unipersonal 2005 € 550 3.7980 Sep-15 PerpetualBBVAInternational Preferred SA Unipersonal 2006 € 500 4.9520 Sep-16 PerpetualBBVAInternational Preferred SA Unipersonal 2007 £ 400 7.0930 Jul-12 PerpetualBBVAInternational Preferred SA Unipersonal 2007 £ 400 7.0930 Jul-12 PerpetualBilbao Vizcaya International Ltd 1999 € 1,000 5.7600 Mar-04 PerpetualBSCH Finance Ltd 1999 € 1,000 5.5000 May-04 PerpetualCaymadrid Finance Ltd 1999 € 900 5.1500 Dec-04 PerpetualRepsol International Capital Ltd 2001 € 1,000 FRN Dec-11 PerpetualUnion Fenosa Preferentes SA 2005 € 750 FRN Jun-15 Perpetual

SSwweeddeennNordea BankAB 2004 € 500 FRN Sep-09 PerpetualSvenska Handelsbanken AB 2005 € 500 4.1940 Dec-15 PerpetualVattenfall TreasuryAB 2005 € 1,000 5.2500 Jun-15 Perpetual

SSwwiittzzeerrllaannddCredit Suisse (Guernsey) Ltd 2007 US$ 1,250 5.8600 May-17 PerpetualGlencore Finance Europe 2006 US$ 700 8.0000 Feb-11 PerpetualSwiss Re 2007 £ 500 6.3024 May-19 PerpetualSwiss Re GB plc 2006 US$ 750 6.8540 May-16 PerpetualUBSPreferred Funding Trust I 2000 US$ 1,500 8.6220 Oct-10 PerpetualUBSPreferred Funding Trust II 2001 US$ 500 7.2470 Jun-11 PerpetualUBSPreferred Funding Trust V 2006 US$ 1,000 6.2430 May-16 PerpetualZFSFinance (USA) Trust I 2005 US$ 600 6.1500 Dec-10 15 December

2065ZFSFinance (USA) Trust I 2005 US$ 700 6.4500 Dec-15 15 December

2065


45



UUKKAbbeyNational Capital Trust I 2000 US$ 1,000 8.9630 Jun-30 PerpetualAbbeyNational plc 2001 US$ 450 7.3750 Nov-06 PerpetualAIB UK1 LP 2004 € 1,000 4.7810 Dec-14 PerpetualAIB UK3 LP 2006 £ 350 6.2710 Jun-16 PerpetualAnglo Irish Capital (3) UKLP 2007 £ 350 6.9490 Jun-17 PerpetualAviva plc 2004 € 700 4.7291 Nov-14 PerpetualAviva plc 2004 £ 500 5.9021 Jul-20 PerpetualBarclays Bankplc 2000 € 850 7.5000 Dec-10 PerpetualBarclays Bankplc 2000 US$ 1,250 8.5500 Jun-11 PerpetualBarclays Bankplc 2001 US$ 750 7.3750 Dec-11 PerpetualBarclays Bankplc 2002 £ 400 6.0000 Jun-32 PerpetualBarclays Bankplc 2002 US$ 1,000 6.8600 Jun-32 PerpetualBarclays Bankplc 2004 € 1,000 4.8750 Dec-14 PerpetualBarclays Bankplc 2005 € 1,400 4.7500 Mar-20 PerpetualBarclays Bankplc 2005 US$ 1,000 6.2780 Dec-34 PerpetualBarclays Bankplc 2005 £ 750 6.0000 Dec-17 PerpetualBarclays Bankplc 2006 £ 500 5.3304 Dec-36 PerpetualBarclays Bankplc 2006 US$ 750 6.6250 Sep-11 PerpetualBarclays Bankplc 2007 £ 500 6.3688 Dec-19 PerpetualFriends Provident plc 2005 £ 500 6.2920 Jul-15 PerpetualHBOSCapital Funding LP 2001 £ 600 6.4610 Nov-18 PerpetualHBOSCapital Funding LP 2004 US$ 750 6.0710 Jun-14 PerpetualHBOSCapital Funding No 1 LP 2003 US$ 1,000 6.8500 Mar-09 PerpetualHBOSCapital Funding No 3 LP 2006 € 750 4.9390 May-16 PerpetualHBOSplc 2005 £ 750 6.0884 May-15 PerpetualHBOSplc 2005 US$ 750 5.9200 Oct-15 PerpetualHBOSplc 2005 US$ 750 6.4130 Oct-35 PerpetualHBOSplc 2006 £ 350 6.3673 Jun-19 PerpetualHBOSplc 2007 US$ 750 6.6570 May-37 PerpetualHSBCBankCapital Funding (Sterling 1) LP 2000 £ 500 8.2080 Jun-15 PerpetualHSBCBankCapital Funding (Sterling 1) LP 2003 £ 700 5.8440 Nov-31 PerpetualHSBCCapital Funding (Euro 1) LP 2000 € 600 8.0300 Jun-12 PerpetualHSBCCapital Funding (Euro 2) LP 2003 € 1,400 5.3687 Mar-14 PerpetualHSBCCapital Funding (Euro 3) LP 2004 € 750 5.1300 Mar-16 PerpetualHSBCCapital Funding (US$2) LP 2003 US$ 1,250 4.6100 Jun-13 PerpetualLegal & General Group plc 2007 £ 600 6.3850 May-17 PerpetualLloyds TSB Bankplc 2002 US$ 850 6.9000 Nov-07 PerpetualLloyds TSB Bankplc 2002 € 500 6.3500 Feb-13 PerpetualLloyds TSB Bankplc 2005 € 750 4.3850 May-17 PerpetualNationwide Building Society 2004 £ 400 5.7690 Feb-26 PerpetualNationwide Building Society 2007 £ 350 6.0240 Feb-13 PerpetualOld Mutual plc 2005 £ 350 6.3760 Mar-20 PerpetualPrudential plc 2003 US$ 1,000 6.5000 Dec-08 PerpetualRBSCapital Trust 1 2003 US$ 850 4.7090 Jul-13 PerpetualRBSCapital Trust A 2002 € 1,250 6.4670 Jun-12 PerpetualRBSCapital Trust B 2002 US$ 750 6.8000 Mar-08 PerpetualRBSCapital Trust C 2005 € 500 4.2430 Jan-16 PerpetualRBSCapital Trust D 2006 £ 400 5.6457 Jun-17 PerpetualRBSCapital Trust II 2003 US$ 650 6.4250 Jan-34 PerpetualRBSCapital Trust III 2004 US$ 950 5.5120 Sep-14 PerpetualResolution plc 2005 £ 500 6.5864 Apr-16 PerpetualRexam plc 2007 € 750 6.7500 Jun-17 29 June 2067Royal & Sun Alliance Insurance Group plc 2006 £ 375 6.7010 Jul-17 PerpetualRoyal Bankof Scotland Group plc 2001 US$ 1,200 7.6480 Sep-31 PerpetualRoyal Bankof Scotland Group plc 2005 € 1,250 5.2500 Jun-10 PerpetualRoyal Bankof Scotland Group plc 2007 US$ 950 6.6000 Jun-12 PerpetualRoyal Bankof Scotland plc 2004 € 1,250 5.5000 Dec-09 PerpetualSocietyof Lloyds 2007 £ 500 7.4210 Jun-17 PerpetualStandard Chartered Bank 2007 US$ 750 7.0140 Jun-37 PerpetualStandard Chartered Capital Trust 1 2000 € 500 8.1600 Mar-10 PerpetualStandard Chartered plc 2006 US$ 750 6.4090 Jan-17 Perpetual


46



UBSPreferred Funding (Jersey) Ltd 2005 € 1,000 4.2800 Apr-15 Perpetual

UUSSBACCapital Trust X 2006 US$ 900 6.2500 Mar-11 29 March 2055BACCapital Trust XIII 2007 US$ 700 FRN Mar-12 15 March 2043BACCapital Trust XIV 2007 US$ 850 5.4800 Mar-12 15 March 2043Citigroup Capital XIX 2007 US$ 1,225 7.2500 Aug-12 15 August 2067Citigroup Capital XVI 2006 US$ 1,500 6.4500 Dec-11 31 December

2066Citigroup Capital XVII 2007 US$ 1,100 6.3500 Mar-12 15 March 2067Citigroup Capital XVIII 2007 £ 500 6.8290 Jun-17 PerpetualComcast Corp 2007 US$ 575 6.6250 May-12 15 May2056Countrywide Capital V 2006 US$ 1,300 7.0000 Nov-11 8 November2066CVSCaremarkCorp 2007 US$ 1,000 6.3020 Jun-37 1 June 2037Enterprise Products Operating LP 2007 US$ 700 7.0340 Jan-18 15 January2068Fifth Third Capital Trust IV 2007 US$ 750 6.5000 Apr-17 1 April 2037Goldman Sachs Capital II 2007 US$ 1,750 5.7930 Jun-12 PerpetualING Groep NV 2007 US$ 1,000 6.3750 Jun-12 PerpetualJPMorgan Chase Capital XI 2003 US$ 1,000 5.8750 Jun-08 PerpetualJPMorgan Chase Capital XVIII 2006 US$ 750 6.9500 Aug-36 Aug-66JPMorgan Chase Capital XX 2006 US$ 1,000 6.5500 Sep-36 15 September

2066JPMorgan Chase Capital XXI 2007 US$ 850 FRN Feb-12 Feb-37JPMorgan Chase Capital XXIII 2007 US$ 750 FRN May-12 15 May2047Lehman Brothers UKCapital Funding III LP 2006 € 500 3.8750 Nov-11 PerpetualMerrill Lynch & Co Inc 2005 US$ 750 6.3750 Nov-10 PerpetualMerrill Lynch & Co Inc 2007 US$ 1,500 5.8500 May-12 PerpetualMerrill Lynch Capital Trust I 2006 US$ 1,000 6.4500 Dec-11 15 December

2066Merrill Lynch Capital Trust II 2007 US$ 950 6.4500 Jan-12 15 June 2062Merrill Lynch Capital Trust III 2007 US$ 750 7.3750 Sep-12 15 September

2062MetLife Inc 2006 US$ 1,250 6.4000 Dec-36 15 December

2036Morgan Stanley 2006 US$ 1,000 FRN Jul-11 PerpetualMorgan StanleyCapital Trust IV 2003 US$ 575 6.2500 Apr-08 1 April 2033Morgan StanleyCapital Trust VI 2006 US$ 750 6.6000 Feb-11 10 February2046National CityCapital Trust II 2006 US$ 750 6.6250 Nov-11 15 November

2066Progressive Corp 2007 US$ 1,000 6.7000 Jun-17 15 June 2037Regions Financing Trust II 2007 US$ 700 6.6250 May-27 15 May2047Travelers Companies Inc 2007 US$ 1,000 6.2500 Mar-17 Mar-37USB Capital IX 2006 US$ 1,250 6.1890 Apr-11 15 April 2042USB Capital XI 2006 US$ 700 6.6000 Aug-11 15 September

2066Wachovia Capital Trust III 2006 US$ 2,500 5.8000 Mar-11 PerpetualWachovia Capital Trust IV 2007 US$ 875 6.3750 Mar-12 15 March 2037Wachovia Capital Trust IX 2007 US$ 750 6.3750 Jun-12 15 June 2047Wells Fargo Capital XI 2007 US$ 1,000 6.2500 Jun-12 15 June 2067XLCapital Ltd 2007 US$ 1,000 6.5000 Apr-17 Perpetual


04CHAPTER

IntroductionAs new investor markets develop globally, hybrid securities offer a valuable source of investmentdiversification, and the growth of investor demand for the product remains vitally important forissuers seeking historically large total amounts of capital.

The ability to choose from different finance instruments including common equity, convertibles,hybrid securities and senior debt in the European, US, UK and Asian markets, and tap intomultiple investor bases in the retail private bank and institutional sectors has become a keycomponent of the contemporary acquisition war chest for many issuers. Only through thedevelopment of new investor markets can these issuer aspirations become reality.

One good example of this was seen in the US when institutional markets were affected by theNAIC shock to insurance company investors. The temporary close of the institutional markets atthis point was buffered by continuing strong demand from the US retail investor base, whichenabled the continuation of hybrid new issue supply at this time.

In the EU zone, the UK sterling institutional investor base has also provided additional depth andflexibility – primarily for financials but also now for corporate issuers, following the opening ofthe market in 2006 with the inaugural sterling corporate hybrid transaction from Linde. Thismarket depth, coupled with the opportunity for diversification, has now also attracted supplyfrom overseas, which has resulted in an increasing volume of funds invested in transactions fromissuer jurisdictions such as Japan, Austral-Asia and the US. The US retail and institutional investorbase continues to provide the key source of funding for US corporates and financials, andEuropean financial institutions also continue to tap into this deep pool of liquidity for additionaldiversification. New and emerging investor bases such as Asia, Canada and Australia are alsoproviding an important source of hybrid funding, particularly for European issuers that issuefrequently in the more traditional euro and sterling currencies.

The first wave of ‘next generation’ corporate hybrids were from strong, well known credits(Burlington Northern, Stanley Works, Vattenfall) that passed the critical first step in the investordecision process – credit risk. The pricing of these hybrids was considered attractive enough tostimulate large order books for liquid benchmark-size deals. In some cases the hybrid spread was3–4 times the senior or credit default swap (CDS) spread for similar tenors. Since the yields forsuch strong credits looked attractive relative to senior or compared with risky high-yield andemerging market (EM) alternatives, the hybrids performed well in secondary trading and werewell supported by dealers. The initial success of these issues can be summarised by:

0 Strong credit profile;0 Attractive yield;0 Benchmark size / index inclusion;0 Good secondary price / spread performance;0 Liquid secondary markets (tight bid/ask).

Within the overall hybrid capital security market, Bank Tier 1 issues are traditionally consideredthe relative safe haven, albeit providing lower spreads for investors. While Tier 1 bank paper isequally subordinate and truly non-cumulative, there is a much more compelling argument thatbanks will respect the investor market place (not abuse the Tier 1 equity features) to preservetheir own market reputation, funding liquidity, and new issue pricing. Relatively higher bankratings, regulatory supervision and national significance of the larger banks (too big to fail)provide further comfort to investors looking for yield pick-up in subordinated paper.

Attempts to model the investor risk factors of hybrid securities and assign a spread to eachstructural feature have been mostly unsatisfactory and the entire topic of modelling security riskwhere there is a limited universe of relevant historical data has been cast in shadow after therecent meltdown in sub-prime and related structured securities. While models are imperfect,they constantly improve and are one of the tools that can be useful to ‘try’ to address complexscenarios.

INVESTOR OVERVIEW

47

The problem in such modelling is often due to the modeller’s need to make many assumptions ascritical inputs to the model, so the model results can then only be relied upon in a range ofscenarios that are far more limited than those encountered in ‘the real world’. The pricing of ahybrid new issue is still more of an art than a science and many factors are taken into accountwhich cannot be modelled for universal application. This evaluation of the pricing ‘X factor’ is akey part of the hybrid deal execution, including road-show marketing, investor price discovery,syndication process, etc.

It is useful, however, to observe the trading history of the outstanding hybrids to see wherevarious credits and various structures trade in relation to one another and to think about why thisis so. It can be instructive to look at the layers of subordination in the issuance by financial institu-tions and consider the difference in payment deferral among Tier 1, Upper Tier 2 and Lower Tier2. By observing the secondary trading of hybrids from frequent issuers of step-up hybrids one canbuild a ’maturity curve’ of sorts based on the call dates. By observing issuers that have both step-up hybrids and True Perps it is possible to observe how the market is evaluating extension risk forthat credit at that point in time and how it changes over time.

Default studies are also a useful reference for the historical behaviour of company management,performance of preferred hybrid securities and the observed occurrence of deferral and/ordefault. Recent default studies from the leading rating agencies have, however, been instructiveand have noted that, overall, very few deferrals and defaults have occurred, and that this has beenparticularly observed in the financial institutions sector.

Further details on these default studies can be found on the rating agencies’ websites:

Moody’s Investor Services - www.moodys.comStandard and Poor’s - www.ratingsdirect.comFitch Ratings - www.fitchratings.com

Investors in hybrid securities

Institutional investorsThe institutional investor universe continues to expand globally, with blue chip corporate issuersand larger liquid deals from financial institutions encouraging greater investor focus and partici-pation in hybrids.

These institutional investors have embraced hybrids as a way to gain yield pick-up from well-known credits. Additionally, the quest for yield has opened the market to lesser known and lowerrated issuers as the hybrid market develops. Investors in general remain credit positive, whichhas been reflective in the increasing demand for hybrid issuance from lower rated issuers furtherdown the credit spectrum. However, investors have also been structurally conservative, leading tothe continuation of features such as quasi-cumulative interest payments and alternative couponsatisfaction mechanisms (ACSM).


48

Asset manager

Banks

Insurance

Pension fund

Hedge fund

35%

20%15%

10%

20%

Figure 4.1: Illustrative investor distribution for an institutional global

hybrid transaction (%)


The key institutional investor types can include the following:

Asset managers Asset managers focus on the professional management of various securities (including fixedincome products such as senior and hybrid bonds), which meet specific investment criteria andtarget investment returns for investors. These investors might be private investors, who willinvest via mutual funds or investment schemes, or institutions such as pension funds, insurancecompanies or corporations that have asset portfolios they wish to invest to maximise returns.

Asset managers are viewed as high quality buy-and-hold investors. As such, they are the mostsignificant investors of fixed income product in the market today, and contribute to, on average,half of the order-book for institutional hybrid transactions.

Pension fundsA pension fund is a type of asset manager which has been set up to invest pension contributionsfrom company plans in co-ordination with trustees. Those assets are invested on a consolidatedbasis in a variety of different assets to ensure that sufficient income is generated to pay pensionersonce they reach the specified age and retire. By their nature, pension funds are relatively riskaverse so the demand for hybrid securities is typically lower than for senior unsecured product.However, hybrid securities remain an attractive product from an asset-liability matchingperspective due to the longer maturities involved (10 years, 12 years, 15 years to call).

Insurance companies Insurance companies offer risk management products to private individuals and institutions tohedge against the risk of contingent losses. In return for receiving protection, a premium is paidby the policyholder, which is then invested on a consolidated basis by the insurance company invarious assets to ensure any claims against insurance policies can be met.

The investment strategies for insurance companies are similar to those of pension funds in thatmedium-low risk strategies are preferred, although the long-dated nature of the securities ensuresthey remain attractive for liability matching purposes.

Hedge funds Hedge funds are investment funds used by institutions and high net worth individuals, whichutilise complex investment strategies and securities, via a number of different asset classesincluding fixed income. Hedge funds are characterised by their ability to short securities, usehigher leverage and derivatives and an increasingly diverse universe of assets and strategies. Assuch, hedge funds support liquidity in hedging traditional asset managers and show a greateropenness in investment diversity and risk. This has in turn given further support to the explosivegrowth of the sector, with funds able to pursue investment strategies to deliver optimal riskadjusted returns.

Hedge funds have become a much larger proportion of the capital markets in recent years and fornew issues have become an important route for distribution. This differs from the early dayswhen hedge funds were viewed as fast-money accounts. Hedge funds are now viewed as anintegral component of the market and some are more closely compared with traditional assetmanagers.

BanksBanks can also invest directly in new hybrid security issues, primarily via their proprietary tradingbooks. Banks’ involvement in the bank capital securities market is typically low compared withtheir involvement in senior unsecured transactions, as they are required to hold an identicalamount of capital to offset any bank capital they may buy (which makes buying into a bankcapital transaction relatively cost-inefficient). This constraint is not such a deterrent for otherhybrid sectors.

Retail private bank marketRPB investors can be split into two distinct groups, pure retail ‘mom-and-pop’ investors, versushigh net worth individuals who invest through private banks (PB).


49

Pure retail investor bases are primarily targeted by commercial banks which have access to largeoften domestic retail banking networks as part of the larger consolidated banking group (severalSwiss, Benelux and German banks have used their domestic distribution capabilities for thispurpose). Distribution of this kind has also been supported through more simple distributionmethods such as advertising in the local press; however, in the majority of cases the transaction isplaced through the lead banks and their corresponding retail network and syndicate members,which will include private banks (as below).

The second distinct retail group is that of high net worth individuals who invest through a PB thatis either independent or part of a commercial bank. This investor group comprises wealthyindividuals, often domiciled in jurisdictions such as Monaco, Switzerland and Singapore.Investors with significant assets to be managed, and established financial sophistication, enablesgreater access to a range of financial products and structures. This investment need is facilitatedmostly by PB’s that can provide wealth management services, personalised banking and financialservices to these individuals.

Figure 4.2 highlights the PB distribution achieved from a Euro-denominated bank Tier 1transaction.

While institutionally-targeted hybrid transactions are generally bigger and cheaper for issuers,the RPB market also offers attractive diversification opportunities for hybrid issuers. At times,certain issuers can also achieve a better transaction from a price and execution perspective bytargeting RPB investors, given their unique evaluation process.

RPB investor activity typically remains intermittent, with demand highly focused on two keyfactors: first, the current rate environment, where private investors are focused on a high couponrelative to the current rate environment (compared with institutional investors who are morefocused on credit spreads); second, private investors will also give consideration to the specificname of the issuer. Strong name recognition, for example banks, insurance, consumer goods,autos, retail, and pharmaceutical, are all well suited to target this investor base with a hybridsecurity. In addition, companies which have a strong history of RPB demand for senior unsecuredbonds (e.g. Benelux, Austria, Germany) could also be well suited to this market.

RPB investors also increasingly participate in institutional deals where possible in the secondarymarket, or primary market given Prospectus Directive compliant documents (smaller 1k denomi-nations are used to stimulate retail investor participation in these transactions).


50

United Kingdom

Benelux

France

Switzerland

Spain

Hong Kong

25%4%

7%

Greece

Germany

Monaco

Portugal

Singapore

Other European countries

8%17%

15%

6%

5%

5%

4%3% 1%

Figure 4.2: Illustrative investor distribution (Perp nc 10 structure) (%)



51

RPB targeted transactions have different structures, as follows:

0 Structures are usually nc 5, not nc 10 (institutional);0 No step-up coupon at the first call date;0 Pricing is driven by the coupon, not the spread;0 Transactions tend to be smaller in size and less liquid;0 Fixed rate and structured CMS (constant maturity swap) varieties have been issued.

Therefore the RPB market can provide advantages to the institutional market for permanentcapital (non step-up non-innovative or unique structured issues).

Investor call options and other structural features can be ‘monetised’ by issuers if they sell theembedded optionality in the swaption market. This can reduce the all-in cost by 10–40bp in somecases.

The US RPB market has offered deep pockets of demand in recent years, facilitating transactionsfrom both domestic issuers (e.g. Citigroup, Morgan Stanley, Bank of America, Freddie Mac) andoverseas issuers (e.g. Aegon, RBS, Deutsche Bank) provided they are SEC registered. These transac-tions have typically been distributed directly by the brokerage networks of the lead managers,with the inclusion of regional US brokers to the syndicate group, which adds additional support tothe distribution.

European investors have been targeted through PBs (often private bank subsidiaries of largerbanking groups). Pure retail distribution in Europe has also been achieved through the networksof local commercial banks where strong retail distribution platforms already exist (e.g. Benelux,Germany, Switzerland). Asia has also facilitated a number of hybrid PB transactions from non-Asian issuers, including Porsche and Glencore. Distribution to investor bases outside these threekey areas has been more modest in terms of overall volume, although local investor basescontinue to support domestic private-placement style hybrid issuance in many jurisdictions (e.g.the Middle East).

Key global investor trendsThe following is a brief analysis of key institutional investor trends, focusing on the three keyinvestor jurisdictions for hybrid securities in Europe (65% of the total European investor base), inaddition to the US.

Profile of select UK investorsInstitutional:

0 The UK investor base is key to all Sterling-denominated transactions and continues to be one of the leading regions for investment for Euro-denominated transactions in the European debt markets. Investors are familiar with the hybrid product and asset class overall, and name, credit, management and underlying business strength are all key criteria in the investment decision making process;

0 Transactions with several bookrunners (we estimate this to be three or more) are preferred for liquidity purposes, in addition to an investment grade rating and benchmark size. UK investors are also supportive of liquidity, remaining active in secondary flows;

0 Some transactions from both the corporate and insurance sectors have seen strong demand from the UK investor base. Investors have seen value in deals, attracted by the volatility and spread;

0 Outstanding sector concerns, however, include hedging event risk and liquidity.

Retail private bank:

0 Investor interest can be variable in this jurisdiction and is typically limited to those transactions with domestic name recognition.


52

United Kingdom28%

Asia

3%

Benelux11%

France20%

Germany16%

Nordic8%

Switzerland7%

Others7%

Figure 4.3: Example distribution for a Euro-denominated hybrid capital issue,

by region (%)


Table 4.2: Select UK investors

Investor Investor typeABN AMRO Fund managerAIG InsuranceDeutsche AM Fund managerECM Fund managerFidelity Fund managerFischerFrancis Fund managerGartmore Fund managerInsight AM Fund managerInvesco Fund managerJPMorgan AM Fund managerM&G Fund managerMerrill Lynch IM Fund managerSchroders Fund manager


Table 4.1: Select UK investor profile

Client Investment issuesAsset managers Credit and underlying business are the most important criteria.

Active buy-and-hold investment strategybut also significant investment in trading accounts (hedge funds) that seekliquid high Beta assets. Remain sceptical of event risk. Like clarityon the rationale, large repeat issuers, and regulated entities. Lower rated deals bought on a case-by-case basis subject to credit profile, structure and yield.

Insurance Veryactive in hybrid asset class. Prefer to invest in high quality, benchmark transactions. Will extend duration forquality credits. Preference for cumulative structures but will buynon-cumulative structures based on the name/sectorof the issuer. Can invest if security ratings are sub-investment grade on provision that seniordebt is investment grade.

Pension fund Buyand hold investment strategy. More riskaverse so prefer strong credit profile and investment grade security rating. Hedge fund Can be significant buyers of hybrid securities – viewed as an integral part of the market. Sub-investment grade rating

could reduce demand but investment typicallynot restrained by rating.


Profile of select German investorsInstitutional:

0 Some of the larger buy-and-hold European investors for hybrid capital product are located in Germany, particularly for domestic issuers – e.g. Bayer, Linde, Pfleiderer, Eurogate;

0 German funds have shown interest in global names and well-known industrial credits. Strong name recognition remains a key part of the decision-making process, with well-known German names and global utilities preferred;

0 Some asset managers remain restricted on lower rated securities due to internal investment limits;

0 Some insurance companies view hybrid capital as a product which may help them meet minimum return hurdles;

0 German investors have shown resilience and there has been less selling from German accounts during volatile periods.


0 The RPB market has also played a role in institutional deals such as Otto and TUI.


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United Kingdom28%

Asia 3%

Benelux11%

France20%

Germany16%

Nordic8%

Switzerland7%

Others7%


by region (%)


Table 4.3: Select German investor profile

Client Investment issuesAsset manager Hybrid issues are part of their investment spectrum. Transaction maturitydoes not constrain investment decision.

Can buysub-investment grade securities – some investors have special fund restrictions and need to applyan internal credit process.

Insurance Investment strategybased on name-specific credit analysis, with focus on minimal riskwith some spread return (some application of coupon vs. return hurdles). Strategybased on a name-by-name basis so rating is not an issue if the sectorand the credit is stable and alreadyknown to analysts. Preference forhigher step-up to give more certaintyof maturityat first call date (liabilitymatching purposes). Deferral mechanism is also an important feature of the structure (cumulative vs. non-cumulative).

Pension fund Invest in hybrid securities, with preference for investment grade issuers with strong credit profiles.Retail private bank Investment decision highly correlated to the issuername and the security coupon (creating cyclical demand).

Rating not a decision point for retail investors if strong name recognition exists


Profile of select French investorsInstitutional:

0 Strong name recognition and select sectors are the key buying criteria for French investors. Benchmark liquidity and performance in the secondary market are also key considerations, particularly in light of spread widening seen in the markets in the first half of 2006 and again in 2007;

0 French asset managers have been key investors in hybrid transactions in the past (e.g. corporates such as Vattenfall, DONG and Südzucker). Despite concerns surrounding market volatility, and hedge funds using the asset class to short the market, investors remain active in the more liquid bank and insurance hybrid sectors;

0 Strong performance (spread tightening) and increased liquidity have helped to improve market perception of the asset class.


0 The RPB market in France can be deep and provide for significant funding sizes, particularly for French issuers with strong brand and name recognition (Casino).


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Table 4.4: Select German investors

Investor Investor typeCominvest Fund managerDeka AM Fund managerDEVK InsuranceDWSDAM Fund managerFrankfurt trust Fund managerGothaer InsuranceR+V InsuranceSIAM InsuranceUnion invest Fund manager


Table 4.5: Select French investor profile

Client Investment issuesAsset Manager Investors have been significant buyers in previous transactions.

Preference fora strong issuer rating – name recognition and strong sector characteristics are key fora non-investment grade transaction. Select investors are unable to invest in split-rating issues.

Insurance Investorpreference for stable credits if a core holding and also for cumulative structures. Strong focus on issuer rating and structure – cumulative/non-cumulative coupon deferral and deferral triggers are keycharacteristics. Accounts most focused on liquid benchmark-size transactions.

Retail Private Bank Continued focus on strong name recognition and sector. Continue to invest on the product but remain cautious overall. While the issuername and sectorare the primaryconsideration, high coupons are a strong incentive for investorparticipation.


Profile of select US investorsInstitutional:

0 Strong name recognition and an investment grade rating for a hybrid security will underpin demand for the transaction. This remains particularly important for non-domestic issuers who want to access the investor base in this market with a hybrid transaction;

0 Investors are open to investing in transactions which are smaller than a benchmark size. Secondary market performance also remains a key consideration;

0 New funds invested in the sector by asset managers continue to drive the majority of demand for hybrid securities in the US market. Investors have remained active in the sector in spite of the volatility seen in the market recently and in March, in not only the more liquid bank and insurance sectors and the corporate hybrid sector;

0 US investors take more types of risk, more complicated structures and longer duration.

US retail:

0 US retail remains a significant component of the total investor base for hybrid securities in the US.


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United Kingdom28%

Asia 3%

Benelux11%

France20%

Germany16%

Nordic8%

Switzerland7%

Others7%


by region (%)


Table 4.6: Select French investors

Investor Investor typeAGF Fund managerAviva InsuranceAxa Fund managerCAAM Fund managerGenerali InsuranceIXIS IM Fund managerGroupma InsuranceHSBCAM Fund managerMACSF Fund managerSGAM Fund managerSogeposte Fund manager


Markets to watch

JapanThe Yen hybrid investor market has been well established for many years and is more frequentlytargeted by the larger international Japanese banks for bank capital transactions. This marketcould be an important source of diversification for those Western issuers that have alreadytargeted the Asian market in US dollar hybrid format (and can avoid, or effectively hedge, thecurrency exposure).


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North East

International

Mid West

South West

West Coast

50%

10%

5%

20%

15%

Figure 4.6: Example distribution for a US$-denominated hybrid capital issue,

by region (%)


Table 4.8: Select US investors

Investor Investor typeAegon InsuranceAIG InsuranceBlackRock Fund managerDeutsche AM Fund managerDresdner Fund managerFidelity investments Fund managerHartford investment management Fund managerING Fund managerJPMorgan Fund managerMetropolitan life Fund managerMoore capital Fund managerSailfish capital Fund managerSigma capital Fund manager


Table 4.7: Select US investor feedback

Client Investment issuesAsset Manager Buy-and-hold investors key for the sectorand underpinning hybrid demand in the market. Investors lookat

issues on a case-by-case basis – credit and sector specific (investments not usually constrained bydeal size orbyminimum rating).

Insurance Preference for longer-dated investments. Require spread but also want to minimise risk. Focus on issuer rating and structure in decision-making process. NAICriskweightings will be critical going forward.

Hedge Fund Active investor in the hybrid market, with strong focus on spread return versus credit and structural risk. Demand not typically constrained by the security rating.

Retail Strong demand forproduct driven by issuername recognition, high coupon and sectorpreference.High coupons continue to attract many investors to participate in new issues even if lower rated.


CanadaThe Canadian market was targeted with an international hybrid transaction for the first time inAugust 2006 with a bank Tier 1 capital issue from Crédit Agricole. This was also an interestingtransaction at the time as the majority of other international markets were closed for the summerbreak (in addition to providing a useful alternative to the US market due to the close correlation ofCanadian dollar to US dollar).

Australia/New ZealandThe Australian hybrid market has been open to domestic bank issuers issuing in the domesticcurrency for some time, but has also been utilised by European issuers (including Rabobank andAxa).

Middle East – market for domestic placementThe Middle East already provides a deep and diverse investor base for local currency transactionsfor domestic issuers (with notable bank capital supply from the various jurisdictions).

Investor dynamics and motivation to buy hybrids

Hybrids versus senior debt with similar credit qualityInvestors have become increasingly familiar with assessing the risks of hybrid security structures.The hybrid institutional investor base overlaps the investor base for senior unsecured debt.Primary to the decision-making process for many investors in terms of whether or not to invest ina hybrid security is the investors’ view on the underlying credit. This credit component of thehybrid spread is the most likely to lead to future performance of the security. Less differentiationbetween senior and subordinated investors has also allowed issuers to better target institutionalinvestors, particularly those that have already issued senior debt. For some issuers the hybridproves investor diversity as new investors are attracted by the higher yield.

For many investors, hybrid capital securities offer a significant and attractive pick-up in spreadwhen compared to the credit spread they receive for buying senior unsecured debt. The spread ofa hybrid structure includes credit and structural risks – subordination, payment deferral andmaturity extension. The hypothetical spread premium for the various components of a hybridstructure can therefore be contemplated and broken down looking at each component on anindividual basis. An additional premium might also be applied – the ‘X factor’ - which will beadded on a credit-specific basis to take into account any additional risk incurred (for example,acquisition risk). These premiums are highlighted in the illustrative example given in Table 4.9.

Hybrid spreads are usually a multiple of the issuers’ senior/CDS spread for the same tenor. Themagnitude of the multiple varies by issuer, deal and sector, and is volatile over time. The illustra-tive example in Table 4.9 is not based on a model and should not be relied on. It merely showshow the incremental hybrid spread could be associated with the major structural risks. Onecompletely reliable model for hybrid pricing is not available to the market since each deal isunique and the X factor requires human judgment and interaction through investor pricediscovery. Each deal has been unique and sometimes factors such as the issuer’s rationale (M&Afunding for example) may result in variance from where the issuer would otherwise be expectedto price.


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Table 4.9: Hybrid capital – considering equity features

Hypothetical riskpremiums (mid BBB credit)Hybrid 10yrstep-up Hypothetical riskpremium1 - Subordination 30-45bps Hybrid premium2 - Non payment 50-75bps approximately3 - Extension 20-30bps 100-150bps4 - X factor (M&A, etc.) - name specific XXbps

Senior 10yrbullet 50bps

Hybrid new issue spread: 150-200bp (plus the ‘XFactor’)

Source: Compiled by CALYON- July 2007

}

Stronger credit quality For those investors searching for higher yielding investment products, hybrid capital can offer arelatively more stable investment compared with other higher yielding products. The risk of lossof the investment and of coupon payments is perceived by the market to be relatively low for ahybrid security. This is particularly prevalent for financial institutions, which are perceived to besomewhat protected by the oversight provided by national regulators (it is thought unlikely thatmany large banks would be allowed to fall into liquidation).

Liquid markets Over time, as investors have become more familiar with hybrid structures and their inherentrisks, the depth of the investor base for the product has facilitated larger size deals across allcurrencies. Issuers have also been able to raise more capital through one single funding exerciseby targeting more than one investor base at a time via dual-tranche transactions – as highlightedin Table 4.11.

With hybrid deal sizes increasing to a more liquid average size, hybrid indices are becoming in-creasingly relevant for institutional investors in particular and stimulating demand from largemoney managers as a result. One frequently referenced index is iBoxx, which applies a criterionfor hybrid debt which is similar to that for senior unsecured debt. With a minimum sizelimitation of €500m and investment grade credit rating, more and more hybrid transactions areable to be included, making hybrid indices larger and therefore a more prominent part ofinvestors’ portfolios. See www.indexco.com for further details on iBoxx.

Strength of new issue performance in the secondary marketsThe tightening of hybrid credit spreads in recent years resulted in hybrids being a top performingasset class. Corporate spreads in particular have seen a strong performance, benefiting fromincreased market liquidity and investor comfort with the risks of payment deferral and subordi-nation. As highlighted in Figure 4.7, corporate hybrid spreads have tightened by 30bp over thecourse of 2006 (senior spreads tightened marginally over the same time period), and in spite ofrecent market widening, corporate hybrid spreads are 100bp tighter (at end-September 2007)than the market wides seen in June 2006.


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Table 4.10: Select dual-tranche transactions, 2006

Issuer IssuerSector nationality Issuer date Currency Size (m) Coupon First call date Maturity

Financial France CNCEP 13-Jan-06 US$ 300 6.7500 27-Jan-12 PerpetualFinancial France CNCEP 18-Jan-06 € 350 4.7500 01-Feb-16 PerpetualFinancial Japan MUFG capital finance II Ltd 10-Mar-06 € 750 4.8500 25-Jul-16 PerpetualFinancial Japan MUFG capital finance III Ltd 10-Mar-06 ¥ 120,000 2.6800 25-Jul-16 PerpetualFinancial Japan MUFG capital finance I Ltd 10-Mar-06 US$ 2,300 6.3460 25-Jul-16 PerpetualFinancial Germany Commerzbankcapital funding trust I 15-Mar-06 € 1,000 5.0120 12-Apr-16 PerpetualFinancial Germany Commerzbankcapital funding trust II 15-Mar-06 £ 800 5.9050 12-Apr-18 PerpetualFinancial France BNPParibas SA 04-Apr-06 € 750 4.7300 12-Apr-16 PerpetualFinancial France BNPParibas SA 05-Apr-06 £ 450 5.9450 19-Apr-16 PerpetualInsurance Switzerland ELM BV(Swiss Re) 04-May-06 € 1,000 5.2520 25-May-16 PerpetualInsurance Switzerland Swiss RE GB pic 04-May-06 US$ 751.5 6.8540 25-May-16 PerpetualInsurance Italy Generali Finance BV 07-Jun-06 € 1,2745 5.3170 16-Jun-16 PerpetualInsurance Italy Generali Finance BV 07-Jun-06 £ 700 6.2140 16-Jun-16 PerpetualInsurance Italy Generali Finance BV 07-Jun-06 £ 350 6.2690 16-Jun-26 PerpetualInsurance France AXASA 29-Jun-06 € 1,000 5.7770 06-Jul-16 PerpetualInsurance France AXASA 29-Jun-06 £ 500 6.6666 06-Jul-16 PerpetualInsurance France AXASA 29-Jun-06 £ 350 6.6862 06-Jul-26 PerpetualFinancial France BNPParibas SA 04-Jul-06 € 150 5.5000 13-Jul-16 PerpetualFinancial France BNPParibas SA 05-Jul-06 £ 325 5.9540 13-Jul-16 Perpetual


Market volatilityThe secondary trading performance of a hybrid security can be compared not only with thetrading performance of comparable hybrid transactions, but also in relation to measures of other‘high beta’ risky assets such as equities and high yield.

Figure 4.8 highlights the comparative performance of hybrid securities against these asset classes,with hybrids showing a strong performance against both high yield and crossover securities.Hybrid securities have also performed well and have shown strength against periods of increasedequity market volatility.

High market volatility from the equity and/or debt markets can, however, still effect hybridperformance and cause increased execution risk and new issue price volatility, as investors chargehigher new issue premiums to hedge the poor secondary market performance of the new issue.

In addition, periods of heavy volume are sometimes followed by a sell-off as the market ‘digests’the supply.


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Euribor spread (bp)

270

220

170

120

70

20

Jan

Mar

May Ju

l

Sep

Nov Jan

Mar

May Ju

l

Sep

2006 2007

Corporates seniorCorporates sub

Figure 4.7: Corporate hybrid spread performance, 2006 to Sep 2007


500

450

400

350

300

250

200

150

100

50

0

01/0

2/07

07/0

3/07

12/0

4/07

16/0

5/07

20/0

6/07

24/0

7/07

27/0

8/07

28/0

9/07

ITRXEX56 currencyITRXEX57 currencyITRXEX58 currencyBanks T1Corporates subordinated

Figure 4.8: Hybrid performance vs. other asset classes, Jan-Sep 2007

Source: International Index Company, Bloomberg L.P.

Dedicated hybrid fundsWhile institutional investors might distinguish their various portfolios by sector or credit rating,they are not typically structured to allow for standalone dedicated hybrid or subordinated funds.This leads to an interesting dilemma for investors who are caught between managing the risk ofthe portfolio (buying the senior paper of a specific credit) and maximising the return (buying thehybrid).

Pure credit funds approach this from the perspective of maximising returns. For many investors,if they like the security from a credit perspective, they will typically choose to buy the hybrid forthe additional spread pick-up, as opposed to the senior paper with a lower spread. Hybridsecurities will typically be placed into generic credit funds which may also be sector specific – notdistinct hybrid or subordinated funds – then benchmarked within the fund against a genericcorporate index (e.g. Lehman Aggregate Index).

There are some specialist preferred and hybrid funds but these are still in a minority (albeitgrowing).

HedgingThe hybrid CDS market has already developed in the US, with the establishment of the PCDS(preferred credit default swap) and PDX index pioneered by Lehman Brothers. This derivativeproduct has allowed investors to more efficiently hedge the hybrid exposures in their portfolios –buying protection is equivalent to synthetically shorting the underlying reference obligation,offsetting price movements in their hybrid security portfolio. A PCDS is also efficient as it allowsthe investor to achieve bullet exposure without extension risk.

The CDS markets overall are also becoming efficient from the perspective of liquidity, withderivative markets not bound by the same physical supply constraints as the market in cashbonds (a cash investor has to trade in a specific security with finite quantity and liquidity withphysical delivery – in the CDS market they simply trade a new contract and settle in cash). Interms of structure, a PCDS is similar to senior unsecured CDS, with corresponding terms andcredit events. The differences in the two structures focus on the hybrid-related features of theunderlying deliverable obligation of the PCDS, which results in deferral being incorporated as acredit event.

In Europe, the hybrid CDS market has yet to develop. In the absence of a single product whichprovides a hybrid hedge, investors use alternatives to best offset the credit and equity-likecomponents of their hybrid exposure. A number of different assets are currently used for thispurpose. Some investors short other hybrid securities to offset the market risk (for example,Vattenfall short/long versus Dong). Senior CDS, or taking a short position in senior debt directlycan also be used; however, this will only offset the investors’ credit exposure, not the subordina-tion and payment deferral features typically included in a hybrid structure. Alternatives with ahigh correlation to hybrid performance, such as the Itraxx crossover index, or common equitycan also be considered. The size of the hedge must also be adjusted to take into consideration thevariations in Beta, and the slippage as Beta changes during spikes in times of market volatility.Therefore most hedging methods remain inefficient.

We are also aware of market participants that think about hybrids in building-block terms ordevelop quantitative models to address hybrid optionality. Some of these models take theapproach of viewing the hybrid security as a series of separate financial components:

0 Zero coupon sub-debt (term equal to call);0 Coupon strip (deferral possible, cumulative/non-cumulative);0 Extension option.

The breakdown of a hybrid security into individual payment risk components could be a usefultool for investors looking to more efficiently trade or hedge specific components of the hybrid (forexample, extension risk or payment deferral). Additionally, by looking at the individual riskcomponents and the potential cost of hedging each component (market price for the risk), theinvestors can evaluate the total spread at which a hybrid is trading to determine if it is rich orcheap. Hedge funds often utilise more innovative strategies to manage risk and optimise returnsand are most likely to take this approach. The development of actual liquid markets to trade inthese types of risk will increase the overall efficiency of the hybrid market.


60

Investor risk factorsInvestors are becoming more discriminating about the terms of hybrids they buy and the returnthey require to take degrees of equity risk. For investors, the evaluation of hybrids involvesquantifying the key risks. Investment grade hybrids are bought initially on the credit and yield –with key valuation considerations being the timing and probability of the return on and return ofinvested capital. Security details have in the past been secondary. For higher yielding hybrids, theperceived risk of non-payment causes a greater focus on the security in terms of investorprotection.

However, while investors are increasingly focused on hybrid structures, the real issues driving themarket continue to be M&A event risk, trading liquidity, the hybrid deal pipeline and therate/spread outlook.

In evaluating the spread differential between senior unsecured spreads and hybrid spreads, asmentioned previously the incremental risk can be explained by breaking it down into itsconstituent parts using the larger universe of hybrid capital securities. Investors also expect ahigher extension risk for corporate names, as there is a greater opportunity cost for a regulatedfinancial institution that does not redeem capital at the step-up/call date. Payment deferral risk isalso greater for corporates but this is partially mitigated since many corporate hybrids are quasi-cumulative, unlike bank Tier 1.

Some key risks for investors in hybrid securities can be defined as follows:

0 Default risk – Hybrids are designed so that the deferral or elimination of payments will not trigger a default. This means payment risk is higher on the hybrid capital securities – particularly for a mandatory deferral structure which requires the issuer to stop hybrid payments if a financial trigger event (as defined in the prospectus) is breached. Therefore investors do not have the right to sue for non-payment of the hybrid capital security coupon (or dividend). The occurrence of an actual default would occur from non-payment on senior or other securities and the hybrid investor would in turn assume their subordinated rank in the legal proceedings;

0 Recovery potential – Because of the subordinated status of the hybrid capital securities ranking just ahead of common stock, there is a lower expected recovery rate than there would be for senior debt;

0 Payment timing – Payment deferral features make periodic cash flows from hybrids more risky. Since the hybrid securities can be structured as perpetuals (or with a very long dated maturity), the ultimate repayment of hybrid capital security principal invested could be reduced to very little in present value terms over such a long time horizon. To mitigate this, step-up interest rate structures have been used to give institutional investors some comfort that they will be called out when the issuer is required to pay the higher rate after 10 years. The step-up rate of return paid after the issuer’s optional call date in year 10 is typically 100bp more than the asset swap spread at issue (limited by rating agencies and regulators). In a higher rate/spread environment, or if an issuer is suffering financial distress, the step-up rate may no longer be high enough to motivate the call and refinancing of the hybrid. The investor is exposed to ‘extension’ risk because of this possibility.

0 Non-cumulative payments – Traditional preferred stock structures were frequently non-cumulative to meet regulatory requirements and because this supports the essential equity characteristics of fully discretionary payments. However, investors prefer to have some protection that they could get paid at a later date, even if the issues do not pay currently. To this end, the market has seen ‘non-cash cumulative’ features, which allow issuers the option (or requirement) to pay arrears via:

0 Increases in principal;0 The cash proceeds of a new sale of common stock; 0 By delivering an in-kind security.

These examples of non-cash cumulative structures are generically known as ACSM;

0 Beta – Hybrid beta is typically 3–4 times senior and CDS, and the beta change expands to 8–10 times (or more) during credit shocks and periods of high market volatility;


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0 Hedging – Investors have few good choices for hedging higher beta hybrids. With beta of three or four times senior debt, the amount of senior or CDS shorted would be high – even if available. Moreover the beta is not static and will create hedge slippage in volatile conditions. Shorting equity could be disastrous if a leveraged buy-out (LBO) bid up the equity while the bonds sold off;

0 Liquidity – Investors are typically looking for a minimum deal size of €500m when considering a liquid ‘benchmark’ transaction and prefer €1bn with three or four banks acting as managers to ensure secondary trading liquidity. Index inclusion is also helpful, so large benchmarks are preferred;

0 Common stock dividend policy – Common dividend history is a major factor for investors. Most hybrids follow the preferred stock model whereby if common dividends are paid, interest on the hybrid must also be paid – and if common dividends are not paid, interest on the hybrid might be deferred.

Table 4.11 summarises the general risk dynamics for investors when considering hybridsecurities.

So standard investment and trading risks remain – credit, liquidity, supply and event risk (buyerand target) – but investors want more protection. The good news for issuers and investors alike isthat, following the 2005 release of the seminal Moody’s Hybrid Toolkit revisions (and subsequentguidelines from other agencies), the market has already seen the flexibility to build in therequired investor protections for non-regulated and/or lower rated issuers that are tapping thehybrid markets, as discussed in Chapter 5 and highlighted in Figure 4.9.


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Table 4.11: Risk dynamics - investor perspective

Stronger WeakerCumulative Non-cumulativeCompound No compoundPusher/stopper in place NoLookback>12 months Lookback< 12 monthsDeferral time limited Deferral time unlimitedMandatorypayment Deferral trigger low probability/out of money MPD triggerhigh probability/in the moneyACSM�Manysecurity types ACSM�Few security types�Must activate �Mayactivate�Short time frame �Long time frameRecovery� relatively less seniordebt (hybrid less subordinate) Recovery� relativelymore seniordebt (hybrid more subordinate)�Capital structure subordinationHigh step-up Low / no step-upDated (loses equity credit below 50 years – more call incentive) Perpetual / undatedWeakreplacement language Strong replacement languageChange of control No COCManagement, familyowner, regulator(s) motives known/trusted Unknown, untested, distrustedMake whole early redemption (tax, regulatory, accounting, rating Par call if early redemption eventagency– benefit lost)


In particular, quasi-cumulative payments – originally included for issuer tax reasons – now alsogive investors the incremental comfort needed to participate in insurance and corporate hybridtransactions. Without this evolution, the hybrid market would be restricted to a much smalleruniverse of issuers. These evolving hybrid features are investor friendly in that they provide amore debt-like instrument than most bank Tier 1 by allowing or requiring issuers to satisfy hybridpayments via one or more ACSM. This addresses one of the major concerns expressed by criticalinvestors evaluating many of the corporate hybrid transactions in the market.

Structural conservatismThere are several structural trends that have resulted in a ‘structural conservatism’ in the latesthybrids in order to comfort investors, increase investor demand and reduce issuer cost.

In France, the TSS legal form of hybrid is a very elegant hybrid capital security in that it is a directissue, tax deductible, perpetual, non-cumulative instrument that meets bank Tier 1 capital re-quirements. The TSS hybrid bank capital structure was sold successfully by high-quality banks toinstitutional and RPB investors for several years.


63

NRBBBBBBA

3,500

3,000

2,500

2,000

1,500

1,000

500

0

2006

Jan

Mar

May Ju

l

Sep

Nov Jan

Mar

May Ju

l

Sep

2007

Figure 4.9: Select unrated/low-rated issuers targeting the hybrid market, 2006–07

Issue date Maturity Size Issue ratings

Porsche 19-Jan-06 Perpetual US$1bn Not ratedVinci 7-Feb-06 Perpetual €500m Baa3/BBBIVG 27-Apr-06 Perpetual €200m Not ratedLottomatica 10-May-06 31-Mar-66 €750m Ba3/BBSolvay 23-May-06 2-Jun-04 €500m Baa1/BBB+Linde 7-Jul-06 14-Jul-66 £250m Ba1/BBLinde 7-Jul-06 14-Jul-66 €700m Ba1/BBSiemens 8-Sep-06 14-Sep-66 £750m A2/A–Siemens 8-Sep-06 14-Sep-66 €900m A2/A–BehrGmbH & Co 15-Dec-06 Perpetual € 100m Ba1/NRWienerbergerAG 25-Jan-07 Perpetual €500m Ba1/BB+IVG Immobilien AG 1-Feb-07 Perpetual €200m Not ratedPfleidererFinance BV 13-Apr-07 Perpetual €250m B1/NR/BB–Eurofins Scientific 11-May-07 Perpetual €100m Not ratedEurogate GmBH 11-May-07 Perpetual €150m Not ratedRexam plc 20-Jun-07 29-Jun-67 €750m Ba2/BB+Voestalpine 15-Oct-07 Perpetual €1bn Not rated


As other credits used the TSS structure for more diverse purposes (i.e. ratings) institutionalinvestors noted the standard TSS format as used by banks is more equity-like than other corporateor insurance structures that have quasi-cumulative payments and ACSM features. Some Frenchinsurance companies have subsequently issued hybrids with these enhancements included.

In Table 4.12 a few variations in corporate hybrids are used to identify the more investor-friendlyfeatures that are becoming more common as the hybrid market develops, such as:

0 Quasi-cumulative payments vs. non-cumulative;0 ACSM payment resolution and ‘fast pay’ ACSM;0 Dated vs. perpetual format;0 Higher step-ups;0 Change of control (COC) clause.

The Vinci hybrid is a traditional TSS format and non-cumulative, whereas the Solvay andLottomatica structures which were issued subsequently have the more investor-friendly quasi-cumulative coupon structures. The Lottomatica issue is also dated, which provides some comforton extension risk since the equity credit decreases as the maturity approaches (creating anincentive to call after 10 years). Lottomatica also has a ‘fast pay’ ACSM which reduces investordeferral risk and avoids the third notch down in ratings from S&P.

Some other issuers have included larger step-up rates to reduce extension risk but this can reduceequity credit and increase the need for strong replacement language.

Increasingly, COC clauses are used for senior debt issues where there is a meaningful risk of theissuer being taken over and being downgraded by the rating agencies due to significantlyincreased leverage post acquisition. Given the subordination, long tenure and potential forpayment deferral or cancellation, hybrid investors are even more vulnerable than the typicalsenior bond holder. Therefore hybrid securities have also started to include these COC protectivefeatures. The COC clause protects the existing creditors by providing for an exit or increased com-pensation if the issuer ratings suffer a significant downgrade following a change of control.

This structural conservatism has helped attract a wider and deeper investor universe since theinvestor-friendly features mitigate the primary investor risks. This also has allowed issuers withhigher credit risk to successfully tap the hybrid market.


64

Table 4.12: Examples of structural conservatism

Vinci €500m 6.250% Lottomatica €750m 8.250% Solvay €500m 6.375%Perp nc 10 (issued Feb-06) 60 nc 10 (issued May-06) 98 nc 10 (issued May 2006)

Issuer Vinci SA Lottomatica SpA SolvayFinanceIssuerType Direct Direct SPVSecurityType Undated DeeplySubordinated Subordinated Interest-Deferrable DeeplySubordinated Fixed to

Fixed to Floating Rate Bonds Capital Securities Floating Rate BondsStatus / Subordination Direct, unconditional, unsecured, The securities will rankpari passu Direct, unconditional, unsecured

and lowest ranking subordinated among themselves and with parity and deeply subordinated obligations (titres subordonnes de securities, junior to all other obligations of the Issuer. The Bondsdernier rang) of the Issuer. The unsubordinated and subordinated will rankpari passu amongBonds rankpari passu among creditors, and senior to ordinary themselves and with all otherthemselves and with all other shares of the Issuer, financial present and future paritydeeply subordinated obligations, instruments (strumenti finanziari), securities of the Issuer, and and subordinated to all prêts anysavings shares and preference subordinated to titres participatifs

shares, and anyotherequity interest and prêts participatifs, ordinaryor juniorobligations of the Issuer. subordinated and unsubordinated

obligations of the Issuer.Maturity Perpetual 31-Mar-2066 2-Jun-2104First Call Date 13-Nov-2015 31-Mar-2016 2-Jun-2016Step-Up at First Call Date +100bps +100 bps +100 bpsEarlyRedemption Yes (Tax / Accounting Event). Bonds Yes (Withholding TaxEvent / Tax Yes (TaxEvent). Bonds redeemed at

redeemed at theirprincipal amount Event / Change of Control Event). the higherof principal orB+75.(TaxEvent - additional amounts). Securities redeemed at theirprincipal Bonds redeemed at higherof amount (Withholding TaxEvent), orprincipalorBunds+75 (TaxEvent - at the higherof principal orBunds+75change to taxdeductibility / (TaxEvent / Change of Control Event). Accounting Event). MandatoryRedemption Event -

mandatory redemption at 101% of


65

Table 4.12: Examples of structural conservatism (continued)

Vinci €500m 6.250% Lottomatica €750m 8.250% Solvay €500m 6.375%Perp nc 10 (issued Feb-06) 60 nc 10 (issued May-06) 98 nc 10 (issued May 2006)

principal at the earlierof the termination of the mergeragreement (Lottomatica/GTECH), and October10th2006 (if acquisition not completed).

Replacement Clause Intent-Based Replacement of Intent-Based Replacement of Intent-Based Replacement of Redeemed Bonds. Replacement RedeemedSecurities. Replacement Redeemed Bonds. Replacement with common equity, pari passu/ with ordinary shares or securities with parity/ junior securities orjunior securities with same terms with similar terms and conditions. ordinary shares.and equal/greaterequity content.

Dividend Pusher / Stopper Dividend Pusher Dividend Pusher / Stopper Dividend PusherOptional Deferral Interest payments are optionally Interest payments are optionally Interest payments are optionally

deferrable and non-cumulative. deferrable. Maximum 10-year deferrable. Maximum 5-yeardeferral period (cumulative). deferral period (non-cash Deferred payments to be settled cumulative). Deferred interest to with cash (first 5-yearperiod) be settled via ACSM.orvia ACSM (next 5-yearperiod).

Rating Agency n/a Interest payments mandatorily n/aMandatoryDeferral deferrable. Trigger - Coverage Ratio

is less than 1.35. No deferral if issuerhas available cash proceeds raised via equity issuance in prior6-month period. Issuer to paydeferred paymentspromptlyvia ACSM. Maximum 10-year

Deferred Payments Non-Cumulative MandatoryDeferral (Non-Cash Non-Cash CumulativeCumulative) / Optional Deferral (Cumulative - first 5 years / Non-Cash Cumulative - next 5 years)

ACSM n/a Settlement of deferred interest Settlement of deferred interest payments immediately, via issuance payments via issuance of of IssuerEquity (ordinary shares). ordinary shares (2% limit) orIssuerundertakes to keep available eligible securities (25% limit). authorised shares to enable payment Issuer shall use all of deferred interest via ACSM. reasonable measures to settle Deferred payments not settled after deferred interest payments. 10 years will constitute an event of Deferred payments cancelled if default. not settled within 5 yearperiod.

Additional Features/ – Fast PayACSM avoided typical third –Comments notch from S&P. Mandatory

Redemption Event - mandatoryredemption at 101% of principal at earlierof termination of MergerAgreement, and October10th 2006(if acquisition not completed).

Source: Transaction Offering Circulars

Observing the secondary market yield of hybrid capitalsecurities

Observing spread relationships for bank capitalThe bank capital market provides the best universe for looking at how investors may evaluate hybrid equityrisk factors. The spread differential between senior unsecured spreads and subordinated bank capital can beshown by breaking the incremental risk down into its constituent parts using the larger universe of hybridcapital securities for banks. A snapshot illustrative example of spread differentials is summarised in Table 4.13.This example is illustrative only, since actual market relationships vary dramatically over time. While inconclusive, the relationships are noteworthy when considering the market trading of hybrid risk.


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Spread observations for corporate hybrid securities

‘Sample skew’ in average rating quality of Basket C versus Basket D populationThe current population sample of more liquid corporate hybrid securities included in Table 4.14 highlightsthis difference – there is ‘sample skew’ in that more of the Basket C securities are rated in the BB range andmore of the Basket D securities are BBB or A. Also, there has not been an issuer of both a Basket C and BasketD security where the required yield premium could be observed for a single credit. So the table requires closeanalysis to adjust for the sample skew when looking past CDS multiples as indications of how hybrids tradeand how the market seems to be pricing hybrid risk at a point in time.

Looking at the current sample, it can be observed that the average credit quality and therefore rating ofissuers of Basket C securities has tended to be lower than the Basket D security issuers. This has been partlydriven by the desire of some of the Basket C security issuers to avoid additional Basket D notching by S&Pwhich could result in a sub-investment grade security rating and negatively impact transaction execution(marketing and cost of the hybrid). We can look deeper to better understand the data.

Isolate sector championsWithin the sample, the utility sector stands out as a leader in terms of credit quality perception – issuers suchas DONG and Vattenfall have the lowest CDS levels in the sample (+23 and +19, respectively), reflective of thehigh perceived quality of the utility sector, national significance and ownership structure. Spreads on thehybrid securities are also some of the lowest in the sample (+76 and +72), partly reflective of the strongexpectation that a strong utility will make interest payments and call the securities at the first call date.

The hybrid/CDS spread differentials (53 in both cases) are also some of the lowest differentials in the sample.

Therefore these credits should only be given significant weight in comparison to other very highly perceivedcredits (such as utilities) that trade beyond their rating levels.

Isolate outliersWhen using the data in the sample it is helpful to isolate any outliers that could distort the results ofcomparison.

Table 4.14: Select corporate hybrid spreads – CDS multiples and rating agency equity credit

Moody’s Currenthybrid 10yrCDS Spread toIssuer Issuer rating basket Moody’s S&P trading (“CS”) interpol. (“CDS”) 10yrCDS CS/CDS (%)

Michelin Baa3/BBB A Ba1 BB+ 116 34.0 82.0 341TUI B1/BB– B B3 B 388 327.7 60.3 118Linde (old) Baa1/BBB B Ba1 BB 85 36.5 48.5 233Linde (new) Baa1/BBB C Ba1 BB 190 52.3 137.7 364Vinci Baa1/BBB+ C Baa3 BBB–(neg) 178 48.4 129.6 368DONG Baa1/BBB+ C Baa3 BBB– 76 22.8 53.2 333Thomson Baa2/BBB– C Ba1 BB 276 97.8 178.2 282Solvay A2/A C Baa1 BBB+ 104 24.4 79.6 426Wienerberger Baa2/BBB C Ba1 BB+ 205 – – –Siemens Aa3/AA– D A2 (pos) A– 72 25.0 47.0 288Bayer A3/BBB+ D Baa2 BB+ 145 37.1 107.9 391Vattenfall A2/A– D Baa1 BBB– 72 18.8 53.2 383Suedzucker Baa2/BBB D Baa2 BBB– 201 49.9 151.1 403Henkel A2/A D Baa1 BBB– 128 23.8 104.2 539Rexam Baa3/BBB D Ba3 BB 204 78.7 125.3 259Lottonatica Baa3/BBB- Ba3 BB 243 - - - -

Source: Compiled by CALYON - July 2007

Table 4.13: Spread analysis - bank capital

Bankcapital (%) Comment1 – Subordination Risk 15-25 LowerTier2 vs. SeniorUnsecured2 – Extension Risk* 30-40 UpperTier2 vs. LowerTier23 – Payment Risk** 40-50 Non-Cum. Tier1 vs. Cum. UpperTier2

Source: Compiled by CALYON - July 2007


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The CDS spreads of some issuers in the sample trade at levels which are relatively wide to the sample average.

TUI (trading at +328) and Thomson (trading at +98) are two examples of this.

These securities are less comparable to most of the others in the sample and should be isolated for use inspecific comparisons with like companies not prevalent in the current sample.

Multiples and spreadsThe cost of basic credit risk – CDS spreads have been referenced for each of the hybrid securities to reflectthe basic market pricing of credit risk for each of the issuers.

CDS spread/hybrid multiples are a ‘quick and dirty’ way to gauge and communicate the trading levelsobserved in hybrid securities relative to senior or CDS. Multiples provide one starting point for further analysisbut they must be carefully interpreted. This need for close interpretation is driven by the relatively wideranges of the multiples generated. This is highlighted in Table 4.14, where CDS multiples for Basket Csecurities range from 282–486% (204% differential), and for Basket D securities 259–539% (280% differential). These ranges can also still remain wide even when outliers are removed from the sample.

The various CDS levels observed in the market can have a distorting effect on multiples. ‘Noise’ in the calculationscan be in either the numerator or denominator or both. Very low CDS spreads for certain issuer names may resultin optically larger hybrid spread multiples and likewise some issuers which have a relatively high CDS spreadscould result in a lower CDS multiple. Multiples have limits in accurately capturing the market perception ofinvestment risk in specific hybrid since the multiplier approach can exaggerate differences. The absolute amountof hybrid spread must be considered in relation to other relevant hybrid credits in addition to the simple multiples.

Hybrid spreads – The spread of a hybrid security can be assessed in relation to other hybrid securities by makingdistinctions based on the differing security ratings (issuer credit quality), hybrid structure (deferral optionality,cumulative versus non-cumulative, ACSM or not, dated versus perp, amount of step-up, level of subordination,etc) and rating agency equity credit (Basket designation and corresponding risks) and market profile of the issuer.

Spread differentials – By observing the sample of hybrid securities, hybrid spread differentials (the bpdifference between the CDS spread and hybrid spread) can be observed. By observing these rating differen-tials across the different issuer credit ratings, some broad spread differential ranges emerge at a given point intime – 50–80bp for A rated issues, 100–150bp for BBB rated issues and 120–180bp for BB rated issues.

The average spread differential for each ratings band can then be broken down into individual components,assessing each of the features of a hybrid security in turn and applying the following illustrative breakdown:

0 Subordination: 30% (25–35% range);0 Extension: 20% (15–25% range);0 Deferral: 50% (45–55% range).

These relationships are highlighted in Figure 4.10 below, but will vary over time and as markets and credits change.

Spread differential

160

140

120

100

80

60

40

20

0

Deferral ExtensionSubordination

A BBB BBSecurity rating

Deferral risk(50% average)

Extension risk(20% average)

Subordination risk(30% average)

Figure 4.10: Spread differential analysis, by rating



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Institutional True Perpetual and step-up Tier 1 distinctions Institutional True Perpetual securities are securities which have a call date, but no step-up coupon at thisdate. At the call date the payments typically switch to floating rate from fixed. Regulated financial institutionsavoid the BIS limits on innovative step-up capital issuance by issuing non-step up securities and are thereforewilling to pay an additional premium to issue a True Perp structure.

However, investors expect the issuer to call for ‘reputation maintenance’ and still require a premium to buythese high beta instruments.

The RPB market can also be used as an alternative to the institutional True Perp market (either for diversification,price benefits or if the institutional market is closed). This could also benefit those issuers who want to issue in non-step True Perp format that stays fixed coupons in perpetuity – retail investors place no value on the step-up coupon,so a step-up does not need to be applied and pricing can vary significantly from the institutional investor market.

Reducing the cost of issuance using a coupon floor One interesting True Perp variation in the US market in March 2007 was a non-call 10-year fixed-to-floating Tier1 security with a coupon floor after the call that was said to save the issuer money (see below). TruePerpFloorfeatured a yield of 5.919% as they priced at T+134bp, (equivalent to 82bp over Libor). After the call, thesecurities will float at the equivalent of the new issue spread over three-month Libor, and the coupon floor willequal the initial yield of 5.919%. This seems like a very good idea that could have broader applicability for otherfinancial institutions (subject to regulatory approvals) and perhaps even more so for corporate hybrids where

Euribor spread (bp)

400

350

300

250

200

150

100

50

0

BA CR 4.75% 20 (non-step)A IB 4.781% 14 (non-step)BA CR 4.875% 14 (non-step)DRES 6.352% 17 (non-step)A IB 7.5% 11 (step)BA CR 7.5% 10 (step)BANCOPOP 6.756% 10 (non-step)BANCOPOP 6.156% 10 (step)

02 Ja

n 07

02 F

eb 0

7

02 M

ar 0

7

02 A

pr 0

7

02 M

ay 0

7

02 Ju

n 07

02 Ju

l 07

02 A

ug 0

7

02 S

ep 0

7

Figure 4.11: True Perpetual vs. step-up hybrid securities, Jan–Sep 2007


Table 4.15: Example of step vs. non-step premiums

Issue Currentspread differntialvsstep-up Approximate spread premium - step vs non-stepAIB 4.781% 2014 +118bp (vs. AIB 7.5% 2011) +93bpBarclays 4.75% 2020 +115bp (vs. BACR 7.5% 2010) +78bp

Source: Compiled by CALYON, September 2007

Spread differentials between Baskets – Observing the sample data in Figure 4.10, it can be noted thatBasket D securities on average trade at a wider spread compared to Basket C securities:

0 Basket D (BBB-rated issue): 120–200bp;0 Basket C (BBB-rated issue): 100–180bp.

When a new hybrid security is priced, syndicate managers will often indicatively price both a Basket D securityand a Basket C security. For a typical blue chip European corporate with BBB ratings, the estimatedincremental spread required for a Basket D security compared to a Basket C has averaged 25–50bp. Thisadditional spread is associated with the payment deferral feature of the Basket D security, and more specifi-cally relates to mandatory payment deferral which is a feature unique to most Basket D securities (subordina-tion and extension risk is similar for both types of security).


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extension risk is a key investor concern. While this deal was a non-step up or True Perp, the same logic shouldapply to a step issue – the floor will add value to investors and improve execution for issuers.

Analysis and rationaleA floor on the floating rate after year 10 provides investors with greater certainty of their return if the issuerdoes not call the securities in 10 years. In a future lower interest rate environment, the investor would enjoy aminimum coupon (5.919%) equal to today's rate – therefore receiving a higher return against the traditionalfloater if rates are much lower beyond year 10. So in a low rate environment, the investor is in the sameposition as owning a traditional Fixed Rate Perp. In a higher interest rate environment, the investor wouldenjoy a coupon increase if rates increase on a floating basis in relation to Libor above the floor. This is thesame position they would be in if they held a traditional True Perp.

At the time of issue a similar Tier 1 step-up would have priced in the T+145bp area in the US – so the floormay have saved 10bp or more (for reference, step-ups from similar credits priced around T+128 or mid-swaps+75bp at around the same time).

Comparing with Europe, a similar issued a PNC10 step-up would have traded at mid-swaps+95bp, which hadtightened to mid-swaps+79bp when the new US deal was marketed. Also, BNP had recently priced a EuroPNC10 step-up at m/s +72bp. Therefore the US TruePerpFloor may have achieved very attractive pricingcompared with European step-ups, considering the usual spread premium between a step-up and True Perpstructure is 50–60bp on average, within a range of approximately 35–120bp. When compared to the then-current Euro True Perp secondary levels below, the value is apparent:

0 AIB True Perp PNC 2014: m/s+132bp;0 Barclays True Perp PNC 2014: m/s+114bp, PNC 2020 m/s+162bp;0 Dresdner True Perp PNC 2017: m/s+131bp;

Therefore, the True Perp floor structure priced a True Perp nearly flat to a Perp NC10 step-up and saved approximately 30bp against the Euro market.

Interview

The following Q&A interview is with Marie-Suzanne Mazelier, Credit Portfolio Manager at Société GénéraleAsset Management (SGAM). SGAM is a global fund management group with over £238bn in assets undermanagement worldwide (as at end-December 2006). This discussion was as of September 2007.

This interview provides an interesting perspective on the rationale for investing in hybrid securities. It alsoprovides a unique insight into the investor’s view on the key risks of a hybrid, how relative value is evaluated,and the relative importance of the structural features and rating of the security.

What position do you normally take as an investor: long-term buy-and-hold or more trading focused,or both?

We favour trading positions (three to six months), with buy-and-hold positions remaining low.

Which sectors (banks, insurance, corporate) do you prefer to invest in? Which sectors are best or worst(e.g. utilities, retail)?

All investment decisions are a matter of risk/return, depending on market conditions and our view on creditfundamentals. At present, we think that the financials sector (both senior and subordinated) offers goodrelative value, especially on the primary market.

What is the process for deciding whether to invest in a hybrid security, in relation to a senior securityfrom the same issuer? Does the credit limit cover both types of security?


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It is often a pricing matter, combined with our global view for credit spread movements (beta). We size theinvestment according to its risk (spread volatility). Hybrids are higher betas by nature. We also look at thevarious features of the structure (for example, the step-up), prefer more liquid sizes, and deals which also havea good correlation with the overall market. We have a separate limit for both senior and hybrid securities fromthe same issuer.

Do you manage your portfolio against a specific index?

We manage both benchmark portfolios (investment grade/high yield/convertibles) against generic bondindices, not hybrid/subordinated-specific indices and absolute return portfolios.

How important is the rating notching of the hybrid security versus the senior credit rating? Are youlimited to investment-grade?

The rating notching should reflect the subordination level. We are not limited to investment-grade except inspecific institutional mandates. We are also not limited to investing in rated transactions, in which case we willassess the transaction internally on the basis of the implicit rating.

Maybe the most important factor is the real rationale for the company to issue a hybrid security as part of thecapital structure and aside from the covenant packages that are often regulatory or agency driven, the realeconomics of the deal and the commitment of the company.

How do you decide what the spread should be? Do you look at the multiple of the CDS credit spread?Or 'building blocks' (additional spread for extension risk, subordination, payment deferral) against thesenior credit spread? Do you also look at the hybrid spread versus returns from other asset classes(high yield, equity)?

All of the above methods are utilised. What is important for us is to assess the return on the security relativeto the risk taken, and issuer credit risk as the first investment criteria to be considered.

We also look at the hybrid spread return versus other asset classes, and have several times bought hybridbonds (financials and corporates) on a relative value basis into our high yield funds.

Do you have any preference in terms of liquidity, i.e. minimum size for a deal?

Yes – we have very active management, so liquidity and the commitment of the dealers is very important tous. We will, however, buy into less liquid deals (less than €500m in size) but for smaller amounts.

What do you view as the key risks for buying into a hybrid security? Payment deferral? Loss ofpayment? Loss of principal? Liquidity? Mark-to-market risk?

The key risk for us will be mark-to-market risk because hybrid securities are high beta credits.

From an investment/pricing perspective, do you distinguish between maturities which are perpetualversus very long dated (e.g. 60 years)? Do you distinguish between securities which are cumulativeversus non-cumulative, or non-cash cumulative (settlement via ACSM)?

We do not distinguish between very long dated and perpetual bonds. The form of subordination for us ismuch more important in assessing the relative pricing perspective.


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How closely do you base your investment decisions on the recent secondary market performance ofthe issuer? And of comparative hybrid securitites in the market?

Both of these criteria are important. Depending on the fundamentals of the issuer, we would weight thesecriteria depending on the market conditions, technical aspects (liquidity, market making) and the fundamentals.

What is your view of ACSM as a method of payment for deferred coupon payments?

The ACSM should reduce the risk of investor losses when settlement is immediate (or within one year).

What is the minimum step-up that you require at the first call date to view the security as being calledat the first call date?

The minimum step-up that we require at the first call date must be significantly higher than the initial spread(in our view 100bp+ is acceptable for a T1 at the time being).

How do you hedge your position when you buy a hybrid security – senior? CDS?

We can go outright long, or use the CDS market to lessen our risk position (jump to default or spreadduration).

Are you a buyer of true perpetuals (i.e. no step-up)? What price premium do you require versus a step-up security?

For the time being we do not invest in non-step bonds. The pricing rationale is not simple so it is not easy toassess relative value. We are not convinced there are long-term investors on this type of structure.

05CHAPTER

IntroductionThe first step in a hybrid structuring project is to scope it out by asking: “What are the issuer’smain objectives?” and “What constituents are they concerned with (i.e. regulators, ratingagencies, analysts, shareholders, etc.)?” Although hybrid issuers from all sectors share thecommon goal of achieving ‘equity’, the hybrid structures are often different between sectors.Difference derives from the constraints of local legal and tax regimes and from different issuerobjectives. Even within a sector structures differ by nationality of issuance. This confoundsinvestors and new issuers alike. The issuer’s objectives are shaped by the constituents they aim tosatisfy and this will drive the structures that result within the constraints of the legal, tax andaccounting regimes. These are the technical aspects of structuring hybrids.

Practical aspects must also be considered – such as selling the securities to investors! Marketingthe hybrid securities to investors is a key part of every successful hybrid transaction and somestructuring innovations evolved specifically to reduce perceived investor risks, increase investordemand and thereby reduce issuer cost – particularly for non-bank issuers.

This chapter highlights some of the structuring challenges and explores some of the reasons forthe differences that can be seen in hybrid securities. A more detailed review of actual transactionsfollows in Chapter 6. As will be seen, the hybrid security universe is far from commoditised at thispoint.

Background issuesRegulatory requirements continue to drive the majority of hybrid security issuance in the market.Many leading banks issue up to the maximum limits allowed by bank regulators for hybrid capitaland subsequently ‘top up’ as the asset base grows, to fine tune the balance sheet (via sharebuybacks or hybrid security re-financing) or to fund M&A transactions. For banks in the majorworld economies a form of hybrid capital exists and is well accepted and readily used by thelargest banks. In recent years further new issuance supply has been derived from emergingeconomies and from smaller banks that are tapping the hybrid market either in their localmarkets, internationally, and via hybrid collateralised debt obligation (CDO) structures whichaggregate smaller issues into a large marketable tranched pool. Structuring innovations haveoften been required to tap these new sources of new issue supply and successfully market them toinvestors in the formats they prefer.

Insurance companies have followed the banks’ lead by issuing hybrid capital to more efficientlymeet their capital requirements. However, the rating agency benefits of hybrid capital furtherstimulated hybrid security innovation – particularly for insurance companies acting as consolida-tors in the industry and buying smaller rivals. In many cases the hybrid structures of insurancecompanies differ from banks of the same country either because banks had specific historicalissuance structuring advantages, or rating agency credit was not sought by the bank, or insurancehybrids were viewed more sceptically by investors and additional investor-friendly features wereincluded to increase their attractiveness. The need to comfort hybrid investors is even more acutefor corporate hybrids. The growth in non-bank issuance has fuelled a trend of structural conser-vatism in hybrid securities and most constituents have been constructive.

Corporate issuers have long been aware of hybrids but have not been significant issuers for about10 years. Historically there was significant corporate issuance of preferred stock (particularlyfrom utilities) and then the first corporate hybrid (in a tax-efficient format) was issued for Texacoin 1993 and a surge of corporate issues followed. At this time the low after-tax cost of hybridsbrought a wave of new first time corporate issuers and spurred a series of large-scale tenders andexchange offers to refinance corporate preferred stock issues with the more tax-efficientcorporate hybrids. The preferred-for-hybrid exchanges worked well since the issuer could offerinvestors a higher hybrid payment but the hybrid issuer still enjoyed a lower after-tax cost withthe hybrid than they had with the preferred.

STRUCTURING HYBRID CAPITAL SECURITIES

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‘Next generation’ corporate hybrids have received significant market focus because corporateissuance was so low for such an extended period. Since 2005, corporate hybrid new issue volumessurged as changes to some accountancy regimes (IFRS) and the clarification of increased ratingagency benefits from hybrids combined with M&A motives, the desire to optimise capitalstructure and very attractive credit markets.

Favourable market conditions have also supported new issuance across sectors but initially thiswas only feasible for the more attractive credits and structures. The market pricing of the hybridequity features becomes very attractive in a low-rate, tight credit spread environment. Sinceinvestors are taking long-term, subordinated positions the pricing of hybrids is at its best duringperiods of strength in the business and economic cycle. Even so, the rebirth of the corporatehybrid market began with large, liquid, benchmark-size deals from issuers that exhibited verystrong credit profiles, reputable management, high levels of institutional investor following andcredible issuance rationale. Over time the hybrid market also opened to lower rated and unratedissuers globally.

However, when risk aversion increases and investors shed high beta assets, then hybrid issuanceprospects are likely to be harshly impacted and the market can close to some or all of thepotential issuers regardless of sector, structure or pricing (as discussed in the investor section,Chapter 4). During these periods, investors that have studied the subtle differences in hybridstructures can make better investment decisions for their portfolios. Diagrams have beenincluded in the form of decision trees that highlight some of the optional and mandatorypayment flows of select hybrid securities to illustrate distinctions that could matter.

Structuring frameworkAfter scoping out a hybrid structuring project in accordance with the issuer’s objectives the nextstep is to consider the details of the various technical areas that will constrain or enable thehybrid security design. It is often said that “the Devil is in the detail” when navigating theprimary technical foundations that define capital security structuring.

The primary technical foundations can be illustrated as a Venn diagram (see Figure 5.1) and thesolution is found in the ‘eye of the needle’ which must be passed through to achieve theobjectives of the hybrid structuring project (tax-efficient quasi-equity). In addition, the practicalaspects of selling the resulting hybrid instrument require the project scope to include the require-ments and constraints of the target investor market.

One of the most useful structuring frameworks that can be observed is the preferred stockparadigm. A classic preferred stock is a deeply subordinated instrument (senior only to commonstock), can be non-voting, and can be non-cumulative with payments that are fully discretionary.Although there are different types of preferred stock (or preference shares) for purposes of con-structing hybrids, the existence of any preferred stock instrument within the jurisdiction inquestion is a useful starting point.


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Figure 5.1: Primary technical foundations for structuring a hybrid security

Hybrid capitalsecurity

Rating agencies

Regulators

Investors

Accounting

Tax

Legal


The structuring considerations that follow relate to how to make it more tax efficient or eliminateany tax inefficiency. Hybrid capital can be constructed by evaluating the legal possibility for thekey instrument debt/equity characteristics:

0 Features of both debt and equity – Where is the dividing line in the jurisdiction for legal, tax purposes?

0 Subordinated to all other debt, senior only to common – In some places there is no legal concept of subordination, preference;

0 Maturities that are long dated or perpetual – What is permitted legally, and what is the tax impact?

0 Payment discretion – What is permitted legally, and what is the tax impact: - Mandatory and optional deferral; - Cumulative or non-cumulative?

By analysing what preferred type security is legally available in the local system a hybridstructuring professional can determine how feasible it will be to strike a balance on the safe sideof the apex or tipping point between debt and equity. Alternatively, if there is no legal concept ofa preferred security in the security law of the jurisdiction of the issue, the options include:

0 Constructing the hybrid from the bond side;

0 Considering issuance from a jurisdiction offshore from the issuer’s home jurisdiction (if permissible) or considering a combination of multiple securities that may be bundled to provide the features required (such as stapled or convertible securities).

Hybrid capital securities are positioned between debt and equity and positioned in terms of their:

0 Legal classification;0 Subordination;0 Payment characteristics;0 Accounting classification;0 Tax treatment;0 Investment return.


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Figure 5.2: Preferred stock paradigm


Ordinary shares (equity)

Preference shares

Bank loans

«

«

«

«

Hybrid capital

Senior bonds

Incr

easi

ng e

quity

-lik

e ch

arac

teri

stic

s

As illustrated in Figure 5.2, hybrid capital securities are instruments like preferred stock whichexist between ordinary debt and equity as a hybrid of the two distinct instruments. While hybridsecurities combine features of both debt and equity, specific capital instruments defined as‘hybrid’ can differ greatly because of the jurisdiction of the issuer and the approach required toconstruct the hybrid structure. Structuring will focus on which point of the debt/equitycontinuum to start at and how feasible it will be to ‘stretch’ the various boundaries toward thecentre zone of the hybrid security Venn diagram – to ‘thread the needle’.

Technical foundations

Regulatory capital Banks issue the greatest volume of hybrid securities in the global market and provide the widestuniverse to look at in making distinctions about hybrid capital securities for regulatory purposes. Thepurpose of bank regulatory capital is to provide a cushion to absorb the potential losses of a deposit-taking financial institution. The regulatory capital takes the first losses before general creditors areimpacted and without damaging the interests of depositors since safety of pubic deposits isparamount to a sound financial system. Furthermore, the equity investors providing regulatorycapital are seen to be risking their ‘own funds’ before those of the depositors and creditors.

The establishment of bank capital guidelines and monitoring adherence to guidelines for bankcapital management by bank regulators is accomplished in part through capital ratios designed toreflect how well a bank can support the asset risks in its business. Regulators in each jurisdictionwill set minimum capital ratios for individual banks.

General characteristics of bank capital (based on BIS guidelines)0 No legal/contractual obligation to pay;0 Ability to absorb losses;0 Fully paid up (cash in bank);0 Issued to independent external investors;0 Permanent.


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Figure 5.3: Hybrid Tier 1 structuring considerations


TTaaxx- Deductibilty- Witholding tax- Stamp duties- DRD

RReegguullaattoorryy- BIS guidelines- Definition of tier 1 (national)- NAIC- Solvency 2- Linkage/ triggers- Limits on hybrid tier 1

IInnvveessttoorr rriisskkss- Credit- Subordination- Deferral- Extension- Event risk- Liquidity- Index inclusion

AAccccoouunnttiinngg- Debt vs. equity distinctions- Minority interest accounting- Consolidation/de-consolidation- Hedge accounting

RRaattiinngg aaggeenncciieess- S&P, Moody’s, Fitch- Equity content/financial flexibility- Ongoing rating concerns- Cash flow & fixed charge coverage- Assigning ratings (notching relative to senior)

LLeeggaall- Debt vs. equity definitions - PFIC/PTP- Preferred stock definitions - SEC registration- Disclosure (144A/SEC) - ERISA- 1940 act issues- Prosperous directive

HHyybbrriidd ssttrruuccttuurree- Maturity - Direct/SPV- Ratings - Debt vs. equity- Step-up/trueperp - Cumulative vs - Retail/inst. non cumulative- Replacement - Call features

language - US/Euro/Other- ACSM - Mandatory deferral- COC

IIssssuueerr oobbjjeeccttiivveess- Strategy- Foreign exchange risk- Asset efficiency- Execution (price/size)- Investor diversity- WACC/ROE- M&A

« «

«

«

«

«

« « « «

«


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Tier 1 hybrid instruments

0 Perpetual (undated in most jurisdictions, some exceptions);0 Deep subordination – rank senior only to common stock; 0 Fully discretionary payments (non-cumulative if eliminated);0 Loss absorbing;0 Issuer call option permitted with regulator’s consent;0 Step-up rates generally allowed (but limited amount of step-up);0 ‘Innovative’ instruments (such as step-ups) limited to 15% of total Tier 1 capital.

Tier 2 hybrid instruments

Upper Tier 2:

0 Perpetual (undated in most jurisdictions);0 Subordinated to senior creditors and depositors;0 Interest deferral option (cumulative);0 Loss absorbing;0 Issuer call option permitted with regulator’s consent;0 Step-up rates allowed but limited.

Lower Tier 2:

0 Dated – minimum original maturity of five years;0 Subordinated senior to Upper Tier 2, but junior to creditors’ deposits;0 Interest cannot be deferred. Non-payment is an event of default; 0 Issuer call option permitted with regulator’s consent;0 Step-up rates allowed but limited;0 Capital value amortises 20% per annum in last five years for regulatory purposes.

Tier 3 capital

0 Dated subordinated debt (minimum maturity two years);0 Issuer call option permitted with regulator’s consent; 0 Lock-in clause stops payment of interest and/or principal if capital too low;0 Supports trading book (market risk not credit risk);0 Does not amortise.

Insurance companies are also major issuers of subordinated capital securities and the capital rulesthat they follow (Solvency) are similar but different to banks’ and are expected to continue toconverge with the capital rules of banks as Basel ll and Solvency ll evolve. Major global insurancecompanies have been active in issuing Tier 1 eligible securities even while the regulatory capitalrules for Solvency ll are still developing. Several major insurance companies have also taken anearly interest in the opportunity to gain greater amounts of rating agency equity credit from theregulatory capital hybrid Tier 1 securities they issue. This has been a catalyst for the evolution ofhybrids for banks and insurance companies.

Tier 1 securities always include common stock and in many cases classic preferred stock (where itexists in the legal system). Hybrid Tier 1 is a synthetic equivalent to such preferred stock (orpreference shares) in terms of permanence, loss absorption, payment discretion (non-cumulative)and other key features, but with some terms tweaked to achieve tax deductibility. The hybridstructuring building blocks therefore include preferred stock equity securities (where it exists)and/or Upper Tier 2 subordinated debt.

Upper Tier 2 subordinated debt is usually a tax deductible security and if one takes that as astarting point to create hybrid Tier 1 then the challenge is to enhance its equity features enoughto increase its capital value without losing the tax status as deductible debt. For example,cumulative Upper Tier 2 payments need to be structured as non-cumulative payments for theinstrument to have a possibility for qualification as Tier 1. The development of ACSM helps spanthe gap by creating a quasi-cumulative payment. ACSM features allow deferred payments to besatisfied with cash from a new sale of equity-rich securities (common, preferred, converts,warrants) to raise the cash or other methods including payment in kind (PIK) with more hybrids.This makes the security more like a cumulative security and therefore more debt like. This can bea crucial difference to the tax analysis and to the investor marketing.

ACSM features are an example of the ‘structural conservatism’ that has been exhibited in recenthybrid product development. Fortunately, there has been a continued spirit of accommodationand a more sophisticated approach from the rating agencies and other key constituents inevaluating equity ‘equivalence’. This has expanded the eye of the needle in the hybrid capitalstructuring Venn diagram and allowed for more hybrid structures that simultaneously:

0 Qualify as equity and/or capital; 0 Achieve tax deductibility; 0 Address investor risk factors.

For example, a hard-line approach to evaluating the equity essence of an instrument would ask:“Is it perpetual or not?” However, there are more sophisticated ways to consider the question. Ifan instrument in present value terms is considered (discounting future payments) a perpetualinstrument (with no maturity requiring payment at a specific date) is somewhat equivalent to aninstrument with a 1,000 year maturity (if you are able to get money today and you do not have torepay for 1,000 years, or at an indefinite future date that you choose, or never – it is about thesame to you).

Working back toward today from 1,000 years to 100 years (60, 30, 20 and so on) the value of thepayment due starts to become more significant. Current thinking by rating agencies seems to bethat 50 to 60 years is long enough to get significant equity credit. Therefore you will see inChapter 6 that deal terms in corporate hybrids started as perpetual but there are more recentexamples of 1,000, 100 and 60-year maturities.

The evolution of international regulatory capital guidelines has historically aimed to create a levelplaying field among financial institutions – particularly as multinationals become morecompetitive with each other on a global basis. National tax and legal regimes have been one ofthe binding constraints preventing this homogeneity across countries. In the US and some othercountries, hybrid Bank Tier 1 can be in the form of a dated security because the tax rules wouldnot allow deductions on perpetual Tier 1 instruments (see the US taxation perspective article laterin this chapter) but the regulator has taken the view that the overall qualities of the security meettheir hybrid Tier 1 standards and the use of such hybrids is limited within the capital structure.Time will tell if various other regulators will also adopt a more constructive view of perpetual re-quirements for hybrid Tier 1 versus a ‘perpetual equivalent’ long dated security and ACSMresolved payment deferrals as effectively the same as non-cumulative payments.

Legal In most major countries the legal form of distinct capital market instruments can be distin-guished as debt or equity and the literal interpretation of ‘security’ can be reliably articulated toascertain the legal rights, obligations, recourse, penalties, claims and cures that form the contractbetween the investor and the issuer. A long history of the actual resolution contested claimfurther assists structuring new instruments with confidence. In such cases a debt security usuallyhas a specific format and an equity security has a specific format and a properly drafted set ofterms will tell a lawyer or a court what the security is meant to be and what obligations, benefitsand optionality are intended.

From a hybrid structuring perspective it is helpful if the legal system also has a clear definition ofpreferred stock or preference shares in addition to debt and common equity. However, in manyemerging jurisdictions this is often not the case and other structural solutions must beconsidered.

Generally, the legal aspects are fairly black and white. The legal perspective focuses to provideproperly drafted documentation at the time of the deal (debt/equity) as instructed by the partiesto the deal based on their negotiations. If the issuer maintains its credit and satisfies the terms ofthe security there should be no legal contest over the term of the issue.

TaxContrast the clarity of issues in the legal documentation process with the opaqueness of most taxlaw. There is real money at stake between the tax authority and the deal parties – yet the taxauthority is often not party to the deal terms when the deal is structured. However, the taxauthorities can take action any time after the deal is closed (deny deductions, impose withholdingtax, etc). Issuers should seek tax-efficient means of financing their businesses to produce optimalshareholder risk adjusted returns.


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Taxes, like all business expenses, should be prudently managed and tax planning involves riskmanagement. Frequently where there is a quirky feature in the structure of a hybrid deal it isdriven by the tax optimisation of the structure within the context of the jurisdiction where it wasissued. International investors do not want to be exposed to the tax risk of the issuer’s home juris-diction (where investors cannot hope to be experts), therefore tax risks are usually borne by theissuer (i.e. gross-up clauses, redemption features).

The determination of expected tax treatment often comes down to reasoned judgment from legaltax experts based on precedent and case law (which may not be available) on the specificstructuring nuances. The use of a strong tax counsel is imperative and where possible a strong taxopinion from the lawyers or ideally a tax ruling from the local tax authority is advisable to ensurebest results. Some of the recent innovations in the US market have been accomplished throughadvances in the application of the US tax law given the greater depth of legal context the industrynow enjoys as the hybrid security product proceeds through its second decade of existence. Pleaserefer to the US taxation perspective article at the end of this chapter for an in-depth look at the UStax issues and their impact on the evolution of hybrid securities.


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SPV hybrids These are one of the most useful and prevalent structures employed in hybrid capital structuring.

The use of an SPV in hybrid structuring can assist in achieving many issuer objectives, including:

0 Accounting minority interest (quasi-equity) – consolidation of SPV onto parent financial statements;0 Deconsolidation (orphan SPV);0 Tax optimisation (withholding tax, stamp duty, deduction);0 Elimination of voting rights;0 Change characterisation (debt in, equity out or the opposite);0 Payment deferral control – switching payment flows to investors ‘on’ or ‘off’ and providing a way to

overcome the rigid limits of the debt securities (tax) in order to meet the capital and equity requirements;0 Investor tax reporting (Trust vs. Limited Partnership investor tax reporting);0 Aggregating/splitting benefits – two or more securities may be input to the SPV and then an aggregation

or subset of the combined features can be provided to the investors with investors only needing to hold one single security.

As the hybrid products have become more reputable globally the system has evolved in some countries tostreamline the available structures for achieving the benefits of hybrids.

For example, it is increasingly common to have direct issue hybrid securities replacing the more complicatedSPV issues which preceded them. This is the case in France, the Netherlands, the UK and Italy to name a few.Sometimes this required a change in law (as in France), other times just a greater leniency from a regulator,rating agency or other constituent that had previously resisted.

One of the catalysts has been the increased issuance by insurance companies and corporates that onbalance have a greater incentive to seek rating agency benefits. Banks did most of their hybrid developmentduring the late 1990s and in some case had exemptions they could use to balance the tax/regulatorytensions. Since then they have been happily issuing on a frequent basis with fairly modest incremental im-provements or changes to the bank capital structures.

Typical SPV structure This can be established in three easy moves:

1) The bank establishes a wholly-owned SPV by investing a nominal amount of capital to acquire 100% of theSPV common equity. The ideal conditions for the SPV include the following:

0 Bankruptcy remote;0 The SPV begins as a clean ‘shell’ – a new pass-through entity, no contingent liability from past operations,

no other activities permitted;0 The SPV can be consolidated as quasi-equity (such as minority interest);0 Fiscally transparent (no/minimal SPV level tax leakage) usually based on jurisdiction of SPV (e.g. Cayman,

Delaware);


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0 The SPV will benefit from a ‘guarantee’ by the parent bank which allows it to benefit from the credit ratings

0 of the parent bank. The guarantee is a subordinated level of limited guarantee suitable to the capital natureof the security (no senior guarantee on capital).

2) The bank issues an instrument (subordinated notes, deposit security) to the SPV in return for cash.3) The SPV issues ‘capital securities’ to third party investors (cash proceeds are used to pay the bank for theinstrument it provided to the SPV and to get the cash to the bank as required for Tier 1 eligibility).

Because of the use of the SPV to issue the actual capital securities these structures are often referred to as‘indirect issues’. At inception, the proceeds from the third party capital security investors are used by the SPVto purchase the subordinated securities from the parent bank. It is important to note that the cash goes allthe way back to the parent bank providing it with the full benefit of the issuance of hybrid Tier 1. Thesubsequent subordinated security payments from the bank to the SPV fund the SPV capital securitypayments to investors.

If a capital event or regulatory event or other specified non-payment event occurs, capital security paymentsto investors can be eliminated by either suspending payments at source on the subordinated security or by retaining cash at the SPV and routing it back to the parent bank as an SPV common dividend payment(since the parent bank owns all the common stock of the SPV). Since the capital security is the securityissued out of the SPV and not the security the SPV acquires from the bank the capital will show up in the consolidated financial reports of the bank but will not be included on a ’solo’ reporting basis where subsidiaries are excluded.

In the first phase of adoption of SPV hybrid Tier 1 by international regulators the accounting treatmentreceived significant focus but over time this has diminished in some jurisdictions. This is a very simplified illustration of the US trust preferred security structure and many of the early SPV structures used in Europeand Asia.

Figure 5.4: Simple SPV Structural Diagram


Issuer

SPV

«

«

«

Investor

«

Cash proceeds

Subordinatednotes (interestpayments taxdeductible)

Subordinatedguarantee

Capital securities

Cash proceeds

«

Summary rating agency guidelines There is a summary later of the guidelines from the major rating agencies. There is a strongcorrelation with the bank capital guidelines and the preferred stock paradigm, in that all concurthat equity is:

0 Permanent (no maturity or long maturity);

0 Has no ongoing payments that cause default;

0 Absorbs losses.

The primary structuring objective with regard to rating agency credit has been to achieve 50–75%equity credit by including key features that the rating agencies consider adequate to meet thesemajor criteria. In the Moody’s terminology, for example, 50% is ‘Basket C’ and 75% is ‘Basket D’.Achieving the high equity credit status of Basket D has been the innovation in most of the nextgeneration hybrids (see the text box below). To obtain even greater equity credit an issuertypically would need to consider a mandatory convertible security linked to its common equityand dilutive to its shareholders. Such securities are considered to be part of a different market;they are sold to different investors and they require different issuer considerations and are notaddressed in detail in this report as a result.

Rating agencies studied the available historical data to evaluate the observable behaviour of capitalsecurities in prior periods when the issuing entity is under severe financial distress and in somecases liquidation. The subordinated securities had low recovery rates in liquidation because theyare ‘loss absorbing’ and paid after senior creditors and depositors with any residual funds. Therating agencies observe that optional payment deferral is often not used to conserve cash or is usedreluctantly by management. This review of the historical performance decreases the rationale forhigh equity credit for optional payment deferral but could encourage investors that deferral isactually somewhat unlikely. Greater equity credit is given by rating agencies if mandatory paymentdeferral is included in the terms but this increases investor risk (as discussed below).


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There are also examples of SPV hybrid Tier 1 structures where the SPV is not owned or guaranteed by thebank (issuer). In such cases the actual capital security is issued directly from the bank to the SPV. The SPV inthis case serves a different purpose – typically to make the bank capital security more marketable to the in-ternational investors (e.g. management of withholding tax). The SPV in such case is owned by an independentthird party or is an ‘orphan’ not owned or consolidated by the bank. The SPV securities will provide a simplepass-through of the capital security payments and the nature of the securities (debt/equity) is not typically amajor factor in the structuring for regulatory capital qualification since they are issued by an independententity. In Chapter 6 there are examples of German and Irish hybrid structures of this variety.

Deft hybrid structuring professionals demonstrated an ability to overcome most concerns the regulatorsidentified with hybrid securities. Good structuring led to SPV hybrid Tier 1 that was by most accountsequivalent to what the regulators said they needed for a Tier 1 instrument. To the extent any one hybridstructure was imperfect in its ability to completely satisfy 100% of the national regulators’ requirements therewere several examples of ’less perfect’ securities that were already accepted as Tier 1 in another country. Theinternational regulators desire to harmonise Tier 1 guidelines globally and to create a level playing field led tocompromise. Since adroit financial engineers seemed to overcome most roadblocks to the adoption ofhybrid Tier 1eventually it was accepted within broad guidelines that provided for national regulator discretionand local tax needs. Instead of continuing to focus on the exact nature of Tier 1 instruments, limits were putin place on the amount that could be included in the capital structure.

One criticism of SPV structures was the perceived complexity, potential complications in a liquidationscenario and the perceived distance from the bank and its regulators. Capital should be pure, said some. SPV structures were also unfairly cast in a negative light because completely unrelated schemes andunrelated business entities sometimes used SPVs to accomplish unsavoury ends (such as money laundering)particularly in countries deemed to be offshore ‘tax havens’. It was important that legitimate bank capitalshould not be tarred with the same brush. Therefore the move to direct issues has increased over time. InChapter 6 there are numerous indirect issue SPV structures and also direct issue structures detailed fromvarious countries.

Practical considerations There are structural deviations from the preferred stock paradigm necessitated by the practicali-ties of the markets:

0 Investor protections – It is no good creating a structure that cannot be sold to investors. Investors seek structural enhancements that strike a balance between risk and reward that justifies investment in the hybrid asset class;

0 Issuer protections – What if it all goes horribly wrong? Issuers need the flexibility to unwind or make a special redemption if all the intended benefits are eliminated.


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How to achieve a Moody’s Basket C or Basket D Assuming the subordinated (loss-absorbing) instrument is very long dated (60 years) or perpetual, the focusshifts to eliminating payments and increasing permanence.

Basket CA Basket C hybrid will normally include ‘Intent-based’ replacement language and optional payment deferral.

Optional deferral – Payment can be deferred/eliminated at the issuer’s discretion if no common dividend wasdeclared at the last Annual General Meeting.

There are several variations in the resolution of the payment deferral among different hybrid transactions:

0 The optionally deferred payments can be either cumulative or non-cumulative, depending on jurisdiction (if non-cumulative, the payment is lost);

0 Optionally deferred payments can be cumulative for a specified or indefinite period of time;0 Optionally deferred payments may be eligible for settlement via an ACSM, wherein the issuer could pay with

proceeds from the selling of existing or new ordinary shares, preferred shares or various benign/parity securities;

0 The ACSM can be an intention from the issuer to attempt to issue stock (soft ACSM) or an obligation from the issuer to use such a mechanism to satisfy deferred coupons (hard ACSM).

Basket DA Basket D hybrid will also include optional deferral but will add either mandatory payment deferral or legallybinding replacement language (LBRL).

Mandatory payment deferral: At the occurrence of a ‘meaningful deferral trigger’ hybrid payment ismandatorily deferred (similar payment deferral resolution alternatives to optional payment deferral). As anexample, the Moody’s original standard of reference is the MetLife trigger, which includes either of thefollowing:

0 Four quarters of net loss and shareholders’ equity down by more than 10% compared to prior 8 quarters; 0 Covered insurance subsidiaries’ risk based capital ratio is less than 175%).

This is seen to increase the hybrid equity content with reference to ‘no ongoing payments’ and mitigates theagency concerns that issuer management will continue to make optional payments when cash conservationwould be better for the senior creditors’ risk exposure.

Replacement language – To increase the hybrid permanency for more equity credit, LBRL can be includedinstead of mandatory payment deferral. If the hybrid securities are called, the issuer must replace them withinstruments of equal or greater equity content.

The replacement issue is not as critical for issuers that are deemed to be strictly regulated (since the bankregulator will monitor capital needs) but has been important for insurance and corporate hybrids.

To comfort investors, some structural features such as the ACSM have become increasinglypopular. As discussed in the investor overview (Chapter 4) there are two major market segments(institutional and retail, private bank or RPB) and each has a different approach to evaluatinghybrid security investment decisions. As the M&A boom has driven the need for larger hybridtransactions the institutional market has been the primary market for execution. Institutionalinvestors tend to put greater focus on the detailed terms of hybrids and the potential risks theycontain, such as:

0 Non-payment;

0 Subordination;

0 Extension risk.

To increase the investor universe willing and able to buy hybrids and to lower the issuers’ cost ofcapital funded via hybrids, more debt-like features have been included in contemporary hybrids(which also helps the tax analysis in some countries).

Addressing investor non-payment riskInvestor payment risk is different across various hybrid structures. Hybrid payments can bedeferred on an optional and/or mandatory basis. The deferred hybrid payments can be either:

0 Cumulative;

0 Quasi-cumulative via ACSM;

0 Non-cumulative, depending on jurisdiction and the structure.

Therefore investors should always focus on these distinctions when comparing hybrid securities.

Payment deferral conditionsOptional payment deferral – Hybrid payments can be deferred at the issuer’s discretion if nocommon dividend was declared (within a specified look back period). This preserves the hybridequity position in ‘preference’ to common equity so that common does not get paid whenpreferred or hybrids do not.

Mandatory payment deferral – Hybrid payments must be deferred if a specified financial trigger(included in the offering documents) is breached. Regulatory capital securities will also be subjectto solvency or capital adequacy triggers and to discretion of the national regulator. In somestructures there may be additional conditions such as the availability of distributable profitsand/or reserves.

Deferred payment resolutionIf the securities are truly non-cumulative like classic Tier 1 (preferred stock, common stock),payments that are not made will be lost forever. Deferred payments can alternatively becumulative for an indefinite or a specified maximum period of time (such as five or 10 years). Atthe end of the specified period, payments may either become due or in other structures will belost forever.

While non-cumulative payments are ideal in ‘equity’ instruments, both fixed income investorsand certain tax regimes are more comfortable with the more debt-like cumulative payments. Non-cash cumulative payments achieved via ACSM reconcile the two divergent constituents andstretch the ‘eye of the needle’ to fit more deals through. Therefore in many recent hybrids theissuer may satisfy deferred payments through the ACSM by paying the coupons with cashproceeds from the sale of new common/ordinary shares, preferred shares or parity securities orPIK. The ACSM can be an intention from the issuer to attempt to issue stock (soft ACSM) or anobligation from the issuer to use such a mechanism to satisfy deferred coupons (hard ACSM). Theinvestor risk is derived in part from these structural differences as shown in the payment flowdecision trees which follow. By comparing these illustrative example, subtle but potentiallyimportant differences can be observed that are typical in the universe of hybrid securities.

Remember, every hybrid security needs to be examined in relation to the full terms andconditions of the offering circular and insight can often be gained from the rating agency write-ups on specific transactions. Differences may exist within sector, within country and even amongseveral hybrids issued by the same company.


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Insurance hybrid, example 1This structure has three primary events that could result in payment deferral or elimination:

1) Optional payment deferral – This is possible if no common dividends have been paid during the12-month look-back period. If the issuer’s option is exercised by company management, thenpayments are lost (non-cumulative);

2) Solvency event – Payments are stopped and lost forever (non-cumulative);

3) Mandatory payment deferral – If this is breached payments are deferred and may be settled viaACSM.

Insurance hybrid, example 2This structure has three primary events that could result in payment deferral or elimination:

1) Optional payment deferral – This is possible if no common dividends have been paid during the12-month look-back period. If the issuer’s option is exercised by company management, thenpayments are deferred and may by settled via ACSM (quasi-cumulative);

2) Solvency event – Payments are deferred and may be settled via ACSM (quasi-cumulative);

3) Mandatory payment deferral – If this is breached, payments are deferred and may be settled viaACSM.


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Figure 5.5: Hybrid, example 1 - interest payment mechanics


Yes

Yes

Yes

Yes

YesNo

No

NoNo

No

Lookback=12 month

period

Payment of common stock

Has a dividendbeen declared

or paid? Coupon is lost

Solvency event Mandatory deferral event Payment outcome

«

«

«

«

«

«

«

«

«

«

«

Is there a solvencyevent?

Is there a mandatory

deferral event?

Coupon is paid (dividend pusher)

Mandatory deferral: couponis deferred ACSM applied

Optional deferral: couponpaid/cancelled at option of

issuer


deferral event?




Yes

Yes

Yes

Yes

YesNo

No

NoNo

No

Lookback=12 month

period



or paid?

Solvency event Mandatory deferral event Payment outcome

«

«

«

«

«

«

«

«

« «

«



deferral event?

Coupon is paid (dividend pusher)

Mandatory deferral: couponis deferred ACSM applied

Optional deferral: coupon isdeferred ACSM applied


deferral event?


Insurance hybrid, example 3This structure has only optional payment deferral, which may be settled via ACSM:

0 Optional payment deferral – This is possible if no common dividends have been paid during the12-month look-back period. If the issuer’s option is exercised by company management, thenpayments are deferred and may be settled via ACSM (quasi-cumulative).

Addressing investor extension riskFixed income institutional investors prefer a known maturity and principal repayment certainty –a step-up rate at the hybrid call date increases certainty. Both regulators and rating agencies limitthe size of the step-up since they think that an excessive step-up will motivate early redemptionand decrease the ‘permanence’ of the hybrid capital in the capital structure. Therefore step-upsare generally limited to 100bp (with several exceptions). The 100bp step-up amount is added tothe original fixed rate spread at the pricing date (expressed as a Libor spread or equivalent). Thestep-up occurs after the call date (usually in year 10) when the coupon changes from fixed rate tofloating rate.

Because banks rely on frequent access to the capital markets for liquidity most market partici-pants expect banks to call the securities and refinance at the call date in order to satisfy investorpreferences and maintain low-cost access to the capital markets. Some high-quality banks withvery reputable management teams have successfully issued perpetual hybrids with no step-up atall. These hybrid securities are referred to as True Perps to distinguish them from step-up hybrids.

For insurance companies and corporate issuers the liquidity incentive is less evident and investorshave greater concerns over the extension risk presented by a step-up which is considered too low.Lower rated issuers further stress the investors risk analysis since there is greater possibility thatthe credit will deteriorate and the hybrid will not be economical for the issuer to refinance. If thehybrid security has a maturity (as seen in several corporate hybrids) this may give some comfortthat eventually the principal will come due, even if the securities are not called when the step-uprate kicks in. Hybrid issues that are not intended to provide regulatory capital or high levels ofrating agency equity (such as those for accounting equity or just long-term low-cost quasi-capital)have used higher step-up to increase the demand from investors by reducing their perceived riskof extension at the call date.


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Dividend stopper - if interest payments are optionally deferred, no dividend payments on any shares of capital stock can be made, and no payment of principal or interest on anypari passu/junior securities can be made (including securities issued of subsidiary level)Source: Compiled by CALYON

Yes

YesNo

No

Lookback=12 month

period



or paid?

Optional deferral Payment outcome

«

« «

Are paymentsoptionallydeferred?

Coupon is paid

Coupon is paid

Optional deferral: coupon isdeferred ACSM applied

«

No «

« Are payments

optionallydeferred?

NOMANDATORY DEFERRAL:

MOODY’S BASKET D ACHIEVED WITHLEGALLY BINDING REPLACEMENT

LANGUAGE

Addressing investor event risk

Change of control clause (COC) Event risk – such as LBO takeover risk – is sometimes addressed via very high rate step-ups(500bp) linked to a rating downgrade threshold (typically below investment grade) that resultsfrom a change in control (merger, takeover). The company can pay or accrue at the higher interestrate or tender to redeem the impacted securities benefiting from the COC. The step-upmechanism is less effective in a truly non-cumulative instrument. The key risk to investorswithout the COC clause is that a company is taken over via a highly leveraged financing thatleaves the company highly geared. Potentially common stock dividends could be cut by the newcompany owners to service senior debt payments. Once the common dividends are cut, thehybrid payment discretion comes into play and hybrid payments could also be deferred oreliminated to service senior debt. Under such a circumstance the hybrid investor could be stuck ina radically different (worse) credit and be holding a zero coupon perpetual subordinated security –ouch!

Issuer protections Issuers pay a yield premium when they issue hybrids compared to what a similar term plainvanilla senior issue would cost. The incremental cost is justified by the various benefits hybridscan provide, but the main benefit is low cost equity. One of the essential features of equity,according to many market constituents, is permanence. Therefore hybrids are structured longdated or perpetual. Even the scheduled optional call date is usually five or 10 years after the dateof issue. So the issuer is making a long-term commitment when they decide to issue hybrids. Ifthe rules change and the key benefits are lost or a new adverse condition arises, the issuerobviously would like the flexibility to redeem (or modify) the hybrid securities. Typical earlyredemption events to protect the issuer in the event a change of rules diminishes the hybridsbenefits are as follows:

0 Accounting event;

0 Capital event;

0 Tax event;

0 Additional amounts event (typically withholding tax);

0 Acquisition event.

Figure 5.8 illustrates the potential functioning of a hybrid security with various early redemptionoptions for the issuer’s protection.

However, investors could suffer a loss due to an early redemption at the issuer’s option, since thehybrid security may be trading at a premium or the investor may have ’locked up’ the asset bymatching it against specific liabilities or hedged it or be prevented by charter from selling. A‘make whole call’ is designed to comfort investors that they should be fairly paid if the issuerneeds to redeem ahead of the scheduled call date. A make whole call price is normally derivedfrom discounting the remaining cash flows by a low discount rate that will provide a premiumprice that is in excess of what the investor might reasonably expect the bond to be at. With amake whole call and a generous call price investors should be interested in allowing a call at anytime, as shown in the structure in Figure 5.8.


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Accounting guidelinesDefining equity instruments under IFRS:

“Under IFRS an instrument is classified as equity if there is no contractual obligation to delivereither cash or another financial asset or exchange financial assets and financial liabilities atpotentially unfavourable terms to the issuer.” “Equity represents a residual interest in the assets of an entity.” “If there is a contractual obligation to deliver cash, the instrument is debt (financial liability).“

According to §16 IAS 32, a hybrid capital instrument issue can be treated as equity if and only if itdoes not bear any contractual obligation to:

0 Pay cash or any other financial asset;

0 Exchange financial assets or liabilities with a counterparty according to conditions that would be unfavourable for the issuer.

Therefore, if a security includes no obligation of financial reimbursement or cash payment, thesecurity should be accounted as equity. The main characteristics of hybrids compatible with anequity treatment according to §17 are as follows:

0 Any call feature is in the hand of the issuer (no investor put);0 The payment must be discretionary – solely the decision of the issuer (like dividends); 0 The past dividend paying payment track record is not deemed an obligation to pay cash;0 Cumulative feature of payments is allowed (like common stock ‘retained earnings’);0 Step-up at call date is allowed. The typical 100bp will not prevent the instrument from being

treated as 100% IFRS equity. Most reasonable step-ups measured in relation to the coupon and market norms should be allowed since economic incentive is not the same at a contractual obligation.

The equity classification of the hybrid instrument ultimately will be determined by the issuer’sauditors and this is a subjective and evolving practice area where divergent judgements ofdifferent firms and individuals may occur.

The IFRS classification of an instrument as equity can also prohibit the use of hedge accounting ifan issuer intends to swap the transaction. Therefore if the characteristics of the security providefor equity treatment under IFRS rules, swapping the issue will not allow for hedge accounting.


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Figure 5.8: Hybrid example 3 - optional early redemption mechanics


Yes

No

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ccaappiittaall eevveenntt ttaaxx eevveenntt

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IIssssuueerr ooppttiioonn ttoorreeddeeeemm sseeccuurriittiieess

- in whole but not inpart

- at 101% of principleamount + accrued

interest



- at special make -whole redemption

price (higher of principle amount orprice equiv. of Bunds

+ 100) + accruedinterest


- in whole, but not inpart

- at principle amount +accured interest

IIssssuueerr ooppttiioonn ttoo rreeddeeeemmsseeccuurriittiieess


-at principle amount +accrued interest

IIssssuueerr ooppttiioonn ttoo rreeddeeeemm sseeccuurriittiieess - in whole but not in part

-at make -whole redemption price (the higher of principle amount orprice equivalent of Bunds +25 + accrued interest

«

« Scheduled call date?

«

«

Has early redemptionevent occurred

Yes

No

SSttaannddaarrdd ffeeaattuurreess::

Rating agency approaches to hybrid capitalThe three major credit rating agencies (Moody’s, S&P and Fitch) contemplate hybrid capitalsecurities from two angles:

0 The credit rating allocated to the specific security signals risk to investors;0 The balance sheet equity content allocated in determining the issuers overall rating.

Therefore, the following two perspectives of the rating agency methodologies will be discussedfor each of the key rating agencies:

0 Methodology for the allocation of equity credit;0 Notching practice for banks, insurance and corporate hybrid structures.

To generalise a metaphor, it could be said that Moody’s published framework for analysis seemsmore focused on the hybrid ‘tool’ while S&P publications seem to consider also the ‘craftsman’that will use the tool and the ‘task at hand’. Clearly, the work completed by the rating agenciesaccelerated the adoption of hybrids by issuers and investors alike and will continue to shape thefuture of the hybrid security market.


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Table 5.1: Hybrid securities – summary primary foundations

Regulatory Rating agency Accounting Legal Taxation Investors

IIssssuueerr aaiimm Tier1 Regulatory Rating agency Equityaccounting Structure permissible Tax Investor-friendlycapital equity credit under IFRS under legal framework deductibility structure to achieve

achieved of issuer jurisdiction achieved widerplacement/ tighterpricing

EEqquuiittyy--lliikkee// More equity - like More equity - like More equity - like EitherEquityorDebt More debt - More debt - likeDDeebbtt--lliikkee (however, some like (if

issuers want debt deduction treatment) desired)

PPeerrmmaanneennccee -Permanent (perpetual) -Permanent -Perpetual (no -Perpetual or long -Overall -Limits to duration-Limits to minimum (perpetual/ long maturity) dated natureof to reduce costcall date dated) -Long call date security -Prefer shorter-Limits on maximum -Limits to -Reasonable considered call datestep up minimum call date step-up taking into -Preferhigher

-Limits to account all step-upmaximum step-up features and-Replacement case rowlanguage precedent

-In some cases,specificsecurity typesare deemeddeductibleunder local law (Preferentes, TSS, Stille Einlage, etc.)

SSuubb-- -Deeply subordinated- -Deeply -Not required for –Case law referred to -Jurisdiction -Price premiumoorrddiinnaattiioonn senioronly to common subordinated- IFRSequity forprecedent dependant required for

equity senioronly to classification -Legal and subordination-Loss absorption common equity accounting

-Loss absorption treatmentmaybe

AAbbiilliittyy ttoo -Non-cumulative -Non-cumulative -Non-cumulative -Civil code referred to observed -Cumulative orddeeffeerr -ACSM where allowed best -Can be quasi -Exchange/other for support quasi-cumulative ppaayymmeennttss -Can be quasi cumulative- but rules applied better

cumulative (ACSM)payments must -Non-cumulative remain fully requires premium discretionary


Until the release of a seminal series of 2005 publications, the rating agency methodology forhybrids was viewed as opaque and lacking clarity, leaving issuers and investors wary. Increasedtransparency at the rating agencies, accompanied by clarification around their methodologies,gave rise to increased levels of issuance and innovation – particularly from the corporate sector.

Investors also benefited from these publications as they helped highlight the potentialrisk/reward trade-offs of hybrid investment, both in the narrative and via a system of ratingsnotches to visually flag the potential incremental risks. Generally, for investment grade issuers,both Moody’s and S&P apply one notch down for subordination and one notch down for possiblepayment deferral. If mandatory deferral is included in the structure, S&P may apply a third notch.Lower rated issuers may be notched further.

Rating agencies continue to refine their methodologies for assessing hybrid securities, with anincreasing focus on the structural detail. However, continued refinements to their methods havesometimes put unwelcome volatility into the system, frustrating issuers and investors grapplingfor stability and clarity in their understanding of the emerging asset class. Given the huge contri-bution of the rating agencies this criticism seems a bit unwarranted and market participantsshould expect changes as the market collectively learns more about the hybrid asset class.


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Table 5.2: Notching for hybrid securities

Corporate Hybrid Insurance Tier 1 BankTier 1 UpperTier2 LowerTier2Moody’s (FSR Cand above) + 2 notches + 2 notches + 2 notch + 1 notch + 1 notchS&P(Seniorabove BBB-) + 2/3 notch + 2/3 notch + 2 notches + 2 notches + 1 notchFitch (Seniorabove A-) + 1 notch + 1 notch + 1 notch + 1 notch + 1 notch


Table 5.3: Development of the ‘meaningful’ mandatory deferral trigger, 2004 - 06

Issue Date Transaction Mandatory deferral trigger20-Feb-2004 Allianz€1.5bn Perp nc2014 1 - Net loss26-Jan-2005 AGF €400m 4.625% Perp nc2015 1 - Net loss with a 4-quarter look-backat capital formation9-Jun-2005 Metlife US$1.5bn 6.5% Perp nc2010 1 - 4-quarterNet loss AND Shareholder’s equityhas fallen bymore than

10% compared to prior8 quarters (with 2 quarter cure period), OR 2 - Covered insurance subsidiaries risk-base ratio is less than 175%

28-Feb-2006 AllianzFinance II BV5.375% Perp nc2011 1 - Net income in preceding year is less than orequal to zero, AND 2 - Adjusted shareholders equityamount as at the end of the most recentlycompleted and published quarterof the Guarantorand as at the end of the quarter that is two quarters before the most recently completed and published quarterof the Guarantorhas declined by10% ormore, as compared to the adjusted shareholders equityamount as at the end of the quarterof the Guarantor that is ten quarters prior to the most recentlycompleted and published quarterof the Guarantor.

4-May-2006 ELM BV(Swiss Re) 5.252% Perp nc2016 1 -Consolidated net income for the two consecutive Reporting Periods ending on the Lagged Reporting Date is less than zero, AND 2 - Adjusted EquityAmount as at the Lagged Reporting Date has declined bymore than 10% as compared to the Adjusted EquityAmount as at the Reporting Date that is 24 months prior to such Lagged Reporting Date (the “BenchmarkAdjusted EquityAmount”), AND3 - Adjusted Capital Amount as at the Current Reporting Date has declined bymore than 10% as compared to the BenchmarkAdjusted EquityAmount.

7-Jun-2006 Generali €1.275bn 5.317% Perp nc2016 1 - Aggregate Net Income of the Guarantor for two consecutive Reporting Period ending on the lagged Reporting Date is less than zero, AND 2 - Adjusted EquityAmount of the Guarantoras at the Lagged Reporting Date has declined bymore than 10% as compared to the Adjusted EquityAmount as at the Reporting Date that is 24 months prior to such Lagged Reporting Date, AND 3 - Adjusted Capital Amount of the Guarantoras at the Current Reporting Date has declined bymore than 10% as compared to the Adjusted EquityAmount as at the Reporting Date that is 30 months prior to such Current Reporting Date.

Moody’s approachMoody’s produced their seminal Toolkit publications in 2005, which first gave clarity to the rating agencies methodology for assessing hybrid securities. To many market participants,Moody's have led in the development of the recent thinking on hybrid capital securities, thedistinction of debt from equity and how to craft a fixed income security that provides financialflexibility and capital structure benefits like common equity. Indeed, the Moody's Toolkitframework has been the most articulate and transparent summary of rating agency methodologyand it sparked a surge of new issuance and increased issuer and investor dialogue.

The essential features of an instrument are assessed compared with the key features of equity,which according to Moody’s include the following:

0 Permanence (no maturity or long dated);

0 No ongoing payments (which could trigger a default);

0 Loss absorption.

The features are scored according to their strength relative to equity using four grades:

0 ‘Strong’ (most-equity-like);

0 ‘Moderate’;

0 ‘Weak’;

0 ‘None’ (most-debt like).

A more detailed description of this framework for classification is given in their January 2006publication ‘Refinement to Moody’s Tool kit: An addendum for Banks and Insurers’.

After these three essential attributes are evaluated individually, the instrument’s aggregate scoreis considered relative to the debt-equity continuum and the hybrid instrument is placed in one offive baskets on the debt-equity continuum.

The amount of equity credit related to the basket of the particular hybrid security will impactpositively on the issuer’s overall credit metrics, provided the proportion is within the ‘tolerance’for total hybrid issuance for the particular senior rating level.

In summary:

0 Essential equity features are scored according to four grades – ‘strong’ (most equity-like), ‘moderate’, ‘weak’ and ‘none’ (most debt-like);

0 The instrument is put in one of five baskets in along the debt/equity continuum based on the essential equity features;

0 Each basket corresponds to a fixed amount of equity content to be used in balance sheet ratios;

0 Issuers should not use excess amounts of hybrid in the capital structure.


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Table 5.3: Development of the ‘meaningful’ mandatory deferral trigger, 2004 - 06 (cont.)

Issue Date Transaction Mandatory deferral trigger29-Jun-2006 Axa €1bn 5.777% Perp nc2016 1 - Accumulated Net Earnings of the Issuer for the two 6-month periods

ending on the Lagged Reporting Date is less than orequal to zero, AND 2 - Adjusted Shareholders EquityAmount as at the Lagged Reporting Date has declined by10% ormore as compared to the Adjusted Shareholders EquityAmount as at the end of the BenchmarkHalf-YearPeriod; AND3 - Adjusted Capital as at the Current Reporting Date has declined by10% ormore as compared to the Adjusted Shareholders EquityAmount as at theend of the BenchmarkHalf-YearPeriod.

Source: Transaction Offering Circulars

Market precedent and application of the Moody’s methodologyOne of the key features to have evolved from the Toolkit to enhance the ‘no ongoing payments’criteria is mandatory payment deferral. In order to increase the equity credit from Moody’s viamandatory payment deferral the term must be legally binding within the hybrid security termssubject to ‘meaningful deferral triggers’. This feature provides an important structural elementwhich has been applied by many recent hybrid issuers in order to achieve a Moody’s Basket Dweighting. A meaningful trigger should incorporate an income and capital trigger for insurancecompanies, capital trigger for banks and a cash flow trigger for corporates. Recent insurance andcorporate hybrid transactions provide the most prevalent precedent for these features (seeexamples in the text box). Since the issuers are legally required to defer payment if the trigger isbreached, investor risk is increased and market pricing is more costly for the issuer compared to aBasket C transaction which is only optionally deferrable. However many issuers consider the extrabenefit to be worth the marginal incremental cost.

Another important structuring aspect is replacement language in relation to the Moody’s criteriaof ‘permanence’. Because hybrids are typically callable (and often have a step-up payment rate atthe call date which could motivate redemption at the call date) it could be argued that suchcallable securities are not significantly permanent within the capital structure. Replacementlanguage seeks to comfort the rating agencies that hybrids will be a permanent part of the capitalstructure. Intent-based replacement language is the most common form thus far. In the offeringdocument the issuer states they intend to replace the hybrid with an equal or better equitysecurity. Intent-based replacement language has been included in all Basket C hybrids and ifmandatory deferral is included, then Basket D status can be achieved (if the other structuralaspects are appropriate). An alternative is the legally binding replacement capital clause.

With a legally binding replacement clause an issuer can achieve Moody’s Basket D withoutincluding the mandatory payment deferral feature in the structure. This could provide a lowercost Basket D hybrid issue since it subjects investors to less payment uncertainty. Also some earlyhybrid issues were notched down one extra notch by S&P to signal the risk of mandatory deferral(further increasing issuance cost) but legally binding replacement language would not attract thisadditional notch. A stifling complication is the impossibility or impracticality of drafting a legalcontract of this type in certain jurisdictions. The contract is not with the hybrid investors or withthe rating agencies, but instead with and independent third party such as a class of senior bondholders. Successful examples have, however, been observed in the US, UK and Australia.


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Mandatory deferralPayment discretion is essential for the financial flexibility of equity as it is defined by most constituents.However, some studies of historical bank hybrid payment behaviour suggest there could be a reluctance onthe part of managers to stop making optional payments. If this is true, the implication is that the value ofoptional payment deferral could have limited value in the determination of the equity nature of aninstrument. Therefore mandatory payment deferral provides greater equity essence within an instrument.

Regulatory bank capital securities typically have a series of events which could cause the issuer to be forcedto stop making its otherwise discretionary payments. Most significant is the ability of the bank regulator tostop payments should they deem it in the best interest of the banks depositors, creditors and/or the nationalfinancial system. Other defined events, such as breach of required regulatory capital thresholds for capitaladequacy, could trigger payment elimination. The same concept exists within regulated insurance hybrids,but solvency ratios are used. To achieve higher levels of equity credit from Moody’s one route is the inclusionof ‘meaningful triggers’ that result in the legal requirement to stop making hybrid payments. Moody’sconsiders these trigger points are set at indicators of financial conditions where cash is better conservedinternally (to protect the senior debt holders) rather than paid out on hybrids. For issuers that are notregulated it is of even greater importance to Moody’s to achieve higher amounts of equity credit. Consideredin isolation the mandatory deferral feature raises the risk of the hybrid investor. To flag the investor’s riskcaused by this, S&P has at times provided a third notch on hybrid ratings where this Moody’s designedmandatory deferral feature is included. For issuers with senior ratings on the cusp of non-investment grade(low bbb) the extra notching could be a discouragement, as the notching into deep non-investment gradecould negatively impact investor demand and pricing of the hybrid. Some issuers avoid this mandatorydeferral feature and either settle for less equity credit or utilise the LBRL (as discussed above) to achieve thesame high level of equity credit. Another structural feature which has evolved to mitigate the negativeaspects of this feature is the ACSM.


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Replacement languageRating agencies value true equity because of its perceived permanence – it has no defined maturity calls(particularly with step-ups) or puts. These features bring hybrid permanence into question. Replacementlanguage provides some reassurance to the agencies, particularly for non-regulated issuers.

For a well regulated industry such as banking in the major world economies there is a belief that the nationalregulator will prudently monitor the banks within its jurisdiction and guide the bank in its maintenance ofadequate capital. There is a long historical period which can be observed to confirm that major regulators havebehaved prudently in most cases over many years and in most major countries with advanced economies andcapital markets. So hybrid capital from well regulated banks is deemed to be as permanent as it needs to befrom the rating agency perspective without specific replacement language in the hybrid documentation.

Insurance regulation is deemed to be in a more developmental stage generally and for unregulatedcorporates there is no oversight body to monitor, guide or enforce the capital structure decision process. Inthese cases rating agencies require the inclusion of replacement language in order for the issuer to achievehigher levels of equity credit. ‘Intention’ to replace is the minimum issuer commitment required, but evengreater equity credit can be achieved if the issuer is willing to be legally bound to replace the hybrid capitalwith equal or better quality equity securities in future (ideally, prior to redeeming the hybrid in question).

Therefore hybrid transactions have been structured that seek to increase the permanency feature of thestructure to get more equity credit by including LBRL in the form of a replacement capital covenant (RCC)with the following considerations:

0 If the securities are called, the issuer must replace them with instruments with same terms and conditions that are ranked pari passu with existing securities;

0 The legal commitment is neither with the rating agencies nor with the hybrid security holders, but instead with a third party set of investors identified outside the hybrid documentation in separate deed of covenant. A specific class of senior bond holders could be parties to the RCC, for example.

One of the more recent methodology changes came from S&P in June 2007 publication. They have nowhardened their view on replacement language, requiring an RCC for new step-up hybrid securities issued bynon-regulated issuers such as corporates, to achieve ‘intermediate’ equity credit from S&P. Legally bindingreplacement language is meant to restore the degree of permanence that the step-up rate destroysaccording to S&P. Existing hybrid transactions with intent-based replacement language will be grandfathered.

S&P allow issuer flexibility via RCC termination events (carve-outs) usually where the hybrid security is nolonger necessary or desirable. For some issuers this will make legally binding language much easier torationalise and accept as part of the hybrid structure. In addition, if the issuer can convince S&P that it is notpossible/practical to include the RCC then they may be able to omit it, but S&P believe it should be possiblein most countries outside Japan. About half of the US hybrids include RCCs now and there have also beenAustralian and UK examples (the UK has been used by English and Greek issuers).

Both Fitch and Moody’s take a different approach. Fitch evaluate the overall issuer credit and the value-add ofthe hybrid to the issuer’s credit profile without giving additional equity credit to any form of RCC. Moody’shave maintained a consistent approach to replacement language since a legally binding RCC was first appliedby First Tennessee Bank in March 2005. Intent-based language will suffice for Basket C or a Basket D withmandatory payment deferral linked to a meaningful trigger. If Moody’s Basket D is attempted via legallybinding RCC the terms must provide for only limited termination events (carve-outs) and not the broader listof carve-outs available for the S&P intermediate category. Carve-outs will therefore need to be selectedconsidering which are allowed by both rating agencies and which Moody’s basket.

This can also be viewed as a ‘belt and braces’ approach – intent-based replacement language and a legallybinding RCC with acceptable carve-outs will be required to reconcile the differing methods of the ratingagencies. Effectively, issuers must meet the typical Moody’s requirements and add a legally binding RCC forS&P as needed.

Standard & Poor’s approachS&P released several papers in 2006, including the restatement of their criteria for assessingequity credit for bank, insurance and corporate securities, and clarification around theirassessment of optional deferral (viewed as affording significant equity benefit). Hybrid securitiesare categorised by S&P into three categories:

0 Category 1 - High equity content;

0 Category 2 - Intermediate equity content (divided into two levels: Category 2: Strong, and category 2: Adequate);

0 Category 3 - Minimal equity content.

An indication of how some different hybrid structures are categorised is given in Table 5.4.

S&P have also been active in reviewing their capital requirements for the insurance sector. Thisbegan at the end of 2005, when S&P indicated that they would be updating their risk-based capitalmodel substantially, adjusting the total adjusted capital (TAC) ratio calculation and changing thetreatment of risk assets so that required capital may change up or down.

The new framework increases the TAC limit to 25% from 15%, which will allow insurers to usemore hybrid capital in the TAC calculations, provided the hybrid security is structured in at least adated Upper Tier 2 style format (such as 30 nc 10 sub-debt cumulative deferrable paymentstructures) or better (but no Lower Tier 2).

S&P adopted a single minimum maturity standard, to be applied in all regions and sectors. Inorder for a hybrid bond to receive an ’intermediate equity classification from S&P and capitalcredit from S&P in their capital analysis, the issue will be required to have a minimum legalmaturity of 20 years.


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This is a developing area and one that issuers have been reluctant or unable to adapt to their needs. Not allcountries have an elegant way to make this work. Most early examples are in the US and Australia, but recentdeals have occurred in Greece (RCC under UK law) and the UK. Issuers that seek higher equity credit fromMoody’s but do not or cannot utilise the RCC have instead opted for the mandatory payment deferralstructure, which is potentially harmful to the hybrid investors and therefore requires a premium yield. Incontrast, the RCC does not require a premium from investors since payments (or deferral probability) are notaffected. This is the evaluation issuers need to make for this structuring detail.

Table 5.4: Classification of hybrid securities for financial services companies

Category ExamplesCategory1: High EquityContent Shorter-dated MandatoryConvertible Securities (<3years)

High qualityhybrids with participating coupons.Category2: Intermediate EquityContentCategory2: Strong Perpetual preferred shares

Most bankand insurerundated deferrable Tier1 instrumentsInsurance long-dated hybrid instruments (residual maturityof 20 years ormore) with coupon deferability

Category2: Adequate Most, but not all, bankUpperTier2 instrumentsLimited life preferred shares (e.g. U.S. trust preferred)Insurance hybrid instruments with a residual maturityof less than 20 years, with coupon deferability*Eligible funded contingent capital for insurers

Category3: Minimal EquityContent Dated hybrid instruments with a residual maturityof five years or lessAuction-preferred securitiesNondeferrable subordinated debtInstruments with put options

Note: Reprinted with permission from the report ‘Revisions In The Risk-Based Insurance Capital Model’ (21 November 2006), published by Standard & Poor’s Ratings, a divisionof The McGraw-Hill Companies Inc. TAC--Total adjusted capital (for insurers). *Within 10 years of the repayment date, Standard & Poor's will gradually treat the instrument as more debt-like, using a five-yearamortization schedule whereby for each year under 10 years, an incremental 20% of the instrument is treated as debt until, at five years of remaining life, the issue is viewed ascompletely debt-likeSource: Standard & Poor’s

While this is not a problem for issues with a perpetual maturity, traditional European insurancesector 20 nc 10 structures will no longer be particularly 'efficient' in S&P terms, as S&P will startto amortise the credit they allow for it by 20% per annum starting in the year after issuance (i.e. 20years before the final maturity). Consequently, a dated issue needs to have a 30 nc 10 structure toget maximum equity credit for the first 10 years from issuance, after which it may be redeemedon the call and step-up date at year 10, just before the 20% annual amortisation of the equitycredit is applied.

S&P seem to be hardening their position on replacement language and seem to be moving towardlegally binding formats wherever it is legally feasible.

Fitch’s approach Fitch introduced the latest version of their hybrid securities criteria in September 2006, with theaim of increasing the clarity and transparency of the rating agency’s approach and streamliningtheir analysis of equity credit for hybrid instruments. The new methodology provides moreclarityand has similarities to Moody’s approach of assessing the key characteristics of a hybridtransaction and the application of a debt-to-equity continuum. However, the application of a look-back clause, coupled with Fitch’s ‘weak-link’ approach have caused a significant reduction ofequity credit to a number of corporate hybrid structures – a significant divergence from Moody’s,S&P and the markets’ evaluation of these securities. Fitch published a unified methodology forhybrids and other capital securities across all financial and corporate sectors. This supercededprevious hybrid equity credit methodologies in the financial and corporate sectors. Fitch apply adebt-to-equity continuum consisting of five classes from A (100% debt) to E (100% equity), similarto that of Moody’s (see Table 5.5).

The proportion of equity credit assigned to an instrument will depend on the evaluation of fourspecific characteristics:

0 Loss absorption; 0 Ability to avoid ongoing cash payments; 0 Permanence/maturity; 0 Covenants and other features.

However, Fitch will apply a weak-link approach, with the security limited by its weakest characteristic.

The look-back provision for payment deferral is a key focus for Fitch in their new methodology.Look-back links recent common dividend payments to hybrid payments by requiring hybrids topay if common was paid (dividend pusher), and assuring the preferred status of hybrids. Forexample, an instrument with a high degree of equity content but with a six-month look-back forpayment deferral could result in only a Basket C classification, while a similar instrument with alook-back of less than six months could result in a Basket D classification.

It is also interesting to note Fitch’s approach to regulatory oversight and the differentiationbetween fully regulated financial institutions (generally banks, although jurisdiction dependant)and insurance companies, which do not enjoy the same perceived degree of beneficial regulatoryoversight. As a result, the rating agency views the majority of Tier 1 bank transactions as a BasketE (100% equity credit), but insurance sector structures are weighted on a much lower, morestructure-dependant basis as D or C.

For non-bank issuers, it is critical that the hybrid look-back is constructed to Fitch specification(i.e. very short look-back – three months).

The Fitch framework also calculates the hybrid tolerance limit used in equity when calculatingequity-credit adjusted ratios. Fitch uses a basket approach and following this methodology nowallows inclusion of hybrids of up to 35% of a bank’s core equity in total capital credit (the amountof capital used by Fitch for leverage calculations).


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Table 5.5: Fitch debt-to-equity continuum

Equity classes (%) Equity credit DebtcreditClass E - SuperiorEquityContent 100 0Class D - High EquityContent 75 25Class C- Moderate EquityContent 50 50Class B - Low EquityContent 25 75Class A - Debt; No EquityContent 0 100

Source: Fitch

Rating agency evolution promotes increasing market sophisticationRefinements to the rating agency methodologies for hybrid capital securities have continued toevolve the market in recent years and this is likely to continue. Moody’s surprised the market andproposed a change to its approach to the notching of approximately 300 non-cumulative hybridsecurities. The proposal (which was withdrawn) suggested these securities should be notcheddown to signal payment ‘omission risk’, compared to other cumulative or quasi-cumulative (fast-pay ACSM) securities. While further clarity around the rating agencies’ approach to hybridsecurities is always welcomed by the market, these changes create market volatility as they signalpotential risks associated with the various structural features and can impact an investor’s abilityto hold hybrid assets. The use of market sounding periods and requests for industry commenthelp to mute the market shock that evolving methodologies can cause.


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Interview

The following Q&A interview is with Ellen Lapson, Managing Director, Global Power and Chairperson of theHybrid Products Committee, and Gerry Rawcliffe, Managing Director, Financial Institutions and Member of theHybrid Products Committee, Fitch Ratings.

What is the internal process of Fitch’s hybrid products committee for assessing the equitycredit of a hybrid security?

“Fitch’s equity credit classification is governed by the criteria paper published on 27 September 2006 called‘Equity Credit for Hybrids and Other Capital Securities’. This paper and subsequent clarifications papers formthe template that Fitch’s analysts employ for analysing equity credit. When a company decides to issue ahybrid security, it is the role of the credit analyst to determine if the security is one that is readily analysedfrom the existing criteria. If not, then the hybrid is brought before Fitch’s Hybrid Products Committee (HPC)which is the ultimate arbiter on these matters.

“The HPC is comprised of six ‘regular’ members and six ‘alternate’ members. The six regular membersrepresent different sectors and geographies, namely one each from the US/Europe,Banks/Corporates/Insurance. The six alternates represent similar areas. It is Fitch’s intention to add anadditional one or two members from the Asian region in the near term. Four out of a maximum of the currentsix voting members (regular or the respective alternate) constitutes a quorum for making decisions.Additionally, to be quorate, there must be at least one regular member voting, and there must be at least onerepresentative (regular or alternate) from each of the three product groups.”

Does Fitch apply different methodologies to hybrid issues from different sectors or different jurisdictions?

“Fitch has a unified and consistent set of equity credit criteria that is applied for all hybrids irrespective of thesector or jurisdiction. Nevertheless it is possible that two identical hybrid instruments may behave differentlyin times of severe financial distress as a result of external factors, such is the influence that regulators mayexert on an issuing entity. As a result, it is feasible that two identical hybrid instruments may receive a differ-entiated equity credit treatment.”

How does Fitch treat hybrid securities in their credit analysis of a company – are they treated inthe same way as common stock?

“From a rating perspective Fitch treats hybrids generally as being debt-like, albeit with lower recoveryprospects, which is why hybrids are generally rated one or more notches lower than any senior debt would beissued by the same entity. From an equity credit perspective, for higher rated issuers we would not expecthybrid issues to unfold their equity-like characteristics (i.e. deferral and loss absorption). These we wouldexpect to become active only in times of severe financial distress. However, in assigning equity credit (whichfor our methodology presumes financial distress) the equity portion that is determined is treated equivalentto common stock in terms of our leverage and capitalisation analysis.”

What is the primary focus for Fitch – issuer benefit or flagging risk to the investor?

“From a rating perspective the primary focus is flagging risk to the investor, although not all investor risks arenecessarily captured in the rating which focuses on default and recovery risks. Additional risks, such asdeferral or extension risk that are very important to investors, are not generally captured by the rating. From


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an equity credit perspective the primary focus is the benefit to the issuer in times of severe financial distress.To put it another way, the extra financial flexibility that an issuer may have through a hybrid potentially beingable to defer or absorb loss (either on an ongoing or liquidation basis), in times of severe financial stress.”

What is the internal process at Fitch for assessing the notching of a hybrid security?

“Notching of hybrid securities is governed by separate criteria papers that each of the bank, corporate andinsurance sectors in Fitch have published. The HPC is not responsible for determining hybrid notching. This isdetermined by traditional rating committees.”

Can notching really communicate the risks of such complicated securities? Is notching too dulla tool?

“Clearly, with only around 20 rating notches from ‘AAA’ to ‘C’ to capture the full spectrum of credit risk fromUS Treasuries to the riskiest of high-yield borrowers, there is a limit to the extent that notching can captureevery nuance of complicated hybrid capital securities, nor is it intended to do so. Nevertheless, thecombination of a clearly understood generic notching approach (to broadly signal to investors the presenceof increased loss given default through subordination), together with greater bespoke flexibility to adjustnotching in specific circumstances, does in Fitch's view add value to investors. An example of the latter wouldbe the wider notching that Fitch applies to banks whose senior debt rating is helped to a given level by thepotential for government support, as expressed in its Fitch Support rating. Fitch generally assumes, however,that such support is unlikely to flow to deeply subordinated hybrid capital instruments, and theseinstruments cannot, therefore, be simply notched off the ‘supported’ senior debt rating. Instead, the hybridrating must be referenced to the bank's standalone Individual rating.”

How does Fitch approach their analysis of a security – an overall ‘average’ view of how equity-like the security is, or a specific review of the individual equity-like features of the security?

“Fitch undertakes a specific review of the individual equity-like features of the security and will apply a weak-link methodology in determining the overall equity credit. The main reason for applying a weak-linkmethodology as opposed to an ‘averaging’ approach is that in times of severe financial distress, it is Fitch’sexperience that if a hybrid security has a flaw from an equity credit perspective (i.e. a very debt-like feature), itis this flaw that will ultimately constrain the issuer’s ability to gain financial flexibility from the instrumentwhen they most need it.”

Is the major focus on regulatory oversight justified? How does Fitch view regulatory oversightfor insurers? Does this vary across different jurisdictions?

“Fitch believes that regulatory oversight can play a key role in whether a hybrid behaves in an equity-like ordebt-like manner. It is our experience that management teams may be reluctant to activate some of theequity-like features of a hybrid (e.g. defer a coupon payment) in order not to upset investors or generatenegative sentiment in general. A regulator may be less concerned about market perceptions and would in ourview be more likely to encourage/insist that management triggers the equity-like features of hybrids irre-spective of market perception in times of severe financial stress. In terms of the effectiveness of regulatoryoversight across differing jurisdictions, Fitch has yet to formally opine on which insurance regulators would inFitch’s view be able to act in a timely manner based on the effectiveness of the regulatory measurementsboth in terms of timeliness and usefulness of the metrics employed.”

What is the Fitch approach to assessing subordination?

“Fitch has a fairly binary approach to determining subordination. It either exists (i.e. the hybrid needs to besubordinate to senior unsecured creditors) or it does not, in which case the hybrid would receive zero equitycredit.”

What is the Fitch approach to assessing effective maturity? What limits are applied in terms offinal maturity, the first call date and step-up?

“Fitch employs an effective maturity regime that can be summarised as follows:0 Class E (100% equity credit) – Perpetual/20 years plus;0 Class D (75% equity credit) – 10th to 20th years;0 Class C (50% equity credit) – Eighth to ninth years;0 Class B (25% equity credit) – Sixth to seventh years;0 Class A (0% equity credit) – Less than five years.


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“Determination of an effective maturity can be summarised as follows:

0 No call = Perpetual/stated maturity;0 Call only = Perpetual/stated maturity;0 Call with step-up only = Call date;0 Call with step-up plus replacement language acceptable to Fitch = Perpetual/stated maturity;0 Call with step-up but replacement provisions do not satisfy Fitch concerns regarding

management intent = Call date.

“We do not impose step-up limits, since even a one basis step-up can be viewed as the effective maturity.However, step-ups significantly above market conventions (notionally referred to by Fitch as threshold levels)on cumulative instruments would be viewed by Fitch as carrying incremental risks to the company that wewould penalise by reducing the equity credit classification by one further class irrespective of other features.

“The above is a brief summary and more detailed guidance is available in our main criteria paper.”

What is the Fitch approach to assessing payment deferral?

“Fitch’s approach views that hybrids in order to be considered for equity credit must be able to avoid makingcash payments in periods of financial stress. Coupon deferral mechanisms (be they optional, mandatory or acombination) and ACSM are structured to achieve this objective, but there is a wide variety in the types andquality of coupon avoidance or deferral features present. Provided a coupon deferral mechanism is uncon-strained and effective for at least five continuous years, hybrids are eligible for the highest equity credit underFitch’s methodology. Any mechanisms that constrain management’s ability to defer or erode the duration ofthe deferral below five years will result in a reduction of the equity credit.


What is the Fitch approach to alternate settlement – ACSM – and PIK?

“A brief summary follows:

0 Non-cash ACSMs – Issuer settles deferred or omitted dividends with common stock. If the underlying optional or mandatory deferral mechanism is cumulative, the effect of non-cash stock settlement is to replicate a non-cumulative deferral, qualifying for a higher equity class (absent a restraint on the class by another factor). If the underlying deferral was non-cumulative, then the stock settlement is neutral (no change in equity class). Although from an equity credit classification perspective this feature appears attractive, it is rarely seen, because it is relatively unattractive to investors and in the US would result in the issue being categorised as equity from a tax perspective. When the non-cash settlement is accomplished with junior securities, similar to PIK settlement, this would be viewed by Fitch as a cumulative feature as the accumulated PIK amount will ultimately have to be paid in cash. Also, if the hybrid gives management discretion to settle in any of a variety of securities including common, preferred, like hybrids, options, etc., it is Fitch’s view that the issuer is more likely to opt for settling with hybrid securities rather than common, and this will be treated as a cumulative deferral;

0 Cash ACSMs via market issuance – Most ACSMs include a pledge by the issuer to attempt the market issuance of new junior or equity securities (once or repeatedly) and to use the proceeds of any issuance of junior securities or equity to settle the omitted coupon on the hybrid issue. Although some may argue that such a settlement mechanism is cash neutral, in that payments are only paid with new funds raised externally, Fitch views this as a burden on the issuer’s financial flexibility at a time of financial stress. Such a provision provides debt-like protections for hybrid holders and lowers the security’s equity quality. When a cash settlement mechanism is merely an option available to the issuer, it is generally neutral to equity credit. When the issuer must pursue cash settlement in connection with a nominally non-cumulative mandatory or optional deferral, prior to resuming coupon payments and common stock dividends, this feature may effectively turn the hybrid’s deferral from non-cumulative to cumulative and thereby reduce the maximum equity class. If the same ACSM were associated with a cumulative deferral, it would have a neutral effect on the equity class. If the issuer is unable to successfully market equity-like securities to settle the coupon, a likely scenario in a stress event, the consequences can vary. In some instances the issuer must continue to use its reasonable efforts to sell equity-like securities until successful, or the unpaid coupons accumulate and must be satisfied with cash whenever the company subsequently sells equity-


98

like securities or pays a common dividend. In both these cases Fitch will view the feature as equivalent to a cumulative deferral. However, in some cases, if the ACSM is unsuccessful, the unpaid coupons are eliminated (as if non-cumulative). Fitch will view such a feature as equivalent to a non-cumulative deferral.


What is the Fitch approach to the look-back?

“Fitch expanded its views on look-backs in a paper published on 10 April 2007 called ‘Hybrid SecuritiesSubject to a Look-Back Constraint’. The areas covered include:

0 The ‘effective’ duration of the look-back;0 The impact of including parity securities in a look-back provision;0 The interaction of look-backs with either mandatory or regulatory deferral mechanisms.

“A very brief summary of the effective duration guidelines would be:

0 < three months look-back period = Unconstrained;0 > three months to six months = Minor constraint (constrains maximum equity credit classification by oneclass);0 > six months to 12 months = Major constraint (constrains maximum equity credit classification by twoclasses);0 > 12 months = Class A (100% debt, 0% equity).”

Does Fitch apply tolerance limits to the issuance of hybrid securities?

“Fitch has a limit for banks and insurers of 30% of eligible capital. This is applied both at the consolidated groupand unconsolidated entity levels, depending on the relevant rating analysis undertaken. The proportion of anyhybrids that exceed that limit will be treated as debt. Fitch’s precise definition of eligible capital can vary acrosssectors, but typically the focus is on core shareholders’ equity, subject to various analytical adjustments (e.g. incertain sectors the deduction of goodwill), plus the amount of eligible hybrid equity.

“For corporate issuers in sectors in which corporate liquidity far outweighs technical measures of capital as ananalytical concern, the hard limit on hybrids used for banks and insurers as a percentage of eligible capitalneed not be strictly applied. For example, when an issuer’s book equity is extremely low or negative due toprior write-downs, it would not be reasonable to limit the benefits of hybrid equity through excessiveattention to the formula. In these circumstances, a rating committee (as distinct from the HPC) maydetermine that more capital can be accepted from this source, depending on individual circumstances; forexample, analysts have used normalised value in place of book value of equity, or considered the benefits ofthe planned use of the capital infusion.

“Whatever the limit, Fitch is generally indifferent to the composition of the hybrids included within it,although rating committees may review the qualitative composition of the hybrids and capital securities, par-ticularly for low-rated companies.”

How does Fitch view the need for something like a hybrid ‘pre-sale’ report (especially useful forthe post-deal period, as a secondary resource for the market)?

“Fitch believes that a hybrid ‘pre-sale’ report could be of value to the market, particularly for more complexhybrid issues, which would give Fitch more scope to address details that may not be readily covered in atypical one-page ‘expected rating’ press release.”

How does Fitch anticipate the market might develop in the future? Where does Fitch see themarket in five years time? In 10 years time?

“Notwithstanding the recent market turmoil, we expect hybrid issuance to remain strong over the longerterm. Although many of the larger bank and insurance issuers may have already reached their limits of hybridequity issuance, we would expect the market to continue developing by growth in the corporate sector andgreater numbers of small and mid-sized financial issuers also tapping the hybrid market either through directissuance, or via structured vehicles that pool smaller hybrid issues (e.g. the Dekania transactions).


99

Figure 5.9: New hybrid transaction – example time and responsibility schedule


Documentation Marketing Execution Documentation

Week 1 Week 2 Week 3 Week 4 Week 5 Week 6 Week 7 Week 8

«

«

«

« «

«

Mandate awarded

Start documentation

Roadshowcommmences

Red OC readyfor distribution

Final signing of

documentation

Books open Pricing andlaunching

Settlement

Consult withrating agencies

and/orregulator

Timeframe Action to be taken RoleWeek1-week4 Documentation -Mandate letter signed (expense clauses, material adverse change) (week1) Lead banks

-Termsheet is finalised based on agreed transaction structure Issuer/banks/lawyers-Draft documentation/ Ts and Cs produced Banks/lawyers-Appointment of counsels, fiscal, paying and listing agent Banks/lawyers-Auditors comfort letter, legal opinions Banks/lawyers-Start establishment of the SPV Banks/lawyers

Discussion with -Notification to rating agencies and regulator (week1) Issuerthe regulator -Draft documentation and terms and conditions sent to rating agencies and/or Banksand rating regulators for commentsagencies -Negotiations with rating agencies and/or regulators to discuss their comments Structuring advisor

-Confirmation of tier1 qualification by the regulator Issuer/banks-Confirmation of the rating of notes Issuer/banks

“Furthermore, we believe that innovation will continue to be a feature of the hybrid market as hybridstructurers at investment banks continue to try and address the disparate (and at times opposing) andchanging views of the various market participants (i.e. issuers, investors, tax authorities, regulators, ratingagencies, etc.). In addition, the changing regulatory landscape in insurance, particularly in Europe throughthe advent of Solvency II, may provide further stimulus for change over the medium to long term althoughthe legislation is too early in formulation to determine whether the impact will be positive or negative.”

Does Fitch have any future plans for changing or clarifying its methodology for allocatingequity credit or rating notching for hybrid securities?

“Fitch intends to publish further papers on the following topics:

0Mandatory deferral triggers and their impact on equity credit; 0 Insurance regulatory environments and their impact on equity credit.

“However, these papers will be giving more detailed guidance and not altering the criteria outlined in theoverarching piece published in September 2006.

“There are currently no plans to change notching methodologies.

“Periodically Fitch will consolidate its base criteria and subsequently published clarifications and detailedcommentary to continue to provide all market participants with a clear and comprehensive understanding ofour approach in what is a highly technical area. Overall Fitch has adopted a principles-based approach, withthese principles being informed as far as possible by empirical evidence. In the light of this, Fitch will onlyengage in material changes to its criteria if, at some point in the future, new, and currently unforeseen,empirical evidence requires it.”


100

Figure 5.10: Global hybrid Tier 1 capital origins

Notes:(1) Issuance via Cayman/Guemsey SVP during 1991-1993.(2) 10 year cumulative approved 12/95, 5-year non cumulative approved.(3) Original structure was approved by the RBA but later dis-allowed because of conflicts with BOE/BIS.(4) Not BIS eligible.(5) Real estate “OpCo” issues.(6) Canada REIT and MIC.(7) “Silent participation preferred stock”. Structure has 10 year term.(8) Japanese bank issued LLC structures with credit linked notes as the LLC’s assets.Source: Compiled by CALYON

1991 1992Sept1996

Oct1996

June1997

July1997

Aug1997

Aug1997

Jan1998

Jan1998

«

Europeanoffshorepreferred

USfixed/adjustablerate preferrds (2) US capital

securities

Portuguesestep-up

preferred (4)

French LLCstep-up

preferred (5)

Canadian preferred

(6)

German preferred

(7)

Japanese LLCstep-up

preferred (8)

Australian step-uppreferred (3)

US REITpreferreds

Timeframe Action to be taken RoleWeek5-week7 Marketing and -Roadshow, books open, pricing and launching Structuring advisor

execution Issuer/banksWeek8 (after Finalisation of -Final signing of documentation –the transaction documentation -Listinghas priced)

NB. Example for schedule only - the timeframe for structuring can vary significantlySource: Compiled by CALYON


101

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102

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103

Eligible capital for insurance companiesBy Christophe Ollivier, Financial Institutions Group, CALYON

IntroductionThe purpose of this note is to provide an update on the current discussion relating to the elements thatshould be eligible for the solvency margin calculation for insurers in the EU.

The current regulationUntil Solvency II application, the solvency margin calculation is currently driven in the EU by two mainDirectives:

0 Directive 2002/83/EC for life insurers (and its amendments);0 Directive 73/239/EEC for non-life insurers (and its amendments).

Under Solvency I, the capital buffer required by the regulator to cope with the uncertainty of their business isequal to the required minimum margin (RMM). The latter is equal to the maximum amount between:

The required solvency margin (RSM), with the following formula:

0 For non-life insurers, the maximum amount between: 0 The result of a function of a premium index;0 The result of a function of a claim index.

For life insurers, the sum of:

0 A fraction of the mathematical provisions;0 A fraction of the capital at risk (if positive). 0 The minimum guarantee fund, being equal to the maximum amount between:0 One-third of the RSM;0 A €2-3m floor amount for non-life and life respectively (reviewed annually since March 2002 on the basis

of the European index of consumer prices - Eurostat).

Under this minimum solvency level, the competent authorities have the power to require a financial recoveryplan for the insurance undertaking where competent authorities consider that policyholders' rights arethreatened.

Practically, most companies have tended to operate with capitalisation levels substantially in excess ofregulatory RMMs, two times the RMM being considered as a minimum threshold.

Available solvency margin

Requiredminimummargin(RMM)

Guarantee fund

Figure 5.11: Available solvency margin: Solvency l minimum solvency level



104

Two directives define the elements that are eligible for the calculation of the guarantee fund:

Without limitation: 0 The paid-up share capital or the effective initial fund plus any member's account for mutual companies; 0 The statutory and free reserves; 0 The profit or loss brought forward; 0 The profit reserves appearing in the balance sheet (subject to national law).

With limitations and subject to the agreement of the competent authority of the member states: 0 The cumulative preferential share capital and the subordinated loan capital (up to 50% of the RSM, sub-

limited to 25% for subordinated loans with fixed maturity or fixed term cumulative preferential share capital);

0 Securities with no specified maturity date and other instruments, including cumulative preferential shares other than those mentioned above (up to 50% of the RSM for the total of such securities and the subordinated loan capital referred to in the point above);

0 Any hidden reserves arising out of the valuation of assets.

The following are the elements acceptable for the calculation of the available solvency margin (ASM), inaddition to those eligible for the guarantee fund (subject to authority review):

For life insurers:0 50% of the undertaking's future profits (not exceeding 25% of the lesser of the available solvency margin

and the required solvency margin until 31 December 2009);0 The difference between a non-Zillmerised or partially Zillmerised mathematical provision and a

mathematical provision Zillmerised at a rate equal to the loading for acquisition costs included in the premium (not exceeding 3.5% of the sum of the differences between the relevant capital sums of life assurance activities and the mathematical provisions for all policies for which Zillmerising is possible).

For non-life insurers:0 One half of the unpaid share capital or initial fund, once the paid-up part amounts to 25% of that share

capital or fund (up to 50% of the lesser of the available solvency margin and the required solvency margin);

0 In the case of mutual or mutual-type association with variable contributions, any claim which it has against its members by way of a call for supplementary contribution, within the financial year (subject to a limit of 50% of the lesser of the available solvency margin and the required solvency margin).

'Revaluation reserves' and 'value adjustments' are not explicitly mentioned in the Insurance Directive but inpractice, they can be recognised as eligible by member states.

Note: Other specific limitations and/or restrictions are provided in the tables at the end of this section.

It is important to highlight the fact that national legislation may be stricter than the Directives. For example, ina number of member states, the cumulative preferential share capital is not an eligible element.

Capital buffer to be required in the Solvency II frameworkUnder Solvency II, there should be two levels of capital buffer considered by the regulator:

0 The minimum capital requirement (MCR) should be the capital threshold defined under Solvency II below which the insurer presents unacceptable risks to policyholders and an insurer will not be permitted to operate below it. In such a case, an ultimate supervisory action would be triggered;

0 The solvency capital requirement (SCR) or target capital should be the threshold above which the company solvency margin will be deemed to be comfortable (closer to an insurer's economic capital requirement). Dropping below SCR would always be a plan of action but would not necessarily trigger an immediate action. The SCR should be determined as the level of capital that reduces the likelihood of ruin to less than 0.5% on a one-year horizon.

The MCR could be calculated using a modular approach similar to that of the SCR but calibrated on a 10%probability of ruin on a one-year horizon. Even simpler, it could be a proportion of the SCR or of requiredcapital in the Solvency I mode.

The MCR is expected to be approximately in line with the Solvency I RMM.


105

The SCR is likely to take the overall capital requirement to a higher level than the Solvency I RMM but aspreviously observed, this does not necessary imply a higher capital requirement since today many regulatorslook to companies to hold a multiple of their RMM.

Eligible elements in the Solvency II frameworkCompared to the Solvency I approach, the total balance sheet approach to be adopted by Solvency II shouldappear less arbitrary, as the eligible elements of capital should be based on the economic ability to absorb risk.

Specifically, eligible capital should be assessed against the extent to which it can do either or both of thefollowing:

0 Reduce the probability of insolvency by absorbing losses on a going concern basis or in run-off; 0 Reduce the losses to policyholders in the event of insolvency or wind-up.

These eligible elements should also be assessed on the following general characteristics:

0 Permanence and availability in times of stress;0 Servicing costs/repayment and their potential for deferral or even cancellation in times of stress; 0 Seniority on interest and principal amount.

Eligible capital could be divided between:

Basic own funds, representing:

0 The free assets (excess of assets over liabilities);0 The subordinated liabilities.

Ancillary own funds, representing the assets other than own funds which can be called up to absorb thefollowing losses:

0 Unpaid share capital or initial fund that has not been called up;0 Letters of credit;0 Any other commitments received by the insurance and reinsurance undertakings;0 For mutual companies, any future claims which it may have against its members by way of a call for

supplementary contribution, within the financial year concerned.

There have been a number of attempts to resolve the divergences in approach between the insurance andbanking sectors, whether these differences are both necessary and justified for prudential soundness orsector-specific reasons.

In its November 2006 consultation paper (CP20), CEIOPS (the Committee of European Insurance andOccupational Pensions Supervisors) suggested a more transparent classification of capital across all sectors,inspired by the classifications used in the current banking accord but taking into consideration a relevantdifference, which is the timescale of their operations that influences the eligibility of capital as follows:

0 In the banking sector a greater emphasis is placed on liquidity of capital to protect against potential runs on deposits, which rules out most forms of contingent capital;

0 For insurers, however, the longer term nature of their liabilities means that contingent capital is a much more valuable resource as long as reliance can be placed on the counterparty's willingness and ability to pay.

Basic principles regarding classification should be:

0 The better the loss absorbency of an element, the higher the tier it should be classified into;0 Non-cumulative elements on a going-concern basis should be treated more favourably than cumulative

elements;0 Perpetual elements should be treated more favourably than fixed-term elements.


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Tier 1 or core capital This should have the following optimal qualities to serve as a buffer:

0 Fully loss absorbent in both a going-concern and a winding-up situation, where:On winding-up it ranks for repayment after all liabilities towards policyholders and any higher ranking debtsand liabilities;

0 Currently and permanently available;0 No fixed costs (i.e. there is no inescapable obligation to pay dividends or interest).

It should therefore include:

For the highest quality core capital, the 'core Tier 1' (which could represent at least 50% of Tier 1 capital):

0 Paid-up voting common shareholders' equity, or paid-up initial or foundation fund, as appropriate;0 Called-up voting common shareholders' equity, or called-up initial or foundation fund, as appropriate;0 Retained earnings calculated using the accounting balance sheet;0 Any net difference, net of tax, in the valuation of assets and liabilities under accounting standards and with

respect to the solvency evaluation (which serves as a reference standard), provided that these amounts comply with the principles set out for Tier 1 capital.

For the ‘non-innovative Tier 1’ capital:

0 Subordinated members' accounts;0 Subordinated liabilities which possess the characteristics of subordination, loss-absorbency in a winding-

up and going-concern situation, and substantively possess the characteristics of perpetuality, absence of requirements or incentives to redeem the nominal sum and absence of mandatory servicing costs (e.g. non-cumulative perpetual preference share capital).

For the 'innovative Tier 1' capital ( to be limited, either with respect to percentages of total Tier 1 capital orwith respect to the maximum of pre-specified percentages of Tier 1 capital and the SCR):

0 Hybrid capital which provides a better loss absorbency than that classified as Tier 2.

Deduction for investment in own shares, intangible assets (goodwill) existing in the current Directive shouldbe maintained.

Tier 2 or supplementary capital This has certain flaws on all three criteria and therefore should be only countable as eligible up to certain limits:

0 Subordinated liabilities which possess the characteristics of subordination and loss-absorbency in a winding-up situation, and substantively possess the characteristics of perpetuality, absence of requirements or incentives to redeem the nominal sum and absence of mandatory servicing costs;

0 Letters of credit and guarantees, provided by credit institutions authorised in accordance with Directive 2006/48/EC, and held in trust for the benefit of insurance creditors by an independent trustee;

0 Members' calls by way of supplementary contribution from members of Protection and Indemnity Associations;

0 Other contingent capital which possesses the characteristics of subordination, loss-absorbency in a winding-up and going-concern situation and substantively possesses the characteristics of perpetuality, absence of requirements or incentives to redeem the nominal sum and absence of mandatory servicing costs, analysed between:

Table 5.7: Tier characteristics defined in Solvency ll

Tier 1 Tier2 Tier3Characteristics to possess: Characteristics to possess : Anybasicand ancillaryown fund items• Subordination • Subordination which do not match with Tier1 orTier2

• Loss-absorbency characteristics.• Loss-absorbency • To a substantial degree : Perpetual, absence • Permanence of mandatory costs• To a substantial degree: Perpetual, absence of mandatory costs.



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0 Unpaid share capital or initial fund that has not been called up; 0 Letters of credit and other commitments received;0 Members' calls by way of supplementary contribution; 0 Other contingent capital which has the characteristics for inclusion in Tier 2 capital.

This tier should furthermore be subdivided with respect to permanence, as follows:

0 Upper Tier 2 capital, which should be perpetual, and could include perpetual cumulative preference shares, perpetual subordinated debt and hybrid capital not eligible as Tier 1;

0 Lower Tier 2 capital, which would be dated, and may include dated subordinated debt and dated preference shares.

Insurance Tier 3 capital This should be limited for the capital items which are typical for insurers and not for banks due to the lowervolatility of insurance business, i.e. certain types of capital that is not yet paid in, such as potential members'calls and unpaid elements of partly paid-in capital, subject to limits and the prior approval of the supervisoryauthority:

0 Subordinated liabilities which do not possess the characteristics for inclusion in Tier 2 capital;0 Contingent capital which does not possess the characteristics for inclusion in Tier 2 capital analysed

between:0 Unpaid share capital or initial fund that has not been called up;0 Letters of credit and other contingent commitments received which do not possess the characteristics

for inclusion in Tier 2 capital;0 Members' calls by way of supplementary contribution.

Regarding members' calls, mutual companies will assess their premium requirements for the forthcoming yearand issue a supplementary call to their members for the required amount. When this 'budgeted' supplementarycall is collected in a single advanced payment or part of it is deferred until a fixed date later in the year, this amountcan be accounted for as premium due in the profit and loss account at net realisable value and therefore feedsinto Tier 1 capital. This is the case under Solvency I and should continue to be so under Solvency II.

If the deferred part of a 'budgeted' supplementary call is not payable until after the relevant accountingperiod and/or, for some reason, it is not recorded in the accounting books of the mutual company, theamount should nevertheless still be treated as premium due and therefore contribute to Tier 1 capital.(CEIOPS suggest that a prudential filter should normally apply for this purpose.)

By opposition, the 'unbudgeted' supplementary calls issued to cover unexpected events (e.g. claims andchanges in regulatory requirements) should be classified as insurance Tier 3 capital and eligible only subjectto specific principles and criteria such as:

0 Clear procedure for issuing supplementary calls (timing, amount, quorum for the vote);0 Clear information on the calling procedure and the member's obligations;

0 Legal incentives (contract cancellation) to increase members' willingness to pay;0 Legal framework for collection and arrangement for debt enforcement;0 Assessment of the creditworthiness of members.

LimitationsThere are still open discussions regarding the limitations to apply to Tier 2 and Tier 3 capital.In the CP20, CEIOPS suggests a limit on the sum of Tier 2 and Tier 3 capital with respect to the available Tier 1capital (only) instead of setting separate limits:

0 For Tier 2 capital , the maximum of Tier 1 capital and a pre-specified percentage of the SCR); 0 For Tier 3 capital, the maximum of the sum of Tier 1 and Tier 2 capital and a pre-specified percentage of

the SCR.

This proposal is currently tested in the Quantitative Impact Study 3 (QIS3).

If Tier 1 capital should not be subject to upper limits, CEIOPS suggests the introduction of minimum levels forcore Tier 1 capital and the overall level of Tier 1 capital to ensure that the quality is not diluted too much bynon-core Tier 1 capital, and that a sufficient amount of Tier 1 capital is available to cover the SCR:


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0 Tier 1 core capital should form at least 50% of Tier 1 capital;

0 An upper limit (a pre-specified percentage of Tier 1 capital) should be set for the percentage of innovative Tier 1 capital. CEIOPS recommends that the results from its internal questionnaire regarding innovative capital should be reviewed before fixing this limit.

To ensure that at least 50% of the SCR and 50% of the MCR is covered with Tier 1 capital, CEIOPS suggests tolimit the sum of Tier 2 and insurance Tier 3 capital with respect to the available capital.CEIOPS also recommends that Tier 3 contingent capital elements are not eligible for covering the MCR.

Using the abbreviations t1, ct1, t2, lt2 and t3 for the amount of Tier 1, core Tier 1, Tier 2, lower Tier 2 and Tier3 capital, the proposed limitation rules can be summarised as follows:

0 Minimum level of eligible capital:t1 + t2 + t3 ≥ SCR

0 Minimum level of Tier 1 and core Tier 1 capital:t1 ≥ 1/2 * SCRct1 ≥ 1/2 * t1

0 Minimum level of the sum of Tier 1 and Tier 2 capital:t1 + t2 ≥ MCR

0 Limits for the sum of Tier 2 and insurance Tier 3 capital:t2 + t3 ≤ t1lt2 ≤ 1/2 * t1

FSA position in the UKDuring 2003-04, the FSA decided to pre-empt the Solvency II regime and to implement a new risk-basedcapital regime for insurance companies (applicable by 2005) with the publication of rules determining howmuch capital life insurers’ with-profits funds, non-life insurance companies and reinsurers have to hold. Theserules are part of the ‘Integrated Prudential Sourcebook for Insurers’. It notably stipulates that:

0 Both non-life and life insurers have to provide the FSA with individual capital assesments (ICAs) based on a confidence level equivalent to 99.5% over a one-year period;

0 A new risk-based minimum regulatory capital requirement, based on a separate calculation of capital needs, carried out alongside the MCR (a similar approach to the one defined in the EU Directive, with a floor being the 'base capital requirement' and a guaranteed fund), the enhanced capital requirement (ECR) now applies for non-life and life insurers and must be communicated to the regulator. The FSA shall in return provide the insurance companies with its own individual capital guidance (ICG):

Figure 5.12: Capital limitations

* Total Tier 1 = Core Tier 1 + Non core Tier 1


CORE TIER 1

Eligible NON CORE TIER 1

Non-innovative Tier 1 - Innovative Tier 1**

Eligible UPPER TIER 2

Perpetual

Eligible LOWER TIER 2

Dated with at least a 5-years original maturity

Eligible TIER 3

Max 15%of totaltier 1*

Max 50% oftotal tier 1*

Max 50%of totaltier 1*



SCR MCR

Tier 1

Tier 2

Tier 3


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0 For non-life companies, the ECR calculation requires a firm to multiply the balance sheet values of its assets and liabilities, and its net premium income, by appropriate percentage risk weights. The risk weights vary for different types of assets and according to the different classes of insurance business undertaken by the firm;

0 For life non-profit business, required capital would comprise current mathematical reserving and solvency requirements based on EU Directives, subject to a few amendments such as reclassifying the resilience reserve as a capital requirement;

0 For life with-profits business, firms with with-profits liabilities over £500m would hold capital based on the higher of a regulatory peak and 'realistic' peak ('twin peaks' approach):

0 The regulatory peak - the sum of a 'prudent' actuarial assessment of the financial resources required to meet only contractual guarantees (with implicit margins for adverse deviation from the expected position included in the mathematical reserves), the EU solvency margin and a resilience requirement;

0 The 'realistic peak' - the sum of an assessment of 'expected' liabilities arising from contractual guarantees and a fair provision for expected discretionary payments, such as future annual and terminal bonuses, plus an explicit risk capital margin calculated on top of realistic provisions (for unexpected risks affecting assets or liabilities).

Capital resources for insurersRegarding capital resources for insurers, the FSA approach is not surprisingly very close to the one currentlypublished in the July 2007 EU Directive.

Tier 1 - Characteristics are the same as described above, with the same subdivisions:

0 Core Tier 1 capital - similar to the EU Directive definition but notably including a fund for future appropriation (comprising all funds the allocation of which, either to policyholders or to shareholders, have not been determined by the end of the financial year);

0 Non-innovative Tier 1 capital - perpetual non-cumulative preference shares; 0 Innovative Tier 1 instruments - precisely defined, notably regarding loss absorption issues, as: 0 A Tier 1 instrument that is redeemable; 0 And a reasonable person would think that:

(a) the firm is likely to redeem it; or (b) the firm is likely to have an economic incentive to redeem it;

0 And the firm's obligations under the instrument (other than a share) either: (a) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or (b) do constitute such a liability but the terms of the instrument are such that:

0 any such liability is not relevant for the purposes of deciding whether:(i) the firm is, or is likely to become, unable to pay its debts; or (ii) its liabilities exceed its assets;

0 a person (including, but not limited to, a holder of the instrument) is not able to petition for the winding up or administration of the firm or for any similar procedure in relation to the firm on the grounds that the firm is or may become unable to pay any such liability; and 0 the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

The FSA also stipulates that, to be admitted in the Tier 1 capital, step-up in instruments should be 'moderate', whichmeans it results in an increase over the initial rate that is no greater than the higher of the following two amounts:

0 100bp, less the swap spread between the initial index basis and the stepped-up index basis; 0 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up

index basis.

Deduction must be made for investment in own shares, intangible assets (goodwill) and other amountsdeducted from technical provisions for discounting and other negative valuation differences.

Tier 2 - This includes:

Upper Tier 2 capital, which can only include perpetual instruments such as: 0 Perpetual cumulative preference shares;0 Perpetual subordinated debt;


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0 Other instruments that have the same economic characteristics (notably subordination, loss absorption and perpetuality) as the one above.

Lower Tier 2 capital, which includes fixed/long-term instruments with the following maturity conditions:0 An original maturity of at least five years; or 0 Redeemable on notice from the holder, but the period of notice of repayment required to be given by the

holder is five years or more.

Deduction must be made for inadmissible assets, assets in excess of market risk and counterparty limits,related undertakings that are ancillary services undertakings and negative adjustments for related undertakings that are regulated related undertakings (other than insurance undertakings).

Other capital resources - These are limited to:

0 Unpaid share capital or initial funds and calls for supplementary contributions;0 Implicit items subject to the supervisory authority agreement (including future profits, Zillmerisation and

hidden reserves).

Regarding limitations:

0 Core Tier 1 must represent at least 50% of the eligible capital;0 Innovative Tier 1 capital must not account for more than 15% of the Tier 1 capital resource of the insurer;0 At least 50% of an insurer's MCR must be accounted for by the sum of Core Tier 1 capital and perpetual

non-cumulative preference shares; 0 An insurer carrying on long-term (or general) insurance business must meet the higher of: 0 One-third of the long-term (respectively general) insurance capital requirement; 0 The base capital resources requirement; with the sum of the Core Tier 1 capital, perpetual

non-cumulative preference shares, upper Tier 2 capital and lower Tier 2 capital .

Note: A regular check should be made regarding the validity of this information, as the FSA regularly updatesthe 'Integrated Prudential Sourcebook for Insurers' to take into account the comments made by the marketand the global evolution of financial institutions' regulations.

Table 5.8: Elements eligible for the guarantee fund

Eligible elements Limitation Other restrictionsPaid-up share capital. None NoneOreffective initial fund plus any The memorandum and articles of association must member’s account formutual stipulate that payments maybe made from these companies. accounts to members only in so faras this does not

cause the available solvencymargin to fall below the required level, or, after the dissolution of the undertaking, if all the undertaking's otherdebts have been settled;The memorandum and articles of association must stipulate, with respect to anypayments referred to in point (i) for reasons other than the individual termination of membership, that the competent authorities must be notified at least one month in advance and can prohibit the payment within that period;The relevant provisions of the memorandum and articles of association maybe amended onlyafterthe competent authorities have declared that theyhave no objection to the amendment, without prejudice to the criteria stated in points (i) and (ii).

The statutoryand free reserves Not corresponding to underwriting liabilities norqualified as equalisation reserves

The profit or loss brought forward Afterdeduction of dividends to be paid.The profit reserves appearing In so faras authorised undernational law.in the balance sheetThe cumulative preferential Up to 50% of the RSMshare capital Sub limited to 25% for subordinated loans with

fixed maturityor fixed term cumulative


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Table 5.8: Elements eligible for the guarantee fund (continued)

Eligible elements Limitation Other restrictionspreferential share capital;Provided that binding agreements exist underwhich, in the event of the bankruptcyorliquidation of the assurance undertaking, the capital element ranks after the claims of all othercreditors and is not to be repaid until all otherdebts outstanding at the time have been settled.

Subordinated loan capital Only fullypaid-up funds maybe taken into account;For loans with a fixed maturity, the original maturitymust be at least five years. No later than one yearbefore the repayment date, the assurance undertaking must submit to the competent authorities for theirapproval a plan showing how the available solvencymargin will be kept at orbrought to the required level at maturity, unless the extent to which the loan may rankas a component of the available solvencymargin is gradually reduced during at least the last five years before the repayment date. The competent authorities mayauthorise the early repayment of such loans provided application is made by the issuingassurance undertaking and its available solvencymargin will not fall below the required level; Loans the maturityof which is not fixed must be repayable only subject to five years' notice unless the loans are no longerconsidered as a component of the available solvencymargin orunless the priorrequired forearly repayment. In the latterevent the assurance undertaking must notify the competent authorities at least sixmonths before the date of the proposed repayment, specifying the available solvencymargin and the required solvencymargin both before and after that repayment. The competent authorities shall authorise repayment only if the assurance undertaking's available solvencymargin will not fall below the required level;The loan agreement must not include anyclause providing that in specified circumstances, other thanthe winding-up of the assurance undertaking, the debt will become repayable before the agreed repayment dates;The loan agreement maybe amended onlyafter the competent authorities have declared that theyhave no objection to the amendment;

Securities with no specified Up to 50 % of the RSM for the total of such Theymaynot be repaid on the initiative of the bearermaturitydate and other securities and the subordinated loan capital orwithout the prior consent of the competent instruments, including referred to in point above. authority;cumulative preferential shares The contract of issue must enable the assurance other than those mentioned undertaking to defer the payment of interest on above. the loan;

The lender's claims on the assurance undertaking must rankentirelyafter those of all non-subordinated creditors;The documents governing the issue of the securities must provide for the loss-absorption capacityof the debt and unpaid interest, while enabling the assurance undertaking to continue its business;Only fullypaid-up amounts maybe taken into account.

Anyhidden reserves arising With the agreement of the home memberstate;out of the valuation of assets. In so faras such hidden net reserves are not of an

exceptional nature.



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References:0 Directive 2002/83/EC for Life insurers (and its amendments). 0 Directive 73/239/EEC for Non Life insurers (and its amendments). 0 CEIOPS consultation Paper n°20 - Draft Advice to the European Commission in the Framework of the

Solvency II project on Pillar I issues - further advice. 0 Solvency II Directive Framework Directive Proposal.

0 FSA CP 190 & 195. 0 FSA Prudential Sourcebook for Insurers.

Disclaimer© 2006, CALYON All rights reserved.This report or summary has been prepared by CALYON or one of its affiliates or branches (collectively“CALYON”) from information believed to be reliable. Such information has not been independently verifiedand no guarantee, representation or warranty, express or implied, is made as to its accuracy, completeness orcorrectness.This report, which is a commercial communication, is provided for information purposes only. Nothing in thisreport should be considered to constitute investment, legal, accounting or taxation advice and you areadvised to contact independent advisors in order to evaluate this report. It is not intended, and should not beconsidered, as an offer, invitation, solicitation or recommendation to buy or sell any of the financialinstruments described herein, nor is it intended to form the basis for any credit or other evaluation and isintended for use only by those professional investors to whom it is made available by CALYON. CALYON doesnot act in a fiduciary capacity to you in respect of this report.CALYON may at any time stop producing or updating this report. Not all strategies are appropriate at all times.Past performance is not necessarily a guide to future performance. The price, value of and income from anyof the financial instruments mentioned in this report can fall as well as rise and you may make losses if youinvest in them. Independent advice should be sought. In any case, investors are invited to make their ownindependent decision as to whether a financial instrument or whether investment in the financialinstruments described herein is proper, suitable or appropriate based on their own judgement and upon theadvice of any relevant advisors they have consulted. CALYON has not taken any steps to ensure that thefinancial instruments referred to in this report are suitable for any investor. CALYON will not treat recipients ofthis report as its customers by virtue of their receiving this report.CALYON, its directors, officers and employees may effect transactions (whether long or short) in the financialinstruments described herein for their own accounts or for the account of others, may have positions relatingto other financial instruments of the issuer thereof, or any of its affiliates, or may perform or seek to performsecurities, investment banking or other services for such issuer or its affiliates. CALYON may have issued, and

Table 5.9: Additional elements eligible for the ASM

Eligible elements Limitation Other restrictionsFor life insurers

50% of the undertaking's future profits. Not exceeding 25% of the lesserof the available When an actuarial report issolvencymargin and the required solvency submitted to the competent margin until 31 December2009. authorities substantiating the The amount of the future profits is obtained by likelihood of emergence of these multiplying the estimated annual profit bya profits in the future; and In so farfactor (not exceed six) which represents the as that part of future profits average period left to run on policies. The emerging from hidden net estimated annual profit shall not exceed the reserves referred to in point (c) arithmetical average of the profits made over has not alreadybeen taken into the last five financial years. account.

The difference between a non-Zillmerised or Not exceeding 3.5% of the sum of the Where Zillmerising is not practised partiallyZillmerised mathematical provision and a differences between the relevant capital sums orwhere, if practised, it is less mathematical provision Zillmerised at a rate equal of life assurance activities and the than the loading foracquisitionto the loading foracquisition costs included in the mathematical provisions forall policies for costs included in the premium.premium. which Zillmerising is possible.Fornon-life insurersOne half of the unpaid share capital or initial fund, Up to 50% of the lesserof the available solvencyonce the paid-up part amounts to 25% of that margin and the required solvencymarginshare capital or fund



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06CHAPTER

IntroductionThis chapter is like an ‘alchemists cook book’ since the story of the evolution of hybrid capitalsecurities can be illuminated with a light hearted metaphor to alchemy – the art and science ofturning base materials such as lead into gold.

Alchemy was a study and experimentation into the true ‘nature’ of things with the hope that un-derstanding will allow manipulation or transmutation to a different (i.e. better) state of nature.Alchemists, were said to literally dissolve and deconstruct things to derive the essence of thething and subsequently sought to reconstitute or put it back together in a more valuable configu-ration. Similarly, financial engineers focus on the essence of debt and equity to structure hybridsecurities that exhibit the desired proportion of the each component.

The alchemist's basic elements were earth, water, fire and air and these are replaced in the worldof hybrid capital security structuring with regulatory, ratings, accounting, tax and legal elements.Hybrid alchemists sought to deconstruct equity to examine all its virtues and reconstituting thosevirtues in a form that was also tax efficient and therefore better and more valuable to the issuersof hybrids. The essence of bonds and the security provided to fixed income investors was reconsti-tuted with elements of equity to create hybrid securities that gained for the issuer regulatory andrating agency benefits far beyond basic bonds, and at a reasonable cost premium to senior debtgiven the new protections that were included (step-ups, quasi-cum, ACSM etc). The evolution ofaccounting, legal, regulatory and tax principles has influenced the process and the rating agenciesalso helped to distil the ‘essence of equity’ in their useful publications.

But not all that glitters is gold and hybrids are not a replacement for common equity and so limitson the use of hybrids have been put in place even by the regulators and rating agencies that havechampioned their usefulness as equity substitutes. So while hybrids are not exactly up to the ‘gold standard’, that same pursuit of gold has led to the development of very useful, robust andflexible alternatives to the purer elemental forms, just as alchemists developed alloys such assteel from iron and carbon that are fundamental to the construction of our modern world. So too,hybrids can play a role in the capital structure of modern companies. As CEBS and others reviewthe ‘essence’ of hybrid equity capital in future it may be useful to consider the evolution ofhybrids over the past 20 years and compare some of the major jurisdictions that successfullyemploy hybrids.

Given the historical background provided on the forces that have led to the creation of hybridcapital securities, it will now be instructive to look at summary terms of illustrative hybrid capitalsecurities in some major countries where they have flourished. In addition, the various catalystsof growth that have driven new issue volumes and the expansion of the hybrid product'susefulness to encompass an ever wider variety of issuers have been highlighted; therefore, in thischapter the major issuer sectors within regions are detailed and some of the the featuresillustrated so that they can be compared and contrasted at a high level.

This chapter aims to serve as a ready reference to readers who may want to see how some hybridstructures compare at a high level within a particular country, or how structures compare acrosssectors or countries. A sample cross-section only has been provided since the universe of hybridsis too diverse to capture in its entirety and continues to evolve. Additionally, investors may findthis a useful catalogue to reference in search of a rapid overview of the country, sector, and/orcategorical comparisons for beginning to evaluate risk and relative value. These summaries are noreplacement for the complete offering circulars which should be read in their entirety beforemaking any decisions.

No doubt by the time this report goes to press there will be changes in the market that invalidate or make obsolete someof the information or references herein. Also, since the chapter summarises and points out highlights, the original andcomplete documents should be referenced for a full assessment of the risks and nuances of the structures.

STRUCTURAL CONSIDERATIONS –FOCUS ON SELECT COUNTRIES

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It is impossible to efficiently convey all the detail of the transactions that are summarised here, butthe summaries will bring to light some major features and allow for more easily processed identifi-cation of similarities and distinctions so that some ‘risk factors’ might be compared and structuraltrends may be observed. It is the case that old solutions may solve new problems, so this chronicleof some structures that have evolved over time will also create a pathway back to older structuringtechnology which can be useful in future development of the market. The extracted stories fromInternational Financing Review relating to these transactions offer additional insight into therationales behind their issuance and into their reception by the market.

UKThe UK FSA and UK banks have always been at the forefront of global regulatory capital develop-ments. As a Basel committee member the UK FSA continues to provide thought leadership aboutthe definitions of regulatory capital and implementation of capital adequacy rules.

UK banks were among the first significant users of preference shares for bank capital purposesand issued significant amounts of preference shares. While these early preference shares werenot tax deductible for the issuing banks some did provide a tax benefit called ACT to someinvestors that could reclaim the ACT tax benefit (ACT benefits were eventually eliminated) whicheffectively increased the investor’s tax adjusted return, thereby increasing the investor demandfor this type of security and effectively reducing the issuer’s cost.

During the late 1990s when regulators began to oppose SPV-oriented Tier 1 hybrids, a shift inhybrid product development led to the first UK direct issue, tax-deductible hybrid Tier 1. Some ofthe early structures had names like Reserve Capital Instruments (RCI), Tier One Notes (TONS), TierOne Non-Innovative Capital Securities (TONICS) and Tier One Preferred InCome Securities(TOPICS). The acronym war among banks was waged in real anger in those days! Some of the UKstructures have had a lasting impact on global hybrid structuring development.

The key advance in these early structures mostly involved the reconciliation of the tax requirement fora cumulative payment, which clashed with the non-cumulative nature of bank capital Tier 1. The in-troduction of various stock settlement mechanisms provided a non-cash cumulative instrument,which is a predecessor to the ACSM structures widely seen today. Other variations followed, includingearly True Perp structures with principal stock settlement features and designs to be counted outsidethe 15% limit on ‘innovative’ step-up hybrids. The rate step-up at the call date is a fundamental charac-teristic of what regulators deemed ‘innovative Tier 1’ and therefore limited to 15%. These new UK TruePerp structures had no rate step-up at the call date, but could optionally settle the principal amount ofthe issue via common stock issuance (which could be deemed an incentive to call the security for cashinstead of incurring the expense and dilution of common settlement).

After a period of stringent FSA adherence to very conservative interpretations of BIS guidelines,the approval of these structures by the FSA gave UK banks a chance to issue tax-efficient Tier 1 ona competitive basis with other global banking players. However, the FSA was challenged by someother national regulators who considered some of the new FSA-approved hybrid Tier 1 securitiesto contain features that rendered the hybrids unworthy of the 1998 BIS guidelines for ‘corecapital’. It was an interesting point in time really. At that time, certain national regulators fromacross the world were pitted against each other in a process of evaluating their own and eachother’s versions of capital to seek a now legendary ‘level playing field’. During the politicalprocess of this reconciliation, national structures were often defended by the home regulator andforeign structures challenged. The ACSM feature has been carried forward but not stocksettlement of principal at the call date in core Tier 1. As the definition of own funds is again beingconsidered by global regulators such political debates may again rage on but hopefully lessons ofthe past and contemporary structuring advances will be exploited so that hybrid capital willfurther evolve to better serve its many constituents.

While the UK led in the development of regulatory capital for banks and insurance companiesand the early issuance of preference shares by corporates in the 1990s, the UK corporates werecuriously absent from the next generation corporate hybrids until Rexam became for first UKcorporate to issue hybrids since the new rating agency rules were published in 2005. Surprisingly,it was a Euro issue and the first Sterling corporate hybrid was previously issued by Linde ofGermany. The Rexam Basket D hybrid deal was however chock full of interesting features (earlyredemption, structural modification flexibility) and could pave the way for more UK corporateissuance.


116

Similar levels of flexibility were included in the L&G preference securities issue which was alsostructured to achieve Basket D. However, the perpetual preference securities issued by L&G got toBasket D via the legally binding Replacement Capital Covenant (RCC) which improvespermanence rather than via the Mandatory Payment Deferral (MPD) used by Rexam in the 60 yeardated subordinated debt obligations to strengthen the ‘no ongoing payments’ dimension.

It is interesting to compare the wide range of features on L&G preference securities versus thecomparatively straightforward Barclays Non-Cumulative Preference Shares which do not seekenhanced rating agency equity credit but rather are classic Tier 1 bank capital. A furthercomparison is provided by summarising a Barclays RCI type issue for comparison to the BarclaysPreference Shares and the other UK examples. The inclusion of features such as the ACSM, thetypes of securities available via any ACSM and any limits on the amount of those ACSM securitiesare distinctions to make when reading the offering circulars of these types of hybrid transactions.

A common theme across geographies exhibited among these few UK examples is that while bankswere the early leaders in structuring hybrids to meet their regulatory objectives it can be observedthat corporate and insurance sector transactions are often cutting edge structures with featuresthat may influence future bank hybrids.

As noted the UK issues are direct rather than through SPVs and the use of ACSM mechanisms supportboth the historical primary aim of achieving tax efficiency (i.e. RCI debt for tax purposes) but also insome more recent cases across sectors ACSM provides additional investor comfort that improves mar-ketability and lowers the issuer’s cost. Variations in the issuer’s early redemption options and thediscretion, duration and potential cure associated with potential payment deferral (or paymentelimination) are also key distinctions when looking at any hybrids for comparative purposes.

More information on the FSA is available on www.fsa.gov.uk


117

UK termsheets

L&G Tier 1 debut packs a punch (Published in IFR, 21 April 2007)

In terms of credit, Legal & General is a no-brainer for investors. So when the conservative issuer, the third-largest UK insurer by market capitalisation, brought to the market its inaugural Tier 1 issuance in the form of a£600m perpetual non-call 10-year trade last week, the challenge was not to achieve the cheapest possiblefunding, but to ensure secondary market performance.

Having issued in UT2 and LT2 format in 2004 and 2005, respectively, the innovative Tier 1, fixed-to-FRN,100bp step-up trade (rated A3/A) rounded off the issuer's capital structure. In view of its relatively low gearingversus peers, L&G opted for a structure designed to maximise ratings agency equity credit, becoming the firstEuropean insurer to use legally binding replacement language (also known as a replacement capital covenantor RCC, requiring that the issue can only be redeemed by either a similar or junior trade) rather thanmandatory deferral, taking a leaf out of National Bank of Greece's £375m Tier 1 issuance last October.

"On the basis that we believe that there should continue to be a place for innovative Tier 1 on our balancesheet, we do not consider this covenant particularly burdensome and certainly preferable to a mandatorydeferral trigger based on P&L criteria as used by European insurers to achieve Basket D," said John Whorwood,group treasurer at Legal and General.

The liberal sprinkling of structural tweaks built into the transaction by joint leads HSBC, Merrill Lynch and RBS(sole structuring adviser) meant that the deal became the first European Basket D transaction (eligible for75% equity credit on Moody's continuum) without mandatory deferral triggers. It is also the first UKtransaction to use preference shares and payment in kind (PIK) securities alongside ordinary shares in theAISM (alternative interest satisfaction mechanism) and the first to incorporate caps in the usage of the AISMto meet ratings agency requirements. Last, but not least, it is the first UK insurance transaction to qualifyunder the FSA's new GENPRU rule book as innovative Tier 1 capital.

The eventual pricing at plus 133bp was the same level at which the issuer priced its UT2 trade three yearsago, which underscores the fact that credit spreads are at historic tights. The proceeds of the trade will beused for commercial paper refinancing and for the acquisition of Nationwide Life and Nationwide Unit TrustManagers (as part of the issuer's distribution agreement with Nationwide).


118

L&G's sparkling debutLegal & General established a number of firsts in the UK hybrid sector with its £600m perpetual non-call 10Tier 1 trade issued last week (see News story for details). The innovative Tier 1, fixed-to-FRN, 100bp step-uptrade (rated A3/A) rounded off the issuer's capital structure, L&G having issued in UT2 and LT2 formats backin 2004 and 2005, respectively.

Following a three-day UK roadshow, joint leads HSBC, Merrill Lynch and RBS opened books last Thursdaymorning with initial price guidance of 135bp–137bp over Gilts, 2bp–4bp inside the benchmark AXA andGenerali 2016 Tier 1s.

Of a total order book that exceeded £3bn (raised in half a day), £500m dropped away when guidance wastightened to plus 133bp and the issuer's size ambition capped at £600m. Compared with Aviva's perpetualnon-call 2020 Tier 1, bid at plus 145bp, the deal did not concede any new issue premium. When freed totrade, the bonds were marked at plus 132bp–130bp, tightening by a further 2bp last Friday.

"We continued to monitor the relative cost of innovative Tier 1 versus UT2 and believed the right spread wasbetween 15bp and 20bp and therefore we were delighted that we were able to achieve a 17bp differential onthis transaction, that is 133bp over Gilts versus the secondary level of plus 116bp on our existing sterling UT2[perpetual non-call 15] trade," said John Whorwood, group treasurer at L&G. "Unlike our previous issues, wehave chosen to swap the issue into floating-rate funds, allowing us to raise tax-deductible Tier 1 capital at alevel of 93bp over Libor," he added.

Of the more than 100 accounts in the book, the UK accounted for 97% of the placement. Asset managersbought half the bonds, followed by insurance and pension funds (42%) and banks and hedge funds (4% each).

Barclays shows human side (Published in IFR, 11 June 2005)When Barclays Bank launched its second euro-denominated preference share issue at the beginning ofMarch – the perp, non-call 2020s – few could have known it had hit the absolute market tights and achievedpricing levels that one banker described (with only a hint of hyperbole) as unlikely to be revisited for ageneration.

From an issuer perspective, it could be thought that this should be viewed as a utopian outcome – the bestpossible in the best of all possible worlds. Not all issuers are quite so simplistic in their approach, however, andBarclays' claim is that it has always prided itself on its reputation for transactions that perform in thesecondary market. Perform is certainly the one thing that it did do, but not quite in the way envisaged.

From an issue spread of 102bp over Bunds, it tightened marginally when freed to trade (all well and good) butthen fell victim to the extreme volatility that hit the whole market in the middle of the month and spent thenext few weeks lurching between plus 135bp and 175bp, before breaking out and at one stage hitting the220bp mark. A level of decorum has been regained – albeit at wider levels – and it has spent the last fewweeks around the high 180s/low 190s.

When the market was at its most turbulent, the deal was still primary. It was large (€1.4bn) and thereforeliquid, and relatively long. If anything was likely to become a proxy for the market in general – and bear thebrunt of traders wishing to hedge existing positions or just take a punt – this was it. While this does not makethe circumstances any easier to bear for investors that bought bonds at launch, it does tend to put things incontext.

While all that might seem like ancient history and not strictly relevant to the present, it does have a significantbearing on Barclays' recent actions. To fund its acquisition of Absa, it announced that it was going to launchmore of the same, or similar in any case. Having already visited the euro market twice, it chose a differenttack, first targeting US institutions two weeks ago with US$1bn of non-call 30s and then concentrating onthe domestic audience for the final leg last week.

When price talk first emerged on the putative sterling issue – 175bp over Gilts – the initial reaction, in somequarters at least, was that it was more than likely a wide mark designed to entice investors into the bookbefore the genuine pricing came in tighter. Much of this reasoning was based on the fact that HBOS's pref hadbeen trading around its launch spread of 162bp over Gilts, and for Barclays to trade back of HBOS would beagainst the natural order of things, even allowing for a 12-year rather than 10-year call and the renewed needfor a new issue premium.


119

At the Tier 1 level, Barclays is rated Aa3/A+ against HBOS's A1/A.

Barclays' announcement, not surprisingly, had the effect of widening out the bid on the HBOS deal and AngloIrish's recent transaction (so recent it is still primary, in fact) by around 10bp. As the news sank in, however,both began to drift back in. Barclays Capital played a lead management role in both of those trades and waswell placed to know the market's state of mind. The thought began to take hold that maybe Barclays waswilling to price at a concession to where it could if it pushed matters, not only in return for size but also tomake amends for investors' experiences on the euro issue.

Whatever the rationale behind the price talk, it had the desired effect and a book of close on £1.6bn built up. Hedgefunds have been noted creeping back into a few deals – and this looked like one that would suit them perfectly.

Barclays' head of capital issuance, Ross Aucutt, was keen to stress the quality of the order book, however, so itlooked as if real-money accounts were keen to participate as well. With £750m the chosen issue amount, thesize of the book allowed for a degree of manipulation, and Aucutt added that allocation was skewed towardsasset managers, with particular emphasis being placed on the bank's equity investors.

Despite the view that the issue was relatively cheaply priced, it did not tighten in dramatically when freed totrade. It narrowed a couple of basis points on the break but did not replicate the performance of the previousweek's US dollar deal, which had come in around 15bp. That deal was also rumoured to have been launchedat a level wider than Barclays could possibly have pushed for, and largely for similar reasons to this time round:namely breaking into a new investor base mindful that they would be aware of what had happened to theeuro deal. By the end of the week, natural order had returned, with Barclays bid at 170bp to HBOS's 171bp.Although that situation was market-driven rather than having anything to do with the pricing or placement, itwas still something that had to be addressed.

Barclays' decision to do so by trying to guarantee performance in its new transactions to the best of its abilityseems to have been successful, although other prospective issuers will be hoping that investors will notexpect all borrowers to follow suit.

FIG hybrids get a new look(Published in IFR, 22 September 2007)

This summer's volatility hit the high-beta market for perpetual securities particularly hard, so much so thatborrowers that had recently issued the instruments are now facing significant coupon reductions after thecall periods. It is against that backdrop that investors, borrowers and underwriters are evaluating how toproceed in a market that has lain dormant for over three months.

Amid the prevalence of coupon step-downs in the market, one investor group lobbed a US$1bn enquirytowards Barclays Bank, and the firm subsequently obliged by issuing US$1.25bn in perpetual non-call 10Aa3/A+/AA securities. Those participating in the deal were quickly rewarded with what was said to be animprovement of 30bp on the break.

Barclays' outstanding 5.926% issue with a call in 2016 was said to be bid 265bp over Treasuries as the creditre-entered the market. That issue priced in September 2006 at 129bp over, which equated to a coupon step-up of Libor plus 175bp after the call. With 10-year swap spreads bid in the 60.25bp area, any coupon step-upon last week's transaction would be likely to arrive in the area of Libor plus 300bp, which is demonstrablymore attractive that the 175bp reset on the outstanding issue.

Although other accounts quickly piled into the trade, the aforementioned investor group was said to haveheld out for the pricing concession that it believed was appropriate. Last week's transaction eventually priced280bp over 10-year Treasuries with a coupon reset of Libor plus 317bp after the call. With the attraction ofthat step-up, the securities snapped into the 250bp area on the break.

The Barclays transaction also had the benefit of rapidly improving market conditions following the FOMCmeeting, and it was debatable whether a tighter pricing level could have been achieved prior to the meeting.The other recent hybrid trade, which was a US$250m A3/BBB+/A– tax deductible trade for FPL, priced with aconcession that was thought to be in the 50bp range.

Several broker/dealers were said to have placed orders for the Barclays Bank securities at the plus 280bp level, and thatdemand, in addition to anchor orders, drove the total size of the order book to the US$7bn range.


120

Those away from the transaction watched the process closely and indicated that the offering should providea foundation for the pricing of subsequent perpetual trades. "The market now knows that there is a level outthere for hybrid securities that can drum up US$7bn in demand," said one observer.

With Barclays reopening the market last week, there should be additional supply forthcoming as investorsrotate away from instruments that carry a coupon step-down after the call. Participants anticipate thatsecurities issued five or six years ago in the earlier stages of the financial hybrid market will soon catch a biddue to their step-ups.

The sharp declines in the value of the dollar against the euro and the pound, which are expected to continue,could also play a role in Yankee issuers' decision to call certain perpetual securities, as the principalrepayment would be reduced.

After pricing a US$1.45bn perpetual non-call five Aa3/A transaction with a dividend of 7.25% last week, RBSGroup is said to be considering a dollar-denominated step-up or non-step institutional trade related to itsacquisition of ABN AMRO.

Bank of America also tapped the retail market last week with a US$500m perpetual non-call five Aa3/A+offering that printed with a dividend of 6.625%. JPMorgan meanwhile filed a shelf registration for preferredand junior subordinated securities.

Rexam's hybrid paves way for UK corporates(Published in IFR, 23 June 2007)Rexam opened a new chapter in the European corporate hybrid market last week when it became the first UKcorporate to use the structure. The €750m M&A-driven transaction met with a very positive reception frominvestors that ensured it was more than five times subscribed at the reoffer level of mid-swaps plus 190bp.

The key reason why UK corporates had not used the hybrid structure until Rexam's deal is that suchcompanies have usually been the ones being acquired in bouts of industry consolidation, rather than beingthe acquirers, said Debbie Keat, a member of the European new products team at Citi. While she acknowl-edged that the Rexam transaction is, therefore, unlikely to open the floodgates for more UK corporates, shebelieves that the deal's success should entice others to follow suit, a view shared by other market partici-pants. Peter Jurdjevic, European head of new products at Citi, suggested that there is also an element ofissuers not wanting to be the first to the market.

"Issuers have to go through a lot of work including tax analysis, legal analysis and ratings agency work whichcan be quite time consuming. The transaction took around 14 weeks from initial discussions to executionand this may have prompted potential issuers to hold back until the first deal is out of the way and themarket's reception is seen. Rexam has laid the cornerstone for this to happen."

Jon Drown, director of group treasury at Rexam, acknowledged that the exercise was more time consumingand more costly than issuing typical senior debt, but he maintained that this is comfortably outweighed bythe product's benefits. "For the amount of work that went into the deal, coupled with the benefits, it offersremarkably good value," he said, adding that a couple of UK corporates had already been on the phone todiscuss the issue.

This was backed up by Khalid Krim, head of European hybrid capital structuring at Barclays Capital, who alsohighlighted additional companies that have expressed an interest in hybrids, although he declined to namethem. "This is a product that is now very available to UK names and there are others that would undoubtedlybenefit their capital structure by limiting dilution to shareholders and avoiding a rights issue," he said.


121

Tab

le 6

.1:

UK

term

shee

ts

Insu

ranc

e Tie

r1Ba

nkTi

er1

Bank

Tier

1 Co

rpor

ate

Hybr

idLe

gala

nd G

ener

al£6

00m

Ba

rcla

ysBa

nkPL

C£7

50m

Barc

lays

Bank

PLC

US$1

.25b

n Re

xam

€75

0m 6

.75%

60

nc6.

385%

Per

p nc

10 (i

ssue

d Ap

r-07

)6%

Per

p nc

12 (i

ssue

d Ju

n-05

) 7.4

34%

Per

p nc

10 (i

ssue

d Se

p-07

)10

(iss

ued

Jun-

07)

Issu

erLe

gal a

nd G

ener

al G

roup

PLC

Barc

lays

Ban

kPL

CBa

rcla

ys B

ank

PLC

Rexa

m P

LCIs

suer

Type

Dire

ctD

irect

Dire

ctD

irect

Secu

rity

Type

Perp

etua

l Pre

ferr

ed C

alla

ble

Capi

tal S

ecur

ities

Non

-Cum

ulat

ive

Calla

ble

Pref

eren

ce S

hare

sSt

ep-u

p Ca

llabl

e Pe

rpet

ual R

eser

ve C

apita

l Ins

trum

ents

Capi

tal S

ecur

ities

Dire

ct, u

nsec

ured

and

St

atus

/ Su

bord

inat

ion

Dire

ct, u

nsec

ured

and

subo

rdin

ated

obl

igat

ions

of t

he

The

Pref

eren

ce S

hare

s will

rank

juni

orto

oth

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ares

Th

e RC

Is co

nstit

ute

dire

ct, u

nsec

ured

, sub

ordi

nate

d

subo

rdin

ated

obl

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ions

of t

he Is

suer

. Is

suer

and

shal

l at a

ll tim

es ra

nkpa

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and

with

out

rank

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in p

rior

ityto

the

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s, e

qual

lyse

curi

ties o

f the

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d ra

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with

out

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will

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pas

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ong

them

selv

es. T

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and

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ms

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and

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with

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clai

ms o

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pari

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ith th

e Pr

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, and

of

the

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and

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-Dec

-201

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29-J

un-2

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at F

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+10

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s-

+10

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bps

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Yes (

TaxL

aw C

hang

e / C

apita

l Dis

qual

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t).

n/a

Yes (

Tax/

Reg

ulat

oryE

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). Re

dem

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n su

bjec

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s (Ac

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edee

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at t

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deem

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empt

ion

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e (C

apita

l Dis

qual

ifica

tion

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t).

prin

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l am

ount

(Add

ition

al A

mou

nts

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mpt

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subj

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iorc

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. Sub

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ding

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al A

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rat t

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qual

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e - h

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rof p

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ipal

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l Ev

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vent

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at 1

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of p

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ipal

(A

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em se

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ties a

t any

time,

at m

ake-

who

le re

dem

ptio

n pr

ice

(hig

hero

f pr

inci

pal o

rBun

ds+

25).


122

Tab

le 6

.1:

UK

term

shee

ts(c

ont)

Insu

ranc

e Tie

r1Ba

nkTi

er1

Bank

Tier

1 Co

rpor

ate

Hybr

idLe

gala

nd G

ener

al£6

00m

Ba

rcla

ysBa

nkPL

C£7

50m

Barc

lays

Bank

PLC

US$1

.25b

n Re

xam

€75

0m 6

.75%

60

nc6.

385%

Per

p nc

10 (i

ssue

d Ap

r-07

)6%

Per

p nc

12 (i

ssue

d Ju

n-05

) 7.4

34%

Per

p nc

10 (i

ssue

d Se

p-07

)10

(iss

ued

Jun-

07)

Repl

acem

ent C

laus

eRe

plac

emen

t Cap

ital C

oven

ant -

repl

acem

ent w

ith

n/a

n/a

Inte

nt-B

ased

Rep

lace

men

t of R

edee

med

qu

alify

ing

secu

ritie

s. S

ubst

itutio

n of

Cap

ital S

ecur

ities

Se

curi

ties.

Rep

lace

men

t with

ord

inar

yw

ith p

refe

renc

e sh

ares

(Cap

ital B

reac

h Ev

ent).

sh

ares

orr

epla

cem

ent c

apita

l sec

uriti

es

(Min

imum

Out

stan

ding

Pri

ncip

al

Amou

nts E

vent

/ Ad

ditio

nal A

mou

nts

Even

t / A

ccou

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g Ev

ent /

Cap

ital E

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xEve

nt)

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nt-b

ased

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g a

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on E

vent

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per

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per

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d St

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bein

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n Is

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g so

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n/a

the

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of p

aym

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med

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fter.

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he F

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time

of p

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. Max

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and

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pon

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rest

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ts o

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axim

um 1

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arIn

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st p

aym

ents

opt

iona

llyde

ferr

able

. 5-

year

defe

rral

per

iod

(cum

ulat

ive)

. Def

erre

d pa

ymen

ts to

ava

ilabi

lityo

f dis

trib

utab

le p

rofit

s. D

efer

red

divi

dend

s de

ferr

al p

erio

d (n

on-c

ash

cum

ulat

ive)

. Def

erre

d pa

ymen

ts

Max

imum

5-y

eard

efer

ral p

erio

d be

settl

ed w

ith vi

a A

ISM

(Alte

rnat

ive

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rest

Sat

isfa

ctio

n no

n-cu

mul

ativ

e.to

be

settl

ed vi

a AC

SM.

Mec

hani

sm).

(cum

ulat

ive

and

com

poun

ding

). D

efer

red

paym

ents

to b

e se

ttled

with

cash

orv

ia A

CSM

. Ra

ting

Agen

cyN

o ra

ting

agen

cym

anda

tory

defe

rral

trig

ger(

see

n/a

n/a

Inte

rest

pay

men

ts m

anda

tori

lyde

ferr

able

.M

anda

tory

Def

erra

lre

gula

tory

paym

ent d

efer

ral a

nd R

CC).

Trig

ger-

Fin

anci

al Le

vera

ge R

atio

(A

djus

ted

Net

Deb

t to

Adju

sted

EB

ITDA

) gr

eate

rtha

n 5.

5, o

rgre

ater

than

4.5

on

four

cons

ecut

ive

dete

rmin

atio

n da

tes.

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suer

requ

ired

to p

ayde

ferr

ed p

aym

ents

im

med

iate

lyvi

a AC

SM. M

axim

um 1

0-ye

arde

ferr

al p

erio

d (c

umul

ativ

e an

d co

mpo

undi

ng).

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d pa

ymen

ts to

be

settl

ed vi

a AC

SM.

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erre

d Pa

ymen

tsN

on-C

ash

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ulat

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h Cu

mul

ativ

eM

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tory

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erra

l (N

on-C

ash

Cum

ulat

ive)

/ O

ptio

nal D

efer

ral

(Cum

ulat

ive

/ Non

-Cas

h Cu

mul

ativ

e).


123

Tab

le 6

.1:

UK

term

shee

ts(c

ont)

Insu

ranc

e Tie

r1Ba

nkTi

er1

Bank

Tier

1 Co

rpor

ate

Hybr

idLe

gala

nd G

ener

al£6

00m

Ba

rcla

ysBa

nkPL

C£7

50m

Barc

lays

Bank

PLC

US$1

.25b

n Re

xam

€75

0m 6

.75%

60

nc6.

385%

Per

p nc

10 (i

ssue

d Ap

r-07

)6%

Per

p nc

12 (i

ssue

d Ju

n-05

) 7.4

34%

Per

p nc

10 (i

ssue

d Se

p-07

)10

(iss

ued

Jun-

07)

ACSM

Settl

emen

t of d

efer

red

inte

rest

pay

men

ts vi

a is

suan

ce o

f n/

aSe

ttlem

ent o

f def

erre

d in

tere

st p

aym

ents

via

issu

ance

of

Settl

emen

t of d

efer

red

inte

rest

pay

men

ts

ordi

nary

shar

es (2

% li

mit

in a

ny12

-mth

per

iod)

, or

dina

rysh

ares

(2%

lim

it). I

ssue

rsha

ll us

e be

st e

ffort

s to

imm

edia

tely

, via

issu

ance

of o

rdin

ary

PIK

Secu

ritie

s (15

% li

mit

of p

rinc

ipal

) orP

refe

rred

Par

ityse

ttle

defe

rred

pay

men

ts. D

efer

red

paym

ents

not

settl

ed

shar

es, w

arra

nts o

rjun

ior/

pari

tySe

curi

ties (

25%

lim

it fo

rPre

ferr

ed P

arity

and

PIK

afte

r10

year

s will

cons

titut

e an

eve

nt o

f def

ault.

secu

ritie

s (25

% li

mit)

in si

xmon

th p

erio

d Se

curi

ties)

. Iss

uers

hall

use

reas

onab

le e

ndea

vour

s to

prio

rto

defe

rral

dat

e. If

Issu

erno

t abl

e to

se

ttle

defe

rred

pay

men

ts. D

efer

red

paym

ents

to b

e se

ttled

pa

ydef

erre

d in

tere

st o

n de

ferr

al d

ate,

w

ithin

5 ye

arpe

riod

.Is

suer

shal

l use

bes

t effo

rts t

o se

ttle

defe

rred

pay

men

ts. D

efer

red

paym

ents

no

t set

tled

afte

r5 ye

ars (

optio

nal d

efer

ral)

or10

year

s (m

anda

tory

defe

rral

) will

co

nstit

ute

an e

vent

of d

efau

lt.Ad

ditio

nal F

eatu

res/

Bask

et D

via

RCC

Not

tax-

dedu

ctib

lePr

e-em

ptio

n: Is

suer

/hol

dco

requ

ired

to ke

ep a

vaila

ble

for

Bask

et D

(MPD

)Co

mm

ents

issu

e su

ffici

ent s

hare

s to

satis

fytw

o co

upon

pay

men

ts vi

a AC

SM.

Sour

ce: C

ompi

led

byCA

LYO

N fr

om re

spec

tive

offe

ring

s ci

rcul

ars

Ireland Irish financial institutions have been very active issuers of hybrid capital securities given therapid growth of the domestic economy and the successful strategies of the institutions to capturedomestic and international opportunities. Irish financial institutions have tapped both the RPBand institutional markets. Within the institutional market both step-ups and True Perps havebeen seen from Ireland. Irish banks and also building societies have been active in issuing Tier 1capital and Permanent Interest Bearing Shares (PIBS) in the international debt markets for manyyears, and evolved the capital security structures in order to optimise the tax and accountingaspects while meeting regulatory and legal requirements. So far no corporate hybrid or insurancesector transactions have been issued by an Irish institution.

The exhibit below details two transactions, one bank – Anglo Irish – and one building societyregulatory capital transaction – EBS Building Society. As in many jurisdiction the structuringobjectives must consider tax efficiency (deductibility, duties, withholding). These two Tier 1capital structures exhibit some of the variety seen in the market over time. Notable differencesinclude the ownership and domicile of the SPVs involved.

Irish banks have issued indirectly via an SPV when raising Tier 1 capital in the markets. As seenwith the Anglo Irish Tier 1 transaction in the exhibit, many of these securities are issued throughan English limited partnership (LP) SPV with subordinated guarantee from the bank. The use of anUK LP SPV was a breakthrough for the Irish financial institutions in meeting the regulatory require-ments of IFSRA, with UK LP securities providing the sufficient equity characteristics to pass as Tier1 capital, with classic Tier 1 terms applied (eg. perpetual maturity, non-cumulative deferrablepayments, deeply subordinated, fully paid up equity securities in the hands of investors).

Some of the Irish building societies have traditionally issued PIBS – the Bank Tier 1 equivalent forbuilding societies and over time the market and structure for these securities has also evolved.The EBS Tier 1 transaction satisfied IFSRA requirements via issuance of Tier 1 qualifying securitiesfrom a Luxembourg SPV to an independent SPV which then sells its own securities to theinvestors. Such an arrangement is in some ways similar to Tier 1 capital structures seen inGermany and Switzerland, as also discussed in this report.

These independent SPV arrangements can be established by the structuring bank and lawyersassisting in the transaction to increase the overall fiscal results and aid in the marketability of thesecurities to international investors.

As regulatory capital Tier 1 was the objective of these issues there are no additional rating agencyenhancements in the structures such as RCC or ratings driven MPD triggers however regulatoryand issuer discretionary deferral are of course possible.

A forward thinking feature included in some Irish Tier 1 was the structural benefit to the issuersthat could allow minor amendment or substitution of the capital securities if needed. Theinvestor could for example continue to hold the SPV securities, with the issuer replacing ormodifying the capital securities issued into the SPV to offset potential future changes or alterna-tively traditional preference shares could be issued to investors to replace the entire hybridstructure. This type of flexibility can now more frequently be seen in some of the recent transac-tions across the world as the potential for CEBS driven changes in own funds definitions isconsidered as a possibility.


124

Ireland termsheets

Anglo Irish spreads wings (Published in IFR, 23 September 2006)While it is a credit well known to UK institutional buyers of subordinated debt and has a well-defined sterlingcurve, Anglo Irish Bank had not offered European investors the opportunity to gain exposure in their corecurrency before last week. It has previously tapped the non-innovative retail market through a CMS-linked Tier 1,but the fund management fraternity had not had such a chance to buy higher-yielding paper in step-up format.

Although the bank frequently updates investors in its senior paper about its strategy and progress, anextensive, subordinated-specific pan-European roadshow was arranged by lead managers ABN AMRO, BNPParibas and Merrill Lynch, initial talk just being of a perpetual callable step-up issue. As to whether this wouldcome in the guise of a Tier 1 or UT2 was at first uncertain, Anglo having clearance for a UT2 but requiringregulatory sign-off for a Tier 1.


125

With sterling having offered better execution than euros throughout much of the summer, there were alsowhispers – mainly away from those close to the deal – that this would turn out to be the preferred currency.But it was not, in spite of the fact that the cost would undoubtedly have been less – by up to 10bp, said some– for such a trade. Anglo's decision was that this was a price well worth paying for the investor diversification aeuro-denominated transaction offered.

Although Anglo had only €300m headroom for innovative capital, the choice made was to opt for abenchmark (€500m minimum) perpetual non-call 10 Tier 1. The bank has been expanding quickly over thelast few years, and the view was that it would grow into any excess issued. There is only a small differentialbetween UT2 and Tier 1 funding levels in the euro market, so the incremental cost was relatively minor. Andwith a September year-end and results announced on December 6, chances are that this growth will comesooner rather than later.

Spread talk of 120bp–125bp over mid-swaps was released and the order book grew quickly. The €500mmentioned was covered within a couple of hours, the final order tally exceeding €2bn. Even when spread talkwas refined to the tight end, there was still around €1.8bn remaining and the final deal size was increased to€600m, leaving Anglo a little more innovative room into which to grow than first envisaged.

There was probably even scope to push inside 120bp, though Anglo was aware of the need to create a goodimpression on its debut visit, especially as it is likely to return. Even so, the level it achieved comparedfavourably with its ratings peer group, though there is a strong belief that its ratings are constrained more bysize than market perception.

Anglo's transaction was rated Baa1/NR/A. Erste Bank recently launched A3 rated 10-year callable paper atplus 127bp, while Sabadell (A3/BBB/A–) was in the market at the beginning of the month with an issue thatwas last week bid around plus 121bp. The bonds weakened slightly on the break, though this was against abackdrop of nervousness prompted by global political developments, the 1bp widening actually being a slightoutperformance.

New issues defy secondary widening(Published in IFR, 23 July 2005) Although secondary turnover was slow, the market spent much of the week in mild retreat. In the context of anumber of weeks of spreads ratcheting tighter, it was a minor move, however, and there was no discernibleeffect on the primary market. “It was mainly Street jockeying,” said one syndicate official. "Accounts are notselling, if anything, they are still better buyers for choice.”

This was certainly borne out by the experiences of Banco Pastor and Resona Bank, both of which priced con-siderably inside initial guidance. And this after Pastor's previous trials at the beginning of May when it had toshelve plans for a non-step up transaction even before the roadshow stage had been reached (see the featureat the start of the Bonds section for comment on Resona and Tier 1 preferreds in general).

This time, its €250m perpetual non-call 10 Tier 1 attracted a final book of €1.38bn. Almost half the orderswere pledged after the spread talk had been tightened by 8bp from early indications of a mid-swaps plus125bp spread. Eventual pricing was at plus 117bp over mid-swaps (126.4bp over Bunds), close to the tights ofall the possible options discussed during the roadshows organised by lead managers Barclays Capital,Dresdner KW and Morgan Stanley.

During the marketing process, the interested parties largely fell into two groups: one that felt 115bp wasspread enough (mainly Dutch accounts) and those that wanted something nearer 130bp (mainly UK). Both ofthese levels was wider than Tier 1 paper from comparable names such as BES (A3/BBB), Kaupthing (A3) andEurohypo (Baa1/BBB+), whose bonds ranged from 100bp to 114bp over, although the stringent mandatorydeferral language that earned Baa1/BBB rated Pastor Basket D (75% equity) treatment from Moody's naturallycame with a price attached. The handful of basis points it cost was less than some were predicting, however,and was largely compensated for by this being the first step-up deal from Spain – and as such had an elementof rarity value attached to it. The differential was further eroded after the bonds were freed to trade,tightening to 122bp–120bp over Bunds from the 126.4bp launch spread.

The transaction featured two mandatory deferral triggers: one if Tier 1 ratios fall below 5% – more stringentthan the 4% required under Spanish law – the other a standard profits test. It was this slightly unusualstructure plus its relatively small size (at €250m it is too small to qualify for either the iBoxx or Lehmanindices) that caused it to price at a small premium, and this situation was repeated on the week's other newTier 1 issue from EBS Building Society.


126

The €125m issue size almost guarantees that EBS will not trade in the secondary market, and this lack ofliquidity necessarily limits the number of accounts willing to consider investing in it. The original marketingwas for a €100m issue, the larger size coming in response to an order book built up by joint leads ABN AMROand Davy Stockbrokers that could have seen the paper sold twice over.

As a mutual, EBS has limited ways of raising capital as it is unable to access the equity market. The way thatbuilding societies in the UK have historically dealt with this situation has been to launch PIBS (PermanentInterest Bearing Shares) issues and this was effectively a synthetic PIBS. It was actually launched through anABN-sponsored vehicle, Chess Capital Securities, and was a perpetual callable after 10-years with a 100bpstep-up in the case of the call option not being exercised. It priced at 145bp over mid-swaps, and was inkeeping with the theme of the week, which was tighter than initially indicated spreads, although it was notquite as aggressively repriced as Pastor's deal. Original talk had been in the plus 150bp area.

Pastor also offered a useful comparable when looking at the issue's relative merits. Both transactions wereBaa1 rated by Moody's, although Pastor also carried Triple B from S&P, and both were small and potentiallyilliquid. That EBS's issue was half the size of a Pastor transaction already viewed by some as too small toparticipate in and the single rating demanded a premium from the Irish issuer, the only question being howlarge it should be. At their respective launch spreads it was 28bp, although because Pastor's issue tightenedslightly when freed to trade it made it more like 30bp. For those whose desire for liquidity is secondary toyield, this made for a healthy pick-up over similarly rated peers.

While Irish investors were the largest single group, they accounted for only 36% of the paper, German buyerstaking almost a quarter and the rest spread around pan-European fund managers. German investors werealso active in the floating-rate market, DZ Bank adding €100m to its perpetual non-call seven Tier 1 FRN,taking it to €300m. The spread at reoffer on the Baa2/BBB– rated paper was 115bp over Euribor.

Table 6.2: Ireland termsheets

BankTier 1 Building SocietyAnglo Irish €600m 5.219% Perp nc 10 (Sep-06) EBSBuilding Society €125m 4.83% Perp nc 10 (Jul-05)

Issuer Anglo Irish Capital UK(2) LP CHESSCapital Securities plcIssuerType Whollyowned guaranteed SPV Independent SPVSecurityType Guaranteed Non-voting Non-cumulative Perpetual Step-Up Guaranteed Non-Cumulative

Preferred Securities Perpetual Capital SecuritiesStatus/Subordination The Securities are ranked junior to all liabilities of the The Securities are ranked junior to all Senior

Guarantor including subordinated liabilities (other than Creditors, pari passu with ParitySecurities,Tier1 Capital oranyother liabilityexpressed to rankpari if any, issued byEBSand anyguarantee passu with or junior to the Subordinated Guarantee); pari or support agreement of EBSranking pari passu with ParitySe passu with the Subordinated Guarantee, and senior to

JuniorSecurities.Maturity Perpetual PerpetualFirst Call Date 29-Sep-2016 29-Jul-2015Step-Up at First +100 bps +100 bpsCall Date EarlyRedemption Yes (Tier1 Event / TaxEvent). Securities redeemed at the Yes (TaxEvent / RegulatoryEvent). Securities

higherof principal orBunds+75 (Tier1 Event) orprincipal redeemed at theirprincipal amount amount (TaxEvent). Redemption subject to prior consent (TaxEvent / RegulatoryEvent). Redemption of the IFSRA. subject to prior consent of the IFSRA.

Replacement n/a n/aDividend Pusher/ Dividend Stopper Dividend StopperStopperRegulatoryEvent Interest payments conditional upon no breach of capital Interest payments conditional upon no breach of

adequacy regulations, orminimum capital requirements minimum capital requirements, and ability to meet or solvency ratios not being met. Interest payments not solvency ratios. Interest payments not paid if instructed paid if instructed by IFSRA. by IFSRA.

Optional Deferral Interest payments optionallydeferrable, to be exercised Interest payments optionallydeferrable, to be exercised upon deferred payments on anyTier1 orTier2 Securities. upon deferred payments on anyTier-1 orTier-2 Deferred payments non-cumulative. Securities. Deferred payments non-cumulative.

Rating Agency No rating agencymandatorydeferral trigger (see No rating agencymandatorydeferral trigger (see MandatoryDeferral RegulatoryEvent). RegulatoryEvent).Deferred Payments Non-Cumulative Non-Cumulative

France

The French ‘TSS’ structure for hybrid securitiesThe explosive growth of hybrid securities has its roots in the development of tax-efficient hybridTier 1 capital securities for financial institutions, where some of the first transactions weredeveloped in Europe and later adapted to the US market which in turn started a new wave ofinnovation in Europe and globally. Since then, the exchange of ideas has driven the growth ofhybrid issuance across sectors across the Atlantic and around the world. Therefore it is onlypossible to understand some of the current opportunities and challenges in structuring corporatehybrids by reviewing the history of the hybrid Tier 1 capital security market.

Some history The Titres Super-Subordonnés (TSS) structure in France came into existence in the French legalsystem in 2003 in response to years of lobbying by the banking community and advisors for amore straightforward direct issue form of Tier 1 capital security. Before the TSS creation in 2003,French banks were only able to structure tax-efficient hybrid Tier 1 capital by using offshore SPVswhich then on-lent the proceeds back to the parent bank. The most common SPV domicilelocations included many that were eventually perceived as tax havens such as the CaymanIslands, Turks and Caicos, Jersey or US ‘incorporation-friendly’ jurisdictions such as Delaware.

There was no suitable preferred stock security in the legal system when hybrids were first con-templated for Tier 1, therefore the use of wholly-owned SPVs from jurisdictions where a preferredtype security could be issued from the SPV created an opportunity to develop some of the firsthybrid Tier 1 before the term hybrid existed in relation to capital.

Operating subsidiary Tier 1In order to satisfy the criteria that capital should be raised via an operating entity (not a shellcompany) there was a period of hybrid product development that really demonstrated the capabil-ities of the banks and the hybrid structuring teams that support them. The structures thatresulted had varying versions of the following:

0 Operating subsidiary – The hybrid capital security issuing entity – this needed to be an entitywith a bona fide business/banking purpose and if the parent bank did not already have asignificant operating subsidiary that was suitable then the ‘bon idée’ was to create an operatingentity that could then issue the capital securities. In order to be deemed an operating subsidiary, abanking business such as asset management/investment (i.e. mortgage investing and portfoliomanagement) was used. Since the operating subsidiary was owned by the parent bank, any excesscash from the asset portfolio could be returned to the parent bank via common dividends fromthe sub to the parent bank and the parent bank could provide credit support to the sub in order toutilise the parent bank ratings for the sale of the hybrid securities. However, the operating sub didhave the value of assets in its capital structure, unlike a shell or pass-through SPV structure.Importantly, the cash raised from the sale of hybrid securities must flow to provide the parentbank in order for the transaction taken as a whole to count as capital;

0 Financial assets – Cash-generating assets (such as mortgages) were used to invest the capitalraised by the SPV hybrid transaction and subsequently make payments on the capital securitiesissued by the operating subsidiary to third party investors. Since most banks had such assets onbalance sheet it was a logical choice for these transactions. By acquiring the assets from the bank,the cash raised by selling the hybrid securities was routed back to the parent bank fulfilling thatelement of the Tier 1 criteria;

0 Hybrid capital security – The nature of the terms of the SPV security issued need to meet the re-quirements of Tier 1 and so the issuing entity and jurisdiction needed to be selected with these


127

Table 6.2: Ireland termsheets (cont)

BankTier 1 Building SocietyAnglo Irish €600m 5.219% Perp nc 10 (Sep-06) EBSBuilding Society €125m 4.83% Perp nc 10 (Jul-05)

ACSM n/a n/aAdditional Features/ Substitution with non-cumulative perpetual preference TaxEvent - best endeavours to arrange substitution of Comments shares, orvariation of existing security terms so that juristiction or change of residence. Substitution of the

theybecome alternative Qualifying Tier1 Securities or Capital Securities with non-cumulative deferred shares, Qualifying UpperTier2 Securities. ornon-cumulative preference shares if EBShas

converted to a PLC (Capital DeficiencyEvent).

Source: Compiled by CALYON from respective offerings circulars

objectives in mind so that perpetual, non-cumulative securities could be issued. On consolidationthese securities would have counted as minority interest or a form of mezzanine equity whichwould support the Tier 1 analysis at that time.

EvolutionTwo change catalysts led finally to the development of TSS and its adoption into the French legalsystem:

0 The SPV-based Tier 1 structures were only accounted for as Tier 1 on a consolidated basis whenthe SPV securities were included at the parent bank level financial statements. SPV hybrid Tier 1was not counted as ‘solo’ Tier 1 on a non-consolidated basis. While some issuers were content tohave consolidated low-cost Tier 1, others continued to lobby for direct issue hybrid securities thatwould count as solo Tier 1 capital at the parent bank;

0 There was an EU community desire to reduce the use of jurisdictions perceived to be taxhavens, even for legitimate transactions such as bank Tier 1.

Outside France, other jurisdictions had forms of preferred stock or preference share types ofsecurities defined in the legal system and this made it easier to create a tax-efficient syntheticpreferred equivalent security that would also eventually satisfy the emerging Basel requirementsfor hybrid Tier 1. Several jurisdictions, such as the UK, were relatively early (1999–2000) to adaptnew hybrid Tier 1 securities for banks that were:

0 Tax efficient; 0 Direct bank issues; 0 Tier 1 qualifying.

Finally, in 2003 the French TSS became a reality and this is the basic structure used for allcorporate and financial hybrid capital securities from French issuers. Although it was slow inarriving, the TSS security is very flexible and it is able to be a very equity-oriented security andtherefore useful in satisfying the accounting and rating agency requirements for equity treatmentin addition to regulatory guidelines.

As the hybrid capital security market develops and investors are becoming more discriminatingabout hybrid structures, an increased demand for investor protection is being seen and more con-sideration given to TSS hybrid variations that could improve the pricing and demand for anissuer’s potential TSS transaction. Therefore more debt-like TSS hybrid structures from corporateissuers can be expected in future.

By observing the highlighted transactions in the summary examples section you will see an illustrativecross-section of the various TSS issues from different sectors in the market that demonstrated theflexibility of the TSS structure. Bank Tier 1 transactions thus far do not exhibit the rating agency en-hancements (RCC, MPD) seen in other sectors like insurance and do not provide additional investorcomforts like ACSM. Pioneering corporate transactions such as the Vinci deal were fully non-cumulative with no ACSM again taking advantage of the highly equity-oriented TSS bank typestructure. The insurance sector shows more diversity among issuers and compared to the othersectors. As always attention to detail is suggested in looking at the complete transaction offeringcirculars for the transactions in the market. In the summary examples below a full featured Basket Dissue by AXA is highlighted that provides significant rating agency equity credit and regulatory capital.

French hybrid issues have been successfully completed across all major sectors in both the RPBand institutional markets.

More recent French bank capital developments

Commission Bancaire sets a maximum limit of 25% on hybrid capital

New framework for eligibility of Tier 1 regulatory capital:

0 Tier 1 must be constituted at least up to 50% by share capital + reserves + carry-forward profits,the remaining 50% with the other type of products;

0Within the remaining 50% threshold, hybrids will be able to amount up to a maximum 25%(innovative or non-innovative, including minority interests resulting from the consolidation of ad-hoc vehicles used for indirect issues of hybrid instruments) but not up to 30% or 33%, as expected;


128

0Within the 25% maximum limit for hybrid securities, the maximum limit for innovativehybrids remains at 15%;

0Minority interests (other than minority interests resulting from consolidation of ad-hoc vehiclesused for indirect issues of hybrid instruments) and preference shares are excluded from theabove-mentioned 25% threshold (but included in the 50% threshold). More information on the Commission Bancaire is available on www.banque-france.fr

There has been a similar move in Italy, where Italian regulators have recently increased the limitfor Hybrid Tier 1 capital from 15% to 20%, allowing for more True Perps but keeping step-upstructures capped at 15%.

More information on the Bank of Italy is available on www.bancaditalia.it

Additional points:0 The preference shares (actions de préférence) are non-deductible and would be admitted within thenon-core and non-hybrid 25% to the extent they meet ‘the relevant criteria of eligibility, notably theloss absorption and the permanence features, with a particular attention to any early buy-backoption’. Since a number of market players raised some concern about the meaning and application ofsuch criteria to preference shares in the French context, the Commission Bancaire indicates that theywill be discussed with the French banking organisations and the Autorité des Marchés Financiers;

0 The French Banking Commission would probably consider non-cumulative prefs, with a step-upand a buy-back option as an innovative hybrid (i.e. within the 15% threshold) and would be stillreluctant to agree to such structure.


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Table 6.3: France – total Tier 1 capital breakdown

Hybrid secuitiesMax. 25% of total tier1 capital:

- Hybrid securities (Innovative, Non-innovative and minority interests resulting from consolidation of ad-hocvehicles used for indirect issues of hybrid instruments).

- Innovative, step-up and deductible hybrids up to 15%- Non-innovative, non step-up and deductible hybrids 0-25%

Non-core and non-hybridMax. 25% of total tier1 capital:

- Preference shares or "actions de préférence"(Non-deductible, no step-up)

- Minority interests (Not resulting from consolidation of as-hocvehicles used forindirect issues of hybrid instruments).

Core tier 1

Min. 50% of total tier1 capital:- Share Capital- Reserves- Carry-Forward profits


25%

25%

50%

}

}

}France termsheets

AXA calms Tier 1 nerves(Published in IFR, 1 July 2006)

AXA's heavily oversubscribed Tier 1 euro and sterling trades brought some semblance of stability back to thevolatility-plagued perpetual hybrid sector. But the issuer's promise of no-return to the same space this year asan added assurance to investors is not an effective insulation against the vagaries of a market recoveringfrom an overhang.

Boxed in by its acquisitions calendar following the Winterthur buy, AXA had to raise capital quickly. But withswings of 5bp–10bp per day in the Tier 1 banks and insurance sector it found itself navigating in choppywaters. Citigroup was roped in as the global co-ordinator across both tranches, with Merrill Lynch and SG


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joining it on the €1bn perpetual non-callable 10-year euro trade and Barclays Capital on the sterling dualtranche – a £500m perpetual non-callable 10-year trade and £350m of perpetual non-callable 20-year paper. The leads had their work cut out; the main challenge was in holding out until a stable window could be foundto unleash the credit. Overall, the leads raised just shy of €2.5bn-equivalent from a market that was hithertonot playing ball. The structure mimicked Generali's Tier 1 issuance of June 16.

For AXA, which was on the verge of launching its own deal, Generali's plans to raise a further €1.2bn in thehybrid market to partly fund its €3.85bn Assicurazioni Toro acquisition later this year or in early 2007 provedto be the unkindest cut of all. Having just taken €2.8bn-equivalent out of the market in June, Generali'sproposed return to the market – see separate story – unnerved investors and spreads widened.

Against these mounting odds, the leads went out with an indicative range of the high 150bps to 160bp overmid-swaps for the euro trade, and Gilts plus 190bp area for the short sterling trade, with a 20bp premium tothat for the long sterling portion. An improvement in sentiment a day later, and a consequent tightening ofspreads, eventually saw the euro trade priced at a tightened 150bp over mid-swaps, the sterling NC 10-yeartrade at Gilts plus 183bp, and the 20-year trade at Gilts plus 203bp, also the tight end.

At the time of AXA's (Baa1/BBB/A) final guidance, Generali (A3/A) was bid at 131bp over mid-swaps, whichindicated a 19bp new issue premium for the AXA euro trade. This compensated for a slight differential inrating, plus the fact that in choppy markets the new issue premium can be put at around 15bp–20bp, arguedone of the leads.

The euro trade garnered €4.7bn of total orders from 195 accounts, mainly anchored in the UK at just under50%. France, the Netherlands and Germany were the other main buyers. More than 70% participation camefrom investment managers, 15% from banks, and hedge funds claimed the remainder.

The £500m of paper raked in £2.2bn of orders from 120 accounts and the perpetual non-callable 20-year£350m trade garnered £1.25bn from around 70 accounts. The UK claimed 92% of the short sterling paper and87% of the long paper. Insurance companies bought 46% of the short paper, followed by asset managers (30%)and hedge funds (10%), among others. The distribution pattern was largely replicated by the long paper.

AXA said it would not access these same markets with perpetual hybrids for the remainder of the year, a bid toaddress investors' concerns about potential flooding of markets on the back of accelerating consolidation inthe industry. But that does not help much if there is a volley of other hybrid issuances, pointed out one assetmanager who bought the sterling trades. "We think it is well priced. It came at an opportune time from aninvestor's point of view. It helps us to diversify our portfolios," he added.

Overall, the lead managers managed to hit the cusp of the swing in sentiment. In the secondary market, theeuro paper traded around 15bp tighter versus both asset swaps and Bunds; the sterling short traded 19bptighter than pricing while the sterling long was bid 18bp tighter

French first(Published in IFR,18 February 2006)When ABN AMRO's £750m UT2 issue drew an order book of £1.8bn and priced inside guidance a couple ofweeks ago, few were left in doubt about the level of appetite for sterling subordinated paper from Europeanfinancials. For Crédit Agricole (CASA) waiting in the wings with its inaugural sterling-denominated Tier 1(indeed, the first such issue from a French bank at all), the prospects looked encouraging. Nothing changed during the days that separated the deals and CASA drew a large audience, although at£850m, the order book did not quite match ABN's behemoth. It was still more than sufficient to warrant anincrease from the initial talk by the lead management triumvirate of ABN AMRO, Calyon and Merrill Lynch of atransaction of £300m plus to an eventual £500m. It also meant that the spread talk could be pared from90bp–93bp over Gilts to plus 90bp (57.5bp over mid-swaps). This put the perpetual non-call 10 some 14bp back of its 2018 callable UT2, a differential in keeping withbanks with established curves in both asset classes (such as HBOS) whose Tier 1/UT2 premium is nearer11bp–12bp. Chances are that CASA's differential will narrow as the new bonds bed down. Indeed, this processbegan as soon as the issue was freed to trade, the paper tightening in by 1bp. Plus 90bp put it at a slight premium over domestic UK names such as Lloyds TSB and HSBC, which trade inthe high 80s, although in terms of spread at launch, it did make it the third tightest print after Rabobank'snon-call 15 (Aa2/AA), which priced at plus 78bp in October 2004 and Danske Bank's non-call 12, which cameat plus 71bp in March 2004. Neither could match it for size (and liquidity prospects), however. Rabo printed£350m, Danske just £150m. Although the bulk of the paper was placed with domestic buyers, almost 25%went to overseas investors, most notably in Asia, which accounted for 11% of the bonds.


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The diverse range of financial credits available in sterling capital is set to continue with ING Groep havingmandated ING Bank, Lehman Brothers and UBS for a benchmark Tier 1 transaction. UK roadshows start thisweek. There is also the possibility of supply coming from Commerzbank, which is considering including asterling element in its upcoming multi-tranche Tier 1 funding exercise. The appointed lead managers areCommerzbank itself, Deutsche Bank, DresdnerKW and Morgan Stanley.

Vinci against the odds (Published in IFR, 11 February 2006)Although many bankers had written the transaction off early last week, the hybrid bond from French con-struction company Vinci eventually found a good reception from real money accounts through leadmanagers Merrill Lynch and SG.

Rival bankers had been predicting the demise of the transaction after a recent profit warning from Frenchelectronics company Thomson helped push the outstanding hybrids 20bp–30bp wider during the marketingperiod. But investors bought into the credit story against the volatile market backdrop. Although the con-struction sector can be notoriously cyclical, Vinci was able to convince investors of its utility-like characteris-tics through its recent purchase of a majority stake in Autoroutes du Sud de la France (ASF).

"The deal finally went to those accounts that had done their credit work and liked the credit story. Vinci is anideal candidate for hybrid bonds having a strong credit profile with utility-like cashflows and a 40% dividendpay-out ratio, which will increase following the integration of ASF," said Jeff Tannenbaum, director, syndicatedesk at Merrill Lynch.

Although the transaction was sold alongside a wider €9.1bn acquisition refinancing package for the purchaseof ASF, it was intended to provide some flexibility in the issuer's financial structure and offers an attractivecost of funding compared with equity with a 6.25% tax deductible coupon against an estimated 8%–8.5%cost of equity.

Following a week of roadshows, the leads announced guidance at Tuesday lunchtime at 275bp over mid-swaps area, and priced at exactly that level with books about twice subscribed in less than three hours. Real-money accounts provided the bulk of the orders, with asset managers taking 69% of the deal while 16% wentto insurers and 6% to banks. Geographically, distribution was broad, with just under a third placed in Francewhile the rest found good interest from UK, Scandinavia, Benelux and Germany.

"Our idea was to go out focusing on real-money demand from investors that had done their credit work, and notto grow the book irrespective of its quality. In this market, a stable and solid investor base is much moreimportant than absolute oversubscription levels," said Jean-Francois Mazaud, head of corporate debt originationat SG. "This view was fully shared with Vinci, which was very keen in getting a solid aftermarket. And such type ofexecution strategy should have a very positive impact for the future of the corporate hybrid market."

While the transaction was able to offer investors some strong credit fundamentals and a chunky coupon, oneof the major criticisms was the non-cumulative coupon deferral structure, which many investors are shyingaway from, particularly following the poor performance of the Thomson hybrid that included the samestructure. But according to bankers involved in the transaction, the issuer's decision was technical.Cumulative coupon structures are associated with mandatory deferral mechanisms and Vinci was forced toopt for optional deferral in order to maintain an investment-grade rating for the issue.

"Ultimately investors are buying into the credit story and if investors are concerned about an issuer beingunable to pay a coupon then it shouldn't make too much difference whether those coupons are cumulativeor not," said Merrill Lynch's Tannenbaum.

In the aftermarket the bonds immediately pushed 6bp tighter on the break and were seen as much as 12bptighter in the week, as trading accounts that had been aggressively shorting the in the grey market wereforced to chase tightly held bonds to cover their positions.

Hybrid volatilityWith hybrids providing the only real liquidity in the secondary market, the sector has become a proxy formarket risk, particularly since GM's notoriously volatile 2033 bond plunged deep into the junk market. Butbankers believe that there is no reason for the entire sector to continue widening at its current rate. "The volatility of the hybrid sector has been tremendous and highlights the importance of stable placement.


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So far the corporate hybrids have tended to trade as a sector. Understanding how to trade these instrumentsby differentiating the credits within that sector is critical to further growth in this product," said Tannenbaum. The transaction might have come some 20bp wider than the issuer could have expected when the deal wasfirst announced, but the end result provides another boost to the corporate hybrid sector, particularly givenlast week's backdrop of extreme volatility and, in particular, the poor Thomson performance. While there arecertainly more transactions on the cards for 2006, bankers believe that the trigger for issuance has becomemore event-driven, with M&A leading the next wave.

"We are now seeing the emergence of a true asset class. When you look at the hybrids issued last year, nonewere directly linked to acquisitions, but this year all form part of a financing package that is linked to acquisi-tions. The instrument has now become truly complimentary to all other sources of funding for acquisitionfinancing," said SG's Mazaud.

However, many issuers will be looking at the wider market performance of the entire sector, and with thespread between senior and subordinated bonds steepening dramatically since the beginning of January (seegraph), some wonder whether one of the real drivers for issuance is fast running its course.

But many bankers dismiss the recent widening trend, given that the lack of regulatory incentive effectivelymakes corporate hybrids an equity proxy, so issuers will increasingly use the cost of equity for comparison ratherthan the cost of debt, as would be considered by financial issuers selling bonds in the capital securities market.

Table 6.4: France termsheets

Insurance Tier 1 BankTier 1 Capital Corporate HybridAXA€1bn 5.777% CreditAgricole £500m Vinci €500mPerp nc 10 (issued Jun-06) 5.136% Perp nc 10 (issued Feb-06) 6.25% Perp nc 10 (issued Feb-06)

Issuer AXASA Credit Agricole SA Vinci SAIssuerType Direct Direct DirectSecurityType Undated DeeplySubordinated Notes Undated DeeplySubordinated Fixed to Undated DeeplySubordinated Fixed

Floating rate Notes to Floating Rate BondsStatus/ Direct, unconditional, unsecured and Direct, unconditional, unsecured, Direct, unconditional, unsecured, Subordination undated DeeplySubordinated undated and deeply subordinated and lowest ranking subordinated

Obligations of the Issuer. The Notes obligations of the Issuer. The Notes obligations (titres subordonnes de rankpari passu among themselves and rankpari passu among themselves and dernier rang) of the Issuer. The all otherpresent and future Deeply with all otherDeeplySubordinated Bonds rankpari passu among Subordinated Obligations of the Issuer, Obligations, and subordinated to all themselves and with all otherDeeplysubordinated to all titres participatifs prêts participatifs and titres participatifs, Subordinated Obligations, and and prêts participatifs, Ordinary OrdinarilySubordinated Obligations subordinated to all prêts participatifs Subordinated Obligations and and Unsubordinated Obligations and titres participatifs, OrdinarilyUnsubordinated Obligations of the of the Issuer. Subordinated Obligations and Issuer. The Notes shall rank in priority Unsubordinated Obligations of the to anyclass of share capital - ordinary Issuer.shares orpreference shares (actions de préférence) issued by the Issuer.

Maturity Perpetual Perpetual PerpetualFirst Call Date 6-Jul-2016 24-Feb-2016 13-Nov-2015Step-Up at First +100bps +100bps +100bpsCall Date EarlyRedemption Yes (Tax / Regulatory / Accounting Yes (Tax / RegulatoryEvent). Notes Yes (Tax / Accounting Event). Bonds

Event). Notes redeemed at their redeemed at the higherof principal redeemed at theirprincipal amount principal amount (TaxEvent). Notes orBunds+50 (Tax / RegulatoryEvent). (TaxEvent - additional amounts). redeemed at the EarlyRedemption Redemption subject to prior consent Bonds redeemed at higherof Amount - higherof principal orBunds of SGCB. principal orBunds+75 (TaxEvent - +87.5 , exchanged for, or terms varied so change to taxdeductibility / securities constitute Tier1 capital or core Accounting Event).capital (Regulatory /Accounting Event). Redemption subject to prior consent of ACAM.

Replacement Intent-Based Replacement of n/a Intent-Based Replacement of Clause Redeemed Securities. Replacement Redeemed Securities. Replacement

with share capital securities, securities with common equity, pari passu/with same terms and conditions, or junior securities with same terms mandatorily convertible bonds/notes and equal/greaterequity content.with a maturityof 3 years or less.

Germany

Bank Tier 1 issued via an SPVAs discussed, bank SPV issues are still the most common form of outstanding Bank Tier 1 capitalsince Basel 1998 because the SPV reconciles structuring challenges within many jurisdictions.

In Germany there are two main alternatives for bank capital SPV issues:

1) Independent SPV holding bank silent participation (Stille Einlage);2) Bank-owned SPV with inter-company deposit/loan to bank.


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Table 6.4: France termsheets (cont)

Insurance Tier 1 BankTier 1 Capital Corporate HybridAXA€1bn 5.777% CreditAgricole £500m Vinci €500mPerp nc 10 (issued Jun-06) 5.136% Perp nc 10 (issued Feb-06) 6.25% Perp nc 10 (issued Feb-06)

Dividend Pusher/ Dividend Pusher Dividend Pusher Dividend PusherStopperRegulatoryEvent Interest payments conditional on Issuer Interest payments conditional upon no n/a

being solvent at the time of payment and breach of minimum capital requirements.immediately thereafter. Interest payments not paid if instructed

by the SGCB.Optional Deferral Interest payments optionallydeferrable Interest payments optionallydeferrable, Interest payments optionally

and non-cumulative. with a view to restoring regulatorycapital deferrable and non-cumulative. to ensure Issuer's continuityof activities. Deferred payments non-cumulative.

Rating Agency Interest payments mandatorily No rating agencymandatorydeferral n/aMandatory deferrable. Trigger - i) the Accumulated trigger (see RegulatoryEvent).Deferral Net Earnings of the Issuer for the two

6-mth periods ending on the Lagged Reporting Date is less than orequal to zero, AND ii) the Adjusted Shareholders EquityAmount as at the Lagged Reporting Date has declined by10% ormore as compared to the Adjusted Shareholders EquityAmount as at the end of the BenchmarkHalf-YearPeriod; AND iii) the Adjusted Capital as at the Current Reporting Date has declined by10% ormore as compared to the Adjusted Shareholders EquityAmount as at the end of the BenchmarkHalf-YearPeriod.

Deferred Payments Non-Cumulative (RegulatoryEvent / Non-Cumulative Non-CumulativeOptional Deferral) / Non-Cash Cumulative (MandatoryDeferral)

ACSM Settlement of deferred interest n/a n/apayments via issuance of ordinaryshares (2% limit in any12-mth period), PIKSecurities orParitySecurities (25% limit forPIKand ParitySecurities). Issuer shall use best efforts to settle deferred payments. Deferred payments cancelled if not settled within 5 yearperiod.

Additional Loss absorbtion upon the occurance Loss absorption upon the occurrence of –Features/ of a solvencyevent. Reinstatement if a SupervisoryEvent. Reinstatement if Comments a positive consolidated net income is a positive consolidated net income is

recorded forat least two consecutive recorded forat least two consecutivefinancial years reported following financial years reported following the the end of a solvencyevent. end of a SupervisoryEvent. Reinstatement

will also occur in certain circumstances (payment of dividends on share capital, redemption of the Notes or liquidation of the Issuer).


Both structures are widely accepted by investors and are well established within the Germanbanking system. Despite the complicated structural diagrams the SPV structures are relativelyeasy to administer once the structure is set up given the large amount of precedent transactionsand experienced, competitive intermediaries to service these transactions (i.e. Trustees, etc).

Taking the second alternative first, the bank-owned SPV is very similar to the other popular SPVTier 1 formats already discussed in several jurisdictions. As a summary example of one suchGerman bank structure the Commerzbank Capital Funding Trust issue is a good example of howthis SPV Tier 1 structure has been issued in the market. This non-cumulative Tier 1 issue achievesconsolidated Tier 1 since the Trust Preferred Securities exhibit the requisite Tier I capital equityfeatures and the inter-company security running from the SPV to the parent bank does not. Tax deductibility, however, is based on inter-company debt/deposit. The bank-owned SPV can be aEuropean rather than US-based SPV entity – particularly if a Euro-denominated issue is intended.Use of the bank owned SPV results in consolidated rather than Solo Tier 1 and this is a keydistinction that results in some issuers selecting the Stille Einlage alternative.

Generally rating agency equity credit is typically ‘low to intermediate’ but can potentially beincreased by raising the mandatory non-payment threshold above regulatory minimums or by incor-porating binding replacement language. Like strong banks in many other countries, the Germanbanks have not placed a high priority on the enhancement of bank regualtory capital for ratingspurposes at this time. Therefore the Commerzbank issue does not exhibit rating agency mandatorydeferral or RCC features. Also this bank Tier 1 issue does not have the ACSM non-cash cumulativefeatures we see in other sectors like insurance and corporates and in some bank Tier 1 such as the UK.

Let us now look at the two main variations of the Stille Einlage SPV Tier 1 structures in themarket. These clever structures address potential cross-border withholding tax issues that wouldmake it difficult to sell the Stille Einlage Tier 1 to international investors on terms acceptable toissuers or investors. These early innovations served as precedent for some transactions in other ju-risdictions (such as Switzerland and Ireland).

Tier 1 issued via a Stille Einlage and German GmbHHighlights:

0 Regulatory Tier 1 capital (solo basis for the bank issuer);0 An independent SPV such as a German GmbH acquires a Tier 1 qualifying Stille Einlage from

the bank and funds this by selling its own securities to investors;0 Cross-border withholding tax concern is addressed by the independent SPV so international

investors are not impacted.


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Figure 6.1: German SPV Tier 1 structure

Source: : COMPILED BY CALYON

Subordinated note proceeds

Partnership interests proceeds

Certificates proceeds

Certificates

Waiver

and improved

agreementLL

CCo

mm

onSe

curi

ties

proc

eeds

LLC

Com

mon

Se

curi

ties

(100

% o

wne

d)

Partnership interests

Subordinated note

Bank/branch

LLC Partnership forUS Tax purposes

SPV

Investors

Tier 1 via a Stille Einlage and Jersey Limited Partnership Highlights:

0 Regulatory Tier 1 capital (solo basis for the bank issuer);0 An independent offshore SPV such as a Jersey LP acquires a Tier 1 qualifying Stille Einlage from

the bank and funds this by selling its own securities to investors;0 A bank subsidiary provides liquidity loans to the Jersey SPV to address Kapitalertragssteuer on

the Stille Einlage payments;0 Cross-border withholding tax concern is thereby addressed so international investors are not

impacted.

Broad tax system changes have been proposed in Germany and the choice of structures will likelybe impacted by the final enactment of any new rules, but both Jersey and Gmbh structures arecurrently in the market. Since the banks were exclusively able to use Stille Eillage structures,other sectors such as corporates needed to devise alternative methods for hybrids.

In the summary examples provided it can be seen that German hybrids can be issued in eitherdirect or SPV format in other sectors.

Several direct issue hybrids have now been issued internationally and have been enhanced toprovide the issuers with both rating agency equity benefits as well as regulatory capital.

As the examples show Basket D type issues have been accomplished by including MDP featuresand investor comfort has been increased by the inclusion of ACSM type features. Issuers ensure adegree of enhanced comfort via several early redemption options to address future uncertainty.Pioneering German hybrids for non-bank issuers exhibited the unique interplay between


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Figure 6.2: German Stille Einlage structure

Source: COMPILED BY CALYON

Stille Einlage

proceeds

Bond proceedsBond issue

Stille Einlage

Bank

German GmbH

Investors

Figure 6.3: German Stille Einlage structure with Jersey LP

Source: COMPILED BY CALYON

Stille Einlage proceeds

Limited partner

Bond proceedsBond issue

Loan

Stille Einlage

Bank

SPV (Jersey LP)Bank subsidary GmbH

Investors

discretionary optional payment deferral (with cumulative resolution) and trigger basedmandatory payment deferral (with non-cash cumulative resolution) which helped to navigate taxrequirements as further explained below. When a direct issue hybrid is used by a German issuer aGerman tax ruling should be obtained from the appropriate German tax authority to ensure bestresults in line with issuing objectives. In the following section we highlight an interpretation ofsome of the fiscal drivers that led to these useful hybrid structures.


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Germany termsheets

Munich Re debuts

(Published in IFR, 9 June 2007)

Even though technicals remained strong, sentiment weakened in the credit markets last week. The iTraxxCrossover index widened, closing almost 20bp wider than its levels of around 190bp seen two weeks ago. Theweakening of sentiment can be attributed to a cocktail of ingredients ranging from the shaken global equitymarkets to a frothing up of interest rates as central banks turn increasingly hawkish.

The debut euro-denominated hybrid transaction (A3/A/NR) from Munich Re was a direct issue (with a taxruling), with the terms being largely similar to the most recent sterling and Australian dollar offering fromSwiss Re through ELM. Joint leads Deutsche Bank, JPMorgan and UBS priced the multiple-times covered

€1.5bn perpetual non-call 10-year fixed to floating-rate note step-up deal at 104bp over mid-swaps (Bundsplus 130.5bp), 1bp tighter than its initial guidance. On the regulatory side, the transaction provides the issuerwith undated subordinated debt under the current capital regulations, caters for future Tier 1 requirements(in line with the UK FSA's rules) and contemplates the publication and introduction of Solvency 2.

The securities qualify for Basket D treatment from Moody's. As on previous occasions, achieving Basket D didnot simply involve a clean replication of former deals. With Moody's new notching approach to meaningfulmandatory deferral triggers, the deal was rated A3, which was three notches below Munich Re's financialstrength rating of Aa3. Munich Re did consider the enforceable replacement capital option at an early stage (which would haveresulted in an instrument rating of A2) but for various reasons (including timely documentation andcorporate governance), it did not proceed with this approach.

On the S&P side, the instrument received “Intermediate-strong” equity credit and is two notches below theissuer's S&P financial strength rating of A (identical to its pre-existing LT2-style dated subordinated issues).This is the second occasion on which S&P has accepted the following 30-day best endeavours languagewithin an ACSM clause.

S&P said in a statement: “It is the intention of the issuer that in the unlikely case of a mandatory deferral inrespect of the bonds (other than in circumstances where the issuer is deferring on distributions on alloutstanding hybrid issues) to use its best endeavours to arrange for the issue or sale of payment shares orplacement securities so as to raise cash to enable the issuer to settle interest no later than 30 days after itsoriginal due date for payment.” The security also achieved 75% equity credit from Fitch Ratings.

A European roadshow held by the issuer encountered robust investor demand, which translated into around€5.8bn in total orders at the initial plus 105bp guidance. Of these, just €300m dropped away when theguidance was tightened by 1bp, where the deal was eventually placed and compared well with the aroundplus 100bp level at which Swiss Re was bid. Shorter-dated outstanding callable trades from AXA and Generaliwere bid in the high 80s and 90s over mid-swaps.

Of the 200 investors in the book, the UK accounted for a quarter of the placement, closely followed by Italyand Germany, with each claiming 21%. The remainder enjoyed pan-European distribution. Asset managersbought 38% of the deal, followed by insurance companies (29%), with the remainder split among banks,private banks and hedge funds. In line with the softening seen in the hybrid market, the issue was bid around7bp wider in the secondary market last Friday.


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Commerz advances on two fronts (Published in IFR,18 March 2006)Whichever way one looks at Commerzbank's dual-tranche Tier 1, it was a sizeable transaction. Whether the€1bn perpetual non-call 10/£800m perpetual non-call 12 combination represented the largest German Tier1 capital raising or the largest such European deal in sterling was largely irrelevant. What was of note was thatthere was substantial oversubscription in both cases on a deal against which there would have been longodds until relatively recently.

This was essentially acquisition finance for Commerz's Eurohypo venture (it is eyeing up banking assets inBerlin as well). The headroom for raising additional Tier 1 was made possible by the sale of its stake in KEB.While the combination of Commerz and acquisition finance is no great surprise, recent history would havepointed to the German bank being the acquisition target rather than the acquirer.

With such a large amount to raise (€2bn equivalent was the number most often mentioned), there was nevermuch doubt that a single-tranche approach would not suffice. The anointed lead managers, Commerzbank,Deutsche Bank, Dresdner KW and Morgan Stanley, made it plain early on that euro and sterling were thechosen targets, although there was no pre-ordained decision on what exactly the split would be.

The two markets have endured different experiences of late. While the euro sector has shown signs ofnervousness, with spreads widening out some 10bp, sterling has remained more resolute. This fact played amajor role in determining the relative sizes. Had the two moved in tandem, talk is that a €1.25bn/£500m splitwould have been more likely, and with respective books of €3.5bn and £2bn, most combinations could havebeen accommodated.

It was the speed with which the sterling book came together that convinced the leads on the eventual split,however. Historically, UK investors are slower than their European counterparts at committing themselves toa deal. This time round, however, they were the driving force. There is still cash to put to work in both markets,although in the words of one syndicate official: in the euro sector, it is "cash without conviction". Sterlingbuyers, on the other hand, are currently more active in their search for yield.

The bonds were priced at 115bp over mid-swaps (Bunds plus 133.9bp) and 150bp over Gilts, both at the tightend of their initial 5bp spread ranges. Because this was an inaugural visit, it was seen as a one-off as far aspricing was concerned; the roadshow was the single most important discussion forum.

Eurohypo has an outstanding 2013 callable that was also taken into account. It was bid at 107bp over mid-swaps. The original guidance came from adding 4bp–5bp per year to take into account the longer call date.This euro range was then used as a staring point for the sterling tranche. The mid-swaps equivalent waspitched at similar levels.

Pricing such issues can be a less than scientific exercise, the accuracy of the final answer often onlyassessable when the bonds are freed to trade. With both tranches tightening by 2bp in early trading, thenumbers arrived at on this occasion look to have been fairly precise.

Siemens sees record demand (Published in IFR, 9 September 2006)For many investors who had yet to dip their toes in the corporate hybrid market, German engineeringcompany Siemens offered the perfect opportunity to buy subordinated corporate credit with a stronginvestment-grade rating and investor-friendly structure. Deutsche Bank and UBS were joint bookrunners,with Morgan Stanley and RBS acting as joint lead managers.

Investors flocked into the A2/A– rated transaction, generating one of the largest ever order books seen for acorporate issue: €9bn of demand seen on the €900m euro tranche and £4bn of orders placed on the £750msterling part. Given the strong ratings, the transaction saw a larger participation from insurers and pensionfunds than on any of the previous corporate hybrids.

With basket D treatment from the ratings agencies, the transaction is closer to equity than the Linde structure due to the mandatory deferral feature. But a number of investor-friendly characteristics made thetransaction particularly attractive to many accounts that have so far been nervous of corporate hybrids.

The mandatory deferral trigger of a cashflow fraction (operating cashflow plus gross interest divided by grossinterest) below three was a particular selling point given that the figure has come in at between 10 and 16.5for the past seven years. In addition, the 100bp step-up feature is significantly more valuable in a transaction


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that prices in the low 100s over mid-swaps rather than a spread of 300bp or more, which has been a typicalfeature on recent corporate hybrid transactions. Final pricing was fixed at 125bp over mid-swaps on bothtranches, equating to Bunds plus 148.1bp on the euro part and Gilts plus 160.2bp on the sterling portion. The final spread level was through initial guidance of 130bp–135bp and significantly through some earlyindications, which suggested spreads as wide as 140bp–150bp.

While some investors continue to talk in terms of CDS multiples, the recent growth of the hybrid marketmakes relative value analysis an easier task. Even so, with such high ratings, investors were being pushed tothe bank capital market for comparables and the deal came through AXA, which has a Tier 1 deal trading atmid-swaps plus 135bp and just outside Generali, which trades at 120bp over.

In the aftermarket, both tranches were seen significantly tighter, the euros jumping by as much as 9bp to 139bpover Bunds, while the sterling paper saw slightly more modest performance, tightening by 4bp to Gilts plus 156bp.

With GECC entering the subordinated space with its own 60 non-call 10 hybrid issue, also in euros andsterling, some thought that Siemens could be overshadowed by the higher quality credit. But with themajority of investors viewing GECC as a financial rather than a true corporate, Siemens was able to stay in thespotlight with corporate investors, and according to bankers involved in the deal, the success of the GECCtransaction helped to further boost confidence in the hybrid market with its high subscription levels and tightpricing (see feature story for GECC comment).

One of the criticisms that some of the more sceptical investors have levelled at corporate hybrids is theirtendency to trade as a market rather than displaying any significant credit differentiation. But given thatSiemens was able to price its hybrid bonds so much tighter than where the rest of the corporate subordinatedmarket currently trades, bankers hope that the new issue will lead to further differentiation between credits.

The iBoxx non-financial corporate subordinated index was trading around Bunds plus 236bp for most of lastweek, but closed aggressively tighter at 232.9bp as the new Siemens bond led a marked improvement acrossthe sector. Sadly for investors, who welcome the opportunity to buy Double A names with a spread pick-up bygoing deeper into the capital structure, similarly rated issuers are few and far between in the corporate world.

And as the rationale for hybrid issuance increases further down the ratings spectrum, top-rated corporatecredits are unlikely to become a regular feature of the market. For Siemens, the transaction is intended toprovide a ratings cushion following its recent €4.2bn acquisition of Bayer's diagnostics division.


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Table 6.5: Germany termsheets

Insurance Tier 1 BankTier 1 Capital Corporate HybridMunich Re €1.5bn 5.767% Commerzbank€1bn 5.012% Siemens €900m 5.250% Perp nc 10 (issued Jun-07) Perp nc 10 (issued Mar-06) 60 nc 10 (issued Sep-06)

Issuer MünchenerRückversicherungs- CommerzbankCapital Funding Trust I Siemens Financieringsmaatschappij Gesellschaft Aktiengesellschaft in NVMünchen

IssuerType Direct SPV SPVSecurityType Undated Subordinated Fixed to Noncumulative Trust Preferred Subordinated Fixed to Floating Rate

Floating Rate Bonds Securities BondsStatus/ The obligations of the Issuerunder the The Class B Securities will rank junior to The Bonds rankpari passu among Subordination Bonds constitute direct, unsecured and the CompanyClass A Preferred Security, themselves, and junior to all other

subordinated obligations of the Issuer and the CompanyClass B Preferred present and future obligations of the ranking junior to SeniorSecurities, Securities will ranksenior to the Issuer, whether subordinated orpari passu among themselves and with CompanyCommon Security. unsubordinated.ParitySecurities, and senior to JuniorSecurities, except foranysubordinated obligations required to be preferred bymandatoryprovisions of law.

Maturity Perpetual Perpetual 14-Sep-2066First Call Date 12-Jun-2017 12-Apr-2016 14-Sep-2016Step-Up at First +100 bps +100 bps +100 bpsCall Date EarlyRedemption Yes (Gross-up Event/ TaxEvent/ Yes (RegulatoryEvent / TaxEvent / Yes (Gross-up Event / TaxEvent /

Accounting Event/ Capital Event / Investment CompanyAct Event). Capital Event / Conversion Event). RegulatoryEvent). Bonds redeemed at Securities redeemed at the redemption Bonds redeemed at theirprincipal theirprincipal amount (TaxEvent / price (TaxEvent), orat the higherof amount (Gross-Up Event), orhigherGross-Up Event), orhigherof principal principal orBunds+50 (Regulatory of principal orBunds+75 (TaxEvent / orBunds+67 (Accounting Event/ Capital Event / Investment CompanyAct Event). Capital Event), orhigherof principal Event / RegulatoryEvent). Redemption Trust Special Redemption Event to result orm/s+50 (Conversion Event).subject to regulatoryapproval. in liquidation of the Trust. Redemption

subject to regulatoryapproval.Replacement Bonds to be replaced byotherat least Replacement of redeemed securities Intent-Based Replacement of Clause equivalent regulatory capital. with subordinated debt securities, Redeemed Securities. Replacement

with terms identical to the redeemed with common equity, and/or treasurysecurities. shares, and/orpari-passu/junior

securities. Replacement clause excludes redemption following a Conversion Event.

Dividend Pusher/ Dividend Pusher Dividend Pusher Dividend PusherStopperRegulatoryEvent Interest payments not paid if instructed Capital Payments will not made if so n/a

by the BaFin, orupon occurance of ordered byBaFin orother relevant solvencyevent. regulatoryauthority, orupon occurrence

of anyother regulatoryprovision prohibiting payment.

Optional Deferral Interest payments optionally Interest payments optionallydeferrable Interest payments optionallydeferrable. Maximum 5-yeardeferral and non-cumulative. deferrable. Maximum 5-yeardeferralperiod (non-cash cumulative). period (cumulative). Deferred Deferred payments to be settled via payments to be settled with cash.ACSM.

Rating Agency Interest payments mandatorily No rating agencymandatorydeferral Interest payments mandatorilyMandatory deferrable. Trigger- (i) the Accumulated trigger (see RegulatoryEvent). deferrable. Trigger - Cashflow Deferral Consolidated Result on the Lagged fraction (net income plus minority

Reporting Date is less than orequal to interest plus amortization, zero; and (ii) the Adjusted Shareholders’ depreciation and impairments, plus EquityAmount as at the Lagged interest expenses, divided by interest Reporting Date has declined by10% expenses. Maximum 5-yeardeferral ormore as compared to the Adjusted period. Deferred payments to be Shareholders’ EquityAmount on the settled via ACSM. BenchmarkReporting Date; and (iii) the Adjusted Capital Amount as at the Current Reporting Date has declined by10% ormore as compared to the Adjusted Shareholders’ EquityAmount on the


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Some German tax influences on hybrid structures OverviewThe legal and tax treatment of the modern corporate hybrid capital security transactions that have becomevery popular in Germany for blue chip German corporate hybrid issuers are based on long-standing ruleswithin the German legal and tax system. This summary provides an indication of the complexity of the taxrules and the subtlety of applying the rules in the context of hybrid structuring. One should always engage oneof the leading German law firms with an international practice when examining German hybrid capital securitytransactions and as noted seek a ruling from the authorities for German direct issues.

While German banks and financial institutions have been issuing tax-efficient Tier 1 capital securities andother tax-efficient subordinated capital securities for many years, the progressive adaptation of the corporatehybrid issuers has brought the need to apply the traditional rules to new hybrid capital securities which aredesigned to satisfy rating agency requirements and/or accounting guidelines rather than regulatory capitalrequirements.

To determine the debt/equity classification of a German financial instrument and therefore create aninformed judgment as to the suitable treatment of the payments on the financial instrument for tax de-ductibility, legal professionals reference Section 8(3) of the German Corporate Income Tax Code which statesthat a ‘mezzanine instrument’ (Genussrecht) – typically subordinate to senior but senior to equity – will beevaluated and classified based upon the nature of two features. The features are:

1. Participation in profits; 2. Participation in liquidation proceeds.

If the mezzanine instrument is structured to simultaneously include both features of equity then thepayments will not be tax-deductible expenses and the security is classified as equity. Under a tax decree, along maturity might be viewed as a participation in liquidation proceeds and, thus, might endanger tax de-ductibility. Although, not mentioned in the decree, we understand that a payment discretion might be viewed

as participation in profits since there is much similarity to a dividend. If one of the two criteria is fulfilled,German withholding tax of approximately 27% will apply, which might be reduced under a double taxationagreement to 15% by way of a refund upon application.

Table 6.5: Germany termsheets (cont)

Insurance Tier 1 BankTier 1 Capital Corporate HybridMunich Re €1.5bn 5.767% Commerzbank€1bn 5.012% Siemens €900m 5.250% Perp nc 10 (issued Jun-07) Perp nc 10 (issued Mar-06) 60 nc 10 (issued Sep-06)

BenchmarkReporting Date. Maximum 5-yeardeferral period. Deferred payments to be settled via ACSM.

Deferred Payments Non-Cash Cumulative Non-Cumulative Cumulative (Optional Deferral). Non-Cash Cumulative (MandatoryDeferral).

ACSM Settlement of deferred interest payments n/a Settlement of deferred interest via issuance of Payment Shares (ordinary payments via issuance of new shares shares orqualifying mandatory and or treasuryshares and/orconvertibles, subject to a total limit of parity/junior securities orPIK(20% 2% in any12-mth period), orPlacement PIK limit and 25% PIK/parity/juniorSecurities (paritysecurities, subject to a securities limit). If Issuernot able to 25% limit). Issuer shall use best efforts paydeferred interest on deferral to settle deferred payments. Deferred date, Issuer shall use best efforts to payments cancelled if not settled within settle deferred payments. Deferred 5 yearperiod. payments not settled after5 years

will constitute an event of default.Additional — Conversion Event - early redemption Features/ upon conversion of Siemens Finance Comments - BV€2.5bn 1.375% 2003/2010

convertible bond.



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Some important German hybrid capital characteristicsMaturity Evaluating and classifying instruments as debt or equity in the German Tax Code requires the consideration ofthe final maturity of the instrument under review. If there is a final maturity term (a dated security) and thedate is within the range which is typical in the capital markets, then the argument is strong for debt classifica-tion and the deductibility of payments is reasonably straightforward (unless there is a cumulative participationin profits and liquidation proceeds).

However, for this reason the German tax authorities consider a very long dated security where the finalrepayment is due more than 30 years from the date of issue as an effectively ‘participating’ security withregard to the liquidation of the company. That is to say, a final maturity of over 30 years makes the securitymore like equity in that the holder could be getting paid out principal only at a potential future liquidationrather than at some more easily imaginable credit scenario at a near-term date (three, five, seven or 10 yearsmaturity) and that the security is therefore more risky than a shorter-term debt issue where principalrepayment can be predicted with greater certainty.

Obtaining medium to high equity content from the rating agencies requires the instrument to exhibit‘permanence’ as one of the three main criteria for equity credit, which generally means perpetual securitiessuch as common stock or some preferred stock or a minimum 60-year final maturity. In Germany some 100-year hybrids have been seen, for example, in addition to perpetual hybrids. Therefore, for the modern Germanhybrid designed to satisfy the rating agencies’ equity definitions, this makes it difficult but not impossible tosatisfy the criterion of no participation in liquidation proceeds. A number of positive binding rulings arebelieved to be issued in this respect.

Payment discretion/obligation Payment discretion is a key feature under both the German tax code and for the rating agencies. The second ofthree major rating agency equity criteria is ‘no ongoing payment obligations which could trigger a default’ Whenevaluating and classifying instruments as debt or equity in the German Tax Code this also requires the carefulconsideration of the obligation or discretion of the payments under the terms of the instrument being evaluated.

If the payments are deemed to be overly discretionary then the instrument is deemed to be equity (likecommon stock or some preferred stock) and the payments should not be treated as tax-deductible expensesfor income tax purposes. This is appears to be in direct conflict with the rating agency criteria, but areconciling solution to the puzzle has been found by using ‘triggers’ based on criteria which must not bedeemed overly discretionary by the German tax authorities but are deemed to provide significant financialflexibility to the German hybrid capital security issuer by the rating agencies.

Participation in profits Given the negative impact of the long-term nature of the hybrid capital security on the participation in liquidationevaluation, it is critical that the instrument have the correct structure for the payment terms. To avoid the taxclassification as equity, which would then eliminate the possible tax deductibility of the hybrid capital securitypayments, the discretionary nature must be limited by the triggers so that, first, the right to defer (cumulative)and/or, second, the obligation to eliminate payments (non-cumulative) are dependent upon a breach or apredefined ‘profit trigger’ for optional deferral and ‘cash flow trigger’ for mandatory deferral respectively.

In practical terms, this has resulted in a class of German hybrid capital securities where the hybrid capitalsecurity can optionally defer payments on a cumulative basis at any time (provided that the payments oncommon equity have also been halted) but payments are mandatorily deferred and lost (non-cumulative) if apredefined cash flow financial trigger is breached (i.e. cash flow/sales < x %). The predefined trigger counter-balances the concern that payments are too discretionary provided that they are not deemed to be profit-par-ticipating payments. Where the ultimate payment determination is based on a cash flow trigger and themandatorily deferred payment is lost due to the non-cumulative nature, the optional cumulative deferral canbe fully discretionary (no profit trigger required).

SwitzerlandSwitzerland has been the source of significant issuance from the financial sector but so far nocorporate issues. In some of the other jurisdictions (i.e. Germany) it has been seen that cross-border capital raising via the sale of hybrid securities to international investors has requiredpackaging in some cases to enhance marketability and improve the economics.

By observing the summary examples provided it can be seen that a variation of the SPV Tier 1structure has been used by Swiss Re whereby an independent SPV is used to raise investorproceeds to fund the Swiss Re Tier 1 capital security. The transaction is full featured for regulatoryand rating agency purposes (Basket D type) and is investor friendly given the ACSM.

By comparison the bank capital Tier 1 issue from Credit Suisse is more straightforward and in theform of a classic bank Tier 1 issue (perpetual, fully non-cumulative with no ACSM, no ratingagency equity enhancements). Notably the Credit Suisse Tier 1 issue is out of its Guernsey branchand so no SPV was required.


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Participation in liquidationAs discussed above, to satisfy the first rating agency equity criteria of ‘permanence’, hybrids are eitherperpetual or have a very long maturity (over 60 years) and this causes an automatic classification asliquidation participating, which means payments may not be deductible if the other features are deemed tooequity-like. The third of the three major equity features is ‘loss absorption’ and this is generally satisfied bystructuring the hybrid to be subordinated to all securities except common equity.

To rating agencies, this level of subordination ‘absorbs loss’ because the hybrid cash proceeds fund theoperations, driving new cash generation during the business growth, then in times of financial stress thepayments can/must be deferred/eliminated and finally in liquidation the senior creditors benefit from acushion created by the hybrid, since hybrid capital security holders are nearly last in line to collect anyremaining proceeds and they do not have the ability to accelerate the debt default proceedings. Therefore,the hybrid can help the corporate hybrid issuer maintain its solvency during a period where accumulatedlosses erode the capital base and retained earnings.

Obtaining a tax rulingIn the event of a direct issue, German corporate hybrid capital security issuers should obtain a German taxruling on the intended tax deductibility and absence of withholding tax for non-German investors for any con-templated hybrid capital security issued from Germany.

Where a non-German SPV is used for the issuance of the hybrid capital security, the SPV jurisdiction could bethe more relevant for determining tax deductibility of payments from the hybrid capital security SPV to hybridcapital security investors – but this will depend on a case-by-case basis. A simple (rather than hybrid) inter-company loan between the SPV and the parent company would not likely need a tax ruling.

Popular locations for SPVs are the Netherlands and Luxembourg, where double tax treaties are in place withGermany, in addition to Delaware and Jersey. UK and Irish SPVs also became more attractive recently due toincreased competition and the Prospectus Directive. In some cases an SPV may be used as a hub to allowproceeds to be directed to where they are needed in the operating entities of the business group In suchcases a hybrid inter-company loan to Germany under German tax law should require a ruling to be prudent.

Market precedent transactions from Germany have been supported by German tax rulings and so significantprecedent exists for the German tax authority; however, where an issuer is located in a region where no hybridshave obtained rulings the process may take longer.

Withholding tax considerationsProvided the security is deemed to be tax debt-based on the key criteria above, there should not be awithholding tax imposed on capital security payments cross-border from Germany to international investorsunless one of the two criteria above is fulfilled.


143

Switzerland termsheets

Overwhelming demand for Swiss Re(Published in IFR, 6 May 2006)

Although the euro tranche of Swiss Re's Tier 1 funding exercise for the acquisition of GE Insurance Solutionswas the senior in terms of size, it was the US dollar piece that many were looking to for answers. With thecontinuing NAIC saga effectively placing insurance buyers hors de combat for the time being, the questionwas: would the insurer manage to satisfy its diversified needs at an acceptable level without them. (See USDebt & Globals for comment on the US dollar tranche).

The fact that so many minds were concentrated on the US dollar tranche seemed to have not disadvantagedthe euro piece, but that is not to say it was not without challenges. It was launched through ELM BV, a pre-existing UBS repackaging vehicle, and was secured over perpetual subordinated loan notes issued directly bySwiss Re. The structure also provides solo capital for regulatory purposes at the parent level. With a total ofUS$2bn required across the two tranches and a 9bp premium needed to ensure placement of the US dollarside of the equation, there was a marginal preference for euros to provide the greater size.

With lead managers Dresdner KW, HSBC and UBS building an order book of €6bn, the potential was there tochoose virtually any size desired. The respective volumes were eventually fixed at €1bn and US$750m, both

coming in perpetual non-call 10 format as expected. Initial talk was at the mid-swaps plus 115bp area,although the book remained intact at the revised level of 109bp (129.8bp over Bunds). With the bondstightening 3bp on the break, there was speculation that the margin could have been squeezed tighter,although gargantuan books can disappear without trace and seemingly without reason when lead managersand issuers conspire to take the last basis point available. Demand was widespread with orders from 256accounts received, 237 of which were allocated bonds. UK-based buyers led the way, taking 43% of the paper,fund managers dominating with half the allocated bonds.

While the post-launch performance prompted some scrutiny of the pricing, arriving at the appropriate levelwas far from a precise science. There was no shortage of opinion as to where the spread should have beenpitched in relation to outstanding paper from the likes of Allianz and Munich Re, each as self-serving as thenext. The acid test, however, was to pick a level that would appeal to investors without appearing to be toogenerous. Despite the 3bp post-launch performance (or perhaps because this marked the extent of thetightening), Swiss Re appears to have been successful in achieving both.

(Published in IFR, 12 May 2007) Some desks commented earlier in the year about the conspicuous absence of Credit Suisse's self-led deals,but the issuer returned to the market last week with what was described as the third-largest dollar-denominated Tier 1 deal.

Acting through its Guernsey Branch unit, the firm issued US$1.25bn in fixed-to-floating perpetual non-call 10Aa3/A securities at 123bp over Treasuries. A US$750m perpetual non-call 10 floating issue priced with acoupon of three-month Libor plus 69bp. Breaching the Libor plus 70bp mark was said to be one significantaspect of the transaction. SocGen's outstanding A1/A+ issue appeared to be the most appropriatecomparable and it was 128bp bid.

The Credit Suisse trade was said to receive about US$4.5bn in demand, and the fixed issue improved to amarket of 122bp/121bp while the floater narrowed to Libor plus 68bp/66bp.

Table 6.6: Switzerland termsheets

Insurance Tier 1 BankTier 1 Swiss Re €1bn 5.252% Perp nc 10 (issued May-06) CreditSuisse US$1.25bn 5.86% Perp nc10 (issued May-2007)

Issuer Swiss Reinsurance Company Credit Suisse (Guernseybranch)IssuerType SPV(Independent) DirectSecurityType Perpetual Subordinated Step-Up Loan Notes Fixed to Floating Rate Tier1 Capital NotesStatus / SubordinationThe Loan Notes constitute unsecured and subordinated The Notes are direct, subordinated and unsecured

obligations ranking junior to SeniorSecurities, pari passu obligations of the Bank, ranking junior to senioramong themselves and with ParitySecurities, and senior creditors, pari passu with parityobligations and seniorto JuniorSecurities. to share capital.

Spain

The Preferentes structure There are similarities between the history and evolution of the current day Tier 1 Preferentesstructure in Spain and that of the French TSS-based hybrid Tier 1 described above. The Preferenteshybrid Tier 1 structure for Spanish banks today is the product of years of lobbying by the Spanishbanking community to eliminate the need to issue hybrid Tier 1 capital securities from offshoreSPVs.

A key difference in Spain is that the essential terms and conditions of the Cayman Island SPVpreferred stock type of hybrid Tier 1 were carried over into the Spanish law 19/2003 which


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Table 6.6: Switzerland termsheets (cont)

Insurance Tier 1 BankTier 1 Swiss Re €1bn 5.252% Perp nc 10 (issued May-06) CreditSuisse US$1.25bn 5.86% Perp nc10 (issued May-2007)

Maturity Perpetual PerpetualFirst Call Date 25-May-16 15-May-17Step-Up at First +100 bps +100 bpsCall Date EarlyRedemption Yes - ParRedemption Event (Recalculation of Interest Yes - Special Event Redemption - (TaxEvent /

Event / Special TaxEvent) / Make Whole Redemption Event RegulatoryEvent). Notes redeemed at greaterof (Accounting Event / RegularTaxEvent / RegulatoryEvent). principal orT+50. Redemption subject to prior consent Loan Notes redeemed at theirprincipal amount (Par of the Swiss Federal Banking Commission.Redemption Event), or the higherof principal orBunds+65 (Make Whole Redemption Event). Redemption subject to prior consent of FOPI.

Replacement Clause Intent-Based Replacement of Redeemed Loan Notes. n/aReplacement with ordinary shares or securities with equal orgreaterequity characteristics to the Loan Notes.

Dividend Pusher/ Dividend Pusher Dividend PusherStopperRegulatoryEvent Interest payments conditional on Issuerbeing solvent at Interest payments conditional on Issuerbeing solvent at

the time of payment. the time of payment.Optional Deferral Interest payments optionallydeferrable. Maximum Interest payments optionallydeferrable and non-

2-yeardeferral period (non-cash cumulative). Deferred cumulative. payments to be settled via ACSM.

Rating Agency Interest payments mandatorilydeferrable. Trigger - MandatoryDeferral (i) consolidated net income forthe two consecutive Reporting No rating agencymandatorydeferral trigger (see

Periods ending on the Lagged Reporting Date is less than zero, RegulatoryEvent).and (ii) Adjusted EquityAmount as at the Lagged Reporting Date has declined bymore than 10% as compared to the Adjusted EquityAmount as at the Reporting Date that is 24 months prior to such Lagged Reporting Date, and (iii) Adjusted Capital Amount as at the Current Reporting Date has declined bymore than 10% as compared to the BenchmarkAdjusted EquityAmount. Maximum 2-yeardeferral period (non-cash cumulative). Deferred payments to be settled via ACSM.

Deferred Payments Non-Cash Cumulative Non-CumulativeACSM Settlement of deferred interest payments via Ordinary n/a

Share Settlement (ordinaryshares orqualifying mandatoryconvertibles), ParityShare Settlement, orPayment-in-Kind.OrdinaryShare Settlement subject to a total limit of 2% of outstanding share capital in any12-mth period, and ParitySecurity/PIKamount subject to 25% of initial aggregate principal of the Notes. Issuer shall use best efforts to settle deferred payments. Deferred payments cancelled if not settled within 2 yearperiod.

Additional Features/ Substitution/ Modification of the Loan Notes following an Modification orAmendment of the Notes.Comments EarlyRedemption Event. OrdinaryShare Settlement

Covenant - best efforts to keep available for issue Payment Securities required to satisfyall interest payments on the Loan Notes fora 12-month period.


determines the current parameters for Preferentes issuance. An SPV is still typically involved butnow it should be Spanish rather than offshore to minimise the investor reporting requirements ofthe issuer. The goal of direct issuance was not accomplished by copying the Cayman precedentbut the alleged offshore SPV ‘tax haven’ taint was removed and the onshore preferentes providedbanks with a domestic tax-efficient Tier 1 capital security and that was the main priority for thebanks.

Therefore, there are elements of the Law 19/2003 Preferentes which are fine for banks, but maybe considered overly restrictive or awkward for corporate issuers. In particular, the Preferentespayment (or deferral) is ‘hard wired’ to the existence of distributable profits. If the Preferentesissuer has distributable profits they must pay the hybrid coupon, and if the issuer does not havedistributable profits they must defer or cancel the payment. This is a focus on ongoing structuringevolution. Recently S&P softened its view on this feature and no longer inflicts a third notch downfor Bank Preferentes.

The equity accounting treatment of a hybrid capital security under IFRS is driven by the securitiesterms and the degree to which the issuer is free to defer or eliminate payments fully at theissuer’s discretion without causing a default. Under most GAAP regimes the SPV minority interestwas equity on consolidation, so IFRS has been a consideration for corporate hybrid issuers seekingequity treatment.

However, banks were not primarily driven by accounting equity treatment when they werelobbying for onshore Tier 1 and this was not considered. If fact, banks typically swap the issueproceeds from a Tier 1 transaction and therefore they may prefer debt treatment for the hybridTier 1 because they can apply hedge accounting to eliminate P&L volatility. For a Spanishcorporate that desires equity accounting treatment for their hybrid the classic bank stylePreferentes may be too restrictive, but with modifications could be used effectively.

The summary examples exhibit two transactions – one bank and one corporate – in order to allowa high level comparison of the modern bank Tier 1 preferentes structure recently used by BBVAand the enhanced format issued by Union Fenosa. So far there have been no insurance Tier 1hybrids from Spain. A key distinction in the Union Fenosa hybrid is the issuer’s option to resolvepayments via a non-cash distribution accomplished by increasing the nominal value of thePreferentes by the amount of the payment deferred. This flexibility helped to support equityaccounting and to obtain significant rating agency equity credit.

The BBVA deal included a pricing novelty that was very clever in the way future investor cashflows would be calculated. The issue was a standard True Perp with no step-up – fixed ratepayments for the first 10 years up to the call date and thereafter there is no step-up but the rateswitches to a floating format. The novelty was that BBVA included a floor equal to the originalfixed rate. This payment mechanism was valued by investors and therefore provided lowerfunding cost for BBVA.


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Spain termsheets

Tweak for BBVA (Published in IFR, 24 March 2007)Spanish bank BBVA issued US$600m in perpetual non-call 10 fixed-to-floating notes with an uncommonlyhigh coupon floor after the call that was said to save the credit 10bp–12bp. The securities featured a yield of5.919% as they priced at 134bp over Treasuries, or 83bp over Libor. After the call, the securities will float at theequivalent issue spread over three-month Libor, but the coupon floor will also be the initial yield of 5.919%,providing investors with some added assurance that the issuer will call the securities.

In a lower interest rate environment, the credit would be facing a higher coupon than it could otherwiseachieve in the market. In a higher interest rate environment, BBVA would face a coupon step-up once thecoupon starts to float.

The perpetual fixed-to-floating callable structure has been used previously and, without the floor, thoughtswere that a new BBVA step-up would print in the mid-140bp area.

One account based its decision to participate in the trade on the floor, noting that it could hedge against whatit knows would be the lowest yield it would receive if BBVA chose to extend past the discrete call. There wassaid to be a good mix of money management, insurance and money fund participation in the deal.


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Table 6.7: Spain termsheets

BankTier 1 Corporate HybridBBVAUS$600m 5.919% Perp nc 10 (issued Mar-07) Union Fenosa €750m 4.814% Perp nc10 (issued Jun-05)

Issuer BBVAInternational Preferred, S.A. Unipersonal Union Fenosa Preferentes S.A. (Sociedad Unipersonal)IssuerType SPV SPVSecurityType Non-Cumulative Guaranteed Preferred Securities Non-Cumulative Perpetual Guaranteed Floating Rate

Preferred SecuritiesStatus and The Preferred Securities rank junior to all liabilities of the The Preferred Securities rank junior to all liabilities of Subordination Issuer including subordinated liabilities, pari passu with the Issuer including subordinated liabilities, pari passu

each otherand with anyParitySecurities of the Issuerand with each otherand with anyParitySecurities of the senior to the Issuer’s ordinary shares. Issuerand senior to the Issuer’s ordinary shares.

Maturity Perpetual PerpetualFirst Call Date 18-Apr-2017 (then every10-years) 30-Jun-2015Step-Up at First Coupon Floor: 5.919% +100 bpsCall Date EarlyRedemption Yes (RegulatoryEvent / TaxEvent). Securities redeemed at n/a

the special redemption price (RegulatoryEvent), orat the higherof principal orUST+75 (TaxEvent). Redemption subject to prior consent of the Bankof Spain.

Replacement Clause n/a n/aDividend Pusher/ Dividend Stopper Dividend StopperStopperDistributable Profits? Distributions conditional on availabilityof distributable Interest payments conditional on availabilityof

profits. distributable profits.RegulatoryEvent Distributions conditional upon no breach of minimum n/a

capital requirements, applicable underSpanish banking regulations.

Optional Deferral Distributions optionallydeferrable and non-cumulative. n/aMandatoryDeferral No rating agencymandatorydeferral trigger n/a

(see RegulatoryEvent).Deferred Payments Non-Cumulative Non-CumulativeACSM n/a n/aAdditional Features/ n/a Issueroption to paya non-cash-distribution byComments increasing the nominal value of the preferred securities

instead of paying the cash distribution. Conditional upon existence of distributable profits and no dividend payment made to ordinary shareholders.


The transaction came under the 144a rule and is QDI eligible based on the classification of the payments toinvestors. The combination of an unregistered trade and the QDI eligibility, which is often seen in retail deals,has surfaced on several Yankee transactions, such as Standard Chartered's perpetual trade late last year.Lehman Brothers led the BBVA offering

Fenosa prefers retail (Published in IFR, 2 July 2005) Spanish utility Union Fenosa turned its back on the revived corporate subordinated market and instead optedfor a retail targeted perpetual preference share, which priced last week through lead managers SCH and CajaMadrid. The issuer raised €750m in floating securities that pay 65bp over Euribor, stepping up to 165bp overEuribor if the securities are not called after 10 years.

The transaction is accounting driven and intended to replace the €609m of preference shares issued in 2003,which counts as debt under the new IFRS accounting rules, whereas the new notes are considered as 100%equity under IFRS.

ItalyItalian banks were early issuers of hybrid Tier 1 securities but the history of the hybrids in Italyhas been constrained by difficulty in obtaining BoI transparency for hybrid structuringinnovations and lack of advance notice of expected changes in regulatory requirements. As aresult, Italian banks were absent from the hybrid Tier 1 new issue market for several years.

Italian banks were active in the first wave of European bank hybrid Tier 1 issuance in the 1990sand some creative financial engineering produced a noteworthy hybrid Tier 1 structure whichwas successful until BoI cut back on what they would permit as capital. For several years, theItalian banks suffered a disadvantage relative to international peers in that their hybrid Tier 1issuance was limited in the calculation of Tier 1 requirements. So far, the possibility to issue core,non-innovative Tier 1 that is tax efficient is not a possibility for Italian banks.

Given the rapidly changing environment in the Italian banking industry, BoI has allowed banks toissue new tranches of innovative hybrid Tier 1 to support the M&A activity that is ongoing in Italy(for example, the innovative Tier 1 issues by Unicredit and Lodi). Innovative structures cantherefore be computed as part of the target Tier 1 ratio requested by BoI. Previously, ‘innovative’was not eligible to reach the minimum targets.

Current innovative Tier 1 structuring opportunitiesFor some time we advocated the theoretical opportunity to update the ‘classic’ style of Italian Tier1 which has historically been issued indirectly through an ‘offshore’ SPV based in the US.However, the majority of M&A-driven innovative Tier 1 issues followed the classic modelinvolving US SPVs (Limited liability company, or LLC, and Trust) since it was a proven structurethat could be quickly executed with limited hassle. The focus was more on the M&A deal andstrategic issues rather than the specific innovative Tier 1 structure – especially since BoI has beenconservative in adopting new innovative Tier 1 ideas in the past.

A logical streamlining of the classic structure would be to use a European SPV to replace the US SPVs(LLC and Trust) or even a direct issue with no SPV. The legacy US structure via Delaware is awkward fora European bank selling Euro-denominated Tier 1 to European investors. So a ‘neo-classical’ EuropeanSPV structure could be an alternative to consider (see Figure 6.3), if not a direct issue with no SPV at all.

Most EU countries have moved away from offshore SPV structures altogether and favour directissuance (UK, France, the Netherlands) even if this required a change in tax or securities law. Thisis because there was a concern among Basel ll members that an SPV in the Tier 1 structuresomehow reduced the quality of the Tier 1 capital and restricted its equivalence to the own fundsdefinition. Other jurisdictions that still use SPVs for innovative hybrid Tier 1 (such as Germany,Ireland and Spain) have moved to EU SPVs since it is easier and often cheaper in Europe than itwas only a few years ago. Based on our discussion with the BoI, they are open to the use of an EUSPV and they see the rationale for doing so, but do not require it as some other regulators do.Direct issues have also finally been seen, as shown in the summary examples where a Tier capitalissue for BPVN is highlighted

Hybrid structuring in ItalyThe ‘classic’ hybrid Tier 1 structure for banks using a Delaware Trust structure is shown in Figure6.4 and highlighted in the summary examples.


147

The bank security issued to the LLC can be structured as either an Upper Tier 2-style bond toobtain Tier 1 capital on a consolidated basis, or a subordinated deposit with a derivative contractthat creates bank level loss absorption in the event of a capital deficiency event. This achieves Tier1 capital on a solo basis.

The Italian bank sets up an SPV in the form of a Delaware LLC in the US and routes the proceedsfrom the issue back to the parent bank in Italy through the US LLC. The use of the US LLC is alegacy left over from BoI approvals of early Tier 1 structures in the past, which were using SPVs inmany European jurisdictions.

Although Tier 1 could be issued by the bank itself, normally the issuer is an SPV which raises thefunds from investors and passes them through a subordinated loan to the bank. The bank willissue a subordinated guarantee in favour of the holders of the securities issued by the SPV and willhave to pay interest on the subordinated loan to the SPV.

Since the SPV will be consolidated, on the group level proceeds from the issue of the securities bythe SPV are recognised as Tier 1 capital at the bank’s level. The SPV is located in a domicile that isfiscally neutral for the issuers and to the investors (such as UK/Ireland/Netherlands), providing thefollowing advantages:

0 Gross payment of interest on the securities issued by the SPV and bank;0 Derivative contract between bank and SPV provides loss absorption;0 Deductibility of payments of interest under the subordinated loan – no withholding tax crossborder.


148

Figure 6.5: Italian hybrid Tier 1 structure – EU SPV


Interest

payments

(tax deductible)

Tier 1

securities

Subo

rdin

ated

guar

ante

e

Proceeds

from Tier 1

Intercompany

securities

Bank

SPV

Investors

Figure 6.4: Italian hybrid Tier 1 structure via a US trust

Source: Compliled by CALYON

LLC Preferred

Securities

Subordinated

deposit and

Derivatives contracts

Trust Preferred

Securities

Trust Preferred

Security Cash

Proceeds

Subordinated

Deposit Cash

Proceeds

Subo

rdin

ated

gua

rant

ees

100%

of L

LCco

mm

on s

ecur

ities

100%

ofT

rust

co

mm

on S

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ities

LLC Preferred

Security Cash

Proceeds

Bank

LLC

Trust

Investors

A variation of the European SPV structure has been used by Generali, which issued €1.275bnthrough an EU SPV based in the Netherlands and listed in Luxemburg. This structure is more s-traightforward and lower cost than the Delaware structure (especially for a first-time issuer). Inparticular, a European SPV is easier to implement, following the implementation of the EUprospectus directive.

More information on the Bank of Italy is available on www.bancaditalia.it

Recent developmentsItaly hybrid capital limit increases to 20% of total capitalIn December 2006, BoI made beneficial changes to banking regulations for Tier 1 regulatorycapital. This provided an opportunity for Italian banks to issue more low-cost hybrid Tier 1 in theform of no-step Tier 1, targeting either the institutional True Perp market or RPB market.

The key change was the increase to the limit on hybrid issuance from 15%, which allows for moreTrue Perp issuance – under the new regulations the hybrid limit was increased to a maximum of20% of total Tier 1 capital. Step-up ‘innovative’ hybrid Tier 1 was still limited to a maximum 15%but the overall hybrid limit was increased to 20% to allow additional issuance of hybrid Tier 1 withno step-up coupon.

This is similar to a recent change to the guidelines in France, where limits on total hybridissuance were recently increased – also allowing for more True Perps but keeping step-ups cappedat 15%. Therefore, in France hybrid Tier 1 can now amount to 25% of total Tier 1.

Ultimately, the future of Italian Bank Tier 1 issuance should lead to direct issues. During strongmarket conditions both step-up and True Perp formats are possible, with the True Perp having theadvantage of falling outside the 15% limit and into the larger 20% limit.

Two key issuesFollowing the publication of BoI's new guidelines at the end of December 2006 there were twokey issues that were ironed out in the latest direct issuance structures:

1. How the hybrid Tier 1 ‘loss absorption’ required by BoI for all hybrid Tier 1 could eventually bestructured – In the ‘classic’ US SPV structure there was an inter-company mechanism whereby thesubordinated deposit amount could be diminished via the parallel derivative agreement betweenthe hybrid Tier 1 US SPV and the Italian parent bank. In the end, BoI has accepted an Upper Tier 2style loss absorption on the direct issue hybrid Tier 1. In prior engineering attempts to modify theclassic structure this was not accepted on the inter-company subordinated loan. The resultingevolved structure simply allows for suspension of the hybrid Tier 1 principal amount in order toavoid an insolvent condition. This amount will be restored if the bank returns to surplus. Mostimportantly, the investor maintains the full claim for the unadjusted principal amount inliquidation;

2. The ‘permanence’ of the security given that most Italian companies have a limited duration –The solution is to link the maturity of the security to the life of the company as seen in recent non-bank hybrid innovation in Italy. Additionally, this resolves the potential tax issue for internationalinvestors as it allows gross payments (no withholding tax) to non-Italian international investors.

Direct issuance was first accomplished by a corporate (Lottomatica), as highlighted in thesummary examples. Since the motivation was rating agency-driven rather than regulatory, thetransaction could be in dated format (rather than perpetual) and still achieve significant equitycredit. By avoiding a perpetual issue format the transaction did not raise concerns with potentialwithholding tax faced by investors on ‘atypical’ perpetual securities. A curious feature of theItalian system is that an issuer cannot issue a financial liability with a term longer than the legallife of the company itself. So for very long dated hybrids the term of the security needed to beharmonised with the company life and extended along with the company itself.

Generali also issued a Tier 1 hybrid in the direct format (and also SPV format) taking advantage ofthe new opportunity. Subsequently, Banca Navarro issued the first direct issue bank Tier 1 in Italywhich should open the way for others to follow. One of the interesting themes which can beobserved is that banks are now being led by the innovations of corporates and insurancecompanies who are leap-frogging the advances pioneered by the banks. All parties are benefitingfrom the evolution of hybrids. Direct issuance is likely to dominate over time. However, where abank already has substantial SPV issuance outstanding they may wish to continue SPV issuancerather than switch immediately. Over time it can be expected that the same pattern seen in otherjurisdictions and direct issuance will become most common.


149

A change in Italian law (Legge Viette) has provided a flexible new preferred stock type of securitycalled Strumenti Finanziari Partecipativi (SFP), which should be considered in the structuring ofItalian capital securities and could potentially provide additional structuring flexibility in future.The SFP could be a useful replacement for the use of common shares in the ‘FRESH’ type structureissued by Banca Monte dei Paschi di Siena SpA without the potential problems caused by the needto issue common stock (i.e. approvals and dilution).


150

Italy termsheets

Smooth operator Generali (Published in IFR, 3 February 2007) In stark contrast to its €2.8bn cross-currency, three-tranche Tier 1 trade launched last June, Assicurazioni Generali(A3/A/A+) raised €2bn-equivalent in a dual-tranche trade last week. While the borrower launched last year's dealin a nervous market stricken by stock volatility that caused spreads to widen out, its latest well thought out andwell executed offering was set against a backdrop of a rock-solid, benign market flush with funds.

The trade amassed one of the largest order books ever seen for a subordinated transaction, scooping €7.8bnof orders for the euro tranche and £4.4bn for the sterling, within around 45 minutes of opening the books.The phenomenal demand and lack of price sensitivity in the books helped the borrower to print both thetrades much tighter than the initial guidance.

The €1.25bn perpetual non-call 10 trade priced at 114bp over mid-swaps and the £495m (to achieve the€2bn target in hybrid Tier 1 exactly) piece priced at 146bp over Gilts. The final pricing was within 3bp of thesecondary trading level of the 2016s on announcement of the transaction and through the interpolated

trading level of the 2016s and 2026s in sterling, which was commendable for a transaction of this size. Thefeat stands out even more coming just seven months after the issuer’s €2.8bn Tier 1 funding exercise.

Close on the heels of its Tier 1 trade last June (IFR 1637), the issuer had announced its intention of raising afurther €1.2bn in the hybrid market (IFR 1640) in the first quarter of this year to part-fund its €3.85bnacquisition of Italian motor insurer Assicurazioni Toro. Although the acquisition made compelling strategicsense for Generali, it required the firm to cancel its share buy-back programme, which was a key element in itscapital optimisation strategy (part of its three-year strategic corporate plan announced in March 2006).

A quick flashback into 2006 would reveal that the strategic plan included a buy-out of minority stakeholdersin several countries and a share buy-back (totalling €4.1bn) that the borrower planned to finance through acombination of hybrid and other debt. In keeping with the plan, soon after the firm completed its minority acquisitions, the borrower priced its €2.8bn hybrid Tier 1 transactions, leaving approximately €1.2bn to beraised in dated subordinated capital. However, the Toro acquisition not only forced the firm to deviate from itsbuyback plan but also raised its capital funding needs to around €2bn.

A combination of the borrower’s natural currency and duration objectives with investor preferences dictatedthe tranching of the transaction, jointly led by HSBC, JPMorgan, Mediobanca (all involved in the June 2006three-part trade) and UBS. As the 2006 exercise relied more on the sterling market (£1.05bn versus€1.275bn), a bias towards euro was the natural choice this time around.

A clear investor bias towards the perpetual non-call 15 as opposed to a perpetual non-call 17 structure for thesterling tranche explained the choice of format. Besides, the former sat comfortably between the two existingsterling benchmarks and optimised the overall funding cost of the trade as the Libor curve in sterling wasmarginally flatter than that available in euros, thus permitting a modest Libor arbitrage for the borrower.

To tailor the trade to fit the specifications put out by ratings agencies, the issuer made some structuraltweaks primarily related to the ACSM (alternative coupon settlement mechanism) clause. Settlement underthe ACSM is only permissible to the extent of funds raised by either issuing new shares (up to 2% of the sharecapital) or by issuing securities ranking junior or pari passu, with the latter threshold lowered from 25% to15%. Besides, when the coupon is deferred, it triggers a best-efforts period of five years if not settled in thefive years (previously 10 years) following the deferral. Neither change had any impact on pricing or distribu-tion, according to the lead managers.


151

“As we were essentially removing a large overhang of supply from the Generali curve, investors acknowledgedthat the premium for a new transaction versus their existing curve would be modest and that proved to bethe case,” said Richard Howard, executive director on JPMorgan's financial institutions syndicate desk.

Although the issuer planned to print a larger euro piece compared with the sterling tranche at the outset, itrefrained from defining the size of either. The leads also left enough room for manoeuvre when announcingthe guidance of mid-swaps plus the mid-to-high teens over 100bp for the euro piece (with the issuer's 2016sbid at 109bp over mid-swaps) and 150bp area over Gilts for the sterling tranche (representing a modestconcession to the interpolation of the 2016s (bid at Gilts plus 138bp) and 2026s (bid at Gilts plus 150bp).Both the trades performed well in the secondary market, with the euro tranche bid at Bunds plus 143.5bp(3bp tighter than reoffer) and the sterling print also bid 3bp tighter through reoffer.

Of the almost 400 orders received across the two tranches, asset managers dominated the euro trade,claiming 58% of the bonds, followed by pension funds and insurance companies, which together bought22% of the issue. Italy accounted for less than 10% of the placement, with the UK and Ireland, France, theBenelux countries and Germany representing the main buying regions. As expected, the UK accounted for92% of the placement on the sterling tranche, which was bought primarily by asset managers, though therewas also participation from insurance firms and pension funds.

Twin-sets in fashion (Published in IFR, 8 October 2005)UniCredito Italiano spread the net wide for its acquisition-related Tier 1 financing, adopting a two-tranchestrategy. It targeted buyers in Continental Europe with a euro-denominated deal and the UK with one insterling. Both were perpetuals with a call after 10 years. JPMorgan and Merrill Lynch were joint lead managerson both tranches, being joined by HVB and UBM on the euro and HSBC on the sterling.

The transaction was extensively roadshowed, giving investors the opportunity to hear UniCredito's version ofevents regarding its merger with HVB. Despite the fact that all three rating agencies are reviewing the credit

with a view to a possible downgrade as a result, the response was enthusiastic – close on €5bn of ordersbeing pledged at the initial spread talk of the mid-swaps plus 80bp area and Gilts plus 110bp–115bp.

The stated intention was to launch benchmark-sized issues in each currency, although the entire €1.2bnequivalent final amount (€750m and £300m) could easily have been raised by concentrating solely on theeuro market and even in sterling, had UniCredito been so minded. It was keen to diversify its investor base,however, and the sterling option opened up a new avenue, this being its inaugural transaction in the currency.It was also its first visit to the euro Tier 1 market for five years, so credit lines were freely available.

Given the level of demand, a downward revision of the prospective spreads was not surprising. The newfigures were mid-swaps plus 75bp–77bp and Gilts plus 107bp–109bp. Even at these tighter levels, bothtranches were still significantly oversubscribed, with final books standing at around €2.5bn on the euro whenit priced at plus 76bp and just short of £1bn on the sterling at its launch spread of 107bp.

At plus 76bp, it was only slightly wider than SG's 2015 callable (plus 72bp) with which it shares current ratingsof A1/A, and inside ING Groep's (plus 84bp), which at A2/A sports the ratings towards which UniCredito isexpected to gravitate. This one-notch downgrade was also factored in when pricing the sterling tranche, thetwo bonds most closely looked at being KBC's 2019 callable (A2/A–), which was bid at 106bp over Gilts, andNAB's 2018 (A2/A) at plus 114bp.

The novelty value of a new issuer meant that the spread could be squeezed further in on the sterling portionas investors clamoured for a fresh name for their portfolios. There were 70 accounts in the final book,comprising most of the largest UK funds, although this was dwarfed by the 200 that participated in the eurotransaction. The UK, France, Germany and the Benelux region took the bulk of the bonds (70%), a further 20%remaining in domestic hands.

The initial indications on the euro tranche had been of a coupon in the 5% area. When €2.3bn worth of ordersflooded in with a rapidity not normally associated with retail transactions, it became clear that demand for sucha product was rife and a journey into the previously uncharted 4% handle territory could be contemplated.

The coupon was eventually pitched at 4.875%, the bulk of the bonds being bought by retail intermediaries fromwhom they would eventually be filtered into their networks. As is normal with this kind of paper, placement wasat a price of 99.00. Those that bought bonds were soon in profit, early trading seeing them bid just above par.


152

Those that invested in the US dollar tranche were sitting on an even greater profit. It moved up to 100.375bid, with buyers attracted by the 6.25% annual coupon. Pricing two days before the euro, its US$400m sizewas smaller than some were expecting, although BNP had only limited requirements and those working onthe exercise will have been aware of the overwhelming demand for the euro, meaning that raising a hugeamount in US dollars was not a pressing necessity.

The order book fell just short of the US$500m that would have afforded a rounder number, although theeventual US$400m was comfortably covered.

BPVN braves rough weatherPublished in IFR, 16 June 2007 Banco Popolare di Verona e Novara (BPVN) last week became the first Italian borrower to issue a direct Tier 1deal and a non-step Tier 1 offering when it launched its dual tranche perpetual non-call 10-year trades.

It is also the first time globally that a step and non-step transaction have been executed simultaneously,claimed joint leads Goldman Sachs, HSBC and JPMorgan. The non-step issuance is the fourth suchtransaction following the two Barclays deals (callable 2014 and 2020) and the Dresdner trade issued last year.

The deal was aimed to raise capital to fund BPVN's merger with Banca Popolare Italiana, which will becomeeffective on July 1. The capital-raising along with the announced share buyback programme form the keyelements of the issuer's acquisition financing plan. After the merger, BPVN will become the third largest bankin Italy, with assets of €120bn and more than 2,200 branches. It is rated A2/A/A+ at the senior level.

To showcase the merged entity, roadshows were held for six days across all the major investor constituenciesin the UK, Germany, France, the Netherlands, and Italy. The issuer met with almost 100 investors.

Though the roadshow concluded in Milan on June 6, investor calls were held by the leads well into lastMonday to give buyers time to monitor and digest the Banca Italease situation, given that BPVN owns 30% of Italease.

BPVN shares had suffered a 15% loss since May 1 due to concern that the Italease crisis might generatefinancial losses and put at risk its planned merger with Banca Popolare Italiana. An improvement in sentimentwas seen last Monday as share prices in Milan rebounded from losses two weeks ago.

Given the volatility in the markets and the widening seen on Tier 1 deals in the secondary market, the leadswaited for a stable window to launch the deal. With the market exhibiting some semblance of stability late lastMonday combined with a strong opening last Tuesday, the leads issued initial guidance of mid-swaps plus130bp–133bp for the step-up deal and mid-swaps plus 190bp–195bp for the non-step tranche.

For the step-up offering, the leads referred to the outstanding euro perpetual non-call 2015 Tier 1 notes,which were bid at plus 112bp, and adjusted for the two-year curve extension and threw in a modest new issuepremium.

Price discovery was tricky in the case of the true perp offering. Absent a like-for-like comparison, the non-steppremium was worked out from a number of different measures, including AIB's outstanding euro Tier 1 stepand non-step benchmarks that trade at a roughly plus 55bp differential in the secondary market.

Targeting an intra-day execution to minimise market risk, the leads closed the books when the trades wereeffectively oversubscribed. At just under €5bn, orders were skewed towards the step-up tranche and reflectedan appropriate step and non-step differential.

Of the 150 investors that placed orders, about 20% dropped off when the guidance was refined to the tightend across both tranches, with the €350m step-up tranche placed at plus 128bp (Bunds plus 156.7bp) andthe €300m non-step piece at plus 188bp (Bunds plus 216.7bp).

Across the two tranches, asset managers bought about 60%, and insurance and pension funds about 25%,with the remainder split among banks, private banks and hedge funds. The UK and the Netherlands were wellrepresented, followed by Germany and France. Notably, domestic participation was less than 10% of thecombined trade.


153

A relatively small deal issued by not the strongest of Italian banking credits in not the strongest of market environments definitely commands a premium, which the issuer paid, said market participants.

The deals performed well in the secondary market, with estimates ranging from 7bp to 11bp tighter on thestep-up tranche and from 14bp to 23bp on the non-step piece – with talk being that some market partici-pants have used these transactions as a market proxy short only to find themselves having to cover theirpositions at higher prices.

Lottomatica picks right number (Published in IFR, 13 May 2006)Italian lottery concessionary Lottomatica’s eagerly awaited €750m 60-year non-call 10 hybrid securities(144a/Reg S) did not disappoint on Wednesday by pricing at the tight end of talk to yield 8.25% at par. CreditSuisse is sole bookrunner and Goldman Sachs joint lead manager.

The price equates to a spread of 405bp versus 10-year mid-swaps, or 425bp versus the DBR 3.5% due January2016. The securities feature a margin step-up after 10 years, flipping to a floating rate of 505bp over six-month Euribor, from which point they are callable at the make whole or margin step-up rates. Interestpayments are deferrable in some circumstances. The Ba3/BB– rated deal had been expected in a8.25%–8.5% range. Settlement is T+5 (May 17).

This issue is a good result for the leads as the lack of benchmarks and the broad mix of potential investorsmeans this was a difficult deal to price. The hybrid allows Lottomatica to retain its Baa3/BBB– corporaterating despite the extra leverage required to finance its circa €4bn acquisition of US gaming group GTech. Assuch, the deal attracted interest from both investment-grade and high-yield accounts.

One of the high-yield investors described the deal as “more generous than expected” and speculated that theleads had probably been careful not to push pricing too tight as doing so could have left the deal vulnerableto a sell-off. Judging by the secondary performance, which saw the deal wrapped around the 102 mark onFriday, the corresponding risk of pricing the deal too richly has also been successfully negotiated. Theremainder of the financing was secured through a €1.9bn senior loan and a €1.4bn rights issue. Theacquisition creates the world's largest lottery company.


154

Tab

le 6

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Ital

y te

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Insu

ranc

e Tie

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Bank

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€75

0m 4

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%BP

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350m

6.15

6% P

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(iss

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Jun-

07)

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mat

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€750

m 8

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%

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nc1

0 (is

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Jan-

07)

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Oct

-05)

60 n

c10

(issu

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ory

Even

t / C

hang

e in

Law

TaxE

vent

/ In

terp

reta

tion

at th

e hi

gher

of p

rinc

ipal

orB

unds

+10

8.35

. Red

empt

ion

Chan

ge o

f Con

trol E

vent

). Se

curi

ties

Even

t) or

thei

rpri

ncip

al a

mou

nt (T

axEv

ent).

Red

empt

ion

TaxE

vent

). Se

curit

ies r

edee

med

at t

he h

ighe

rof p

rinci

pal

subj

ect t

o pr

iorc

onse

nt o

f Ban

kof

Ital

y.re

deem

ed a

t the

irpr

inci

pal a

mou

nt

subj

ect t

o pr

iorc

onse

nt o

f ISV

AP.

orBu

nds+

50 (C

apita

l Eve

nt / I

nves

tmen

t Com

pany

Even

t /

(With

hold

ing

TaxE

vent

), or

at th

e hi

gher

TaxE

vent

), or

the

prin

cipa

l am

ount

(Cha

nge

in La

w Ta

xEve

nt /

of p

rinc

ipal

orB

unds

+75

(Tax

Even

t /

Inte

rpre

tatio

n Ta

xEve

nt).

Rede

mpt

ion

subj

ect t

o pr

ior

Chan

ge o

f Con

trol E

vent

). M

anda

tory

cons

ent o

f Ban

kof

Ital

y.Re

dem

ptio

n Ev

ent -

man

dato

ryre

dem

ptio

n at

101

% o

f pri

ncip

al a

t the

ea

rlier

of th

e te

rmin

atio

n of

the

mer

ger

agre

emen

t (Lo

ttom

atic

a/GT

ECH

), an

d O

ctob

er10

th 2

006

(if a

cqui

sitio

n no

t co

mpl

eted

).Re

plac

emen

t Cla

use

Inte

nt-B

ased

Rep

lace

men

t of R

edee

med

Sec

uriti

es.

n/a

n/a

Inte

nt-B

ased

Rep

lace

men

t of R

edee

med

Repl

acem

ent w

ith o

rdin

arys

hare

s ors

ecur

ities

with

Se

curi

ties.

Rep

lace

men

t with

ord

inar

yeq

ual o

rgre

ater

equi

tych

arac

teris

tics t

han

the

Not

es.

shar

es o

rsec

uriti

es w

ith si

mila

rter

ms a

nd

cond

ition

s.


155

Tab

le 6

.8:

Ital

y te

rmsh

eets

(con

t)

Insu

ranc

e Tie

r1Ba

nkTi

er1

Bank

Tier

1 Co

rpor

ate

Hybr

idGe

nera

li €1

.25b

n 5.

479%

Un

iCre

dito

Ital

iano

€75

0m 4

.028

%BP

VN €

350m

6.15

6% P

erp

nc10

(iss

ued

Jun-

07)

Lotto

mat

ica

€750

m 8

.250

%

Perp

nc1

0 (is

sued

Jan-

07)

Perp

nc1

0 (is

sued

Oct

-05)

60 n

c10

(issu

ed M

ay-0

6)

Div

iden

d Pu

sher

/Sto

pper

Div

iden

d Pu

sher

Div

iden

d Pu

sher

Div

iden

d Pu

sher

Div

iden

d Pu

sher

/ Sto

pper

Regu

lato

ryEv

ent

Inte

rest

pay

men

ts co

nditi

onal

upo

n no

requ

est f

rom

ISVA

PIn

tere

st p

aym

ents

cond

ition

al u

pon

no b

reac

h of

In

tere

st p

aym

ents

cond

ition

al u

pon

no b

reac

h of

min

imum

n/

a(o

rany

othe

rsup

ervi

sory

auth

ority

) to

rest

ore

the

requ

ired

min

imum

cap

ital r

equi

rem

ents

. Int

eres

t pay

men

tsca

pita

l req

uire

men

ts. I

nter

est p

aym

ents

not

pai

d if

proh

ibite

d so

lven

cym

argi

n at

this

tim

e.no

t pai

d if

inst

ruct

ed b

ythe

Ban

kof

Ital

y.un

derI

talia

n le

gisl

atio

n.O

ptio

nal D

efer

ral

Inte

rest

pay

men

ts o

ptio

nally

defe

rrab

le. M

axim

um

Inte

rest

pay

men

ts o

ptio

nally

defe

rrab

le a

nd

Inte

rest

pay

men

ts o

ptio

nally

defe

rrabl

e an

d no

n-cu

mul

ativ

e.In

tere

st p

aym

ents

opt

iona

llyde

ferr

able

. 5-

year

defe

rral

per

iod

(cum

ulat

ive)

. Def

erre

d pa

ymen

ts to

no

n-cu

mul

ativ

e.

Max

imum

10-

year

defe

rral

per

iod

be se

ttled

via

ACSM

. (c

umul

ativ

e). D

efer

red

paym

ents

to b

e se

ttled

with

cash

(firs

t 5-y

earp

erio

d) o

rvia

ACSM

(nex

t 5-y

earp

erio

d).

Ratin

g Ag

ency

Inte

rest

pay

men

ts m

anda

tori

lyde

ferr

able

. Tri

gger

- N

o ra

ting

agen

cym

anda

tory

defe

rral

trig

ger(

see

No

ratin

g ag

ency

man

dato

ryde

ferr

al tr

igge

rIn

tere

st p

aym

ents

man

dato

rily

defe

rrab

le.

Man

dato

ryD

efer

ral

(i) th

e ag

greg

ate

Net

Inco

me

of th

e G

uara

ntor

fort

wo

Regu

lato

ryEv

ent).

(see

Reg

ulat

oryE

vent

).Tr

igge

r- C

over

age

Ratio

is le

ss th

an 1

.35.

co

nsec

utiv

e Re

port

ing

Peri

ods e

ndin

g on

the

Lagg

ed

No

defe

rral

if is

suer

has a

vaila

ble

cash

Re

port

ing

Date

is le

ss th

an ze

ro, a

nd (i

i) th

e Ad

just

ed E

quity

proc

eeds

rais

ed vi

a eq

uity

issu

ance

in

Amou

nt o

f the

Gua

rant

oras

at t

he La

gged

Rep

ortin

g Da

te h

as

prio

r6-m

onth

per

iod.

Issu

erto

pay

decl

ined

bym

ore

than

10%

as c

ompa

red

to th

e Ad

just

ed E

quity

defe

rred

pay

men

ts p

rom

ptly

via

ACSM

. Am

ount

as a

t the

Rep

ortin

g Da

te th

at is

24

mon

ths p

rior

to su

ch

Max

imum

10-

year

defe

rral

per

iod

Lagg

ed R

epor

ting

Date

, and

(iii)

the

Adju

sted

Cap

ital A

mou

nt o

f(c

umul

ativ

e).

the

Gua

rant

oras

at t

he C

urre

nt R

epor

ting

Date

has

dec

lined

by

mor

e th

an 1

0 pe

rcen

t. as

com

pare

d to

the

Adju

sted

Equ

ityAm

ount

as a

t the

Rep

ortin

g Da

te th

at is

30

mon

ths p

rior

to su

ch

Curr

ent R

epor

ting

Date

. Max

imum

5-y

eard

efer

ral p

erio

d (c

umul

ativ

e). D

efer

red

paym

ents

to b

e se

ttled

via

ACSM

.D

efer

red

Paym

ents

Non

-Cas

h Cu

mul

ativ

eN

on-C

umul

ativ

eN

on-C

umul

ativ

eM

anda

tory

Def

erra

l (N

on-C

ash

Cum

ulat

ive)

/ O

ptio

nal D

efer

ral

(Cum

ulat

ive

- firs

t 5 ye

ars /

Non

-Cas

h Cu

mul

ativ

e - n

ext 5

year

s)AC

SMSe

ttlem

ent o

f def

erre

d in

tere

st p

aym

ents

n/

an/

aSe

ttlem

ent o

f def

erre

d in

tere

st p

aym

ents

("

best

effo

rts"

) via

issu

ance

of n

ew sh

ares

(2%

lim

it in

im

med

iate

ly, v

ia is

suan

ce o

f Iss

uerE

quity

any1

2-m

th p

erio

d), j

unio

rorp

ari p

assu

secu

ritie

s (15

%

(ord

inar

ysha

res)

,.Iss

ueru

nder

take

s to

juni

or/p

ari p

assu

secu

ritie

s lim

it). D

efer

red

paym

ents

not

ke

ep a

vaila

ble

auth

oris

ed sh

ares

to

settl

ed a

fter5

year

s will

be

canc

elle

d.en

able

pay

men

t of d

efer

red

inte

rest

via

ACSM

. Def

erre

d pa

ymen

ts n

ot se

ttled

afte

r10

year

s will

cons

titut

e an

eve

nt o

f def

ault.


156

Tab

le 6

.8:

Ital

y te

rmsh

eets

(con

t)

Insu

ranc

e Tie

r1Ba

nkTi

er1

Bank

Tier

1 Co

rpor

ate

Hybr

idGe

nera

li E€

1.25b

n 5.

479%

Un

iCre

dito

Ital

iano

€75

0m 4

.028

%BP

VN €

350m

6.15

6% P

erp

nc10

(iss

ued

Jun-

07)

Lotto

mat

ica

€750

m 8

.250

%

Perp

nc1

0 (is

sued

Jan-

07)

Perp

nc1

0 (is

sued

Oct

-05)

60 n

c10

(issu

ed M

ay-0

6)

Addi

tiona

l Fea

ture

s/n/

an/

aLo

ss a

bsor

ptio

n up

on th

e oc

curr

ence

of a

Cap

ital D

efic

ienc

yFa

st P

ayAC

SMav

oide

d ty

pica

l thi

rd n

otch

Co

mm

ents

Even

t. Re

inst

atem

ent i

f a ca

pita

l def

icie

ncye

vent

is n

o fro

m S

&P.

Man

dato

ryRe

dem

ptio

n Ev

ent -

lo

nger

occu

ring

. Rei

nsta

tem

ent w

ill a

lso

occu

rin

cert

ain

man

dato

ryre

dem

ptio

n at

101

% o

f ci

rcum

stan

ces (

rede

mpt

ion

of th

e N

otes

orl

iqui

datio

n of

the

prin

cipa

l at e

arlie

rof t

erm

inat

ion

of

Issu

er).

Mer

gerA

gree

men

t, an

d O

ctob

er10

th

2006

(if a

cqui

sitio

n no

t com

plet

ed).

Sour

ce: C

ompi

led

byCA

LYO

N fr

om re

spec

tive

offe

ring

s ci

rcul

ars


157

USAIn the early 1990s the US already had a healthy preferred stock market which as mentionedpreviously included variations such as auction rate preferred, fixed rate perpetual preferred,adjustable rate preferred, etc. While these variations of classic preferred stock were not taxdeductible some institutional investors were able to benefit from something called the DividendReceived Deduction (DRD). This improved the tax adjusted return to these investors and couldthereby reduce the issuers cost of preferred capital. The DRD in the US is similar to the UK ACT interms of the end result of improving the issuer’s tax adjusted cost. It is an interesting point to notein the history of preferred securities, since the current tax deductibility of hybrids is threatenedfrom time to time as if it is an inappropriate result of financial engineering. Historically, there isprecedent for preferred debt/equity ‘hybrids’ to have tax benefits that result in lower cost to theissuer. As discussed in great clarity by Tom Humphreys, tax lawyer at MoFo, in the tax article hecontributed to this publication, tax remains the key binding constraint to further equityenhancement of US hybrids (see Appendix).

The early US market activity included preferred stock issuance from many domestic and some in-ternational sectors including banks, utilities, energy companies and other industrials. Europeanissuers tapped the US market with so called ‘Yankee’ issues.

Texaco issued a first ever SPV oriented hybrid security in the US back in 1993. The structure,which resembled some European SPV concepts, kicked off a wave of new corporate hybridissuance that evolved through various types of SPV issuing entity (LLC, LP, Trust) and spreadeventually to bank issuers as a tax-efficient form of capital. These SPV securities provided theequity benefits of preferred shares but were also tax deductible. Many prior issuers of preferredstock started to issue these SPV capital securities instead and some engaged in preferred stocktender and/or exchange programmes to replace outstanding preferred stock with the more costeffective SPV capital securities. US bank issuance exploded into the multi-billions and sparked aninternational drive to develop, promote and evolve variations of the hybrid capital securitytheme. US hybrids have many debt oriented characteristics that comfort investors and secure thetax deductibility. Compared to other jurisdictions there are no perpetual structures that are taxdeductible and the deferral provisions are investor friendly. The US hybrid market has alsoexhibited great diversity in call structures (American, European, nc10, nc30) and leads in thedevelopment of hybrid hedging tools such as Preferred CDS (PCDS). The US retail investor marketremains a unique and very important niche in the global hybrid market. For issuers that can meetthe SEC registration requirements the US retail market offers at times the most attractive marketto issue hybrids both in terms of low cost and flexible structure. Over time the size and diversityof transactions executed in this market has grown dramatically and very large deals (over US$1bn)have been successfully completed. It was noteworthy that this segment continued to functionduring some periods of market turmoil that reduced access to the institutional investor market.RPB markets have developed rapidly in Europe and elsewhere (with no SEC registration hurdles)but still lag behind the development of the US retail market.

The summary examples provide an indication of just some of the varieties in the US market today(some others were also mentioned in the article by Tom Humphreys). The recent drive tomaximise rating agency equity has been a catalyst for new structuring creativity – particularlyregarding maturity extension. For this reason you will see in the summary examples somereferences to a ‘Scheduled Maturity’ at 30 years with a later ‘Final Maturity’ such as 60 years fromissue date. The use of legally binding RCCs has also taken off far faster in the US than elsewhere inthe world as shown in two of the transactions summarised here. The historical use of SPVs is morefrequently complemented by direct issues as also seen in the summary examples.


158

US termsheets

AIG tests market(Published in IFR, 10 March 2007)

American International Group's euro and sterling trades gave slight positive momentum to a market lookingfor direction. The borrower's SEC-registered global junior subordinated issuance programme (Its inauguralsuch deal) was done in three parts, with AIG raising around US$3.75bn-equivalent in total. As well as raising€1bn and £750m through 60-year final maturity/30-year scheduled maturity non-call 10 step-up trades, italso sold US$1bn of paper structured with a 2087 final and a 2037 scheduled maturity (see US Debt andGlobals report for details).

The proceeds will be used to fund the bulk of the borrower's approximately US$5bn stock repurchaseprogramme, with the remainder coming out of its free cashflow. Citigroup, Deutsche Bank and JPMorgan acted asglobal co-ordinators and structuring advisers on the trades, while ABN AMRO and Credit Suisse joined them asbookrunners on the euro deal and Barclays Capital and HSBC were similarly employed on the sterling tranche.

Since US companies issue more dated debt for tax reasons, the final maturity of 60 years was chosen,replicating the structure used by GE Capital when it issued debt last September. The offering has sufficientinvestor-friendly language thrown in. It has a cumulative, compounding structure (unlike many in Europe), aprovision for an alternative payment mechanism (similar to the ACSM), which means that after five years ofdeferral the company has to issue securities of a junior nature in order to pay the coupons.

The Aa3/A+/AA– deal has no mandatory deferral feature (unlike the AXA and Generali transactions of lastyear) and is more similar to earlier offerings from Allianz and Clerical Medical. It qualifies for Basket Dtreatment (75% equity) from Moody's.

In view of the spike in volatility experienced in the last two weeks, the issuer was keen not to have overnightmarket exposure, hence intra-day execution was targeted. The US dollar trade, which performed well in thesecondary market, set the stage for smooth execution for the European offerings and they raked in multi-billion euro order books within two hours of book-building. At the guidance of 73bp–75bp over mid-swaps, theeuro portion was four times covered and at Gilts plus 110bp–112bp, the sterling tranche was five timescovered. Although the issuer lost a number of accounts in the euro transaction at the final pricing of plus73bp, the sterling book had limited price sensitivity at the plus 110bp pricing level, despite the fact that, on aLibor basis, that was 3bp tighter.

Although there are no direct comparables for the trades, compared with the perpetual non-call 2015 UT2issue from HBOS (bid at mid-swaps plus 55bp) and insurance Tier 2 from Allianz (perpetual non-call 2017, bidat 82bp over mid-swaps), AIG conceded only a modest new issue premium.

While the sterling print was unsurprisingly bought mainly by UK asset managers, the euro paper also sawsubstantial take-up from the UK, with Germany, France and the Netherlands also prominent. Again, thoughparticipation from asset managers was strong, pension funds, agencies and banks also claimed their share.While over 200 accounts participated in the euro trade, around 175 investors bought the sterling issue.

The transactions held well in the secondary market, with the sterling deal bid 3bp–4bp tighter and the eurowrapped around its reoffer level of 97.3bp over Bunds, closing on Friday at 97.5bp–96.5bp.

CVS rings up year's largest (Published in IFR, 26 May 2007) While participants recognised last week's US$5.5bn trade for CVS Caremark as the largest investment-gradedeal this year, the M&A-related offering was also notable for the rare combination of a non-finance hybrid andmultiple senior tranches as the company looks to improve its ratings after a string of major acquisitions.

To gain some equity credit and move towards an eventual ratings goal of Single A, which it possessed beforeits acquisition of the Eckerd chain, CVS Caremark issued US$1bn in hybrid securities that carried a 55-yearfinal tenor, 30-year scheduled maturity, a call option in year five, and a 100bp step-up after the call. "We arevery committed to our credit ratings. This combination of debt and equity improves upon our existing capitalstructure and demonstrates our strong desire to maintain and improve upon our investment-grade rating,"said company spokesman Mike McGuire.


159

Although any acquisition totalling US$26.5bn is sure to give potential investors pause for thought, CVSCaremark's substantial free cashflow, as well as a change of control covenant on the senior tranches,mitigated some of the risk for investors.

In terms of the pricing, the company and sole active lead Lehman Brothers found the appropriate level on the10-year senior, and backed into the hybrid level from there. The company has an outstanding 6.125% issue of2016 that does not have change of control language and was trading in the low 100bp area as the credit re-entered the market. Five-year protection on CVS Caremark was quoted at a Treasuries equivalent of about65.75bp, while 10-year protection was quoted with an equivalent bid of 97bp.

Thoughts were that a new five-year senior issue without a change of control would price in the range of80bp–85bp, and a senior-to-hybrid premium for an industrial credit was estimated to be in the 75bp area. Thatplaced the US$1bn hybrid offering, which receives 50% equity credit from Moody's, at 155bp over Treasuries.

Although it seems that investor requests for change of control covenants on hybrid deals are set to increase,CVS Caremark said from the outset that the language would not be included on the hybrid portion .Considering the 6.125% issue is in the low 100bp area, a new 10-year without a put option was estimated at115bp over. The US$1.75bn 10-year senior with the change of control then priced at 107bp, for a slightnegative basis to CDS of about 10bp. Although some accounts were said to have employed a negative basis trade, the amount was not said to be meaningful amid a total order book of more than US$12bn and anallocation to 220 accounts.

Banks and money market funds were prevalent in the US$1.75bn three-year non-call 18-month floater, whichwas priced at three-month Libor plus 30bp and was said to draw multiple orders for US$100m or more. Avariety of investors received allocations in the 10-year issue, while insurance accounts and pension funds hada strong presence in the US$1bn 20-year issue that was priced at plus 135bp.

The hybrid received interest from insurance accounts, hedge funds and dedicated preferred funds. There wassaid to be a decent number of investors that received both senior and hybrid allocations, and some accountsthat were in every tranche offered.


160

Table 6.9: US termsheets

Insurance Hybrid BankTier 1 Corporate HybridAIG €1bn 4.875% 60 nc 10 Citigroup £500M 6.829% CVSCaremarkUS$1bn 6.302% 55 nc5 (issued Mar-07) 60 nc 10 (issued Jun-07) (issued May-07)

Issuer American International Group, Inc. Citigroup Capital XVIII CVSCaremarkCorporationIssuerType Direct SPV DirectSecurityType Series A-3 JuniorSubordinated Fixed Rate/Floating Rate Enhanced Enhanced Capital Advantaged

Debentures Trust Preferred Securities Preferred SecuritiesStatus / The JuniorSubordinated The Issuers obligations are subordinated The Issuers payment obligation underSubordination Debentures will be unsecured and and junior to all senior indebtedness of the ECAPSwill be unsecured and

will rank junior in payment to all Citigroup. Senior indebtedness will not subordinated and will rank junior to allexisting and future seniordebt, include any indebtedness that is senior indebtedness and will rankpari passu with the US$ and GBP subordinated to or ranks equallywith equallywith anypari passu securities.Debentures, and will be effectively the junior subordinated debt securities.subordinated to all subsidiarylevel liabilities.

Maturity 15-Mar-2067 28-Jun-2067 1-Jun-2062(scheduled 15-Mar-2037) (scheduled 28-Jun-2037) (scheduled 1-Jun-2037)

First call date 15-Mar-17 28-Jun-17 1-Jun-12Step-Up at first 100bps (March-2017) 100bps (June-2037) 100bps (June-2012)call dateEarlyRedemption Yes (TaxEvent/Rating Agency Yes (TaxEvent/Investment Company Yes (TaxEvent/Rating AgencyEvent).

Event/Additional Amounts Event). Event/Rating AgencyEvent/Regulatory ECAPSredeemed at the higherof Debentures redeemed at the CapitalEvent/Additional Amounts Event). principal orT+50 (within 90 days afterahigherof principal orBunds+50 Securities redeemed at principal amount TaxEvent/Rating AgencyEvent), orat(TaxEvent/Rating AgencyEvent), (Investment CompanyEvent/Regulatory the higherof principal orT+25 (notorat theirprincipal amount Capital Event/Additional Amounts Event), within 90 days aftera TaxEvent/Rating(Additional Amounts Event). orat the higherof principal orG+50 (Tax AgencyEvent).Issueroption to redeem securities Event/Rating AgencyEvent). Issuerat any time, at the higherof option to redeem securities at any time, principal orBunds+25. at the higherof principal orG+20.

Redemption subject to prior consent of the Federal Reserve.

Replacement Replacement Capital Covenant - Replacement Capital Covenant - Replacement Capital Covenant - Clause replacement with common stock, replacement with common stock, replacement with common stock, rights

rights to acquire common stock, debt exchangable for common stock, to acquire common stock, mandatorilymandatorily convertible preferred rights to acquire common stock, and/ convertible preferred stock, debtstock, debt exchangeable for ormandatorily convertible preferred exchangeable forequityand certainequity, or certain qualifying stockbefore June-2047. qualifying capital securities beforecapital securities before June-2047.March-2047.

Dividend Pusher/ Dividend Stopper Dividend Stopper Dividend StopperStopperRegulatoryEvent n/a SupervisoryEvent. Payment/APM may n/a

be restricted by the Fed.Optional Deferral Interest payments optionally Interest payments optionallydeferrable. Interest payments optionally

deferrable. Maximum 10-year Maximum 10-yeardeferral period. deferrable. Maximum 10-yeardeferraldeferral period. Deferred Deferred payments to be settled via period (cumulative). Deferredpayments to be settled via cash cash/ACSM (first 5-years) orACSM payments to be settled via cash. (first 5-years) orACSM (next 5 years). Deferred payments not settled after10(next 5 years). years will constitute an event of default.

Rating agency n/a n/a n/amandatorydeferralDeferred payments Cumulative - first 5 years/ Non-Cash Cumulative Cash Cumulative

Non-Cash Cumulative -next 5 years.

ACSM Settlement of deferred interest Settlement of deferred interest payments n/apayments via APM - common via APM - common stock (180m share stock (100m initial limit), limit)orqualified warrants. Issuer shall qualifying warrents (100m initial use commercially reasonable efforts to limit) and qualifying non- settle deferred payments. Deferred cumulativepreferred stock (25% payments not settled after10 years will limit). Issuer shall use constitute an event of default. Issuercommercially reasonable efforts option to utilise APMin first 5 years via


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to settle deferred payments. issaunce of common stock.Deferred payments not settled after10 years will constitute an event of default. Issuer subject to APMin first 5 years if current interest paid (2% limit on issuance of common stock/qualifying warrents).

Additional Bankruptcy/insolvencyclaim forfeatures/ deferred/unpaid interest comments payments limited.

Source: Compiled by CALYON from the respective offering circulars

07CHAPTER

Introduction Looking at the past as precedent one can only realistically expect continued evolution –‘perpetual change’ – for the hybrid market. There will be even more widespread applicationsamong issuers and new developing investor markets.

From the early niche applications for a variety of preferred stock securities to the highly specifictax-efficient hybrid capital security structures of today, the asset class has morphed and evolved tomeet the needs of an ever wider universe of issuers and investors alike.

Market conditions, global economics and the business credit cycle will play a role in the demandfor hybrid capital securities. As has been discussed, new issue volumes surged when equityfeatures became cheap for issuers in a low rate, tight credit spread environment. These conditionsalso facilitate M&A activity which has been a catalyst for hybrid issuance as an equity-richenhancement to the consolidating companies’ capital structures post-merger.

For the same reasons investors were driven in their quest for yield to buy ‘riskier’ structures –initially only from strong rated, regulated entities and later stretching to lower rated, unrated,and unregulated issuers.

However, the product development road map is not a smooth linear progression and rather tendsto proceed in a ‘stair step’ fashion with bursts of innovation followed by an integration periodwhen innovation becomes more marginally incremental and hybrid products begin tocommoditise.

Growing the investor baseFor investors this commoditisation can be an advantage, as less energy is required to track andevaluate product structural nuances within the hybrid security asset class and investors’ focus canbe concentrated on the investor’s core competence of credit analysis.

Another benefit of more standardised structures is the ability to develop hedging products such as PCDS. The ability to hedge the risks in a hybrid portfolio on an efficient basis is vital to theexpansion of the institutional market. PCDS is still new in the US where it originated and has apromising future globally. Ideally, investors in the future would be able to buy/sell payment risk,extension risk, and subordination individually or in a bundle to fine-tune their risks.

Because the US has a comparatively large and homogenous pool of hybrid securities, innovationssuch as the hybrid CDO have flourished first in the US before export to global markets wherelocal jurisdictional differences defy standardisation. Through these structures a pool of smallerhybrid issues (i.e. US$10–50m each) are aggregated into a pool with critical mass to provide a sizeattractive to institutional investors (US$300–500m or more). These smaller issues might not beable to generate investor demand at reasonable issuer pricing on their own but can be placed inthe CDO on an attractive basis.

A further benefit of the hybrid CDO is that the pooled cash flows can be structured to providetranches of securities with a range of ratings from triple A senior (higher than the individualsecurities input) down to the CDO ‘equity’ tranche – thereby creating more investor choice. This technology has spread and can be expected to continue to provide benefits to issuers andinvestors alike, but it works best when the securities input to the CDO have enough structuralsimilarity in features so that the CDO cash flow modelling can be reasonably completed toestimate the expected risk of the tranches in accordance with rating agency guidelines for CDO structuring.

So commoditisation can actually help the product proliferate and become more liquid and readilytradable in the major global markets.

Additionally, however, there can be unique local markets that provide extremely attractivecapital raising opportunities for well known issuers in their home national markets. It can beexpected that these choices will increase as global markets develop.

THE FUTURE OF THE HYBRID MARKET

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For many years the US retail investor market has provided attractive funding to issuers that canmeet the SEC registration disclosure requirements. In the past several years the Asian andEuropean RPB markets have developed in a similar fashion and at times provide extremelyattractive opportunities. In all these markets strong name recognition is key, therefore localplayers tend to get the best execution. As the capital markets of Asia, Eastern Europe and theMiddle East continue their rapid development, the wealthier investors will look to hybrids for aportion of their investment portfolios.

The institutional market generally provides larger size and at times more sure execution but theRPB markets are continuing to expand and should always be considered as an alternative.Occasionally the turmoil suffered in the institutional markets is not spilled over into the RPBmarket and it can provide the only alternative for funding, as was seen during the market turmoilin August 2007 when the only hybrid deals being completed were in the US retail market.

New and emerging investor jurisdictions around the world look set to continue to deepen andsupport new hybrid supply. This will be particularly relevant going forward for domestic issuancein those jurisdictions where smaller issuers will be able to benefit from local name recognition(jurisdictions such as the Middle East have already provided for a significant amount of subordi-nated private domestic issuance). The expansion of investor jurisdictions will also allow for newcross-border transactions, providing for some issuers attractive diversification away from themore traditional US and European markets (the Canadian and Australian markets have recentlyopened for this reason).

Expansion of the issuer pool Issuers across the world will increasingly take advantage of new structural innovations, with newtechniques continuing to develop and providing issuers with more reasons to issue. This willenable issuers from more sectors to better optimise their balance sheets and gain maximumbenefits from the rating agencies, investors, regulators or other key constituents.

Issuers particularly focused on liability management are also likely to increase interest in theproduct, with the flexible and innovative nature of hybrid securities ideally suited to the process.It looks certain, therefore, that hybrids will increasingly become a standard product in themarket, both for corporates and for regulated banks and insurers.

More frequent cross-border issuance has been seen by issuers of hybrids, as they seek to diversifytheir international investor bases and create new pools of demand that can be tapped at will or asopportunities present themselves, thereby minimising reliance on any one market. Ability toissue in a variety of currencies also allows for funding global expansion on a currency-hedgedbasis – including hybrids.

There has been a marked increase in lower rated and unrated issuers as the market expands toseek new issuer names for investor portfolio diversification. This trend will continue and moreissuers from more sectors and more geographies will enter the international markets and seek todevelop local markets in their home jurisdictions. As shown in Table 7.1, there are an increasingnumber of jurisdictions that are tapping the hybrid market more frequently.

Tax, accounting, rating agency and regulatory The stair steps of progress can of course go up or down. Continued developments at the ratingagencies and regulators will also drive structuring innovation forward, even if a less accommodat-ing stance from any of these constituents were to develop. Any change from one of the currentlysupportive constituents (tax, accounting. rating agencies, regulators, others) could reduceissuance even while structural modifications flourish to patch up the holes.

The deductibility of US Trust Preferred Securities was questioned by the last Clinton administra-tion – hopefully for the last time. However, the ability to work around the very restrictive US taxrules on maximum debt maturity was a key factor in the development of recent high equitycontent hybrids in the US. Any future attack on hybrids could limit the availability of thesestructures and set off a new wave of hybrid structuring. In the past the hybrid market has beenable to adapt to overcome these threats.

Issuers and investors alike were stunned when the NAIC unpredictably turned negative on theperceived investor risk of some hybrid structures that had been in the market for years. Theseshocks have a major impact on the hybrid market but still it moves forward.


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The implementation of IFRS accounting rules caused a series of structural revisions in hybridissuance and the impact of hedge accounting required new thinking about the implications ofswapping hybrid proceeds at issue. Again the hybrid market was resilient and moved ahead.

While rating agencies have been one of the most significant drivers of recent growth in issuanceand structural refinements they have also created some shocks by changing or ‘considering’changes to their still young hybrid methodologies.

Some potential corporate issuers are hesitant to pursue hybrid issuance for fear the currentlytouted benefits could be easily eliminated if the rating agencies were to make a policy ormethodology change for the worse over the next 10 years (before the typical first scheduled calldate of a hybrid). This concern is reflected in the documents of recently completed hybrid transac-tions which provide for optional early redemption if issuer benefits are lost due to tax,accounting, regulatory and rating agency rules. The current batch of next generation corporatehybrids rely on the guidelines of today – what about the next generation of rating agencyexecutives? It can be hoped they will recognise the need for affirming the longevity of theirmethodologies, but it is likely that issuers will continue to seek flexibility by including earlyredemption options in their hybrids.

The development of Basel ll and Solvency ll should be positive for regulated financial institutionswho will potentially benefit from lower capital requirements (as diversified asset risk is betterunderstood) and the global regulators try once again to level the playing-field regarding availablecapital instruments.

ConclusionIn conclusion, the rate of change may vary for structural innovation and the new issue volumeswill wax and wane over time but the continued use of hybrid capital securities in the capitalstructures of sophisticated issuers seems assured for the foreseeable future.


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Table 7.1: Select new entrants to the hybrid capital market

Nationality of risk Issuer Issue date (yr) Currency Tranche value CouponBrazil BANESPA 2005 US$ 500 8.7000Hong Kong Swire PacificCapital Ltd 1997 USD 300 8.8400India State Bankof India 2007 US$ 400 6.4390India ICICI BankLtd 2006 US$ 340 7.2500India State Bankof India (Nassau) 2007 US$ 225 7.1400India State Bankof India 2007 US$ 225 7.1400India UCO BankLtd 2006 RUP 2,300 9.3500Kazakhstan BTA Finance Luxembourg SA 2006 US$ 400 8.2500Kazakhstan ALB Finance BV 2006 US$ 150 9.3750Kazakhstan KazkommertsbankOAO 2005 US$ 100 9.2000Malaysia Syarikat Prasarana Negara Bhd 2002 M$ 1,000 3.7000Malaysia PublicBankBhd 2006 M$ 1,200 5.1000Malaysia SBB Capital Corp (Labuan) 2005 US$ 200 6.6200Malaysia AMBB Capital (L) Ltd 2006 US$ 200 6.7700Malaysia PublicBankBhd 2006 US$ 200 6.8400Mexico C10-EUR Capital Ltd 2007 EUR 730 6.2770Mexico C10 Capital Ltd 2006 US$ 900 6.7220Mexico C8 Capital Ltd 2007 US$ 750 6.6400Mexico BBVA BancomerSA (Grand Cayman) 2007 US$ 500 6.0080Mexico C5 Capital Ltd 2006 US$ 350 6.1960Mexico Cemex International Capital LLC 1998 US$ 250 9.6600Mexico Banorte (Cayman Islands) - Banco Mercantil 2006 US$ 200 6.8620Mexico Banco Macro SA 2006 US$ 150 9.7500Mexico Metrofinanciera SA de CV 2006 US$ 75 11.2500Mexico Metrofinanciera SA de CV 2006 US$ 25 11.2500Philippines Metropolitan Bank& Trust Co - Metrobank 2006 US$ 125 9.0000Philippines Development Bankof the Philippines 2006 US$ 130 8.3750Philippines Rizal Commercial Banking Corp - RCBC 2006 US$ 100 9.8750Singapore DBSCapital Funding Corp 2001 US$ 725 7.6570Singapore Development Bankof Singapore Ltd 2001 S$ 1,100 6.0000Singapore UOB Cayman I Ltd 2005 US$ 500 5.7960Singapore Oversea-Chinese Banking Corp Ltd 2003 S$ 500 4.5000Singapore OCBCCapital Corp 2005 S$ 400 3.9300Singapore OCBCBank (Malaysia) Bhd 2005 M$ 400 6.2700Singapore DBSCapital Funding Corp 2001 S$ 100 5.3500South Africa Investecplc 2005 EUR 150 7.0750South Korea Woori Bank 2007 US$ 6.2080South Korea Shinhan Bank 2006 US$ 350 6.8190South Korea Korea First Bank 2004 US$ 300 7.2670South Korea Shinhan Bank 2005 US$ 300 5.6630South Korea Hana BankFunding Ltd 2002 US$ 200 8.7480Taiwan Chinatrust Commercial BankLtd 2005 NTD 9,000 3.3500Taiwan Chinatrust Commercial BankLtd 2005 NTD 3,000 3.3500Thailand Krung Thai BankLtd (Singapore) 2006 US$ 220 7.7380Thailand TMB Bankpcl 2006 US$ 200 7.7500


APPENDIX

01Anyone looking at the tax treatment of US hybrid securities transactions for the first time wouldbe understandably confused. There is no one simple, completely reliable way to create a taxdeductible US hybrid. Instead, US issuers are installing billions of dollars of hybrids in their capitalstructures that are diverse, complicated and in a few cases, tax risky. No one structure isuniversally accepted. Each structure has a full menu of tax issues.

To understand why the US hybrid market operates this way the reader must understand the briefhistory of US hybrid transactions – the first part of this article. Only then will the US system, in allits grand complexity, begin to make sense. The second part of this article then explores currentdevelopments in the US hybrid market from a US tax perspective.

Early attempts to create deductible equityUS taxpayers have for many years tried to create tax deductible equity. The most relevant history,however, begins in the 1980s, a time of great turmoil for US financial institutions. The storybegins with a published Internal Revenue Service (IRS) ruling sought by desperate bankers to helpshore up US bank capital during these turbulent times.

Revenue Ruling 85-119In the early 1980s US banking regulators adopted their first capital requirements for banks andbank holding companies. Among the instruments that qualified for primary capital treatmentwere ‘mandatory exchangeable securities’. Revenue Ruling 85-119 dealt with one such securityissued by a bank holding company (BHC). The instrument was denominated as debt. It had a 10-year term. If interest was not paid, the debt was not accelerated, the holder could only sue for thedefaulted interest. At maturity, the issuer paid the holder with primary capital securities(common or preferred stock) with a value equal to the debt instrument’s face amount. The holdercould either take the stock or have the issuer sell it on the holder’s behalf. In the latter case, thesales proceeds would be paid to the holder. A shortfall gave the holder a right to sue for thedifference.

The IRS held that the instrument was debt for federal income tax purposes. The holder’s weakremedies did not pose much of an issue according to the ruling. While the ‘payable in equity’feature gave the government more pause, the ruling reasons that the holder always had anultimate debt claim and therefore was entitled to principal payment in all events.

The mid-1980s were as bad for the banking business as the late sixties and early seventies werefor the securities business. Penn Square Bank went bankrupt in 1982 and, soon after rumours ofits impending bankruptcy, Continental Illinois was bailed out by federal regulators in 1984. Onesuspects it is not a coincidence that the government decided that lowering the cost of capital bygranting a tax deduction is a cheap price to pay for shoring up the nation’s bank holdingcompanies2. Unfortunately, the markets did not accept mandatorily convertible securities andonly a handful of transactions were actually done. Nevertheless, it is apparent today that the debt-equity line moves farther towards debt when a regulated industry is in financial distress.

1 © 2007, Thomas A. Humphreys2 Rev. Rul. 83-98, 1983-2 C.B. 40, involving adjustable rate convertible notes (ARCNs), shows the IRS’s relatively lessfavourable treatment of non-regulated taxpayers in the same time frame as Revenue Ruling 85 119, 1985-2 C.B. 60. AnARCN was a 20-year debt issued by a corporation. The debt was subordinated to general creditors. It was issued forUS$1,000 or 50 shares of issuer’s publicly traded common stock (which had a US$20 per share price). At maturity, theholder could elect to receive US$600 or 50 shares of stock. It paid interest equal to dividends on the underlying common;the issuer’s comparable yield for non-convertible, non-contingent debt was 12%. Revenue Ruling 83-98 holds that theARCNs are equity for federal income tax purposes. The ruling is based on the notion that there was no sum certain payablebecause of the “very high probability” that the ARCN would be converted into stock. This, in turn, was based on the deep-in-the money nature of the conversion feature. The IRS discounted the fixed principal and fixed interest on the ARCNs onthe basis that buyers did not given them any value – the ARCNs were sold for a price equal to that of the underlyingcommon stock. According to the IRS, Revenue Ruling 68-54, 1968-1 C.B. 69 was “fundamentally different” because therewas an obligation to pay a sum certain on a given date and although interest was dependent to some degree on the issuer’searnings, it was not tied to dividends and the notes were not convertible.

TAX DEDUCTIBLE EQUITY AND OTHERHYBRIDS IN THE US – A BRIEF HISTORYAND CURRENT DEVELOPMENTSBy Thomas A. Humphreys1, Morrison & Foerster LLP

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MIPS, etc.The first MIPS transaction was done by Texaco Corporation in 1993. Texaco had gone bankrupt in1987. In the MIPS transaction Texaco set up Texaco Capital LLC, a Turks and Caicos limited lifecompany (The Company). The Company issued US$25 par value ‘Cumulative Adjustable RateMonthly Income Preferred Shares, Series A’ to investors. It issued common securities to Texaco.The Company then made a 50 year subordinated loan to Texaco. In a new feature, not previouslyseen in the debt markets, Texaco had the right to defer interest payments on the subordinatedloan for 18 months without a default occurring. If Texaco deferred interest for more than 18months then a default was declared and the subordinated loan was accelerated. The subordinatedloan was extendable by Texaco for another 50 years but only if certain conditions were met. Thesefinancial conditions, while objective, were not very stringent.

The net effect of the transaction was that Texaco was able to deduct interest on the subordinatedloan. The Company was treated as a partnership for federal income tax purposes. Accordingly, thepartnership itself did not pay tax. Instead its income was allocable to the preferred securityholders and to Texaco. For GAAP accounting purposes, Texaco consolidated the results of theCompany with its own because it controlled the Company through its common securities. Theaccountants treated the preferred securities as a ‘minority interest’ on Texaco’s balance sheet.Accordingly, they were not shown as debt. The rating agencies apparently gave the MIPSsubstantial equity credit.

The Texaco transaction was followed in short order by a transaction by Enron Corporation, then anewly emerging oil and gas powerhouse.3 By the spring of 1994, the MIPS security was gainingacceptance in the market place. It is not coincidental that at this point the IRS issued Notice 94-47.4 This Notice discusses various debt equity factors and then sets out some markers fortaxpayers. It remains the most recent published guidance by the IRS on the factors used to weighdebt versus equity. It has been cited by the courts, although not frequently.5

The next development was the issuance of preferred securities by a grantor trust. This solvedwhat had been a nagging problem – the fact that a MIPS-type partnership was required to giveinvestors Schedule K-1s. Investors in the preferred securities associated K-1s with partnership taxshelter investments. In addition the K-1 rules require reporting to the ultimate beneficial ownerin a manner that can be quite expensive.6

In the prototypical ‘trust preferred’ transaction, the end-user creates a Delaware statutory trust.The trust issues two classes of beneficial ownership: preferred securities and common securities.The preferred securities are perpetual on their face; however, they must be retired if theunderlying subordinated loan is retired. The preferred securities are senior to the common uponthe trust’s liquidation. The trust invests the proceeds of the trust preferred offering in a subordi-nated, long-dated (e.g. 49 year) debt issued by the end-user. Interest on the debt instrument can bedeferred, usually for up to five years, without default. As in a MIPS, from a federal income taxstandpoint, interest on the subordinated loan is deductible. The trust is a grantor trust for federalincome tax purposes and its income does not attract a separate tax.7

The next milestone in the development of deductible equity was a Federal Reserve Board an-nouncement in October 1996.8 The Federal Reserve Board held that trust preferred securitiescould be counted as Tier 1 capital9 for a BHC so long as certain requirements were met.10 Since1996 the BHC market has seen billions of trust preferred issuances. One of the more recentinnovations is to pool trust preferreds issued by smaller banks or bank holding companies. Thesetransactions, which are arranged by investment banks, allow smaller issuers to obtain the samebenefits of trust preferreds as larger issuers. Importantly, none of the other US bank regulatorshave been comfortable that trust preferreds should be counted as Tier 1 capital. For example, theOffice of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC)and Office of Thrift Supervision (OTC) all treat trust preferreds as Tier 2 capital. Therefore, at thebank level, as opposed to the BHC level, trust preferreds have been of little use.

3 LEE A. SHEPPARD, IRS ATTACKS ENRON MIPS, TAX NOTES TODAY, 98 T.N.T. 104-4 (June 1, 1998).4 I.R.S. Notice 94-47, 1994-1 C.B. 357.5 The most recent citation was in Castle Harbour, TIFD III-E Inc. v. United States, 342 F. Supp. 2d. 94 (2004), where the courtused the factors in Notice 94–47 to conclude that an interest held by Dutch banks was in reality equity, rather than debt, ataxpayer-friendly finding on the facts of the case.6 See I.R.C. § 6031; see also DEPARTMENT OF THE TREASURY AND INTERNAL REVENUE SERVICE, INSTRUCTIONS FORFORM 1065 available at http://www.irs.gov/pub/irs-pdf/i1065.pdf.7 Treas. Reg. § 301.7701-4(c), Example 2. 8 Press Release, Federal Reserve Board, Use of Cumulative Preferred Stock in Tier 1 Capital of Bank Holding Companies(October 21, 1996) [hereinafter FRB 1996 Press Release] available athttp://www.federalreserve.gov/boarddocs/press/bcreg/1996/19961021/default.htm.9 See the discussion at III. C.10 FRB 1996 Press Release

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Prior to the Federal Reserve Board’s press release at least one other approach was taken to developdeductible equity. In the best known transaction, Chase Manhattan Bank formed Chase PreferredCapital Corporation (CPCC) as a subsidiary. CPCC qualified as a real estate investment trust (REIT)for federal income tax purposes. CPCC sold US$550m of preferred stock to the public. It used theproceeds to buy real estate mortgages from Chase. The preferred stock was perpetual andcumulative. This structure achieved the same results as deductible equity because the incomestream on the mortgages was paid out by the REIT without a corporate level tax. Chase treated theCPCC preferred stock as a minority interest and as Tier 1 capital of the bank. A handful of similartransactions have been done since the Chase transaction.

Treasury department and legislative responsesThe Treasury Department’s administrative response to the proliferation of deductible equity hasbeen a measured one.11 In Notice 94-4712 the IRS set out familiar factors to distinguish debt fromequity and added a few new ones to the mix including treatment by rating agencies andtreatment for accounting purposes.13 It posted an ‘off-limits’ sign around certain transactions andwarned that taxpayer attempts to expand Revenue Ruling 85-119 beyond its current scope wasnot advisable.

On the legislative front, while there has been plenty of talk about curbing deductible equity,relatively little legislation has actually been enacted. In 1992, Congress did add a consistency rulein subsection 385(c) of the Internal Revenue Code of 1986, as amended (‘the Code’).14 This boundthe issuer and holders (but not the IRS) to an issuer’s characterization of a corporate interest asstock or debt. Holders may take an inconsistent position so long as the inconsistency is disclosedon their tax returns. Congress recognised that there was (and is) no definition in the Code that canbe used to determine whether an interest in a corporation is debt or equity for federal taxpurposes.15 However, instead of taking the opportunity to create one, Congress instead opted forthis administrative rule.

Next, several Clinton Administration budget proposals included proposed changes that wouldhave limited the tax benefit of hybrid securities. The first budget proposal was the ClintonAdministration’s proposed plan for a balanced budget which was initially released on 7 December1995. All of the tax proposals in this budget proposal were reintroduced later in January 1996,March 1996, and February 1997.16 Since 1997, the Treasury has also re-proposed deferringinterest deductions for ‘original issue discount’ on certain convertible debt instruments.17

11 This may reflect the government’s wariness over divining debt-equity questions since withdrawal of the I.R.C. § 385 regulations.

12 I.R.S. Notice 94-47, 1994-1 C.B. 357.13 The Notice 94-47 factors are:

(i) Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future(ii) Whether holders of the instruments possess the right to enforce the payment of principal and interest;(iii) Whether the rights of the holders of the instruments are subordinate to the rights of general creditors;(iv) Whether the instruments give the holders the right to participate in the management of the issuer;(v) Whether the issuer is thinly capitalised;(vi) Whether there is identity between the holders of the instruments and stockholders of the issuer;(vii) The label placed on the instruments by the parties; (viii) Whether the instruments are intended to be treated as debt or equity for non-tax purposes.

14 Energy Policy Act of 1992, Pub. L. No. 102-486, § 1936, 106 Stat. 2776 (1992).15 H.R. REP. NO. 102-1018 (1992).16 See, e.g., STAFF OF THE JOINT COMMITTEE ON TAXATION, 104th CONG., DESCRIPTION OF THE TAX AND HEALTHINSURANCE REFORM PROVISIONS IN THE PRESIDENT’S SEVEN-YEAR BALANCED BUDGET PROPOSAL RELEASED ONDECEMBER 7, 1995 (JCX-58-95) at 64-65 (1995); H.R. 2903, 104th Cong. (1996); STAFF OF THE JOINT COMMITTEE ONTAXATION, 104th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1997BUDGET PROPOSAL (RELEASED ON MARCH 19, 1996) (JCS-2-96) at 64-65 (1996); STAFF OF THE JOINT COMMITTEE ONTAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1998BUDGET PROPOSAL (JCX-6-97R) at 53-54 (1997).17 See, e.g., Office of Management and Budget, Analytical Perspectives, Budget of the United States Government, FiscalYear 1999, at 69, available at http://www.gpoaccess.gov/usbudget/fy99/pdf/spec.pdf; see also, STAFF OF THE JOINTCOMMITTEE ON TAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’SFISCAL YEAR 1999 BUDGET PROPOSAL (JCS-4-98) at 143-144 (1998).


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The first of these proposed tax changes would have disallowed interest and original issue discountdeductions for issuers of a debt instrument (i) with a weighted average maturity of more than 40years, or (ii) which is payable in the stock of an issuer or a related party (within the meaning ofsections 267(b) and 707(b) of the Code).18 A debt instrument that is payable in equity of the issueror a related party included an instrument that would be (a) mandatorily convertible, (b)convertible at the issuer’s option, or (c) convertible at the holder’s option if there was asubstantial certainty that it would be converted into the issuer’s (or a related party’s) equity.19

While this proposal originally only excluded demand loans, the 1997 version of this proposal alsoexcluded redeemable ground rents and certain other specified debt instruments.20

The second proposed change would have deferred interest deductions in the case of certainconvertible debt instruments until the interest was actually paid.21 This, in essence, would havebeen an expansion of the ‘applicable high yield discount obligation’ limitations of Code sections163(e)(5) and 163(i).

Third, for purposes of section 385 of the Code, equity treatment would have been given tocorporate interests that (i) had a term of more than 20 years and (ii) were not shown as debt onthe issuer’s balance sheet.22 This proposal was reintroduced several times and the term waslowered from 20 to 15 years in the Clinton Administration’s budget proposal for fiscal year1998.23

Of these legislative tax proposals, only one, the non-deductibility of interest on debt payable instock, was adopted by the Taxpayer Relief Act of 1997 and became effective as Code section 163(l)on 9 June 1997.24 That section provides that interest on debt payable in equity is not deductiblefor federal income tax purposes. The section is so broad that it arguably encompasses the factpattern in Revenue Ruling 85-119 where, although the debt was payable in the issuer’s equity, theholder had a claim if the amount of issuer’s stock was insufficient to repay the debt instrument.

The IRS also weighed in on MIPS during an audit of a taxpayer (apparently Enron) in 1998. Thisresulted in the issuance of Technical Advice Memorandum 199910046 (15 March 1999). The TAMheld that the issuer can deduct interest on a MIPS-like security. This TAM joins the ranks of otherheavily negotiated technical advice memoranda and bears the earmarks of a TAM wheresubstantial advice was solicited from or provided by market participants.

Congress briefly reawoke after the Enron scandal and again began looking at deductible equitysimply because Enron had been one of the early MIPS issuers.25 However, this effort wentnowhere. The only tax remnant of the anti-Enron sentiment were amendments to Section 163(l)to expand its scope to debt payable in stock of unaffiliated parties held by the issuer or a relatedparty.26

18 See STAFF OF THE JOINT COMMITTEE ON TAXATION, 104th CONG., DESCRIPTION OF THE TAX AND HEALTHINSURANCE REFORM PROVISIONS IN THE PRESIDENT’S SEVEN-YEAR BALANCED BUDGET PROPOSAL RELEASED ONDECEMBER 7, 1995 (JCX-58-95) at 64 (1995).19 Ibid. at 64.20 STAFF OF THE JOINT COMMITTEE ON TAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINEDIN THE PRESIDENT’S FISCAL YEAR 1998 BUDGET PROPOSAL (JCX-6-97R) at 54 (1997).21 See Staff of the Joint Committee on Taxation, 104th Cong., supra note 18 at 65.22 Ibid. at 64.23 See, e.g., STAFF OF THE JOINT COMMITTEE ON TAXATION, 105th CONG., DESCRIPTION AND ANALYSIS OF CERTAINREVENUE-RAISING PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1998 BUDGET PROPOSAL (JCS-10-97) at54 (1997). In addition, the Taxpayer Relief Act of 1997 added a rule that certain ‘debt-like’ preferred stock would be treatedas ‘boot’ for purposes of sections 351 and 356 of the Code, which would result in taxable gain but no loss to the recipientof such stock in transfers to controlled corporations and tax-free reorganisations. This rule applies if (a) the holder of suchstock has the right to put the stock to the issuer or a related party, (b) such stock is mandatorily redeemable by the issueror a related party, (c) the issuer or a related party has the right to call the stock and such right is more likely than not to beexercised, or (d) such stock has a floating dividend rate. 24 Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1005, 111 Stat. 788 (1997).25 John D. McKinnon and Greg Hitt, How Treasury Lost In Battle to Quash A Dubious Security --- Instrument Issued byEnron and Others Can be Used as Both Debt and Equity --- Win for Flotilla of Lobbyists, WALL STREET JOURNAL, February4, 2002, at A1.26 Taxpayer Relief Act of 1997, supra note 24.


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Regulatory developments As noted previously, the FRB decided in 1996 to treat ‘trust preferred’ securities as Tier 1 capital,subject to a limit equal to 25% of a BHC’s Tier 1 capital.27 The FRB guidance treated suchinstruments as Tier 1 capital so long as they (i) were subordinated to all subordinated debt, (ii) hadthe longest feasible maturity, and (iii) provided for a minimum five year deferral period. As “withother preferred stock includable in capital” according to the FRB, FRB approval was requiredbefore the instrument could be redeemed. It appears that the most important feature to the FRBwas the five year interest deferral, the thought being that a financial institution would either bebankrupt or recovered in five years.

In 1998, the Basel Committee issued its own press release dealing with ‘innovative capitalinstruments’. The press release was apparently a response to developments in the market forbank capital both in the US (such as trust preferreds) and outside the US28 For example, variousEuropean issuers had issued preferred stock out of tax haven subsidiaries in order to avoidwithholding taxes in their home country.29 Apparently concerned that a bank would convert asubstantial amount of its capital structure into these ‘efficient’ instruments, the press releasestated that common stock and disclosed reserves or retained earnings should be the predominantform of Tier 1 capital.30 The press release also reminded banks that transparency in terms of thecomponents of Tier 1 capital was required. Most importantly, the press release focused oninstruments such as trust preferreds and stated that such instruments should be included in Tier1 capital only to the extent they met certain criteria including permanence, deferability of distri-butions on a non-cumulative basis and ability to absorb losses within the bank on a going concernbasis. The press release also dealt with one other feature: rate step-ups. It stated that a Tier 1instrument could include a rate step-up after 10 years but that instruments with such a feature (orany other that might lead to early call) would be limited to 15% of Tier 1 capital. Outstandinginstruments that violated the tenants of the press release were grandfathered.31

The Federal Reserve Board then responded the same day by issuing its own press release thataffirmed its treatment of trust preferred in light of the Basel Committee’s press release.32

In 1998, the Basel Committee adopted amendments to Basel I in the so-called SidneyAgreement.33 The Sydney Agreement stated that internationally active bank holding companiesgenerally would be expected to limit restricted core capital elements to 15% of the sum of corecapital elements, net of goodwill. Prior to the Sydney Agreement, the FRB was informallyencouraged bank holding companies to comply with this standard even though no formal rulewas in place.34

In March, 2005 the Federal Reserve Board amended its risk-based capital requirements to reflectthe Sidney Agreement. At that time, the FRB explained its approach to tax-deductible Tier 1instruments. It commented that the original 1996 decision on trust preferred had been based ontwo key factors: the long life of the underlying debt instrument ‘approaching perpetuity’ and the‘dividend’ deferral rights (allowing deferral for 20 consecutive quarters) approaching economical-ly indefinite deferral.35 It noted that those features provide substantial capital support. The FRBalso noted the change in GAAP accounting treatment for trust preferreds,36 but said that “Achange in the GAAP accounting for a capital instrument does not necessarily change theregulatory capital treatment of that instrument.”37 It went on to state: “Regulatory capital re-quirements are regulatory constructs designed to ensure the safety and soundness of banking or-ganisations, not accounting designations established to ensure the transparency of financialstatements.”38

27 FRB 1996 Press Release, supra note 8. 28 See Joyce M. Hansen, Ivan J. Hurwitz and Diane L. Virzera, Capital Regulation and Supervision of International BankingOrganizations, in Regulation of Foreign Banks (Michael Gruson and Ralph Reisner eds., 2003) [hereinafter ‘CapitalRegulation’] at 175.29 Ibid. at 174.30 Ibid. at 175.31 Ibid. 32 Ibid.33 Federal Reserve System, Risk-Based Capital Standards: Trust Preferred Securities and the Definition of Capital, 69 Fed.Reg. 28851 at 28853 (May 19, 2004).34 Ibid.35 Preamble to Final Regulation (March 1, 2005) [hereinafter FRB Final Rule] available athttp://www.federalreserve.gov/boarddocs/press/bcreg/2005/20050301/attachment.pdf.36 Ibid.37 FRB Final Rule, supra note 35 at 4.38 Ibid.


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The FRB’s final rule allowed the continued limited inclusion of trust preferred in a BHC’s Tier 1capital. The FRB considered “its generally positive supervisory experience with trust preferredsecurities, domestic and international competitive equity issues, and supervisory concerns withalternative tax-efficient instruments.”39 The FRB made clear that it is aware of competitivepressures noting that:

“Approximately 800 BHCs have outstanding over US$85bn of trust preferred securities, thepopularity of which stems in large part from their tax-efficiency. Eliminating the ability toinclude trust preferred in Tier 1 capital would eliminate BHCs’ ability to benefit from this tax-advantaged source of funds, which would put them at a competitive disadvantage to both US andnon-US competitors. With respect to the latter, the Board is aware that foreign competitors haveissued as much as US$125bn of similar tax-efficient Tier 1 capital instruments.”40

The final rule permitted trust preferred to be included in Tier 1 capital but limited to 25% of thesum of core capital elements. Internationally active BHCs are subject to a limit that trustpreferreds not exceed 15% of the sum of core capital elements. An internationally active BHC isbasically defined as one that has significant activity in non-US markets. The final rule permittedqualifying mandatory convertible preferred securities to be included in Tier 1 up to a 25% limit.Finally, the FRB continued to prohibit interest rate step-up provisions in Tier 1 capitalinstruments and Tier 2 subordinated debt but dropped a requirement that trust preferredsecurities include call provisions.41 The changes were effective, with various grandfathers andphase-ins beginning 11 April 2005.

Current tax developments

Tax treatment of new (and old) equity-like featuresIn early 2005, Moody’s Investors Service rolled out refinements to its ‘tool kit’ which sets forth thevarious criteria for classification of instruments as equity or debt for ratings purposes.42 Ingeneral, those refinements made it easier for hybrid instruments to be classified as equity forrating agency purposes. Since that development, issuers have been developing new hybridfeatures in order to get the highest possible rating agency equity credit while still maintaining atax deduction. These new features include mandatory deferral, replacement covenants, longermaturities, scheduled maturities, and interest caps.

Mandatory deferralOne of the features of some current hybrids is mandatory deferral of interest payments. As seenpreviously, a typical trust preferred provides for five year optional deferral of interest. If theobligor continues to defer interest beyond the five year period then, in most cases, a defaultoccurs. The problem with optional deferral is that the rating agencies believe there may beoutside factors that influence whether optional deferral is exercised.43 Therefore, in effect, thereis still an obligation to make ongoing payments on the instrument.

A mandatory deferral feature, on the other hand, must be exercised. A typical mandatory deferralfeature provides that if the obligor fails certain financial tests, then distributions on theinstrument must be suspended.44 There are various types of financial covenants, for example,whether the issuer has suffered net losses for a sustained period or if the issuer’s leverage ratioincreases above a certain threshold. The mandatory triggers are designed to give the issuer somelatitude, if they are too tight then they may cause the very problem they are designed to cure.45

On the other hand, they cannot be so loose that the issuer is on the brink of bankruptcy when thetrigger occurs.46

39 Ibid. at 6.40 Ibid. at 7.41 Ibid. at 14. 42 NEW INSTRUMENTS STANDING COMMITTEE, MOODY’S INVESTORS SERVICE, RATING METHODOLOGY – MOODY’STOOL KIT: A FRAMEWORK FOR ASSESSING HYBRID SECURITIES [hereinafter MOODY’S TOOL KIT] (1999).43 See MOODY’S TOOL KIT, supra, note 42 at 5-6.44 For example, a recent Burlington Northern Santa Fe Corporation (BNSF) (NYSE:BNI) trust preferred offering, the BNSFFunding Trust I (the Trust) uses the proceeds from the sale of its trust preferred securities to purchase junior subordinatednotes (the Notes) issued by BNSF. In addition to a discretionary interest deferral feature, the Notes provide that BNSF will beprohibited from paying interest, except from the net proceeds of certain sales of its common stock and/or qualifyingpreferred stock, in certain circumstances such as when for the preceding three calendar quarters, the total leverage of BSNFis more than 5:1 or if BSNF’s interest coverage is less than 2:1. See BNSF Funding Trust I US$500,000,000 6.613 percent FixedRate/Floating Rate Trust Preferred Securities Prospectus Supplement, Registration No. 333-130214, filed pursuant to Rule424(b)(5) as of Dec. 12, 2005, available at http://www.sec.gov/Archives/edgar/data/934612/000119312505242274/d424b5.htm.45 See MOODY’S TOOL KIT, supra, note 42 at 4-5.46 See STANDARD & POOR’S COMMENTARY REPORT, EQUITY CREDIT FOR BANK AND INSURANCE HYBRID CAPITAL, AGLOBAL PERSPECTIVE (2006) at 7.


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Deferral on debt instruments has been one of those unique features that gives the non-taxaudience comfort but does not cause the tax advisor too much pain. There seem to be severalreasons. First, at the end of the deferral period the instrument’s holders still have creditor’srights.47 This assists in showing that the ‘intent of the parties’ is that the holders are creditorsrather than equity owners. Second, the deferral feature is analogised to a zero coupon instrument.The tax advisor reasons that if the issuer could have issued a long-term zero coupon debt thendeferral of five years interest (or 10 years for that matter) is really no worse.48 Of course underthis analysis, the advisor must be comfortable that the issuer’s credit quality is so strong that a 60-year zero coupon bond would still fall on the right side of the debt-equity line.

Mandatory deferral seems in some ways both better and worse than optional deferral. Dependingon the triggers, it may be better because it takes discretion on the payment of interest out of theobligor’s hands. Unless the trigger is hit, interest must be paid. Of course if the mandatorydeferral is coupled with optional deferral, which it may be, this argument cannot be made.Mandatory deferral is worse than optional deferral because its links the instrument more closelyto the issuer’s business fortunes. In this sense it is much like provisions that provide for interestcontingent on earnings of the obligor. While these are not by any means fatal to debt classifica-tion they are nevertheless negative factors.49

The other feature that may be coupled with mandatory deferral is an obligation on the part of theissuer to sell additional equity in order to pay interest if mandatory deferral occurs. Thus, in atypical provision, interest is mandatorily deferred if the trigger is hit but an issuer must continueto pay interest out of the proceeds of stock sales, if it can sell stock. While this is a little betterthan flat out mandatory deferral it would seem that selling stock when the issuer’s financialfortunes are declining may not be that easy. Again, much depends on the mandatory deferraltrigger. If the issuer will still be rated investment grade even though the trigger is hit, it may wellbe possible to sell stock to pay interest. If the trigger is hit on the brink of bankruptcy, thepossibility of selling stock is speculative at best and should be disregarded.

Replacement covenantsAnother current rating agency favourite is a replacement covenant. In the base case, ‘replacementlanguage’ simply says that the issuer will not redeem the instrument unless it does so out of theproceeds of equal or better equity content securities. If the issuer ignores the replacementlanguage, the instrument’s holders are not harmed – they are repaid. Instead, the harm is to theissuer’s senior creditors; however, they are not in privity of contract with the issuer, at least as faras the replacement language is concerned.

47 These rights may be to sue for the unpaid interest or may be a default that gives the debt holders the right to acceleratethe instrument.48 See, e.g., Fed. Exp. Corp. v. United States, 645 F. Supp. 1281 (W.D. Tenn. 1986) (Holding that the interest deferralreceived “no weight” in determining whether the debentures were debt or equity, because the deferral of interest untilafter payment of superior indebtedness does not affect the accrual of that interest or the obligation to repay). See alsoWilliam T. Plumb, Jr., The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L.Rev. 369 (1971), at 603 (“[b]ut if cumulative interest is unconditionally payable at maturity regardless of the sufficiency ofearnings, the interim deferability of the payments, whether or not discretionary, should be given no adverse weight at all”.Plumb, supra, at 603. A footnote explains: “Since all or part of the obligation to pay interest may be properly deferred untilmaturity in the case of bonds issued at a discount, it should make no difference that a part of the ultimately fixed amountof interest may be paid sooner, on whatever conditions.” Plumb, supra, at n. 1386. Plumb notes that debt equity proposalsof the American Law Institute, the American Bar Association and the Advisory Group would have made it sufficient for adebt safe harbor provision if interest were payable no later than maturity. Plumb, supra at n. 1386.49 See, e.g., John Kelley Co. v. Comm’r, 326 U.S. 521 (1946); Crawford Drug Stores, Inc. v. United States, 220 F.2d 292, 296(10th Cir. 1955) (a debt holder is usually entitled to interest even though there are no net earnings and the fact thatinterest is payable absolutely is a factor tending to establish a true debt); Tribune Publ’g Co. v. Comm’r, 17 T.C. 1228, 1234(1952). See Note, Bonds—Income Bonds—Rights of Bondholders and Deductibility for Federal Income Tax Purposes, 56Mich. L. Rev. 1334 (1958), cited in Plumb, supra note 46, at n. 348.


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Recently, issuers have attempted to strengthen replacement language to address thisshortcoming.50 The issuer enters into a ‘Declaration of Covenant’. Under the Declaration ofCovenant, the issuer is contractually obligated to redeem the subject instrument only out of aspecified security, with equal or better equity content. The Declaration of Covenant identifiesspecific senior debt that is the beneficiary of the promise made. It is thought, although it has notbeen proven, that the senior debt holders could sue for damages if the issuer acts in contraven-tion of the Declaration of Covenant. This type of feature gives Moody’s comfort and pushes theranking on an undated hybrid from moderate to strong in terms of the ‘no maturity’ factor.51

From a federal income tax standpoint, neither type of replacement feature should be a negativedebt factor. The replacement language only affects the issuer’s right to call the security before thematurity date. It does not affect the issuer’s unconditional obligation to repay its obligation atmaturity. Accordingly, it does not diminish the issuer’s unconditional obligation to pay. On theother hand, an instrument that is payable upon maturity only out of the proceeds of the sale ofstock has a high risk of being treated as equity for federal income tax purposes. 52

Longer maturitiesThe US tax law on maturity dates is fairly well known. A debt instrument must have a maturitydate that is not unreasonably far in the future. Courts have tested long-dated debt instruments byinquiring whether the obligor will be around at the time the debt matures.53 On one level, thistest does not make much sense because no-one knows whether any of the obligors in today’sworld will be around in 10 years, much less 60 years or 100 years. In that sense, the relevant courtopinions should be seen as a test of credit quality: what is the assessment that the instrument willbe paid?

After Notice 94-47,54 issuers limited the subordinated debt underlying trust preferreds to 49 yearsor less. More recently, issuers have been extending maturities to 60 years, mainly because therating agencies view that as ‘perpetual’. However, 60-year or 100-year debt is not unknown andwith the right issuer should not tip the scale on debt classification.55

50 See, e.g., USB Capital VIII $375,000,000, 6.35 percent Trust Preferred Securities Prospectus Supplement, RegistrationNo. 333-124535, filed pursuant to Rule 424B2 as of Dec. 21, 2005, available athttp://www.sec.gov/Archives/edgar/data/1325524/000095013405023855/c00888be424b2.htm.51 See NEW INSTRUMENTS STANDING COMMITTEE, GLOBAL BANKING TEAM AND INSURANCE TEAM, MOODY’SINVESTORS SERVICE, REFINEMENTS TO MOODY’S TOOL KIT: AN ADDENDUM FOR BANKS AND INSURERS [hereinafterREFINEMENTS II] (2006) at 4.52 Dillin v. United States, 433 F.2d 1097, 1101 (5th Cir. , 1970). In Dillin, the demand notes in question were payable onlywhen the issuer issued stock in an initial public offering.53 Monon Railroad v. Commissioner of Internal Revenue, 55 T.C. 345 (1970).54 Notice 94-47 states: “The [IRS] also is aware of recent offerings of instruments that combine long maturities withsubstantial equity characteristics. Some taxpayers are treating these instruments as debt for federal income tax purposes,apparently based on [Monon Railroad] which involved an instrument with a 50-year term. The [IRS] cautions taxpayersthat, even in the case of an instrument having a term of less than 50 years, Monon Railroad generally does not providesupport for treating an instrument as debt for federal income tax purposes if the instrument contains significant equitycharacteristics not present in that case. The reasonableness of an instrument's term (including that of any relendingobligation or similar arrangement) is determined based on all the facts and circumstances, including the issuer's ability tosatisfy the instrument. A maturity that is reasonable in one set of circumstances may be unreasonable in another ifsufficient equity characteristics are present.” I.R.S. Notice 94-47, 1994-1 C.B. 357.55 Arguments have been made that 100-year debt should be treated as debt for federal tax purposes because it moreresembles debt than equity particularly where the yield difference between an issuer’s 100-year debt and its (or a similarissuer’s) 30-year debt is relatively small. See, e.g., KAM C. CHAN & P.V. VISWANATH, CENTURY BONDS: ISSUANCEMOTIVATIONS AND DEBT VERSUS EQUITY CHARACTERISTICS, September 2002, available athttp://webpage.pace.edu/pviswanath/research/papers/kamchan_final_version_102303.pdf.


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Scheduled maturitiesSeveral recent issuers of trust preferred securities have bifurcated their security’s maturity into a‘scheduled’ maturity and a ‘final’ maturity. In general, these securities have 30 year scheduledmaturities and 60 year final maturities. However, the issuer’s obligation to fully repay theinstrument after 30 years is generally limited to the extent of proceeds raised from the sale ofqualified ‘replacement securities’ such as, in the case of trust preferred securities, securities (othercommon stock, rights to acquire common stock, and securities that convert into common stock)that qualify as the issuer’s core capital and generally rank either pari passu or junior to the trustpreferred securities. This bifurcation changes the debt/equity analysis for US federal tax attorneyswho are asked to opine on a hybrid security’s debt/equity character in connection with theoffering. The relevant question now is whether the issuer will be able to sell enough replacementsecurities to pay off the hybrid in 30 years. If the answer is yes, the 30 year maturity favourablyimpacts the debt classification of the instrument from a US federal income tax perspective. US taxadvisers generally view this reduction in a hybrid security’s maturity date as a trade-off for othermore equity-like features.

Interest capsAnother feature seen recently is interest caps in bankruptcy. In a typical formulation, theinstrument provides that interest on the instrument can be deferred for up to 10 years. Theinstrument also provides that if interest has been deferred and the issuer goes bankrupt, then theholder will have a bankruptcy claim for interest limited to 25% of the face amount of the debtinstrument. Accordingly, the excess interest is not treated as a bankruptcy claim and is forfeited.All principal is still payable.56

There is little tax authority on the treatment of such interest limitations. In the first instance, thequestion is whether interest on the instrument is unconditionally payable. It would seem that thecorrect analysis is to say that only an amount equal to 25% of the face amount is unconditionallypayable. Another way to view the interest cap is a form of subordination. In either event, interestcaps of this sort are a negative feature. On the other hand, the issuer may conclude that the cir-cumstances under which interest will be forfeited are remote and that, therefore, the feature isnot too damaging to debt treatment.

56 For example in a 2005 offering by BNSF Funding Trust I, the issuer was obligated to sell stock to pay interest during amandatory deferral period. There was no obligation to sell stock, however, during a ‘market disruption event’. A marketdisruption event included (i) a trading halt on US exchanges generally or with respect to the issuer’s stock, (ii) failure toobtain a regulatory body’s consent to issue stock despite reasonable attempts to obtain consent, or (iii) an event occurs thatcauses an offering document for the issuer’s securities to be defective. If the issuer did not pay all accrued and unpaidinterest for two consecutive years during a mandatory trigger period, all claims with respect to such interest after the two-year period and to the last day of the mandatory trigger period would be extinguished if the issuer went bankrupt duringthe period. Conceivably, according to the prospectus, this could result in extinguishment of claims for five years worth ofinterest. See BNSF Funding Trust I $500,000,000 6.613 percent Fixed Rate/Floating Rate Trust Preferred SecuritiesProspectus Supplement, supra note 44 at s-15.


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Current structuresThe new wave of hybrid securities57 addresses the fundamental contradiction inherent betweentax and non-tax precepts. From a non-tax standpoint substantial equity credit is only given forinstruments that are perpetual and non-cumulative. From a federal income tax standpoint aperpetual non-cumulative debt instrument would be treated as equity for federal income taxpurposes. In 2005 and 2006 a number of different structures emerged to address these competinggoals. By mid-2007 two structures appeared to have gained broad market acceptance. The first isthe enhanced trust preferred. It works in the classic hybrid fashion – creating an instrument thathas characteristics of both debt and equity. The second involves two instruments that are heldtogether with a ‘velcro’ strip. That is, a perpetual non-cumulative security is issued along with aterm cumulative security. The intent is to have the instruments treated as one instrument fornon-tax purposes and as two separate instruments for US federal income tax purposes.

Enhanced trust preferred - CENTs, etc.One winner in the competition for the next generation hybrid is the ‘enhanced trust preferred’. Anexample of this is the Capital Efficient Notes (CENTs) created by JP Morgan.58 In the typicalenhanced trust preferred the underlying debt instrument has a 30-year scheduled maturity with a60 year legal final maturity. It provides for interest deferral for five years coupled with anadditional five year interest deferral for another five years. During that five years, the issuer isunder an obligation to sell its securities, including common stock or warrants to buy commonstock to repay the deferred interest. The obligation to sell such securities is limited, usually to 2% ofmarket capitalisation at the time the securities are sold. Also, in some transactions part, but not all,of the deferred interest may be permanently cancelled, even if the issuer is not bankrupt orinsolvent, if (i) interest is deferred for a period of 10 years, (ii) no event of default and accelerationis continuing, and (iii) the issuer is unable to raise sufficient proceeds to pay the deferred interest(whether because of caps on the amount of securities that must be sold, or otherwise). The additionof this interest cancellation feature helps certain issuers of hybrid securities gain the enhancedrating agency equity credit they seek. From a federal income tax standpoint, the tax advisor mayaccept them if the possibility that an actual interest cancellation will occur seems remote.

WITS and HITSThe second winner is the WITS/HITS instrument.59 In these structures, the issuer issues a non-cumulative security (actually a forward contract to buy a non-cumulative security) along with along-dated subordinated debt instrument. The forward contract requires the investor to purchasenon-cumulative perpetual preferred stock of the issuer in five years. The subordinated note has amuch longer term, say 40 years. Sometime before the five year forward settlement date, theinterest rate on the subordinated note is reset and the subordinated note is remarketed tounrelated third parties. The investor uses the cash from the sale to deliver the purchase priceunder the forward. If the subordinated note cannot be remarketed (presumably because theissuer is in bad financial shape) then the subordinated note is transferred to the issuer as thepurchase price for the preferred stock.

57 This new wave includes the following transactions: Lehman Brothers Holdings E-Capital Trust I $300,000,000 [thepublic document is an Offer to Exchange its Floating Rate Enhanced Capital Advantaged Preferred Securities (ECAPSSM)which have been registered under the Securities Act of 1933 for any all of its outstanding Floating Rate Enhanced CapitalAdvantaged Preferred Securities, Form S-4, SEC File No. 333-129195, dated Oct. 21, 2005 (subject to completion) availableat http://www.sec.gov/Archives/edgar/data/806085/000104746905025084/a2163393zs-4.htm]; BNSF Funding Trust I$500,000,000 6.613 percent Fixed Rate/Floating Rate Trust Preferred Securities, supra note 44; Stanley Works Capital TrustI $450,000,000 5.902% Fixed Rate/Floating Rate Enhanced Trust Preferred (November 22, 2005), seehttp://www.sec.gov/Archives/edgar/data/93556/000134100405000414/nyc521812.txt; Wachovia Capital Trust III $2,500,000,000 5.80 percent Fixed-to-Floating Rate Normal Wachovia Income Trust SecuritiesProspectus, SEC File No. 333-131237 and 333-131237-01, filed pursuant to Rule 424(b)(2), dated January 25, 2006 availableat http://www.sec.gov/Archives/edgar/data/36995/000095014406000558/g99243bae424b2.htm; Washington Mutual, Inc.$1,150,000,000 5.38 percent Trust Preferred Income Equity Redeemable Securities Prospectus Supplement, RegistrationNo. 333-63976, filed pursuant to Rule 424(b)(3) as of January 21, 2003, available athttp://www.sec.gov/Archives/edgar/data/1143930/000090730303000015/prosupp12103b.htm, see also Washington Mutual,Inc. Annual Report for Fiscal Year Ended Dec. 31, 2005 Filed Pursuant to Section 13 and 15(d) (Form 10-K) as of March 15,2006 available at http://www.sec.gov/Archives/edgar/data/933136/000110465906016786/a06-2446_110k.htm; USB CapitalVIII $375,000,000 6.35% Trust Preferred Securities Prospectus Supplement, File No. 333-124535, Filed Pursuant to Rule424B2 as of August 3, 2005, available athttp://www.sec.gov/Archives/edgar/data/36104/000095013405023741/c00888b2e424b2.htm; USB Capital IX $1,250,000,0006.189% Fixed-to-Floating Rate Normal Income Trust Securities Prospectus Supplement, File No. 333-132297, filed pursuantto Rule 424(b)(2) as of March 10, 2006, available athttp://www.sec.gov/Archives/edgar/data/36104/000095013406005305/c02886b2e424b2.htm. 58 See, for example, JP Morgan’s own CENTs; JP Morgan Chase Capital XXII $1,000,000,000 6.450% Fixed Rate CapitalSecurities Prospectus Supplement, File No. 333-126750, filed pursuant to Rule 424(b)(5) as of January 26, 2007, available athttp://www.sec.gov/Archives/edgar/data/19617/000119312507016403/d424b5.htm.59 See, for example, Bank of America’s BAC Capital Trust XIII $700,000,000 Floating Rate Preferred Hybrid Income TermSecurities Prospectus Supplement Registration Nos. 333-133852 and 333-133852-08, filed pursuant to Rule 424(b)(5) as ofFebruary 12, 2007, available at http://www.sec.gov/Archives/edgar/data/70858/000119312507029674/d424b5.htm


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The subordinated note and the forward contract can be separated through some rathercomplicated mechanics which essentially involve substituting Treasury securities for the subordi-nated note. The investor can also extract the note and accept the remarketing-set interest rate solong as it deposits cash necessary to exercise the forward contract.

The WITS/HITS structure basically relies on Revenue Ruling 2003-97.60 That ruling dealt with aninvestment unit composed of (i) a debt instrument, and (ii) a forward contract to buy stock.Revenue Ruling 2003-97 concludes that the two components of the investment unit are separatefor federal income tax purposes so long as (i) they are not legally linked, and (ii) there is noeconomical compulsion to hold them together.61 Assuming the note and forward are separate,the other tax conclusions follow. Interest on the debt instrument is deductible and the instrumentis not payable in equity and therefore does not run afoul of Code section 163(l).

The WITS/HITS creates Tier 1 capital outside of the 15% basket and instead subject to the 25% limitapplicable to ‘mandatory convertible’ securities.

The FRB on 23 January 2006 issued a letter62 that considered this structure. The letter concludedthat the security would count outside of the 15% basket as Tier 1 capital. The Federal Reserve tookthis position despite the fact that the market viewed the structure as having a step-up in rate afterfive years. Thus, the FRB has historically not permitted Tier 1 instruments to contain stepped-upinterest rates coupled with a call option. The thinking apparently is that the step-up will inducethe issuer to exercise the call, creating a de facto maturity date for what the FRB requires be aperpetual instrument. In the transaction the letter was written for when the perpetual preferredstock is issued, the issuer will be paying a non-deductible coupon as compared to a deductiblecoupon on the subordinated note. The regulatory issue is whether the issuer will be induced tocall the perpetual preferred because its after-tax cost of keeping the security outstanding hasincreased dramatically. So far, there is no indication the FRB believes that this constitutes a defacto step-up. Moreover, in 2007 the FRB dropped its objection to step-ups in Tier 1 capitalinstruments.

Hybrids issued by foreign issuers in the USAnother aspect of the current hybrid market involves hybrid securities issued by foreign issuers toUS holders. In 2003, Congress reduced the US tax rate on dividends received by individuals to15%.63 To qualify, the dividend must be ‘qualified dividend income’ (QDI). Congress decided thatdividends on equity issued by foreign corporations should also qualify for the preferential rate. Ingeneral, the foreign corporations are ones that reside in a jurisdiction that shares tax informationwith the US or foreign corporations whose shares are traded on a public exchange. Also, theforeign corporation cannot be a ‘passive foreign investment company’ under US tax rules64 whichbasically means that the foreign corporation must be in an active business.

What makes this provision attractive is that the US treats perpetual debt as equity for federalincome tax purposes. Therefore, a foreign corporation can issue perpetual debt which may qualifyfor a tax deduction in the home jurisdiction. In the US, however, it is treated as equity andindividual US holders are treated as receiving qualified dividend income. A number of foreignissuers have taken advantage of this opportunity.

In March 2007 Representative Richard E. Neal (D.-Mass.) introduced legislation (HR 1671) thatwould exclude foreign equity from QDI treatment. The bill would deny the special 15% individualUS tax rate on dividends to the extent stock is issued by foreign issuer and foreign issuer receivesa deduction in home country for the dividend or the instrument is treated as other than stockunder the foreign country’s tax law. A companion bill (S. 1006) was introduced by Sen. John Kerry(D.-Mass.). The proposed effective date is for dividends received after enactment. The proposedlegislation has not yet been enacted and its prospects are uncertain.

60 Rev. Rul. 2003-97, 2003-2 C.B. 80.61 The genesis of Revenue Ruling 2003-97 was an instrument known as “Feline PRIDES”. This instrument was originallyadopted by corporate issuers. 62 Letter from the Federal Reserve Board to Wachovia Corporation dated January 23, 2006 available at http://www.federal-reserve.gov/boarddocs/legalint/bhc_changeincontrol/2006/20060123/attachment.pdf.63 Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L.108-27 (108th Cong. , 1st Sess).64 Section 1293 et. seq.


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APPENDIX

02SELECTED STANDARD & POOR’S GUIDELINES

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Primary Credit Analystss: Scott Sprinzen New York (1) 212-438-7812 scott_sprinzen@ standardandpoors.com Scott Bugie Paris (33) 1-4420-6680 scott_bugie@ standardandpoors.com Emmanuel Dubois-Pelerin Paris (33) 1-4420-6673 emmanuel_dubois-pelerin@ standardandpoors.com Publication Date May 8, 2006

CRITERIA

Criteria: Assigning Ratings To Hybrid Capital Issues Note: This article supercedes the one that was published on March 28, 2006. We have

subsequently decided not to implement the possible, alternative approach discussed at that

point. (See separate release.) This write-up also provides additional guidance on our

methodology for assessing the risk posed by mandatory deferral triggers, among other matters.

In the Corporate and Financial Services sectors, Standard & Poor’s Ratings Services assigns

two types of credit ratings—one to issuers and the other to individual issues. The first type is

called an issuer credit rating (ICR), counterparty credit rating, or corporate credit rating. It is

our current opinion of an issuer’s ability and willingness to meet its financial commitments on

a timely basis. In contrast, while issue ratings address timeliness, they also address the

potential for recovery of principal in the event of a bankruptcy or liquidation of the issuer—

that is, the ranking of the issue.

Conventional preferred stock and certain other forms of equity hybrids, such as trust

preferred, afford equity benefit to issuers in part by having ongoing payment requirements that

are more flexible than interest payments associated with conventional debt and by being

contractually subordinated to such debt. Obviously, these characteristics make the instruments

more risky for investors than debt. In assigning issue ratings to equity hybrids, we seek to

assess the incremental risks associated with the issue in terms of payment timeliness and

principal recovery compared to the ICR and to debt. We reflect these risks in the issue ratings

of equity hybrids by assigning them ratings that are “notched down” from the ICR. Owing to

the unpredictable nature of some of the risks to which hybrid capital issue ratings are subject,

the ratings are potentially more volatile than the ratings on conventional debt issues.

This article discusses our methodology for assigning issue ratings to equity hybrids. (For a

broader discussion of issue ratings, see “Rating Each Issue: Distinguishing Issuers and Issues, “

published on RatingsDirect on Oct. 24, 2004.)

Criteria: Assigning Ratings To Hybrid Capital Issues

Standard & Poor’s | CRITERIA 2

We utilize a common framework across our Corporate and Financial Services practices and across

regions. However, the rating dynamics can work differently. For example, in the banking sector most

instances of companies deferring payments on trust preferred have reflected the intervention of

regulators. In theory, given the high funding needs of banks and the importance of maintaining

confidence in the specific bank and the entire financial sector, the regulatory order to defer may occur

when the credit quality of the company is still stronger than the point where most corporates would

consider such an action. So, in certain circumstances, where a bank is experiencing a trend of

deteriorating credit quality, we may decide to widen the gap between the ICR and hybrid equity issue

rating at an earlier point than for a corporate on a similar trajectory.

We also utilize this framework across the rating spectrum. In the case of highly rated issuers, the

prospect of financial distress is, by definition, extremely distant. Still, issue ratings reflect our relative

assessment of how different instruments in the issuer’s capital structure might fare, should the

downside case materialize.

Subordination

Subordination adversely affects the ultimate recovery prospects of subordinated obligation holders in a

bankruptcy, since claims of priority creditors must be satisfied first. For issuers with ICRs that are

investment grade, we take away one notch from the ICR for issues that are subordinated (but not

deferrable). In the case of issuers with ICRs that are speculative grade, we take away two notches from

the ICR for issues that are subordinated (but not deferrable). We do not distinguish in the notching

between gradations of subordination: junior subordinated issues and senior subordinated issues are

rated the same. Experience has shown that, in bankruptcy, ultimate recoveries for different classes of

subordinated instruments tend to be similar—and poor. (Likewise, other things being equal, we don’t

distinguish between hybrid capital issues that are cumulative versus those that are noncumulative, since

there is little reason to suppose recovery prospects of the two are materially different.)

Deferral

Payment risk is heightened in the case of equity hybrids due to:

The right of optional deferral, where management has the option under the terms of the instrument

to suspend or cancel distributions without triggering a legal default;

The requirement of mandatory deferral, where, with the breaching of one or more predetermined

triggers, the issuer is required to suspend payments and;

The ability of regulators, in certain cases, to order companies to defer payments.

Our objective is to fully reflect payment deferral risk in equity hybrid issue ratings, whatever the

potential driver of the deferral.

Optional deferral

We assume that issuers will be loath to exercise their right of optional deferral, given the negative

reaction this evokes among investors and hence the ramifications it can have for the issuer’s future

access to capital markets. Deferral risk is heightened when the issuer faces increased prospects of

financial distress, such that management’s reluctance to defer may ultimately be overcome in favor of

the need to conserve cash. As referred to above, the “pressure points” may differ for different types of

issuers, meaning the consideration of deferral may come at earlier or later stages in the course of credit


www.standardandpoors.com 3

deterioration. One danger sign is when a company curtails or eliminates its dividend on common stock:

This is sometimes a precursor to a deferral on equity hybrids. (Most equity hybrids have a “dividend

stopper” that prevents the company from making any distributions to its common stockholders while it

is deferring distributions on the hybrid.)

If a corporate has an unusually large proportion of equity hybrids in its capitalization, this may give

it an added incentive to defer, due to the significance of the cash flow savings that would result.

However, in the case of large, regulated financial institutions, we believe this could cut both ways: The

greater the amount of outstanding hybrids, the greater the potential for a systemic disruption or a

backlash in the capital markets. This could result in more of an incentive for the issuer to continue

payments under all circumstances.

Mandatory deferral

Triggers for mandatory deferral vary. Some consist of earnings-, cash flow-, or capitalization-based

financial ratio tests; others refer to the issuer’s incurrence of a loss over a defined period or the failure

to meet specified minimum regulatory capital requirements. Still others tie the payment of the

distribution on the equity hybrid directly to the company’s payment of the common stock dividend.

Obviously, the payment deferral risk for the equity hybrid investor is higher when the likelihood that

the trigger will be breached is greater. If, for example, it would take only a minor and temporary

shortfall in profitability to cause the deferral, then risks to the equity hybrid investor could be

dramatically higher than they would be for debtholders. On the other hand, if it would take

circumstances so dire for the trigger to be breached that the issuer would likely be on the brink of

bankruptcy, then the payment risks for the equity hybrid investor would not be materially different

than they would be for debtholders.

Regulatory deferral

In some regulated financial services sectors, regulators have the authority to direct companies to defer

payments on equity hybrids based on the regulators’ own assessment of what is prudent. In certain

cases, banks have been ordered to defer even when they met all regulatory capital requirements (for

example, Riggs National Corp., a bank holding company that was required to defer payments on trust-

preferred securities in December 2004). Assessing the risk of deferral in the case of a regulated

company requires careful consideration of sector- and country-specific factors, including precedents of

deferral ordered by the regulatory body in question. Especially important is the identification of

financial measures to which the regulator is particularly sensitive.

The authority and intent of financial regulators to order deferral of payments in circumstances—

whether or not clearly defined—means that most hybrid capital securities of regulated financial

institutions can be viewed as having de facto mandatory deferral. Regulated financial institutions

structure hybrids according to rules established by national regulators for regulatory capital measures.

This includes the definitions of the capital ratios or performance measures that would trigger payment

deferral if breached. The triggers for deferral—typically the regulatory minimum capital ratio for banks

and insurers—are usually made explicit in the covenants of the hybrid security. Less often, the trigger is

not explicit in the document but is understood by both issuer and regulator. In most cases, the

regulator has the authority and intent to intervene and order deferral under defined circumstances.



Factoring payment risk into issue ratings

In reflecting payment/deferral risk in hybrid capital issue ratings, we evaluate the different sources of

deferral risk that are present and seek to assess their combined significance. Where deferral is possible

but we believe the prospect of a deferral is relatively remote over the foreseeable future, we take away

at least one notch from the ICR in setting the issue rating, whether the ICR is investment grade or

speculative grade. A one-notch differential is the typical treatment for issues that have optional deferral

alone. For example, the subordinated and optionally deferrable issue of an issuer rated ‘BBB+’ would

generally be rated ‘BBB-’—one notch for subordination and one notch for payment deferral risk. If the

issue were senior and deferrable (a rare but not unheard of combination), the issue would be rated

‘BBB’. We take the same approach even at the highest rating levels. A subordinated and deferrable issue

of a ‘AAA’ rated issuer is rated ‘AA’.

In defining “remote,” we use the hypothetical test that the ICR would have to decline by more than

three notches (i.e., a full rating category) for the issuer to be in such a condition that deferral would be

considered. When we have heightened concerns that the issuer may defer—whether due to the exercise

of its right to defer optionally, the breaching of a mandatory deferral trigger, or the exercise of the

prerogatives of a regulator—we increase the gap between the ICR and the issue rating, and we do not

impose any arbitrary limit on the size of the gap. So, in an extreme example, if the ICR of an issuer was

investment grade but we believed that there was a substantial risk that the payment on the issuer’s

trust-preferred securities could be deferred within a few quarters, the issue would have a low

speculative-grade rating.

Combinations of different forms of deferral may or may not increase deferral risk. For example, if an

issue has mandatory and optional deferability, and the mandatory triggers are defined in such a manner

that they could be breached without there necessarily having been fundamental erosion in the issuer’s

credit quality, then the risks to investors would be greater than if there were optional deferability alone.

The same would be true if the triggers were more reflective of fundamental credit quality, but could be

breached in advance of the point where the issuer would contemplate optional deferral. In either of

these cases, a lower issue rating would be warranted than if there were optional deferability alone. On

the other hand, if the mandatory trigger were sufficiently remote that we believed it would be unlikely

to be breached before the company would otherwise have optionally deferred, then we would not take

away additional notches for the mandatory deferability compared to what would be appropriate for

the optional deferability alone.

For example, MetLife Inc. (A/Negative/A-1) issued $2.1 billion of noncumulative perpetual preferred

in 2005 that was rated ‘BBB’, or three notches below the ICR. The issue has both optional and

mandatory deferral. The mandatory deferral is breached by the triggering of either of the following:

Consolidated net income during any consecutive four quarters is zero or less AND shareholders’

equity declines 10% or greater over the most recent eight quarters AND MetLife cannot reduce the

decline in shareholders’ equity within the subsequent two quarters to less than the 10% threshold

through equity issuance; or

The risk-based capital ratio of Metlife’s largest U.S. life insurance subsidiaries falls below 175% of

the company action level.

Analytically, it was deemed reasonably possible, while not expected, that MetLife could have an

atypical earnings event or a decline in its GAAP equity that would cause the first trigger to be breached,

even while the company remained financially strong. Furthermore, and more importantly, the second



trigger relates only to measures of solvency for a portion of Metlife’s U.S. life insurance operations,

while the ICR reflects the diversity afforded by the company’s U.S. property and casualty operations as

well as its growing presence outside the U.S.

We have rated a number of mandatory deferrable issues where, as in the first trigger in the MetLife

transaction, triggers are defined in such a way as to give the issuer the chance to make up for a decline

in shareholders’ equity by issuing new equity. Some issuers of these instruments have argued that this

completely mitigates mandatory deferral risk, since it would always be their company’s intention to

take whatever actions were necessary to forestall the breach of the trigger. However, we must be

skeptical about such assertions, just given the remoteness of the prospect of deferral, and the adverse

changes the issuers might have undergone by the time that point was reached. In such a case, if we did

somehow come to be convinced that the company, however dire its situation, would always avail itself

of whatever financial resources were available to avoid having to defer—optionally or mandatorily—

we would not notch down for deferral risk. However, there would then be little basis for ascribing

equity credit to the issue.

In the case of regulated financial institutions, explicit mandatory deferral triggers do not add to

deferral risk stemming from regulation if—as is generally the case—the triggers just replicate the capital

standards that a regulator applies in determining whether to order a deferral. Also, in the case of banks,

we consider it to be particularly unlikely that a company would exercise unilaterally its right to defer

optionally. Moreover, we would generally presume that bank regulators would act preemptively to

force banks to raise capital (or divest some activities) to prevent regulatory capital guidelines from

being breached. Thus, in most instances we take away only one notch for deferral risk in rating hybrid

capital issues of investment-grade banks, even where there is a combination of optional deferral and

regulatory deferral risk—although, as indicated above, we still notch to a greater extent in cases we

view as exceptional.

Default And Distress

(Note: this discussion supplements Standard & Poor’s published rating definitions.)

In the case of equity hybrids where distributions are deferrable, the ‘C’ issue rating is assigned where

we expect the next scheduled distribution to be deferred. The ‘C’ rating is also used in cases where the

distributions are cumulative and the issuer has resumed distributions following a deferral, but where an

arrearage still exists.

An equity hybrid issue is rated ‘D’ if a deferrable distribution has been deferred. (The ‘D’ rating is

also assigned if there is a payment default on a nondeferrable distribution or principal repayment or if

the issuer has filed for bankruptcy.) The deferral is not a legal default if the option to defer is provided

for under the terms of the instrument. However, the deferral is viewed as tantamount to a default in

our rating system, and the risk of deferral occurring is addressed by the issue rating. (Note: The issuer

credit rating would not be changed to ‘D’ or ‘SD’ in such a case if the nonpayment on the hybrid were

permitted under the terms of the instrument. Still, the nonpayment would in virtually all cases be

symptomatic of problems at the company—problems that would need to be reflected in the issuer

credit rating, along with the cash savings resulting from the deferral.)

Where the terms of the equity hybrid provide the issuer with the option to make interest/dividend

payments by delivering more of the same equity hybrid, shares of common stock, or some other

security, in lieu of cash, we do not view use of the alternative as a form of default, as long as the



consideration distributed can be readily monetized by investors and the value approximates that of the

cash that otherwise would have been paid out. Even if the consideration were not in a readily

monetizable form and/or if the value fell short, we would not view it as a default if we believed it is

widely understood by investors at the time of issuance that the issuer will utilize the in-kind option to

make payments initially (and perhaps continuing for an indefinite period). However, if the payment is

with cash at the outset and the issuer later reverts to in-kind payments due to perceived financial stress,

then distribution of the in-kind payments would be treated as a default, even when permitted under the

terms of the instrument.

Some issues with mandatory deferability have clauses that require the issuer to undertake the sale of

common or preferred stock and utilize the proceeds to make the distribution. If the payment can be

made on a timely basis, we would not view this as a default. In such circumstances, we believe a grace

period of up to 30 calendar days is appropriate -– equivalent to the grace period commonly found in

conventional debt issues. However, there is the risk that the company would be unable to complete the

required share issuance, depending on the company’s circumstances and conditions in the capital

markets. In the case of corporates, we have not notched down for mandatory deferability in cases

where “best efforts” share issuance (or issuance of other securities) would then be immediately

required. However, we could reassess this approach as we gain more insights into the practicability of

this requirement. In any event, we will notch down in cases where we believe that under the most likely

scenario where a deferral could occur the issuer’s financial strength and share price would have

declined so precipitously that the issuer’s ability to complete even a modest-size common stock issuance

(or issuance of other securities) could be dubious.

Government Support

The policy for rating the hybrid equity securities of government-supported entities deserves particular

mention. When Standard & Poor’s expects that the government would act to support a government-

supported entity’s debt obligations but has less confidence that the support would be extended to the

government-supported entity’s equity hybrids, then the base for the notching of the equity hybrid issue

rating is not just the ICR (which factors in the imputed government support). The issuer’s stand-alone

profile (absent government support factors, including extraordinary intervention and rescue) is also a

relevant rating factor in these situations.

This indeed was the case in Japan in the late 1990s and the early years of the current decade, when

the government of Japan provided massive support to the private banking sector to maintain

confidence and prevent the failures of many institutions. The government support did not extend to all

hybrid capital securities of Japanese banking groups during that period, however, and some of the bank

hybrids, notably the operating company (OPCO) preferred securities, deferred payments. Two

prominent cases of deferral were those of Resona Bank and UFJ Bank (through OPCO Tokai Preferred

Capital Co.). During this period, Standard & Poor’s widened the notching of hybrid equity securities,

including OPCO preferred securities, up to six notches below the ICR of the issuing groups. In the

cases cited, the banks avoided liquidity problems after the payment deferrals: UFJ was merged with

higher-rated Mitsubishi Tokyo Financial Group, and Resona Bank was under the direct control of the

government.



Our approach would be similar in the case of an entity whose ICR benefited from support of a

strong parent, but where we doubted whether parental support would be extended to hybrid capital of

the subsidiary.

Standard & Poor’s is hosting a Hybrid Securities Hot Topics Conference on May 25, 2006, in New

York. The conference will provide attendees with an overview of Standard & Poor’s criteria for

assessing and rating hybrid securities issued by corporate and financial services companies. For more

information please log on to www.events.standardandpoors.com/hybrid.



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@

FINANCIAL SERVICES CRITERIA

Financial Services Criteria: Equity Credit For Bank And Insurance Hybrid Capital, A Global Perspective (Editor’s Note: This article (published alongside "Credit FAQ: Recent Hybrid Capital

Issuances By U.S. Bank Holding Companies May Be Models For Future Transactions")

presents the first comments regarding Standard & Poor's criteria prepared under the aegis of

our recently established New Instruments Committee (see related press release entitled "New

Instruments Committee To Hold Teleconference On Rating Hybrid Bank And Insurance

Capital," also published on Feb. 16, 2006). In the coming months, we also plan to publish: an

updated version of our corporate equity hybrid criteria; a discussion of how we assign issue

ratings to equity hybrids; and an article comparing and contrasting the corporate and financial

services frameworks for the attribution of equity credit. We also plan to comment regularly on

our views regarding new instruments in the market.

Standard & Poor's Ratings Services is requesting comments from investors, issuers, and other

market participants regarding any aspects of our methodology for assessing equity credit for

bank and insurance hybrid capital. Kindly submit your comments on any aspect of this

proposal by March 17, 2006, to [email protected] or by contacting

any of the individuals listed as contacts in this article.)

Executive Summary

Investors, issuers, and market intermediaries increasingly seek clarification of the value of

specific hybrid securities in Standard & Poor’s Ratings Services’ analysis of a bank or

insurance group’s capital. Our approach closely resembles that of financial regulators, since

they have the power to intervene in the operations of a financial services company, and

determine whether to do so based on their own perceptions of capital adequacy, as reflected in

Financial Services Criteria: Equity Credit For Bank And Insurance Hybrid Capital, A Global Perspective

Standard & Poor’s | FINANCIAL SERVICES CRITERIA 2

their definitions of capital. Even so, Standard & Poor’s has developed generalized guidelines that vary

somewhat from regulators’ to facilitate cross-border comparisons. We differentiate the capital value of

hybrid securities by their equity-like characteristics, and classify them as follows:

Category 1: High Equity Content

Category 2: Intermediate Equity Content (divided into two levels: Category 2: Strong and Category

2: Adequate)

Category 3: Minimal Equity Content

This streamlined approach is coordinated across Standard & Poor’s Financial Services and Corporates

Ratings groups. The approach allows for the different regulatory environments facing many issuers of

hybrid securities.

Standard & Poor’s includes qualifying hybrid securities in its published total capital measures for

banks and insurers up to limits that are the highest for Category 1 (High Equity Content) hybrids, but

that exclude Category 3 (Minimal Equity Content) hybrids. Standard & Poor’s applies limits for the

inclusion of hybrids in its capital measures. These limits vary by category and broadly reflect the

regulatory policy of capping the inclusion of hybrids in regulatory capital.

Standard & Poor’s capital measures and classification of hybrid securities by category complement

measures based strictly on regulatory capital. At the very least, qualification as Tier 1 or Tier 2

regulatory capital by national bank regulators is necessary for Standard & Poor’s to include a hybrid

security in its published total capital measures. For regulated insurance companies, qualification as

regulatory capital by the national insurance regulator is necessary. When insurance regulators express

no views on specific hybrid securities, Standard & Poor’s establishes its own stance on likely regulatory

policy with respect to the instrument.

The regulatory treatment of hybrids issued by regulated financial services companies matters because

regulators typically have the legal authority to intervene in operations to stop or suspend coupon

payments on hybrid securities of troubled entities. Standard & Poor’s considers that regulators will

intervene to suspend hybrid coupon payments at an earlier point than an unregulated corporate would

decide to suspend coupons on its hybrids. This has been demonstrated most clearly in the U.S. banking

sector.

Standard & Poor’s treatment of hybrid securities issued by nonregulated financial services companies

is likely to increasingly mirror the treatment for other unregulated corporate issuers. Standard & Poor’s

will publish additional articles on this topic.

Standard & Poor’s includes hybrid securities in capital analysis when it concludes that the hybrids

can act like equity when the issuer is under stress: for example, they preserve cash and to some degree

bear the downside risk of poor performance. We limit hybrids in capital because:

The quasi-fixed cost of most hybrids increases coverage requirements (the servicing cost is usually

not linked to the performance of the company),

The complexity of many hybrids introduces uncertainty of performance under stress, and

Regulators limit hybrids in regulatory capital.

The growing inclusion of call options with step-up clauses weakens the permanency of hybrid

securities. This trend heightens the importance of analyzing the regulatory approval of the call and the

replacement covenants that commit the issuer to replace the retired security with hybrid capital of

equivalent strength. Mandatory, enforceable replacement covenants restore permanency and equity

value to hybrid capital securities that have call options and step-up clauses, but clear regulatory policy



can also achieve this for regulated financial services companies. In many cases, regulators can prevent a

call if unhappy with the company’s financial standing, or can insist on the instrument being replaced

with one of equivalent strength.

The existence of a clause that obligates the issuer to defer or suspend the coupon payment under

defined circumstances makes a hybrid capital security more equity-like, all else being equal.

Nevertheless, for regulated financial services companies a mandatory coupon deferral clause is not a

material factor in the classification as a Category 1, Category 2: Strong, Category 2: Adequate, or

Category 3 hybrid security. This is because regulators retain authority over the deferral of coupon. The

mandatory deferral clause may be a factor that increases the potential for payment deferral, but the

regulatory intent and authority is more important analytically. Furthermore, in the event of a stress at a

company, the ability to write down the instrument’s principal on a going-concern basis may be a more

important signifier of equity content than the coupon deferral clause.

Overview

The recent rapid growth in hybrid capital issuance by banks and insurance companies highlights the

important role played by hybrid instruments in capital and balance-sheet management. U.S. banking

regulators effectively launched the hybrid capital market in the early 1980s, when they were seeking a

way to encourage the then-overleveraged U.S. financial sector, and particularly the so-called money

center banks, to build capital. Since then, the issuance of hybrid capital by financial institutions has

spread globally and has followed an uninterrupted upward path of development. Hybrid capital’s

usually tax-deductible coupon payments, lack of dilution of common shareholders, wide access to

fixed-income investors, regulatory capital credit, and benefits for reported ROE, have made it an

unbeatable capital markets product for banks and insurers, particularly in the past decade of low

interest rates and recent very low credit spreads.

The global markets have also experienced a proliferation of innovative hybrid capital structures in

recent years. Several trends are behind this. The dynamic growth of risk assets and the high amount of

mergers and acquisitions in the financial services sector have fueled a need for capital, often in a short

timeframe. In addition, the global acceptance of hybrids as regulatory capital, and the convergence of

banking and insurance regulation, has led national authorities to allow more variations in hybrid

structures over time. Moreover, many financial institutions have reached regulatory limits for

“traditional” types of hybrids. Lastly, market participants and financial regulators have worked with

unlisted cooperative and mutual banking and insurance groups unable to issue common equity to

develop innovative hybrid instruments that allow them to raise regulatory capital like their listed

counterparts.

Standard & Poor’s Approach Parallels Regulators’

Standard & Poor’s employs a simple methodology for analyzing hybrid securities that parallels the

regulatory approach, classifying hybrids into three categories, reflecting their relative degree of equity

strength. We include hybrid capital in our published total capital measures up to limits established in

relation to the following categories:


Category 2: Intermediate Equity Content (divided into two levels: Category 2: Strong and Category

2: Adequate)




Table 1 summarizes the criteria for inclusion of hybrid capital securities in Standard & Poor’s

published total capital measures for financial services companies. The limits for inclusion by category

broadly parallel the regulatory policy of capping the inclusion of hybrids in regulatory capital, and

allow for global comparisons of capital measures.

Table 1.

Classification Of Hybrid Securities For Financial Services Companies (cont.'d)

Category Inclusion in Standard & Poor’s total capital measures Examples


Up to 35% of ATE or up to 25% of TAC Short-dated mandatory convertible securities (<3 years)

High quality hybrids with participating coupons

Category 2: Intermediate Equity Content

Category 2: Strong

Up to 25% of ATE or up to 15% of TAC Perpetual preferred shares

Most bank and insurer undated deferrable Tier 1 instruments

Insurance long-dated hybrid instruments (residual maturity of 20 years or more) with coupon deferability

Category 2: Adequate

Up to 10% of ATE or up to 15% of TAC Most, but not all, bank Upper Tier 2 instruments

Limited life preferred shares (e.g. U.S. trust preferred)

Insurance hybrid instruments with a residual maturity of less than 20 years, with coupon deferability*

Eligible funded contingent capital for insurers


Not included in ATE or TAC Dated hybrid instruments with a residual maturity of five years or less

Auction-preferred securities

Nondeferrable subordinated debt

Instruments with put options

ATE—Adjusted total equity (for banks). TAC—Total adjusted capital (for insurers). *Within 10 years of the repayment date, Standard & Poor’s will gradually treat the instrument as more debt-like, using a five-year amortization schedule whereby for each year under 10 years, an incremental 20% of the instrument is treated as debt until, at five years of remaining life, the issue is viewed as completely debt-like.

Why Regulators Matter

Standard & Poor’s approach parallels the regulatory approach for an important reason: financial

regulators have the authority and the power to intervene in the operations of a bank or regulated

insurance company, and they make this determination based on regulatory capital. The capital policy

of financial regulators is inscribed in the terms of most bank hybrid capital issues, and increasingly so

for regulated insurance company issues. Not only will the chosen structure of a hybrid instrument be

influenced by the regulatory treatment, but also the redemption of hybrid capital instruments typically

is subject to regulatory review. Regulators can intervene to enforce the suspension or nonpayment of



hybrid coupons, can restrict the amount of hybrids that an entity can issue, and can also require any

redeemed hybrid to be replaced with an instrument of equivalent strength.

Regulators define and accept hybrid capital instruments to allow financial groups to build and

manage regulatory capital. They seek instruments that rank below debt in liquidation and that absorb

losses while permitting the financial institution to continue to operate.

Bank regulators in mature and emerging markets around the world have adopted the Tier 1 and Tier

2 categories of hybrid instruments to rank the instruments by relative capital strength and to regulate

capital and leverage in the industry. They distinguish between “plain vanilla” subordinated debt, which

provides protection to depositors and senior creditors in liquidation, and stronger types of regulatory

capital, which defer or eliminate coupon payment under defined circumstances. In many countries, and

notably in the European Union, regulators further define Tier 2, setting specific standards for eligibility

as Upper and Lower Tier 2 capital.

Differences among definitions and interpretations of regulatory capital have multiplied with the

expansion of the hybrid capital market; consequently, no single definition of Tier 1 or Tier 2 capital

exists. That said, hybrids that qualify as Tier 1 regulatory capital are generally either deeply

subordinated, permanent (although callable under certain circumstances), and the coupon deferral is

noncumulative. Upper Tier 2 instruments generally are permanent (although not in all countries),

subordinated to debt, but the coupon deferral is cumulative. Lower Tier 2 is usually subordinated debt

with nondeferrable coupons.

Consequently, when Standard & Poor’s reviews the hybrid capital instrument of a financial

institution, the regulatory intent with respect to the instrument is a dominant factor in the analysis of

equity content and of payment deferral risk. If insurance regulators express no view on a specific hybrid

security issued by an insurer, Standard & Poor’s establishes its own stance on likely regulatory policy

with respect to the security.

Standard & Poor’s criteria, and capital ratios, are not the same as regulators’. This would be

impracticable, since our goal is to produce capital measures that are globally comparable, while

regulators’ concerns are first and foremost at the national level.

Hybrids Act Like Equity

Hybrid capital securities of banks and insurers are designed to act like equity:

They preserve cash when the issuer is under pressure,

Nonpayment does not provoke default,

Their value fluctuates with the performance of the issuer, and

In certain circumstances for some instruments, the principal may be available to be written down

without provoking a legal default or liquidation.

Standard & Poor’s considers that all hybrid capital securities issued by regulated financial services

companies—banks and insurers—carry a high risk of nonpayment if the issuer falls below the

minimum capital requirements set by the national regulator.

While the incidence of payment deferral generally has been low over the past decade, many cases of

payment deferrals and even write-down of principal have occurred. The incidents of deferral and

principal write-down are in the U.S., Japan, and Germany, the latter two countries having financial

sectors that came under stress during the last decade.



U.S. bank regulatory policy is to order a deferral of interest in cases where the issuing financial

institution is considered a troubled institution and needs to preserve cash because it is taking losses or is

under threat of losses in the future. The institution may be close to regulatory capital minimum, but

this is not a necessary criterion for regulatory action. The regulators, and notably the Federal Reserve

Bank, have broad powers to intervene with respect to hybrids. U.S. bank regulators have directed

banks to defer hybrid coupons even in cases where the banks have been in compliance with regulatory

capital standards. Prominent cases in the U.S. include: Riggs National Corp., a bank holding company

whose trust preferred securities deferred payment in December 2004 and resumed in June 2005; Bay

View Capital Corp., a bank holding company that deferred payments on its preferred shares in

September 2000 and resumed in 2002; and City Holding Co., a bank holding company that deferred

payments on its preferred shares in July 2001 and resumed in July 2002. Many other cases of interest

deferral of smaller institutions occurred during the past five years.

In Japan, two recent prominent examples of interest deferral are: Resona Bank, whose perpetual

preferred shares suspended payment in 2003; and UFJ, whose preference certificates suspended

payments in mid-2005, prior to its merger with The Bank of Tokyo-Mitsubishi.

In Germany, a prominent recent example is WestLB AG (A-/Stable/A-2), whose hybrid capital

securities specific to the German market, silent partnership certificates called “stille Einlagen” (included

in regulatory Tier 1), absorbed losses in 2003 and 2004, even though its other Tier 1 hybrids continued

to pay coupons. Lastly, a current case to cite is that of Allgemeine Hypothekenbank Rheinboden AG

(AHBR; BB+/Negative/B). AHBR, a troubled German mortgage bank, has Tier 1 stille Einlagen and

dated upper Tier 2 cumulative profit participation certificates called “Genussrechte” in its regulatory

capital base. Standard & Poor’s expects these unrated instruments will forego coupons and be written

down in 2006, following the recent U.S.-based Lone Star Fund’s takeover of AHBR.

The U.S., Bermudan, and Japanese insurance sectors have several cases of hybrid security coupon

nonpayments over the past five years. U.S. insurance examples include Conseco Inc. (BB-/Stable/N.R.),

whose Feline Prides hybrids stopped paying coupons in October 2002; and Southwest Life Holdings,

whose preferred shares stopped paying coupons in February 2000. In Bermuda, La Salle Re Holdings

stopped paying preferred share coupons in December 2002. Many Japanese insurers maintained

payments on their hybrids through periods of stress, but some nonpayments did occur, such as Asahi

Mutual Life’s nonpayment of coupons on its “kikin” hybrids in 2003. Many prominent examples of

nonpayment of insurers are due to default of the issuer rather than simply coupon deferrals of hybrids.

In the insurance cases, the hybrids of the holding companies defaulted, while the operating

companies did not. This shows that the hybrids provided a degree of protection to the operating

companies.

Standard & Poor’s expects to see a higher incidence of coupon deferrals and suspensions on hybrid

securities of financial services companies in the future, as the amount of issuance grows and when the

financial services industry experiences a cycle of weaker performance.

Why Limit Hybrids In Capital?

Excessive reliance on hybrid securities increases financial leverage due to the fixed cost of servicing the

hybrids and potential concentrations in the redemption dates of dated or callable instruments. The

servicing cost of hybrids is less flexible than that of common equity, and many hybrids are less

permanent than common equity. Investors expect hybrid securities to pay a fixed coupon. Hybrids



often contain features that create incentives for management to retire the instrument, or to repurchase

common shares that might be issued as a result of a conversion clause. Moreover, many hybrid

securities include highly complex combinations of different features and are still relatively novel and

untested, making it difficult to foresee how the securities would perform for issuers in different

scenarios—and may cast doubt over how they would absorb losses on a going-concern basis. Thus, a

prudent financial policy dictates a degree of caution about reliance on capital in this form.

Hybrid issuance that exceeds Standard & Poor’s limits for published total capital measures is

reflected in financial flexibility, regulatory capital strength, and the overall quality of the capital base.

Excess issuance could improve the quality of capital if the new issuance has higher equity content than

the existing stock of hybrids.

With respect to insurance holding companies, Standard & Poor’s generally views incremental hybrid

capital issuance over the limits as more debt-like than equity-like, and reflects this in its analysis of

leverage as is appropriate. Nevertheless, we review an issuer’s potential to defer coupons on hybrids

excluded from Total Adjusted Capital (TAC), and the role the hybrid plays in overall balance-sheet

management.

Companies may decide to issue hybrids above regulatory limits and rating agency guidelines to

opportunistically exploit low financing rates, or to achieve a sufficiently liquid issue size.

Assessing The Quality Of Hybrid Instruments

Standard & Poor’s defines capital as funds that are permanent in nature, lacking repayment

requirements or fixed financing costs, are able to defer payments without provoking a default or

liquidation, and are sufficiently fungible within a group to be able to absorb losses on a going concern

basis. Capital is a cushion of protection subordinated to all claims of creditors.

To assess where a hybrid security sits in the spectrum between capital and debt, Standard & Poor’s

reviews the economic merit of its capital characteristics as defined above, as well as aspects that could

make it more debt-like, such as features that could render coupon deferral difficult and trigger early

redemption, including in times of stress.

Management intent is important. Standard & Poor’s discussion of financial policy with senior

management provides insights into potential future retirement and replacement of hybrids. Just as a

financial institution can buy back or issue new share equity or issue additional shares, it can structure

and manage hybrid capital securities in a way that makes them less permanent. Preferred shares

increasingly contain provisions for redemption or exchange, if not an outright stated maturity. A

preferred share issue that will likely be refinanced with debt down the road is more debt-like than

equity-like from the time of issue. Other aspects to consider when assessing management intent include

voting rights of the instrument, the potential for dilution of existing common shares, and conversion

features.


Category 1 High Equity Content hybrids have very strong equity-like characteristics and materially

improve the overall quality of the issuer’s capitalization. They convert to common equity in the short to

medium term, or have a coupon that varies with the earnings of the issuer, much like the common

dividend. Investors in Category 1 hybrid instruments typically bear equity-like risk; the value of a

Category 1 hybrid security will have a high correlation with the value of equity. High Equity Content



hybrids will usually have acceleration triggers that lead to a conversion into common equity if the

issuer is under financial stress.

Hybrids are more equity-like when the coupon is linked to the issuer’s performance. A hybrid with a

coupon linked to the common dividend, even if a portion of the coupon is fixed, is more like common

equity than a security with a coupon that is wholly fixed to an external indicator such as a market

interest rate.

Category 1 hybrids include mandatory convertible securities (MCS) that convert to equity in the

short to medium term, usually defined as three years or less. Short to medium dated MCS are High

Equity Content provided that the conditions surrounding the conversion do not encourage the issuer to

redeem existing shares so that the issuer can prevent shareholder dilution upon conversion. (The

securities should have a robust mechanism that ensures that conversion will not excessively dilute the

issuer’s share price. This mechanism should reduce to a minimum the potential buy-back of newly

issued shares resulting from conversion.) Longer dated MCS that are not classified in Category 1 at

issuance due to the long time period to conversion become considered as Category 1 when the residual

period to mandatory conversion falls to three years or less. Recent examples of Category 1 High Equity

Content MCS include a $650 million MCS issued in December 2005 by XL Capital Ltd. and a Swiss

franc 1.25 billion MCS issued in December 2002 by Credit Suisse Group.

Rabobank Nederland’s membership certificates are another example of a Category 1 instrument.

The membership certificates are permanent, deeply subordinated, and the fixed coupon is suspended if

the bank does not report a profit. As Rabobank has a cooperative ownership structure that precludes

common shares, the certificates represent the most equity-like instruments that the cooperative bank

can issue.

Category 2: Intermediate Equity Content

Category 2 Intermediate Equity Content hybrids have equity-like features that protect senior

bondholders and insurance policyholders and enhance regulatory capital flexibility in the event of

stress. Nevertheless, a Category 2 Intermediate Equity Content hybrid is debt-like in some respects,

typically due to the fixed nature of the coupon. Investors expect the coupon to be paid. This category

is divided into two levels: Category 2: Strong, and Category 2: Adequate.

Standard & Poor’s removes securities from Category 2 as they approach maturity. A dated

instrument is excluded from total capital measures when it has five years or less left to maturity.

Category 2: Strong

Standard & Poor’s classifies the majority of regulatory Tier 1 bank securities as Category 2: Strong.

Bank Tier 1 instruments have a clearly defined role in acting like risk capital in the event of stress—this

has been reinforced by regulatory action in the U.S., Japan, and Germany in recent years, as noted

earlier. Most perpetual preferred shares are in the Category 2: Strong classification. Bank perpetual

preferred shares typically have an optional coupon, although in practice the set coupon payment is

much more reliable than the common dividend. Issuers increasingly include an option to call perpetual

(and long-dated) hybrid securities after 10 years. The result is that perpetual and long-dated preferred

shares trade like fixed-income instruments with assumed maturity at the first call, but with a risk

premium that reflects the potential payment default risk, and extension risk.



A recent example of a Category 2: Strong instrument is the January 2006 issue of WITS (Wachovia

Income Trust Securities) by Wachovia Corp. The Federal Reserve Bank accepts WITS in Tier 1

regulatory capital.

With respect to insurers, the market for perpetual deferrable subordinated debt/trust preferred

traditionally was not strongly developed. Insurance hybrid securities are almost always dated, although

Standard & Poor’s considers that perpetual instruments are stronger and more like common equity.

Influenced by the Tier 1 eligibility requirements of the U.K. insurance regulator, a number of leading

British insurance groups have succeeded in issuing undated Category 2: Strong hybrids, including

Prudential PLC (AA-/Negative/A-1+), Aviva PLC (A+/Stable/—), and Friends Provident PLC

(A-/Stable/—). Longer dated (at least 20 years) insurance deferrable subordinated debt and trust

preferred are considered Category 2: Strong hybrids. The difference between bank and insurance

treatment reflects the different regulatory and market environment for the insurance sector, where

regulators generally do not tier hybrid capital.

Category 2: Adequate

Category 2: Adequate instruments are sufficiently able to defer payments and act like capital in a stress

situation, but relatively less than Category 2: Strong hybrids due to their limited life and/or limits on

payment deferral (usually five years or less).

Regulatory classification is an important factor for hybrids issued by regulated financial institutions.

An eligible hybrid issue included in Tier 2 by the national regulator is likely to be classified as Category

2: Adequate. For example, European bank Upper Tier 2 instruments are classified in Category 2:

Adequate. Standard & Poor’s considers that Tier 1 hybrids are more likely to defer payments and

absorb losses through write-down of principal than Upper Tier 2 instruments, due to the more

stringent regulatory requirements for Tier 1. While insurance regulators generally do not make this

distinction, insurance issuers have adopted the same hybrid structures as banks, with the result that

they vary in relative equity strength as well. In some countries, notably the U.K., regulatory policy

concerning hybrid capital securities is the same for banks and insurers. Standard & Poor’s classifies

traditional U.S. trust-preferred securities, which have limited life and limited coupon deferral

characteristics, as Category 2: Adequate rather than Category 2: Strong, even though the U.S.

regulators include them in Tier 1. In the case of U.S. banks, enhanced trust preferred is classified as

Category 2: Strong, but is still limited to up to 15% of ATE because of regulatory considerations. (See

“Credit FAQ: Recent Hybrid Capital Issuances By U.S. Bank Holding Companies May Be Models For

Future Transactions,” published on Feb. 16, 2006.)

Category 2: Adequate instruments includes shorter dated instruments issued by insurers, namely

those with an initial maturity of 10-20 years. For insurers, it also includes instruments that are callable

under 10 years (typically, five years). In order for shorter dated instruments to receive equity credit,

Standard & Poor’s must be comfortable with management’s intent to maintain a capital structure

consistent with the expectations embedded in the insurers’ ratings. Category 2: Adequate instruments

for insurers also include pre-funded contingent capital arrangements, although only up to 5% of TAC,

only for investment-grade issuers, and only assuming acceptable security features.




Instruments excluded from Standard & Poor’s financial services published measures of capital

Certain instruments have insufficient equity-like features for inclusion in ATE or TAC. Nondeferrable

(plain vanilla) subordinated debt, whether perpetual or limited life, is excluded because it only absorbs

losses in liquidation. Instruments with put features (where the investor can redeem at a sign of

deteriorating performance) and auction preferred securities are also excluded. Auction preferred are

perpetual in name, but often represent merely a temporary debt alternative for companies that are not

current taxpayers until they can once again benefit from the tax deductibility of interest expense.

Moreover, the holders of auction preferred would pressure for redemption in the event of a failed

auction or a ratings downgrade.

Standard & Poor’s also excludes from its capital measures hybrid instruments that are felt to be ring-

fenced within a group structure, or where the proceeds are otherwise insufficiently fungible within the

group for the instrument to be expected to defer coupon payments or to be written down in the event

of group stress. For example, Standard & Poor’s has excluded from ATE several Tier 1 trust-preferred

securities issued by German banks via trust structures. This is because the instruments are considered

sufficiently ring-fenced that the resources would not be available to absorb losses on a going-concern

basis. (This was shown in the case of WestLB, where coupons were skipped on directly issued Tier 1

instruments (and the principal was written down), but nondirectly issued Tier 1 securities continued to

pay their coupons in full on a timely basis.)

Table 2.

Definitions Of Standard & Poor’s Capital Measures

Adjusted common equity (ACE)

ACE includes common equity, share reserves, retained earnings, most equity minority interests, and asset revaluation reserves on insurance investments where appropriate. ACE excludes intangible assets, unseasoned asset revaluation reserves that may not be accessible in times of stress, and equity held in unconsolidated subsidiaries.

Adjusted total equity (ATE) (measure used for bank analysis)

ACE plus hybrid capital issues up to prescribed limits: (1) Category 1 High Equity Content: up to 35%; (2) Category 2: Strong: up to 25%; (3) Category 2: Adequate: up to 10%; (4) Category 3 Minimal Equity Content: excluded at 0%. Total hybrids (Categories 1, 2, and 3) limited to 35% of ATE. Total of Category 2: Strong and Category 2: Adequate limited to 25% of ATE. ATE excludes intangible assets, asset revaluation reserves, and equity held in unconsolidated subsidiaries.

Total adjusted capital (TAC*) (measure used for insurance analysis).

ACE plus equity-like reserves, a percentage of realizable intangibles, and hybrid capital issues up to prescribed limits: (1) Category 1 High Equity Content: up to 25%; (2) Total of Category 2: Strong, and Category 2: Adequate: up to 15%; (3) Category 3 Minimal Equity Content excluded at 0%. Total hybrids (Categories 1, 2, and 3) are limited to 25% of TAC. Total of Category 2: Strong and Category 2: Adequate limited to 15% of ATE. Pre-funded contingent capital facilities limited to 5% of TAC. For the purpose of calculating hybrid equity tolerances for U.S. and BermudA-based insurance companies, TAC is defined as total common equity, preferred shares and other hybrid securities, minority interest, and debt less unrealized appreciation (depreciation) on fixed-income securities.

*TAC represents the total economic capital of the company or group calculated at market values.

Call Options And Step-up Clauses Reduce The Permanency Of Hybrids

Call options are common features in perpetual hybrid capital instruments. Over the past decade, issuers

have retired hybrids at the first call date with such regularity that investors assume that the call is

automatic. The main reason for this is the widespread inclusion of step-up clauses, whereby the coupon

rate steps up (increases) starting from the call date. The step-up creates a strong incentive to retire the

instrument at the first call. Hybrid capital issues with call and step-up features provide the issuing

entities with the best of both worlds—an instrument that trades as a dated fixed-income security, has

(usually) deductible interest payments, and counts as capital.



Banking regulators impose restrictions on call and step-up features to limit the incentives to retire

regulatory capital that is intended to be permanent. In 1998, the Basle Committee on Banking

Supervision issued a notification for regulators to limit acceptance of “innovative capital instruments”

with calls and step-ups to a maximum of 15% of Tier 1 capital and to subject innovative hybrids to

stringent conditions:

The call option with step-up should be a minimum of 10 years after the issue date,

The step-up should be less than or equal to 100 basis points, less the swap spread between the initial

index basis and the stepped-up index basis,

The step-up should be less than 50% of the initial credit spread, less the swap spread between the

initial index basis and the stepped-up index basis,

There should be no more than one rate step-up over the life of the instrument, and

The swap spread should be fixed as of the pricing date and reflect the differential in pricing on that

date between the initial reference security or rate and the stepped-up reference security or rate.

Regulators in mature banking markets around the world generally have implemented a 15% Tier 1

limit on innovative hybrids broadly in line with the conditions suggested by the Basel Committee

(although there are some exceptions based on the “grandfathering” of previous regulatory agreements).

Bank regulators usually forbid issuers from committing to call at a particular date, and require financial

institutions to obtain regulatory approval to exercise a call. This makes bank hybrids with a call more

equity-like than similar hybrids issued by an unregulated corporate.

Regulatory policy in the insurance sector is less developed, thus many insurance regulators look to

banking regulators for guidance in establishing policy on inclusion of hybrid instruments, including

securities with calls and step-ups, in regulatory capital. In some countries, from the U.K. to The

Netherlands and Financial Center regulators in the Gulf, the combination of bank and insurance

regulation under one roof (the Financial Services Authority in the U.K.) has facilitated a convergence of

bank and insurance regulatory policy with respect to hybrid capital. Standard & Poor’s typically

expects 10 years to the first call for an insurance issue with a step-up feature, although the different

regulatory environments mean that hybrids with shorter call dates may still be included in TAC.

Standard & Poor’s considers a hybrid with a longer period to the call date to be stronger (more

equity-like) than one with shorter period to the call, all else being equal. This reflects the longer period

that the former will remain in the capital structure on an obligatory basis. Moreover, an instrument

with a step-up at an optional call date is less permanent than one without a step-up. Everything else

being equal, Standard & Poor’s assessment of an issuer’s capital base will be weaker if there is heavy

use of hybrids with step-up features and with call dates that are close together.

Standard & Poor’s excludes from ATE or TAC hybrids with step-ups that exceed the regulatory

limits. For insurance issuers operating without regulatory policy in the area, Standard & Poor’s

excludes from TAC hybrids with step-ups greater than 100 basis points, consistent with market

practice. If a step-up is linked to deterioration in the issuer’s credit standing or rating, the instrument

will become excessively expensive when the issuer is under stress, and the issue is therefore excluded

from ATE or TAC.

The Value Of Replacement Covenants

Issuers increasingly commit to replace hybrid capital securities retired at the first or subsequent call

dates with securities that are at least as strong from the point of view of capital. Even if there is a step-



up provision, the replacement language in the issue can restore a degree of permanency to the security,

by providing a formal statement of management’s intent—even though it is questionable whether such

a stipulation is legally enforceable, particularly outside of the U.S. In the U.S. in July 2005, First

Tennessee Bank N.A. demonstrated the feasibility—at least in certain jurisdictions—of providing a

legally binding replacement clause when it made a “declaration of covenant” in connection with its

preferred stock issuance. The covenant runs in favor of holders of the bank’s covered debt.

Nevertheless, among regulated financial institutions, the existence of a replacement clause or

covenants is a secondary factor in the classification as a Category 1, Category 2: Strong, Category 2:

Adequate, or Category 3 hybrid security. This is because regulators retain authority over the retirement

of a hybrid capital security irrespective of the existence of any replacement provision—the regulator

can prevent redemption or enforce the replacement with another instrument of equivalent strength. The

spirit of financial institution regulation is to maintain a sound level of capital. Standard & Poor’s

expects bank and insurance regulators to step in and prohibit the retirement of a hybrid capital security

if that retirement would materially weaken the capital adequacy of the institution in question, although

regulators may in some cases focus only on whether minimum solvency requirements are met. The

replacement provision is a comforting factor, but the regulatory intent and authority is more important

analytically.

For unregulated financial institutions, the form of the replacement provision and the capital policy of

management assume greater analytical significance. A hybrid security with a call option and an

acceptable replacement provision is more equity-like than one without a replacement cause, “ceteris

paribus”. For unregulated firms, instruments with nonlegally binding replacement provisions do not

qualify for Category 1 treatment, but can be included in Category 2.

Standard & Poor’s monitors the profile of potential redemption dates for hybrid securities as well as

long-term debt when assessing the quality of capital and balance-sheet management.

Mandatory Coupon Deferral

The existence of a clause that obligates the issuer to defer or suspend the coupon payment under

defined circumstances makes a hybrid capital security more equity-like, all else being equal.

Nevertheless, for regulated financial institutions a mandatory coupon deferral clause is not a material

factor in the classification as a Category 1, Category 2: Strong, Category 2: Adequate, or Category 3

hybrid security. This is because regulators retain authority over the deferral of coupon. For banks, the

national regulator has the explicit or implicit authority to intervene and stop a coupon payment of a

hybrid qualifying as regulatory Tier 1 and Upper Tier 2 capital, usually when the entity in question is at

or below the then-applicable regulatory capital limits. Standard & Poor’s expects national financial

authorities to stop payments in these situations, irrespective of whether the status of the coupon

deferral is optional or mandatory. The mandatory deferral clause may be a factor that increases the

potential for payment deferral, but the regulatory intent and authority is more important analytically.

Furthermore, in the event of a stress at a company, the ability to write down the instrument’s principal

on a going-concern basis may be a more important signifier of equity content than the coupon deferral

clause.

For unregulated financial institutions, a mandatory coupon deferral clause makes the instrument

more equity-like, but may restrict the options of an entity to manage situations of temporary financial

stress. The nature of the mandatory deferral trigger and the capital policy of management take on



greater analytical importance for unregulated financial institutions. Standard & Poor’s expects coupons

to be deferred in a material stress situation, but recognizes that the suitable management behavior in

some temporary stresses could be to keep paying coupons on the hybrid until the problem is corrected,

thus maintaining debt market confidence and access.

Classification Reflects Many Factors

Hybrid capital securities are increasingly complex, combining several features; for example, coupon

deferral, payment in common shares, conversion to common under certain circumstances, varying

triggers for coupon deferral, contingent call features, among others. The classification of a specific

hybrid as a Category 1, Category 2: Strong, Category 2: Adequate, or Category 3 hybrid, and the

reflection of the hybrid in the overall capital analysis of the issuer, reflects the analysis of these specific

features, and also takes account of regulatory restrictions, relative servicing costs, investor profile and

expectation, and importantly, the overall capital and credit profile of the issuer. The classification is

often a judgment call that is not clear cut.

While qualitative assessment of a specific hybrid capital security is obligatory to classify the security

by its relative equity value, it is rare that the detailed features of a hybrid instrument have a material

impact on an issuer’s overall creditworthiness (see “Capital Is More Than A Ratio” below).

Banks Versus Insurers

Standard & Poor’s applies compatible methodology when assessing the capital strength of banks and

insurers, while recognizing the different nature of business risk and regulation in the two industries.

The capital analysis of banking groups, which are highly leveraged, principally focuses on common

equity and retained earnings, along with loan reserves and hybrid securities that can absorb losses in

times of difficulties.

Meanwhile, the capital analysis of insurance companies focuses more on broad capitalization

inclusive of eligible hybrid capital. For insurers, the ability to pay cash claims derives from several

sources: routine cashflows, reinsurance proceeds, the liquidation of investment assets at prevailing

market values, bank and capital market borrowings, and the potential realization of the present value

of future profits on the current “in-force” book of life business or the securitization of other insurance

flows.

Regulated financial institutions issue hybrid capital securities first and foremost to build regulatory

capital. Qualification as regulatory capital (Tier 1 or Tier 2) by national bank regulators is a

mandatory requirement for Standard & Poor’s to include a hybrid security in its total capital measures

for banks. If the bank regulator excludes an instrument from regulatory capital, the instrument

provides no cushion between minimum capital and regulatory action, which could include closure.

In contrast to many banks, insurers traditionally have maintained capital well in excess of regulatory

requirements. Insurance groups issue hybrid capital securities to manage economic capital and satisfy

constituents (including rating agencies like Standard & Poor’s) in addition to boosting regulatory

capital. Regulatory intent historically has been less of a factor in the analysis of hybrid instruments

issued by insurance concerns, given that many insurance regulators have been less prescriptive

regarding hybrid instruments than have bank regulators, but the situation is changing. The increasing

use of risk-based capital adequacy methodologies by insurance regulators places greater emphasis on

hybrids as a way of complying with more onerous regulatory capital requirements. Some insurance



regulators, such as those in the U.K., are adopting certain bank-type hybrid structures as suitable for

insurance issuance. As in the banking sector, if the insurance regulator excludes an instrument from

regulatory capital, the instrument provides no cushion between minimum capital and regulatory action.

Note that in jurisdictions where the insurance regulators have expressed no view on a specific hybrid

capital instrument issued by an insurance group, Standard & Poor’s establishes its own stance on likely

regulatory policy with respect to the instrument.

Capital Is More Than A Ratio

The analysis of hybrid capital must be placed in the context of the broader analysis of capital, and of

the creditworthiness of a bank or insurer. Formulaic ratio-driven analysis represents only a part of the

overall quantitative and qualitative assessment of capital, which in turn can only be analyzed within the

broader commercial and financial profile of the rated company. Capital ratios are visible shorthand

signals of balance-sheet strength, but are not correlated with credit rating levels. Qualitative analysis of

capital policy is fundamental to the global assessment of the creditworthiness of banks and insurers.

No single measure fully captures the breadth of information needed to evaluate an entity’s capital

adequacy. Industry participants—investors, securities analysts, the company management itself—at

times focus excessively on the management of bank and insurance capital with respect to a specific

ratio, to the detriment of analysis of broader issues such as risk profile and management. Capital ratios

based on historical data are also less meaningful than expectations of future capitalization under

various scenarios.

Components in the qualitative analysis of capital include: unrealized capital gains or losses, and

hidden reserves or losses, access to capital and liquidity from third parties, the nature and extent of

minority interests, dividend policy, potential for earnings generation and retention, and management

strategy with respect to acquisitions, disposals, and investments.

For insurers particularly, analytical factors also include overall financial leverage, the manner in

which structural subordination and double leverage are treated by local regulators, interest and fixed-

charge cover, the use of reinsurance to mitigate peak exposures, and reserving policy for long-tail and

other technical liabilities.

While the classification of hybrid instruments affects Standard & Poor’s capital ratios for financial

services companies, the overall assessment of capital adequacy is based on many quantitative and

qualitative factors rather than ratios alone.

Primary Credit Analystss: Solomon B Samson New York (1) 212-438-7653 sol_samson@ standardandpoors.com Scott Sprinzen New York (1) 212-438-7812 scott_sprinzen@ standardandpoors.com Emmanuel Dubois-Pelerin Paris (33) 1-4420-6673 emmanuel_dubois-pelerin@ standardandpoors.com

Publication Date May 8, 2006

CRITERIA

Criteria: Equity Credit For Corporate Hybrid Securities Equity hybrids—as the name suggests—combine features of debt and of equity. The many

combinations and permutations of such features are growing, as new instruments are devised

almost daily. Standard & Poor’s Ratings Services’ analytical treatment reflects this varying

equity content—basically attributing ‘partial credit’ to various hybrid instruments.

Hybrid Hierarchy Has Been Streamlined

We introduced the equity hybrid hierarchy in 1999, pioneering a quantitative approach to the

equity credit associated with hybrids securities issued by corporates. Last year, we streamlined

that hierarchy in order to communicate our position more effectively. The different levels of

equity content consist of three categories:

‘Minimal equity content,’ which includes instruments with little or questionable

permanence; terms or nomenclature that restrict or discourage discretion over payments;

after-tax costs or conversion terms that may become unattractive to the issuer.

‘Intermediate equity content,’ which encompasses most the of preferred stock genre, from

30-year trust preferred with five-year cumulative deferral rights to perpetual, tax-deductible

preferred (as in the U.K.), with unlimited and/or non-cumulative deferral rights.

‘High equity content,’ which include features that support the current rating. These typically

involve a mandatory component, either regarding deferral of ongoing payments at

appropriately high trigger levels, or near-term conversion into a fixed number of common

equity shares (on a basis that would not be deemed unpalatable to the issuer at the time of

conversion).

The treatment of hybrids for ratio calculation purposes is discussed below (‘Rating

Methodology’). We recently decided to change how we calculate ratios for the intermediate

Criteria: Equity Credit For Corporate Hybrid Securities


equity content category. Going forward, we will emphasize the ratios that split hybrid-related amounts

50%-50% between debt and equity.

We use a common framework across our Corporate and Financial Services practices and across

regions. However, there are significant differences, reflecting the different nature of the companies and

the rating methodologies. The analysis of regulated financial institutions emphasizes capital

adequacy—and, in particular, regulatory capital. In turn, the hybrid methodology for financial

institutions does not follow the partial approach described above; rather, it grants full equity credit

with certain threshold limits, which are set depending on the degree of equity content.

Moreover, potential regulatory intervention is a critical aspect of the financial institution dynamic.

Given the high funding needs of banks and the importance of maintaining confidence in the specific

bank and the entire financial sector, regulators may order deferral when the credit quality of a bank is

still stronger than the point where most corporates would consider such an action.

Standard & Poor’s ratings on the hybrid securities themselves highlight the risk of nonpayment—

even while the company has not legally defaulted. Since we deem payment deferral or partial payment

deferral a (nonlegal) default, upon such deferral, the issue rating would be ‘D’. Working backwards,

the impending issue default risk rises as the triggers for nonpayment approach, and the initial rating on

such securities can be several notches below the corporate rating. (See “Corporate Default Risk With A

Twist,” published July 5, 2005, on RatingsDirect, Standard & Poor’s web-based publishing system.)

Equity Has Several Attributes

What constitutes equity in the first place? Traditional common stock—the paradigm equity—sets the

standard. But equity is not a monolithic concept; rather, it has several positive characteristics:

Equity requires no ongoing payments that could lead to default;

It has no maturity or repayment requirement;

It provides a cushion for creditors in the case of a bankruptcy; and

It is expected to remain as a permanent feature of the enterprise’s capital structure.

Equity hybrids normally possess some—or all—of these characteristics to some degree. Yet, because

equity has these several defining attributes, it should be apparent that a specific security can have a

mixed impact. Hybrid securities, by their very nature, can be equity-like in some respects and debt-like

in others. Moreover, the specific features may provide the positive characteristic only to a limited

extent.

In any event, the security’s economic impact is most relevant: its nomenclature is a secondary

consideration. A transaction labeled debt for accounting, tax, or regulatory purposes may still be

viewed as equity for rating purposes, and vice versa.

Soft capital—a commitment from a nonaffiliated provider of capital to inject equity capital at a later

date—can be valuable. Still the company does not have the funds now, when it might be invested to

support the health of its business. And, by making the funds available at the company’s discretion,

there is the risk that a delay in exercising that option may lead to a situation of too little, too late.

Ongoing payments.

Equity pays dividends, but has no fixed requirements that could lead to default and bankruptcy if

these dividends are not paid. Moreover, there are no fixed charges that might, over time, drain the

company of funds that may be needed to bolster operations. While a company is under pressure to pay



both preferred and common dividends, it ultimately retains the discretion to eliminate or defer payment

when it faces a shortage of funds. The degree of discretion, however, can vary.

We assume a company will have greater reluctance to pass on a preferred dividend than to reduce or

eliminate its common dividend. Accordingly, there is a difference in ‘equity credit’ afforded to common

equity relative to preferred equity. Similarly, common equity issued in conjunction with so-called

income depository securities (IDSs), master limited partnerships, and real estate investment trusts

(REITs) is viewed as possessing less discretion over dividends: investors are promised a payout of

virtually all cash flow, and they are marketed with an expected yield.

The longer a company can defer dividends, the better. An open-ended ability to defer until financial

health is restored is best. As a practical matter, the ability to defer dividend payments for five or six

years is most critical in helping to prevent default. If the company cannot restore financial health in five

years, it probably never will. The ability to defer payments for shorter periods also is valuable, but

equity content diminishes quickly as constraints on the company’s discretion increase.

We also discount the right of deferral if it entails some potential disincentive. For example, some new

instruments require the company to issue stock—common or preferred—once they have deferred for

one or two years. Because companies presumably would want to avoid such a requirement, they would

be even more reluctant than usual to defer in the first place.

Debt instruments can be devised to provide equity-like flexibility with regard to debt service.

Deferrable payment debt issued directly to investors—i.e., without a trust structure—legally affords the

company flexibility regarding the timing of payments that is analogous to that of preferreds. Yet, the

identification of a security as debt constrains the company’s practical discretion to defer payments,

thereby diminishing the equity credit attributed to such hybrids compared with deferrable payment

preferred stock.

By removing the discretionary element, mandatory trigger mechanisms can increase comfort that

deferral actually will occur when the circumstances of the issuer make this desirable from the creditors’

perspective. (Historically, income bonds—i.e., where the payment of interest is contingent on achieving

a certain level of earnings—were designed with this in mind. However, to the extent that cash flow

diverges from earnings measures, income bonds tend to be imperfect instruments.) The equity content

of such instruments is a function of the trigger levels used to determine when payments are diminished.

For example, if the level of cash flow that triggers payment curtailment is relatively low, that

instrument is not supportive of high ratings. A more straightforward concept entails linking interest

payments to the company’s common dividend, creating an equity-mimicking bond. (A number of

international financial institutions issued such bonds in the late 1980s.) Of course, if a company had an

inordinate amount of dividend-linked issues outstanding, this ultimately could increase its reluctance to

curtail its common dividend.

Maturity or repayment requirement.

Obviously, the ability to retain the funds in perpetuity offers the company the greatest flexibility.

Extremely long maturities are next best. Accordingly, 100-year bonds possess an equity feature in this

respect (and only in this respect) until they get much nearer their maturity. (To illustrate the point,

consider how much, or how little, the company would have to set aside today to defease or handle the

eventual maturity.) However, interest payments are not deferrable and cross-default provisions would

lead to these bonds being accelerated.



Preferred equity often comes with a maturity—as a limited-life or sinking-fund preferred—which

would constitute a clear shortcoming in terms of this aspect of equity. Limited credit would be given

for this type of preferred; even if it could be assumed the issue successfully is refinanced at maturity, the

potential for using debt in the refinancing would be a concern (see the following discussion on the

permanence of equity). Our normal standard for intermediate equity credit is 25 years remaining life.

Cushion for creditors in the event of default.

What happens in bankruptcy also pertains to the avoidance of bankruptcy and default, albeit

indirectly. Companies’ access to debt capital depends on providers feeling secure about the ultimate

recovery of their loans in the event of a default. Debt-holders’ claims have priority in bankruptcy, while

equity holders are relegated to a residual claim on the assets. The protective cushion created by such

equity subordination allows the company access to capital, enabling it to stave off a default in the first

place.

Subordination typically is a secondary consideration compared with other beneficial aspects of

equity. Thus, if an instrument is senior, but ongoing payments are deferrable and it has a long-dated

maturity, we could well view it as having substantial equity content. On the other hand, if an

instrument is subordinated, but lacks the other equity-like traits, it would be viewed as predominantly

debt-like.

The distinction between subordination and deep subordination generally is not significant in our

analysis, although deep subordination incrementally is somewhat more supportive. Also, many U.S.

securities—to meet IRS guidelines for tax-deductibility—may be termed subordinated while providing

pari passu status to trade creditors. This can be a meaningful shortcoming—although, in the total

scheme of things, it rarely would determine the overall equity category.

Permanence.

At any time, a company can choose either to repurchase equity or to issue additional shares.

However, some securities are more prone to being temporary than others. Our analysis tries to be

pragmatic, looking for insights as to what may ultimately occur. For example, auction or remarketed

preferred stock is designed for easy redemption. Even though the terms of this type of preferred provide

for its being perpetual, failed auctions or lowered ratings typically prompt the issuer to repurchase the

shares. (They are sold as commercial paper equivalents, which leads to failed auctions if credit quality

ever falls to ‘A-3’—or even ‘A-2’—levels. While the company has no legal obligation to repurchase the

paper—i.e., the last holder could be left with this ‘perpetual’ security—the issuer invariably bows to

market pressures, and chooses to repurchase the preferred. Accordingly, such frequently remarketed

preferreds are treated as debt.)

The ability to call always gives reason for pause; however, we have not placed much emphasis on

this feature if the instrument is truly low-cost—such as tax-deductible preferred—and, therefore, should

not pressure the company to refinance. Calls exercisable after five years are very common to long-dated

hybrids. (We would question the rationale for a call date only two to three years after issuance.)

However, coupon step-ups are designed to motivate calling the issue. To address the risk of refinancing

with a less equity-like security, issues should have at least 10 years of no call and incorporate

replacement language that specifies the type of replacement security to be used. To achieve intermediate

equity treatment, it ordinarily suffices to establish management intent regarding replacement—even

though companies’ financial policies can vary over time, future capital market conditions could limit

the ability to issue specific types of securities, and legal enforcement is dubious.



Another important consideration is the issuer’s tax-paying posture. It is difficult for a nontaxpaying

issuer to make the case that the company will continue to finance with non-tax-deductible preferred

stock once it becomes a taxpayer, and can lower its cost of capital by replacing the preferred with debt.

Other clues can come from the nature of investors in the issue (e.g., money market, as opposed to

long-term fixed-income investors) and the mode of financing that is typical of the company’s peer

group. For example, utilities traditionally finance with preferred stock, and industry regulators are

comfortable with it; therefore, the usual concern that limited-life preferred stock will be refinanced with

debt is less of an issue in the case of utilities.

In the case of so-called tax-deductible equity, risk exists that their favorable tax status is overturned,

and—especially with new hybrids—that risk may be substantial. This concern can be mitigated by

provisions in the transaction to convert into another equity-like security in the event of loss of tax-

deductibility.

Rating Methodology

Different attributes of equity hybrids are relevant to different elements of Standard & Poor’s analytical

methodology. The aspect of ongoing payments is considered in fixed-charge coverage and cash-flow

adequacy; equity cushion in leverage and asset protection; need to refinance upon maturity in liquidity;

and potential for conversion in financial policy. The before- and after-tax cost of paying for the funds

also is a component of both earnings and cash flow analysis.

How to reflect hybrids in credit ratios, though, is not a simple question. One possibility is to divide

the amounts involved in proportion to the equity content of the specific security. However, the

resulting numbers can be misleading. To illustrate: the company will either pay the stipulated amount

or defer it; in no scenario would it defer a fraction of the payment. So calculating a fixed charge

coverage ratio with a fractional amount has no intuitive meaning.

Accordingly, hybrids with minimal equity content are treated entirely as debt for ratio purposes;

hybrids with high equity content are treated entirely as equity for calculating ratios.

For hybrids with intermediate equity content, we have computed financial ratios both ways—viewed

alternatively as debt and as equity, i.e., two sets of coverage ratios are calculated—to display deferrable

ongoing payments (whether technically dividends or interest) entirely as ordinary interest and

alternatively as an equity dividend. Similarly, two sets of balance-sheet ratios are calculated for the

principal amount of the hybrid instruments, displaying those amounts entirely as debt and entirely as

equity.

For these hybrids in the middle category, analytical truth lies somewhere between the two. Analysts

can interpolate between the two sets of ratios to arrive at the most meaningful depiction of an issuer’s

financial profile. They can note and give effect to each more-equity-like/less-equity-like feature of

various hybrids in the same category—although such nuances play, at most, a very subtle role in the

overall rating analysis. (The numerical gradations we used to indicate equity content never implied

fractional treatment for the purpose of ratio calculations—as we clearly stated.)

However, this methodology also has drawbacks, including the challenges for issuers in appreciating

the potential impact on our view of their financial profile. Therefore—notwithstanding the issues

mentioned above—we decided to calculate ratios with the amounts relating to intermediate category

hybrids split 50%-50%. This set of ratios will be emphasized as the basic adjusted measures, and these

are the ratios we intend to publish. We expect the advantages of this approach—greater transparency



and ease of comparability (including with measures used by other rating firms)—will outweigh the

negatives. Analysts are encouraged to continue viewing hybrids from all perspectives—i.e., continuing

to compute additional ratios with the security as debt and, alternatively, as equity.

Tax-Deductible Preferreds: A Major Innovation In Hybrid Securities

Texaco Capital LLC issued the first of the so-called ‘tax-deductible’ preferred stocks in 1993. This

hybrid equity security was a major innovation in corporate finance, creating a modern-day version of

the long-existing preferred stock. A version of this instrument was introduced the following year that

used a trust as the issuer—leading to the term ‘trust preferred’. The typical terms of this very popular

instrument set the minimum standard for intermediate equity content. These include:

Optional deferral of payments for up to 60 months, as long as no common dividends are being paid.

(Conventional preferreds have unlimited potential for nondeclaration of dividends, subject only to

board representation by preferred holders after six quarters of nonpayment.)

Deep subordination.

Thirty-year life. (Conventional preferreds are perpetual, although many have call provisions. The

new-genre preferreds also are nominally perpetual, but terminate when the intercompany loan

matures, normally in 30 years. As the remaining life of the specific issue dwindles over time, the

equity attribution is reduced. Conventional preferreds, by way of comparison, typically possess

equity content that does not diminish over time, given their perpetual tenor.)

To broaden investor appeal, preferreds with variable rates were introduced. This does not, in our view,

alter the equity content, although the exposure to floating rates, if material, can pose a risk that is

considered in other aspects of the analysis.

A further ‘innovation’ called for resetting rates after an initial five- or 10-year period. The idea was

to create an incentive for the company to call the issue at that point, to avoid a penalty rate. We regard

issues with step-up rates (of 50 basis points or more) as having an effective maturity at that point,

thereby largely undermining their equity content.

A reset that merely captures any change in the issuer’s credit spreads is less troublesome, because the

company presumably would have little incentive to refinance the issue. That still could be problematic,

if, for example, the issuer dropped to noninvestment grade: its cost for long-term funds might be

expected to widen to the point that only shorter-term alternatives would be palatable.

To mitigate the impact of stepped-up rates on the equity credit afforded to that financing, some

issues proffer replacement language, promising that any refinancing of the instrument will come from

proceeds of an equity issuance or a new instrument of equivalent equity content. The legal

enforceability of such terms is highly dubious. Nonetheless, we put some stock in such provisions as

expressions of intent—as long as the company involved has a decent record of credibility, and the

language is highly specific regarding the definition of instruments that would qualify as replacements.

Some European deals introduced greater restrictions on the ability to defer dividends. The issuer can

defer only after curtailing its common dividend for some period of time. This translated into seriously

lower equity credit afforded to those issues. In the case of companies that do not pay a quarterly

common dividend—not unusual in Europe—the problem is compounded, because there might be an

even longer period between when the company experiences financial distress and when it can defer

preferred dividend payments. Similarly, the value of deferability is diminished if the deferral can only



occur following a period when the company has reported a net loss, but where the company reports

results on a semiannual, rather than quarterly, basis.

On the other hand, the quest for enhancing equity content continues. Recent preferred instruments

make payment deferral automatic upon reaching certain triggers or occurrence of certain events.

Indeed, replacing issuer discretion with a formulaic approach to deferral adds significantly to the equity

content—if the threshold for stopping payments is set high. Each issuer’s situation requires a unique

analysis, making standardization impossible. Triggers can be based on financial data or ratios or rating

levels. (Alternatively, payments could be linked to the company’s common dividend.)

Additionally, some issues offer longer deferral periods and/or longer tenor. Others are non-

cumulative, and do not require the company to make up for payments skipped because of financial

distress. (Beyond that, forgiveness of part of the principal in cases of company stress could theoretically

be offered.)

The rub is that investors would be leery about accepting the risks associated with nonpayment

associated with high thresholds. (Such incremental risk of nonpayment is reflected in our rating policies

for notching of issue ratings.) The key is to find the right balance that would be meaningful for the

issuer and still acceptable to investors at a reasonable rate. In any case, the stigma in the capital markets

that might be associated with involuntary deferral needs to considered, apart from the cash savings that

result.

Our High Standards For The High Equity Content Category

Much of the recent innovative efforts in designing mandatory instruments are intended to achieve

rating-agency treatment as ‘high equity content’; however, we believe most of the proposed and actual

recent mandatory securities only merit the intermediate equity category. Securities that would warrant

high equity content recognition would entail the following features:

High thresholds. The mere existence of a mandatory deferral provision is meaningless: Everything

depends on the thresholds that define the deferral trigger. To illustrate: If the trigger for nonpayment

is 10 years of losing money, that provision is virtually worthless. The company would probably have

defaulted prior to the deferral provision going into effect. To be included in the high equity category,

an instrument’s trigger must go into effect at a level relatively close to the current rating level. The

scenario that triggers deferral must be within two or three rating notches from the company’s current

credit quality. A threshold that approximates crossing over to noninvestment grade does not suffice

(unless, of course, the corporate rating happens to be within two or three notches of that level.) A

variety of financial benchmarks can serve as a proxy for that threshold level—and need to be crafted

to fit the specific corporate context. In any event, we need to be mindful that a single ratio cannot

entirely be relied upon to capture all of the business and financial changes the credit may have

undergone by the time the trigger activates. This fact itself lends support to the tight standard we

apply.

No loopholes. For example, some deals stipulate that the mandatory deferral must be simultaneous

with or following cessation of common dividends (a look-back period). As long as the company

chooses to pay even a paltry dividend, the security continues to pay. Obviously, such an instrument is

‘mandatory’ in name only. (With respect to the intermediate equity category, these limitations may

also be problematic, for other reasons. While the middle equity category only calls for the company’s



discretion over payments, an extended look-back period undermines the flexibility of discretionary

deferral.)

No back-door payment mechanisms. Many proposed high-equity structures provide for requiring

payment or allowing payment in common stock while mandatory deferral is in effect. While

appealing on the surface, we believe such provisions could defeat the purpose of mandatory deferral.

The likelihood is that the company will feel pressured—if not actually obliged—to make the

payment, and then turn around and repurchase the stock it issued (unless it were otherwise inclined

to issue common stock for whatever reason). Ironically, the higher the threshold of the instrument,

the greater the likelihood the company would pay and repurchase.

No step-up without a legally binding replacement provision. A key equity attribute is longevity.

Securities with five- or 10-year step-up/call provisions are designed to terminate at the step-up date—

and our policy has been to treat that date as an effective maturity. To restore the equity credit for

step-up deals, companies have proffered so-called replacement language in the issue that promises to

replace the called instrument with one that is equivalent in terms of equity content. These clauses in

the hybrid security itself are not legally enforceable: The investors who are called out of the security

definitely will not sue regarding how they are replaced. Essentially, then, the clauses represent a

statement of intent on the part of current corporate management. For the high-equity category, that

does not suffice. In July 2005, First Tennessee Bank N. A. demonstrated the feasibility of providing a

legally binding replacement clause when it made a declaration of covenant in connection with its

preferred stock. The covenants run in favor of holders of the bank’s covered debt. For us, this created

a litmus test for companies to now back their declarations of intent with a legally enforceable

provision.

Similarly high standards apply with respect to mandatory convertibility. (See “Hybrids’ ‘High Equity

Content’ Category Held To High Standards”, published Sept. 7, 2005, on RatingsDirect, Standard &

Poor’s web-based publishing system.)

Frequently Asked Questions

Does it make a difference whether a security is identified as preferred stock or junior subordinated

debentures?

We consider the legal form and nomenclature of a security to be relevant to the amount of equity

credit. The rationale is that there would be a distinction in the investor perception of the instrument—

and, consequently, to the issuer’s discretion over deferring payments. We all along have made a

distinction between trust-preferred and the debt version of that security—despite the two having

identical economic substance. That distinction was explicit in the hierarchy of hybrids that we

published for many years—and translates into an ‘intermediate equity category’ for the preferred stock

version and ‘minimal equity category’ for the debt version in our current terminology.

However, we look at equity features of a given hybrid security in a holistic fashion. Recent proposed

securities incorporate enhancements to the original trust preferred genre—such as doubling the

maturity and providing longer deferral periods—and these would serve as offsetting positives to the

weakness associated with debt form. Taking such enhancements into account, even a debt-form hybrid

would qualify as ‘intermediate’.



Is a mandatory share issuance feature positive, neutral, or negative?

Some new-variety securities require the issuer to pay the dividend with proceeds of a common-stock

issuance, if certain financial triggers have been breached, or if optional deferral continues beyond a year

or two. We view this apparent plus as a potentially serious step backward in terms of equity content.

The advantage associated with deferral of payments can be undermined when the company still needs

to pay—albeit with the proceeds of a share issuance. The company presumably will want to repurchase

shares that it is not inclined to issue, especially given the likelihood that its share price would be

depressed (because of the stress situation the company would face at the time of a trigger breach). If the

forced share issuance follows a period of optional deferral, this requirement could be a disincentive for

the company to exercise its right to defer in the first place. For an instrument with optional deferral to

achieve intermediate equity content, we consider five years of unfettered deferral to be a minimum

requirement.

Generally speaking, companies cannot be ‘forced’ to issue stock: They can always repurchase it (that

is, if they cannot manage to find a legal loophole to avoid enforcement of the provision in the first

place). And, if a particular company were in fact inclined to issue stock, it could always have done so

without being coerced. The same is true with respect to being forced to issue ‘equity-like’ preferred

stock. When a company faces distress, the pricing for very long-dated preferred stock could be

prohibitive, indeed.

Our concern with mandatory share issuance precludes securities with such features from meriting

even intermediate equity treatment. However, there a two possible ways to neutralize this problematic

feature:

The security could preserve the right of optional deferral in the face of breaching the mandatory

triggers. That would allow them to get to the intermediate category—just like other optional deferral

instruments. (In reality, though, most proposed term sheets we see provide for the mandatory

remedies trumping the optional deferral provisions.)

If the optional deferral provision included a requirement to issue common or other hybrids within

five years, this could deter the deferral, as explained above, and we would relegate such a hybrid to

the ‘minimal’ equity content category. To avoid this outcome, the security could mitigate the risk by

allowing flexibility as far as timing of the issuance; allowing choice of common or various hybrids;

and/or limiting potential dilution (for example, by restricting the maximum share issuance

requirement to 2% of number of shares outstanding).

Some companies seem prepared to foreswear their ability to repurchase shares—and to covenant to

that effect in a legally enforceable fashion. As long as the no-repurchase period extends for as long as

the company is in breach of the triggers—and perhaps some period thereafter—the security could

still qualify for the intermediate category. (Restricting repurchases helps with regard to stock issued

subject to mandatory triggers; with respect to stock issued subsequent to optional deferral, any

restriction in repurchases would just exacerbate the problem—by further discouraging the choice to

defer.)

Shouldn’t such forced share issuance help—at least as far as the issue rating is concerned?

It certainly could help avoid the incremental subtraction of notches that otherwise would apply to the

issue ratings of securities with mandatory deferral—since the payment would, after all, be made with

proceeds from the share issuance. However, timeliness of payment is also critical. Timeliness can be



accomplished either by immediate issuance of shares that equal in value the stipulated dividend directly

to the holders or by allowing sufficient time between the determination of a breach and the dividend

payment date to market new shares.

Is there a limit to the amount of hybrids a company can issue and still get ‘equity credit’?

Without drawing any red lines, we would, indeed, be sensitive at a certain point. That is not because

the character of the security changes when a lot of it is issued. Rather, beyond a certain point, a

company’s nonstandard, complex, or over-engineered balance sheet begins to puts its financial policies

in a negative light. In turn, this could lead to market pressures to restructure or normalize company

finances. This concern would be compounded to the extent that a company also uses various off-

balance-sheet financing vehicles, derivatives, and long-term contracts, and/or other techniques that

contribute to an overall opaque financing structure. The perception of financial aggressiveness—by us

or the investment community—would certainly overshadow any theoretical benefit from the equity

content that might be afforded to hybrid securities.

It helps to focus on measures that would indicate little or no concern. In simple terms, there should

be no problem with issuing conventional hybrids in an aggregate amount up to 15% of capitalization.

(Capitalization is defined as debt + hybrids + book equity, adjusted for substantial goodwill.)

Some European deals incorporate look-backs: In these instruments, the right to defer applies only

after a period with no share repurchases or payment of common dividends. When do these features

cause concern?

The main point of payment-deferral securities is to accommodate a company that has a crisis and

would like to save cash. Look-backs constrain this flexibility, as a practical matter, if the company had

recently paid a dividend or repurchased any stock. (By way of contrast, we are not concerned about

‘dividend stoppers’ that merely restrict common dividends from being paid in the future—until the

preferred arrearages are paid up. This makes sense, as a company that is deferring its preferred

dividend payments should not be paying common stock holders.)

The details of the look-back provision dictate the extent of the potential problem. For example: Does

even the repurchase of a trivial amount of stock in conjunction with an employee option plan violate

the look-back? Is the look-back period a quarter? Six months? One year? How do the frequency and

juxtaposition of common and preferred dividend payment dates affect the possible delay?

The existence of a look-back that could potentially impose a maximum delay of one year would

disqualify a security for our intermediate equity category. (In the case of hybrid issuers that are already

rated speculative grade, even a potential delay of six months would rule out equity treatment.)

Importantly, even where a look-back period is shorter and does not in itself disqualify the security, the

potential for delay is still problematic—and, in combination with other features of the security, can

affect its equity credit categorization.

With respect to mandatory-deferral instruments, look-backs undermine the nondiscretionary aspect

of the deferral. The company can choose to short-circuit the deferral by paying a paltry common

dividend, for example. Such issues would, therefore, never qualify for our high equity content category.



How has Standard & Poor’s thinking evolved about call provisions?

We continue to limit our concern to those securities that build in incentives to exercise the call—i.e., by

stepping up the yield at the call date. Where such a step-up applies, we assume the issue will be called.

The higher the differential, the greater the likelihood of a call—but even a 50 basis point penalty,

compared with the market rate, could be sufficient incentive to refinance such a long-dated instrument.

And, ordinarily, we could not presume the instrument will be replaced with a security of equivalent

equity content.

To merit being in our high equity category—if the current security otherwise qualified—only legally

enforceable replacement language suffices to give us confidence regarding the outcome. Provisions in

the instrument itself are not enforceable as a practical matter: Investors called out of the issue have no

interest in what replaces that issue. Covenants on behalf of other creditors are, therefore, key. When

such legally enforceable provisions exist, it is acceptable if the non-call period were as short as five

years.

To qualify for the intermediate category, we use a lower standard. If the instrument includes highly

specific wording regarding the replacement with an equity equivalent, we take such statement of

management intent seriously. Obviously, situations can change—and management itself will change;

nonetheless, companies tend to honor this type of public commitment. However, in those cases where

we rely on statement of intent to qualify for intermediate equity treatment, we expect the non-call

period be at least 10 years.

Also, we expect to revisit the question of whether to accept mere intent once there is some track

record with the legally enforceable approach, which only recently has been introduced. If there are no

drawbacks that become apparent with the legally enforceable approach, it will be hard for a sincere

management to explain why they are not prepared to offer this provision. This determination will take

more than just a few quarters.

In any event, legally enforceable provisions remain stronger than statement of intent. Since we

approach the combination of hybrid features in a holistic fashion, the length of the non-call period and

the strength of replacement provisions can still play a role in determining the overall characterization of

a specific instrument.

APPENDIX

02SELECTED MOODY’S GUIDELINES

217

Rating Methodology

New YorkBarbara Havlicek 1.212.553.1653Glenn EckertMark GrayHarshan JeyakumarJim MannoiaKaren NickersonAtsi ShethKevin StoklosaNicolas WeillLondonLynn Exton 44.20.772.5454Niel BissetTimour BoudkeevHong KongSombat Jiwariyavej 852.2509.0200SydneyCharles Macgregor 61.2.9270.8120

Contact Phone

February 2005

Refinements to Moody’s Tool Kit:Evolutionary, not Revolutionary!

A Product Of The New Instruments Standing Committee

Summary Of Refinements To Moody’s Tool Kit

Moody’s Tool Kit, which is a framework for calibrating the relative debt and equity characteristics of hybrid securities,was introduced to the market in 1999. Since that time, the New Instruments Committee (NIC) has assessed hundredsof instruments, positioning them along the debt – equity continuum in baskets from A to E1. Against this backdrop,the NIC decided to step back and review its approach to assessing hybrids with the benefit of five years’ experience andfeedback from market participants.

The conclusion of the NIC review process was that Moody’s Tool Kit, which compares the characteristics ofhybrids to the features of common equity, remains a relevant and useful framework. At the same time, there are anumber of areas where refinements to our thought process are warranted. For example, in addition to consideringhow a hybrid behaves relative to common equity, it is also important to recognize the support that a hybrid may pro-vide for senior creditors as well as its ability to impact the issuer’s probability of default2. The NIC also revisited howa number of hybrid characteristics compare to the features of common equity to ensure that the same criteria are beingapplied consistently.

In summary, the evolution in our thought process has led to changes in the way that certain hybrid characteristicsare ranked along the three dimensions of equity:

No Maturity

The NIC’s thinking has changed on undated hybrids with cash calls3, which confer a right rather than an obligation torepay the hybrid. In general, capital structures have become more fluid as issuers determine the most cost-effectivecushion to cover their risks. Driven by economic considerations, an issuer may repurchase common shares at any timeor refinance existing hybrids by exercising a call option. This general lack of permanence is not driven by the featuresof common equity or the hybrid’s characteristics themselves, but is driven by the issuer’s view of the optimal capitalstructure. Consequently, a cash call is viewed less negatively than previously.

No Ongoing Payments

In shifting focus to consider how a hybrid may impact an issuer’s probability of default, the NIC recognizes that non-payment of deferrable distributions generally does not result in an event of default. This is the same outcome as forthe non-payment of common dividends. A hybrid may have one of a number of deferral mechanisms, which mayresult in the cessation of distributions at a time of financial distress. While continuing to calibrate the relative equity-like benefit of each, deferral mechanisms overall will now receive greater equity benefit than in the past due to the rec-ognition of their generally favorable impact on an issuer’s probability of default.

Loss Absorption

In many cases, hybrids provide a loss absorbing cushion for senior creditors with recovery far closer to common equitythan to either senior or subordinated debt in a default. The NIC now more fully recognizes this benefit by giving pre-ferred securities, and certain types of subordinated debt, a ranking that is closer to that of common equity.

In subsequent sections, this rating methodology describes in detail the refinements that are being made to Moody’sTool Kit, the rationale for the changes, and how they impact commonly issued hybrids.

Refresher on Moody’s Approach to Hybrid Analysis

Before discussing the refinements to Moody’s Tool Kit, it is important to start with a refresher on the thought processused to assess hybrids. In 1999, Moody’s introduced a comparative framework, which ranks, on a relative basis, varioushybrids and places them in a basket from Basket A (more debt-like) to Basket E (more equity-like) on the debt – equitycontinuum. Through this analysis, the hybrid is broken down into its basic characteristics including maturity, calloptions, conversion options, deferral mechanisms, and priority of claim in liquidation. These basic attributes are thencompared to the following features of equity:

• No maturity.• No ongoing payments, the absence of which would result in an event of default.• Loss absorption for all creditors.

1. Please refer to the section below entitled Refresher on Moody’s Approach to Hybrid Analysis. In addition, see also Moody’s Tool Kit: A Framework for Assessing Hybrid Securities, dated December 1999.

2. This approach is consistent with Moody’s expected loss ratings, which incorporate the probability of default and severity of loss.3. Specifically, the issuer can exercise a call for cash without having to replace the hybrid with a security that has the same or more equity-like characteristics.

2 Moody’s Rating Methodology

The hybrid’s characteristics are then scored in terms of their strength relative to common equity. The four grada-tions of modifiers used are none, weak, moderate, and strong relative to common equity with none corresponding tomost debt-like and strong corresponding to most equity-like. Once these scores have been assigned, the hybrid iscompared to hybrids already on the debt – equity continuum and placed in a basket. There is a specific percentage ofdebt and equity associated with each basket, which is used to adjust full sets of financial statements4. The hybrid is thenconsidered within the context of each issuer’s overall credit fundamentals and its impact on the rating is left to the rel-evant rating committee.

Changes in Scoring for Certain Hybrid Characteristics

The following chart summarizes the changes that have been made to the scoring for certain hybrid characteristics. Itis applicable to investment grade issuers including corporates, insurers, and banks. The changes are classified accord-ing to the dimension of equity that is impacted, with explanations provided below.

Changes to Scoring: Hybrid Characteristics that Impact No Maturity

The scoring changes impacting the No Maturity dimension of equity relate solely to an issuer’s ability to call anundated hybrid. When the Tool Kit was first introduced, a cash call5 was viewed negatively because the hybrid couldbe called in the future with no guarantee that the replacement security would be neutral in its effect on other seniorcreditors. While a call is only likely to occur when the issuer’s financial condition is sound and there is economic justi-fication for doing so, it could potentially hurt creditors if the replacement security is debt. A call was viewed as detract-ing from the instrument’s permanency, which made the instrument less equity-like.

The concept of capital permanency has increasingly become a fluid notion as issuers have become more active inadjusting their capital structures in response to changing operating environments. Driven by economic consider-ations, an issuer may repurchase common shares at any time or refinance existing debt or hybrids. This general lack ofpermanence is not driven by the features of common equity or the hybrid’s characteristics themselves, but results fromdecisions made by the issuer regarding its view of the optimal capital structure.

In addition, the existence of a cash call does not necessarily result in a de-facto maturity. When a hybrid with acash call is issued, the call does not result in an obligation to repay the hybrid, but only provides the issuer with the rightto repay the hybrid. As a result, a call, when exercised, acts in a manner similar to a common share repurchase6.

For these reasons, we have shifted scoring of a cash call on undated hybrids to weak from none for corporates.While the argument could be made to shift the scoring further to moderate, the new designation reflects the uncer-tainty in terms of the replacement security. The scoring for a cash call where the hybrid can only be called if it is

4. On the balance sheet, the hybrid is classified in accordance with the weights assigned to its equity and debt features. The income statement is also adjusted to reflect interest expense or dividends, depending on the balance sheet classification. Similar thinking is applied to the cash flow statement, again reflecting cash outflows as interest or dividends depending on the balance sheet classification. Ratios are then computed based on the adjusted financial statements in the same manner for both investment grade and non-investment grade issuers. This is a change to the approach described in Hybrid Securities Analysis: New Criteria for Adjustment of Financial Ratios to Reflect the Issuance of Hybrid Securities, dated November 2003, which established that fixed charge coverage ratios would generally not be adjusted for investment grade issuers while coverage ratios for non-investment grade issuers would be calculated both with and without hybrid coupons that are defer-rable, payable-in-kind, or payable in common stock.

Feature Old NewNo MaturityCash call for an undated hybrid (corporates)Cash call for an undated hybrid (banks and insurers)Cash call for an undated hybrid with replacement language (all issuer types)

NoneNone

Moderate

WeakModerateModerate

No Ongoing PaymentsMandatory deferrala, non-cumulative (all issuer types)Mandatory deferrala, stock settled (all issuer types)Optional deferral, non-cumulative (all issuer types)

ModerateModerate

Weak

StrongStrong

ModerateLoss AbsorptionPreferred securitiesSubordinated debt (no rights; only common equity is more junior)Subordinated debt (no rights)

ModerateModerate

None

StrongStrong

Moderatea Mandatory deferral of distributions tied to the breach of pre-specified triggers.

5. See footnote 36. Note that the ability to repurchase common stock or call a hybrid may be viewed similarly in terms of equity replication. However, both actions may have negative rat-

ing implications.

Moody’s Rating Methodology 3

replaced by a similar or more equity-like security remains moderate. While such replacement language signals anissuer’s intent regarding the form of replacement security for the hybrid if called, it only signals intent. As a result, it isnot viewed as legally enforceable, although an issuer may have some moral obligation to act in accordance with its pub-lic statement of intent.

A further distinction has been made for banks and insurers on this dimension of equity. The ability of regulatorsto prohibit a cash call for a hybrid7, if regulatory capital has deteriorated, is viewed to be at least as effective as a corpo-rate with the intent to replace a hybrid with the same or more equity-like security. Consequently, for undated regula-tory capital hybrids issued by banks and insurers, a cash call will receive moderate on No Maturity, which is the samescoring for a corporate that issues a hybrid with a cash call subject to replacement language. The moderate score ismore equity-like than the weak that corporates receive with a cash call and no replacement language.

Changes to Scoring: Hybrid Characteristics that Impact No Ongoing Payments

The change in scoring for hybrid characteristics that impact the No Ongoing Payments dimension of equity relates todeferral mechanisms and whether a dividend is skipped entirely or settled with common shares. Many hybrids posi-tively impact an issuer’s probability of default because non-payment of deferrable distributions does not result in anevent of default. Since non-payment of common dividends also does not result in an event of default, many hybridscorings where deferral features are present have been shifted to stronger equity-like designations.

Moody’s continues to believe that investment grade corporates, insurers, and banks are not likely to defer onhybrid distributions in order to retain capital market access. Consequently, mandatory deferral of distributions tied tothe breach of triggers is viewed as a way to level the playing field between common dividends (which an investmentgrade issuer may opt to defer) and hybrid distributions (which an investment grade issuer is unlikely to defer). Byintroducing triggers, the decision to defer hybrid distributions is taken out of the hands of the issuer and based onobjective criteria. The investor knows upfront that deferral is a possible outcome. While leveling the playing field,mandatory deferral may also result in a hybrid that provides more equity-like benefit than common equity itself.

Due to these considerations, we still view mandatory deferral based on the breach of pre-specified triggers to bebeneficial, but it is now scored as strong rather than moderate. Moreover, we will score hybrids with optional defer-ral as moderate rather than weak. The moderate scoring for optional deferral captures the same optionality thatexists for the payment of common dividends, but considers that an issuer will always be less likely to defer hybriddistributions than common dividends.

The revised designations assume that the deferral of hybrid distributions, whether optional or mandatory, arenon-cumulative and will effectively be skipped if unpaid. An alternative to skipping dividends, which also scores strongon this dimension of equity, is stock settlement of the distribution if pre-specified triggers are breached. While sharesettlement results in the “payment” of distributions, it is a non-cash payment that provides the issuer with flexibility ata time of financial distress and is covered by the issuance of the most junior form of capital.

Changes to Scoring: Hybrid Characteristics that Impact Loss Absorption

The primary change impacting the Loss Absorption relates to the scoring for preferred securities and subordinateddebt that effectively behaves like preferred securities. To date, preferred securities have received moderate on LossAbsorption because while preferred securities have always provided a loss absorbing cushion, it is clearly secondary tothe cushion provided by common equity. However, Moody’s defaulted bond recovery studies have shown that indefault, the average recovery rate on preferred securities is closer to the recovery rate on common equity than it is tothe recovery rate for either senior or subordinated debt holders8. Consequently, preferred securities are now scored asstrong versus moderate on this dimension of equity.

There are certain jurisdictions, primarily in Europe, where preferred securities do not exist or issuers themselvesmay not have board resolution to issue preferred securities. Consistent with our past views9, we have become comfort-able with subordinated debt as equivalent to preferred securities if:

• It cannot default or cross default and has no rights in bankruptcy.

• Only common equity is more junior during the life of the subordinated debt. If more junior capital is issuedbetween the subordinated debt and common equity, the original terms of the subordinated debt requirethat it will be exchanged into or refinanced by the more junior capital.

7. That is, a hybrid qualifying for regulatory capital treatment.8. Please refer to Default & Recovery Rates of Corporate Bond Issuers: A Statistical Review of Moody’s Performance, 1920 – 2003, dated January 2004.9. Please refer to An Application of Moody’s Tool Kit: Characteristics of a Basket C Perpetual Preferred for Financial Institutions and Corporates, dated May 2004.


For this type of subordinated debt, consistent with the scoring for preferred securities, the designation has alsoshifted to strong from moderate on this dimension of equity. For subordinated debt, which has no rights, but whichmay have more junior capital issued under it10, the scoring shifts to moderate from none.

Refinements in Practice: Some Examples

The charts below illustrate the impact of the Tool Kit’s refinements on commonly issued hybrids for investment gradeissuers. There is no change to basket designations for trust preferred securities. The biggest impact of the refine-ments is on perpetual preferred securities and, depending on their characteristics, they will generally be placed in moreequity-like baskets.

Perpetual Preferreds with Replacement Language and Mandatory Dividend Deferral

• Perpetual preferred securities.• Callable only if it is replaced with a security that has the same or more equity-like characteristics.• Mandatory deferral of dividends tied to the breach of meaningful triggers; non-cumulative if deferred (i.e.,

dividend is skipped). If triggers are breached, dividends may also be settled with common shares.

Perpetual Preferreds without Replacement Language, but with Mandatory Dividend Deferral

• Perpetual preferred securities• Callable, but without replacement language.• Mandatory deferral of dividends tied to the breach of meaningful triggers; non-cumulative if deferred (i.e.,

dividend is skipped). If triggers are breached, dividends may also be settled with common shares.

Perpetual Preferreds with Replacement Language and Optional Dividend Deferral, non-cumulative

• Perpetual preferred securities.• Callable only if it is replaced with a security that has the same or more equity-like characteristics.• Optional deferral of dividends; if deferred, dividends are non-cumulative (i.e., dividend is skipped).

10. For example, subordinated debt issued by Australian companies.

Equity Replication Summary Old New No MaturityNo Ongoing PaymentsLoss AbsorptionBasket

ModerateModerateModerate

C

ModerateStrongStrong

D


NoneModerateModerate

A

Weaka

StrongStrong

Ca Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket D.

Equity Replication Summary Old NewNo MaturityNo Ongoing PaymentsLoss AbsorptionBasket

ModerateWeak

ModerateB

ModerateModerate

StrongC


Perpetual Preferreds without Replacement Language, with Optional Dividend Deferral, non-cumulative

• Perpetual preferred securities.• Callable, but without replacement language.• Optional deferral of dividends, non-cumulative if unpaid (i.e., dividend is skipped).

Perpetual Preferreds with Replacement Language and Optional Dividend Deferral, cumulative

• Perpetual preferred securities.• Callable only if it is replaced with a security that has the same or more equity-like characteristics.• Optional deferral of dividends; if deferred, dividends are cumulative.

Subordinated Debt with No Rights and Inability to Issue More Junior Capital

• Perpetual subordinated debt which: 1) cannot default or cross default and has no rights and 2) nothing elseis more junior to the subordinated debt except common equity . If more junior capital is issued, it will beexchanged for or refinance the subordinated debt.

• Callable, but without replacement language.• Optional deferral of dividends; if deferred, dividends are non-cumulative (i.e., dividend is skipped).

Subordinated Debt with No Rights, but the Ability to Issue More Junior Capital

• Perpetual subordinated debt, which cannot default or cross default and has no rights.• Callable, but without replacement language.• Optional deferral of dividends; if deferred, dividends are non-cumulative (i.e., dividend is skipped).


NoneWeak

ModerateA

Weaka

ModerateStrong

Ba Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.


ModerateNone

ModerateB

ModerateWeakStrong

B


NoneWeak

ModerateA

Weaka

ModerateStrong

Ba Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.


NoneWeak

ModerateA

Weaka

ModerateModerate

Bb

a Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.b Note that in this example and the previous one (subordinated debt with no rights and the inability to issue more

junior capital), the designation for loss absorption is different. However, the basket outcome is the same because less weight is given to the Loss Absorption dimension of equity for investment grade issuers.


Trust Preferred Securities

• Trust issues preferred securities and proceeds are on-lent to the parent company through a deeply subordi-nated loan. The terms of the subordinated loan mirror the terms of the preferred securities.

• The maturity is typically 30 years.• Callable, but without replacement language.• Optional deferral of dividends for 5 years; if deferred, dividends are cumulative

Mandatorily Convertible Preferred

• Preferred securities, which mandatorily convert into equity within 3 years.• Non-callable for life.• Optional deferral of dividends; if deferred, dividends are cumulative.

Summary and Conclusion

This research methodology describes the refinements that we have made to Moody’s Tool Kit. While not affecting thebasket designations for certain hybrids such as trust preferred securities, they generally result in more equity-like treat-ment for perpetual preferred securities. The changes are evolutionary, not revolutionary. They better reflect the sup-port that hybrids provide for more senior creditors and give more weight to characteristics that are similar to thefeatures of common equity. The changes also consider the fluidity of an issuer’s capital structure, which increasinglyneeds to provide more flexible support than in the past to cover a range of risks that issuers continue to face.

List of Publications by the New Instruments Committee

Rating Methologies:Hybrid Securities Analysis: New Criteria for Adjustment of Financial Ratios to Reflect the Issuance of HybridSecurities Products, November 2003, #79991Moody’s Tool Kit: A Framework for Assessing Hybrid Securities, December 1999, #49802Special Comments:An Application of Moody’s Tool Kit: Characteristics of a Basket E Mandatorily Convertible Security, November 2004,#89899An Application of Moody’s Tool Kit: Characteristics of a Basket C Perpetual Preferred for Financial Institutions andCorporates, May 2004, #86981Aussie Hybrids: The Search for Equity-Like Instruments, March 2001, #64504An Application of Moody’s Tool Kit: The Analysis of Foundation Funds or Kikin for Japanese Mutual Life Insurers,September 2004, #88441A Time to Unwind: Moody’s Views about the Use of Exchangeable Bonds by Insurers, March 2000, #54632


NoneNoneWeak

A

NoneNoneWeak

A


StrongModerate

StrongE

StrongModerate

StrongE


http://www.moodys.com/cust/getdocumentByNotesDocId.asp?criteria=PBC_86981







The Role of The New Instruments CommitteeThrough the use of Moody's Tool Kit, the New Instruments Committee (NIC) primarily assesses the relative debt and equity characteristics ofhybrid securities. In addition, the NIC assesses monetization structures that seek to unlock the value of specific balance sheet assets orinvestment holdings as well as liquidity products provided by the capital markets. Given the proliferation of hybrids, monetization structures, andliquidity products worldwide, the NIC is focused on achieving global consistency.

© Copyright 2005, Moody’s Investors Service, Inc. and/or its licensors including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALL INFORMATIONCONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHERTRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANYFORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained byMOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “asis” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitnessfor any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by,resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees oragents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect,special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of suchdamages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the informationcontained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY,EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHEROPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in anyinvestment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and ofeach issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling.

MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated byMOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to $2,400,000. Moody’s Corporation(MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS’s ratings and ratingprocesses. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publiclyreported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder Relations — CorporateGovernance — Director and Shareholder Affiliation Policy.”


To order reprints of this report (100 copies minimum), please call 1.212.553.1658.Report Number: 91696

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The New Instruments Committee Jim Mannoia Alba Ruiz

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Rating Methodology

New Instruments Committee:New YorkBarbara Havlicek 1.212.553.1653Peter AbdillGlenn EckertJim MannoiaMichael McDermittPeter NecklesKaren NickersonAtsi ShethAllen TischlerLondonNiel Bisset 44.20.7772.5454Timour BoudkeevJanne ThomsenSydneyCharles Macgregor 61.2.9270.8100

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Contact Phone

January 2006

Refinements to Moody’s Tool Kit: An Addendum for Banks and Insurers

A Product of the New Instruments Committee and the Global Banking and Insurance Teams

Why Publish an Addendum Specifically for Banks and Insurers?

In February 2005, the New Instruments Committee (NIC) released its report entitled, Refinements to Moody’s Tool Kit:Evolutionary, not Revolutionary! In it, a number of refinements were made to Moody’s thought process regarding hybridsecurities. In addition to considering how a hybrid mirrors the features of common equity, greater recognition wasgiven to the support that a hybrid may provide for more senior creditors as well as the positive impact of a hybrid on anissuer’s probability of a default1.

The refinements impacted all issuer types including banks, insurers, and corporate entities. At the same time,additional benefit was given to hybrids issued by regulated financial institutions due to their oversight by regulators.The purpose of this report is to provide greater clarity around the benefit of regulatory oversight in hybrid analysis andother issues covered in our February piece related specifically to banks and insurers. Moody’s views on the use of man-datory deferral triggers and how they are evaluated for regulated financial institutions is also discussed. Finally, greaterdetail on how the baskets are used to adjust financial statements is provided.

Background on the Refinements to Moody’s Tool Kit

The refinements have generally resulted in more equity-like treatment for certain hybrids on Moody’s Debt – EquityContinuum, which classifies hybrids in a basket from A to E according to their relative debt and equity characteristics(Basket A is closest to debt while Basket E is closest to equity). The hybrid’s characteristics are ranked relative to thefeatures of common equity including No Maturity2, No Ongoing Payments3, and Loss Absorption4. The rankings canbe either none, weak, moderate, or strong relative to equity with none being the closest to debt and strong being theclosest to equity. For more detail on how baskets are assigned, refer to Appendix A.

The refinements made to the rankings of certain hybrid characteristics are summarized in the chart and explainedbelow:

1. This is consistent with Moody’s approach to ratings, which captures expected loss defined as the product of the probability of default and the expected severity of loss.2. There is no requirement to repay common equity.3. Non-payment of a common dividend does not result in an event of default and there is no accumulation of unpaid dividends.4. Common equity provides a loss absorbing cushion for more senior creditors in bankruptcy.

Feature Old New

No Maturity

Undated hybrid with a cash call (corporates)Undated hybrid with a cash call (banks and insurers[a])Undated hybrid with a cash call and replacement language (all issuer types)Undated hybrid with a cash call and binding replacement language (all issuer types)Undated convertible hybrid with provisional call[b] (all issuer types)Undated hybrid, non-callable (all issuer types)

NoneNone

Moderate——

Strong

WeakModerateModerate

StrongStrongStrong

No Ongoing Payments (for all issuer types)

Mandatory deferral[c], non-cumulative or non-cash cumulative[d]

Optional deferral, non-cumulative or non-cash cumulative[e]

Optional deferral, cumulativeRestricted optional deferral[f], non-cumulative or non-cash cumulative[g]

Restricted optional deferral, cumulative

ModerateWeakNone

——

StrongModerate

WeakWeakNone

Loss Absorption (for all issuer types)

Preferred securitiesSubordinated debt (no rights; only common equity is more junior to it)Subordinated debt (no rights)

ModerateModerate

None

StrongStrong

Moderate

[a] If an undated hybrid with a cash call is issued by a bank or an insurer, the ranking may be favorably impacted by the benefit of regulatory oversight in certain circumstances. [b] Callable only if equity trades at a substantial premium to the equity conversion strike price.[c] Mandatory deferral tied to the breach of pre-specified, meaningful triggers.[d] Moody's standard for non-cash cumulative settlement of hybrid distributions will be described in greater detail in a future publication. One way that non-cash cumulative settlement can be achieved is by settling distributions with the issuance of common shares within one year of the skipped distribution payment . Additionally, if distributions are not settled due to a market disruption event (defined as a remote event where the issuer's common shares have been suspended from trading), certain accumulated distributions would be forgiven in liquidation. If the issuer adds settlement with preferred securities, they must have a perpetual maturity, replacement language if there is a call, mandatory deferral of distributions tied to the breach of meaningful triggers, and be non-cumulative. Such “benign” preferred securities are subject to a cap of 25% of the principal amount of the issued hybrid. [e] Same as footnote [d].[f] With restricted optional deferral, an issuer does not have the option defer on hybrid distributions unless certain well out-of-the-money triggers are breached. For example, an issuer may not have the option to defer unless minimum regulatory solvency ratios are breached or if the issuer has deferred on its common dividends for a minimum of 12 months. These restrictions may prevent an issuer from deferring a hybrid distribution until it is in severe financial distress, potentially limiting the benefit of the deferral mechanism and reducing its equity-like characteristics.[g] Same as Footnote [d].




The modifications made to the rankings for the No Maturity dimension of equity reflect more equity-like treat-ment than previously for undated hybrids5 with cash calls, which confer a right, rather than an obligation to repay thehybrid. Driven by economic considerations, an issuer may repurchase common shares at any time or refinance exist-ing hybrids by exercising a call option. This general lack of permanence is not driven by the features of common equityor the hybrid’s characteristics themselves, but by the issuer’s view of the optimal capital structure. Consequently, a cashcall is viewed less negatively than in the past.

In terms of No Ongoing Payments, the modifications recognize that non-payment of deferrable hybrid distribu-tions does not result in an event of default. This is the same outcome as for the non-payment of common dividends. Ahybrid may have one of a number of deferral and settlement mechanisms, which result in the cessation of distributionsat a time of financial distress. While continuing to calibrate the relative equity-like benefit of each, deferral mecha-nisms overall receive greater equity benefit than in the past due to their generally favorable impact on an issuer’s prob-ability of default.

For Loss Absorption, the modifications reflect the loss absorbing cushion that hybrids provide for senior creditorswith recovery far closer to common equity than either senior or subordinated debt in liquidation. This benefit is morefully recognized by giving preferred securities, and certain types of subordinated debt that act like preferred securitiesin practice, a ranking that is closer to that of common equity.

The Impact of Regulatory Oversight for Banks and Insurers in Hybrid Analysis

Unlike corporate entities, banks and most insurers6 are subject to the oversight of regulators, which ascertain thesoundness of a given country’s banking and insurance systems and provide strict guidance in terms of capitalizationstandards. In the case of banks, regulators are interested in protecting depositors while insurance regulators are focusedon protecting policyholders. Banks and insurers may be subject to both state and federal or national regulation. In addi-tion, for banks, Basle I established a global capital adequacy framework, which will be enhanced by the forthcomingintroduction of Basle II with risk-based capital adequacy requirements and a global supervisory framework.

With our February 2005 special comment, Moody’s recognized the benefit of regulatory oversight in its hybridassessment framework for the first time. The benefit is now given on the No Maturity dimension of equity, which cap-tures the degree of permanence that a hybrid has in an issuer’s capital structure. Specifically, for an undated hybrid witha cash call, the benefit of regulatory oversight is recognized if we believe that regulators will:

• not allow a hybrid to be called if the bank or insurer is in financial distress; and

• generally require that a hybrid be replaced with a similar or more equity-like security due to regulatorytiering of the capital structure.

In many countries, regulators facilitate the tiering of capital structures by designating issued securities as UpperTier 1, Upper Tier 2, or Lower Tier 2 Capital where Upper Tier 1 Capital provides the greatest loss absorption char-acteristics. While there is no guaranty that the replacement hybrid will have similar features to the security that itreplaces, regulatory tiering of capital, which roughly corresponds to Moody’s basket designations, provides some com-fort that this will happen.

The Benefit of Regulatory Oversight for Banks and Insurers Varies with the Regulatory RegimeThe benefit of regulatory oversight will be given to banks or insurers that issue hybrids from the holding company oroperating company to the extent that regulatory oversight, including strict capital requirements, extends to the issuingentity and Moody’s is satisfied with its quality. Bank operating companies are usually subject to this criteria on a globalbasis. As a result, in most countries, hybrids issued by bank operating companies receive the benefit of regulatory over-sight and do not need replacement language7 to receive a more equity-like ranking.

For bank holding companies, regulation can vary widely from country to country. For example, in the US, bothbank holding and operating companies are tightly regulated with strict capital requirements at both the holding com-pany and operating company level. Therefore, hybrids issued by either one of them do not need replacement language.

5. Very long-dated hybrids may also receive more equity-like treatment.6. European reinsurers are generally not subject to regulatory oversight.7. Replacement language typically states that it is the issuer's intent to only call the security if it is repaid with proceeds from the issuance of the same or more equity-like

security. The replacement security must be issued within 6 months prior to the call date. Additionally, statements such as "it is the issuer's current intention" or "there is no obligation to abide by this statement of intent" weaken the issuer's intention and, as such, do not meet Moody's criteria for acceptable replacement language.


In contrast, thrift holding companies in the US are not subject to capital requirements and, as a result, a hybrid issuedby a thrift holding company still requires replacement language to receive a more equity-like ranking.

In Europe, there are far fewer bank holding companies than in the US. In most of these cases, a single regulatorprovides strict oversight of a bank group in its entirety and there is tiering of the capital structure. In Asia, not manybanks have holding company structures and regulatory treatment of them is inconsistent. While organizational struc-tures may vary, regulators in Japan, Singapore, and Australia provide sufficient regulatory oversight generally and, con-sequently, replacement language may also be unnecessary. As bank organizational structures and regulatory capitalrequirements continue to evolve in Asia, Eastern Europe, and Latin America, Moody’s will adjust its views on the ben-efit of regulatory oversight accordingly.

For US insurers, hybrids are generally issued by the holding company while it is the operating company that isregulated. Consequently, hybrids issued by a US insurance holding company do not receive the benefit of regulatoryoversight and need to put replacement language in place.

Outside the US, insurance groups have holding and operating company structures, but their nature is different thanin the US.8 Except in the UK, where insurance regulators have put in place well-defined capital standards applying toboth holding and operating companies, European regulators have not yet defined their capital requirements in a waythat encourages replacement of a hybrid with a similar-type security. Therefore, in Europe, hybrids issued by all insurersoutside the UK, regardless of whether the issuing entity is a holding or operating company, do not receive the benefit ofregulatory oversight and need to put replacement language in place. In some countries in Europe, banks and insurers areconverging into one group and are subject to bank regulatory oversight (the Solvency 2 Initiative). While this regulatoryframework may provide benefit for some insurers from Moody’s perspective, the process will take time to implement.

The Benefit of Regulatory Oversight is as Good as Intent-based Replacement Language for CorporatesIn reaching its decision to incorporate the benefit of regulatory oversight in its hybrid assessment, Moody’s consideredthe use of intent-based replacement language by corporates that issue hybrids. Since replacement language is onlyintent-based, it is not viewed as legally binding or enforceable.9 For banks and insurers, the regulators play the role ofreplacement language in the corporate setting by having some say about the timing of the call and the terms of thereplacement security. Consequently, an undated hybrid with a call subject to replacement language, which is issued bya corporate, and an undated hybrid with a call subject to regulatory oversight (as previously described), which is issuedby a bank or insurer, will both be ranked moderate on the No Maturity dimension of equity.10

A Recent Innovation: Strengthening Replacement LanguageA recent innovation in the US market has been the introduction of a more binding form of replacement language. Inits issuance of a hybrid, US Bancorp11 achieved a Basket C by entering into a legally enforceable Declaration of Cove-nant (Declaration). Under the terms of the Declaration, the bank is contractually obligated to redeem its preferredstock only with the proceeds from the issuance of a specifically defined security, which has equal or greater equity con-tent. The Declaration identifies specific classes of debt as Covered Debt that could potentially be harmed by the bank’sinaction.12

Through a Declaration, a more direct link is established between the potentially harmed party (more senior cred-itors) and the issuer, if it fails to issue the identical security or equity. If the issuer fails to act in accordance with theterms of the Declaration, Covered Debt holders have the right to sue. With this strengthening of replacement lan-guage, the ranking for an undated hybrid on the No Maturity dimension of equity shifts to strong from moderate.13

Consequently, assuming all other characteristics of a Basket D hybrid are the same,14 an issuer can achieve a Basket D

8. In the US, there is typically a holding company, which is a shell, and an operating insurance subsidiary. In contrast, European holding companies may have many operating subsidiaries and the holding company may, at the same time, act as a non-life operating company.

9. Intent-based replacement language is not a binding obligation and the holders of the security will not be harmed if a similar replacement security is not issued. The potentially harmed parties are more senior creditors, which always have the right to sue, although the link to the damaged party is not direct.

10. Note that Moody's views a strong regulatory environment as effectively a substitute for replacement language. As such, combining the two does not serve to provide additional benefit in terms of the No Maturity dimension of equity.

11. Refer to the press release dated December 19, 2005 entitled, "Moody’s Assigns Aa3 To Trust Preferred Securities of US Bancorp's Subsidiary USB Capital VIII.”12. It is preferable to designate subordinated debt rather than senior debt as Covered Debt because subordinated debt holders will more likely be harmed than senior

debt holders. If a company fails to replace a hybrid that ranks below subordinated debt with an equity-like replacement security, the subordinated debt holders will have less loss-absorbing cushion beneath them and thus may be exposed to more losses than previously. For senior debt holders, as long as the replacement secu-rity is not senior debt, they will be less harmed than subordinated debt holders because there will still be the same amount of junior debt behind them.

13. For an undated hybrid with a call covered by a Declaration to be eligible for a strong ranking on the No Maturity dimension, the Declaration must: 1) cover a desig-nated class of subordinated debt that meets certain criteria regarding size and maturity, or, in the absence of existing subordinated debt, a class of senior debt that meets the same criteria with language stating that any newly issued class of subordinated debt meeting the criteria will be included as covered debt; 2) clearly define a replacement security having the same or more equity-like characteristics; and 3) be supported by an enforceability opinion from outside counsel that the Declaration is legally enforceable.

14. A Basket D security is typically an undated preferred security or very long-dated subordinated debt with limited rights. If callable, it is subject to replacement language.


http://www.moodys.com/moodys/cust/research/MDCdocs/19/2004700000425043.asp?search=5&searchQuery=Moody

classification for its hybrid by either strengthening replacement language or using mandatory deferral triggers withappropriate deferred distribution and settlement mechanisms.

Defining Mandatory Deferral Triggers

Hybrid securities typically allow an issuer, at its option, to defer distribution payments without creating an event ofdefault. Hybrids can also be structured with mandatory deferral where the breach of certain pre-specified meaningfulfinancial triggers result in automatic deferral of distribution payments. There has been heightened interest in manda-tory deferral triggers because, if structured with them, a hybrid may potentially receive significant equity benefitdepending on its other characteristics.

Moody’s Views on the Benefit of Mandatory Deferral TriggersMoody’s continues to believe that investment grade insurers and banks are not likely to defer hybrid distributions dueto concerns about potential loss of capital market access. Consequently, mandatory deferral of distributions tied to thebreach of meaningful triggers is viewed as a way to level the playing field between common dividends (which an invest-ment grade issuer may opt to defer) and hybrid distributions (which an investment grade issuer is unlikely to defer). Byintroducing triggers, the decision to defer hybrid distributions is taken out of the hands of the issuer and based onobjective criteria. The investor knows upfront that deferral is a possible outcome and receives a higher coupon for tak-ing this risk.

While Moody’s considered extending the benefit of regulatory oversight to the payment of hybrid distributions,our conclusion was that regulators may react differently to a period of stress at a financial institution. Specifically, aregulator in one jurisdiction may prohibit hybrid distribution payments far earlier than a regulator in another jurisdic-tion. Moreover, even within the same jurisdiction, regulators may behave differently for a different financial institu-tion. Given this lack of consistency and predictability, mandatory deferral triggers based on objective criteria mayprovide more consistency in terms of conservation of cash flow at a time of financial stress.

Moody’s general concept behind meaningful mandatory deferral triggers is, if breached, they result in the deferralof hybrid distributions and provide cash flow relief in a deteriorating financial situation. The triggers should be basedon publicly available financial and/or operating parameters that best capture an issuer’s deteriorating financial condi-tion and not be set at a level that is too tight, thereby creating the very market access disruption that they were meantto protect against. Moreover, they should not be set at such a low level that they are breached only when the financialinstitution is in such a severe state of financial distress that it is taken over by regulators. Our view is that the appropri-ate level for a trigger breach is close to the time that a financial institution would consider suspending or cutting itscommon dividend payments.

Assuming that a meaningful trigger is determined and any deferred hybrid distributions are non-cumulative, theranking for the deferral and settlement mechanism would be strong on the No Ongoing Payments dimension ofequity.15 In the absence of a meaningful trigger, the ranking would drop to moderate. Finally, if optional deferral isrestricted to a trigger breach, which is well out-of-the money, the ranking may be lowered further because the restric-tion could limit the issuer’s ability to opt for deferral when needed.

Triggers for Banks in Concept and PracticeMandatory deferral triggers for banks are designed to capture a deteriorating financial situation prior to regulatoryintervention. One indicator of a bank’s financial health is regulatory capital ratios that measure available capital relativeto the risks that a bank retains. Consequently, a number of European banks have issued hybrids with this type of trig-ger either by itself or combined with a distributable profits or net loss test (see chart on next page), which Moody’s hasviewed as meaningful. No such precedent has yet been established for US banks.

15. This also applies to corporate issuers.


While the definition of distributable profits may vary from country to country, Moody’s does not view the lack ofdistributable profits (when defined as accumulated or retained profits) by itself to be a meaningful trigger because abank may experience several years of losses and substantial depletion of its capital position before it lacks distributableprofits. We believe that for financial institutions, including banks, most meaningful triggers should incorporate both anearnings or profitability test and a capital adequacy or leverage test. Such triggers have already been used for hybridsissued by a number of non-bank financial institutions including Lehman Brothers, CIT Group, and Met Life.

The combination of both tests better captures financial deterioration at a bank than either one on its own.16 Forexample, a 4-quarter cumulative loss would be strong evidence of a weakening in a bank's financial condition. To theextent that such losses caused a significant erosion in capital, it would indicate a strong need to conserve capitalresources even if the bank’s capital was still above trigger levels. On the other hand, a decline in a bank's regulatorycapital ratios below some “well capitalized” threshold would also indicate a strong need to conserve capital, even ifearnings remained positive.

In assessing triggers for banks in the context of hybrid analysis, Moody’s will consider the type and/or combinationof triggers used as well as the proposed level for a breach. The strength of the regulatory environment is also a consid-eration and may result in the trigger level being set under the level required for a bank in a weak regulatory jurisdic-tion. Particular scrutiny will be given to any jurisdictions where a regulator has overridden a mandatory deferraltrigger and forced payment of a hybrid distribution. In these cases, Moody’s believes that the determination of a mean-ingful trigger is not possible.

Triggers for Insurers in Concept and PracticeThe concept behind mandatory deferral triggers for insurers is the same as for banks: they are designed to capture adeteriorating financial situation in advance of regulatory intervention. Triggers for insurers have been used both inEurope and the US and have evolved over time:

The current trigger standard for all insurers is the one used in the Metropolitan Life transaction. The combina-tion of financial tests is consistent with the insurance business model and the way that Moody’s analyzes the creditwor-thiness of insurers. That is, if an insurer has a significant increase in claims payout, it may have the ability to raisepremiums and access the equity capital markets, potentially repairing any damage to its capital base.17

Consequently, this “or” trigger looks at a cumulative net loss, the change in the capital base over a period of time,and allows for a cure period where financial strength may be restored through the issuance of equity. The second pieceof the trigger is a minimum solvency ratio, which is another important facet in the credit analysis of insurers. Taken

Bank Mandatory Deferral Trigger

Banco Comercial Portugues[a] Dividends > Distributable Funds (Net Loss) or Tier 1 Capital < 5%.

Banco Pastor[b] Distribution Requirements > Distributable Profits (Net Loss) or Shortfall in Group’s Own Resources > 20% of Minimum Own Resources (capital adequacy requirement) or Group Basic Own Resources < 5/8 of Minimum Own Resources required for compliance with Tier 1 Capital > 5%.

DZ Bank[c] Tier 1 Capital < 5% or Consolidated Net Loss.

Fortis Bank, SA/NV[d] Tier 1 Capital < 5%.

[a] €500,000,000 Series D Perpetual Non-Cumulative Guaranteed Non-voting Step-Up Preference Shares, issued on October 12, 2005.[b] €250,000,000 Fixed/Floating Rate Non-Cumulative Perpetual Guaranteed Preferred Securities issued on July 27, 2005.[c] €400,000,000 Non-Cumulative Trust Preferred Securities issued on November 23, 2004.[d] €1,000,000,000 4.625% Directly Issued Perpetual Securities issued on October 27, 2004.

16. The combined trigger would likely be an “or” test.

Insurer Mandatory Deferral Trigger

Allianz[a] Net Loss.

AGF, a subsidiary of Allianz[b] Net Loss with 4-quarter look-back at capital formation.

MetLife, Inc.[c] (i) 4-quarter Net Loss and shareholders’ equity has fallen by more than 10% compared to prior 8 quarters; 2-quarter cure period, or (ii) the covered insurance subsidiaries’ risk-based capital ratio is less than 175%.

[a] €1,500,000,000 Perpetual Subordinated Notes issued on February 27, 2004.[b] €400,000,000 Undated Deeply Subordinated Notes issued on January 27, 2005.[c] $600,000,000 Floating Rate Non-Cumulative Preferred Stock, Series A, issued on June 13, 2005, and $1,500,000,000 6.50% Non-Cumulative Preferred Stock, Series B, issued on June 16, 2005.

17. This is particularly true for property/casualty insurers.


together, these financial tests are designed to isolate a one-off credit event and capture an ongoing decline in credit-worthiness.18

Some Examples of Hybrid Securities Issued by Banks and Insurers

To illustrate the application of Moody’s Tool Kit to investment grade banks and insurers, examples of two generichybrids issued by each are provided.

Perpetual Preferred Issued by a Bank or Bank Holding CompanyThe characteristics of the hybrid are:

• The security has a perpetual maturity and can be called after 10 years. There is no replacement language,but the bank or bank holding company is regulated and subject to regulatory capital requirements.

• Dividends can be deferred at the option of the bank or bank holding company and, if deferred, are non-cumulative.

• The security has a preferred claim in bankruptcy.This security is then compared to the features of common equity and ranked none, weak, moderate, or strong rel-

ative to common equity with none closest to debt and strong closest to equity:

The rationale for each ranking and the basket is described below:(1) The security has a perpetual maturity with a call after 10 years. Since the bank or bank holding company is a

regulated entity and subject to capital requirements, our view is that the regulator will not allow the security tobe called if the bank is in financial distress. In addition, if the security is called, the regulator may require thatit be replaced with a similar or more equity-like security. As a result, the security has some permanence relativeto common equity and is ranked moderate on the No Maturity dimension of equity.

(2) Dividends can be deferred at the issuer’s option and are non-cumulative, if deferred. Although a bank or bankholding company is less likely to defer a preferred dividend than a common dividend, it has a degree of flexibil-ity at a time of financial distress. Moreover, similar to common dividends, any preferred dividends that aredeferred are non-cumulative. This deferral and settlement mechanism is ranked moderate on the No OngoingPayments dimension of equity19.

(3) A preferred security has a claim in liquidation that is only senior to equity and provides a cushion to absorblosses. As a result, it is ranked strong relative to equity on the Loss Absorption dimension.

Perpetual Preferred Issued by an Insurance Holding CompanyThe characteristics of the security are:

• Perpetual maturity that can be called in 10 years. Regulatory oversight does not extend to the insuranceholding company, but there is explicit, intent-based replacement language. It says that the insurer intends tocall the security only if it is repaid from proceeds of the issuance of the same or more equity-like security.

• Dividends must be deferred if certain pre-specified, meaningful triggers are breached. If deferred, dividendsare non-cumulative or may be stock-settled under certain circumstances (as previously described).

• The security has a preferred claim in bankruptcy.This security is also compared to the features of common equity and ranked none, weak, moderate, or strong rel-

ative to common equity with none closest to debt and strong closest to equity:

18. For insurers outside the US, regulatory group solvency ratios are generally not well developed. As a result, a solvency test would not be included in a trigger.

Features of Common Equity Ranking Relative to Equity

No Maturity (1) ModerateNo Ongoing Payments (2) ModerateLoss Absorption (3) StrongBasket C

19. In this example, the bank or bank holding company has the ability to defer dividends without restriction. However, in certain hybrids, the issuer’s ability to defer may be limited. For example, if a bank or bank holding company has the right to defer dividends only if a minimum regulatory capital ratio is breached, we view this as restricted optional deferral and would assign a weak ranking on the No Ongoing Payments dimension of equity. Since the bank or bank holding company only has the right to defer when a minimum regulatory capital ratio is breached and it is in severe financial distress, the issuer has less flexibility than it has with truly unre-stricted optional deferral (effectively, optional deferral is available too late). When combined with the other characteristics in this example, the Basket would shift from C to B.


The rationale for each ranking and the basket is described below:(1) The hybrid has a perpetual maturity with a call after 10 years. While we do not believe that regulators will

impose standards for the replacement security if this security is called, there is intent-based replacement lan-guage, which does provide some discipline. Similar to the ranking for the security issued by the bank, thischaracteristic is ranked moderate on No Maturity.

(2) There is mandatory dividend deferral tied to the breach of certain pre-specified meaningful financial triggers.The lead analyst and rating committee at Moody’s reviewed the type of trigger and believes that it is effectiveat capturing a deteriorating financial condition. In addition, with verification through back testing and peercomparison, it has been set at a level where there would likely be a breach at the time the common dividend issuspended or cut. At the insurer’s option, dividend payments are non-cumulative or stock-settled under certaincircumstances (as previously described), which means they preserve internally generated cash. This deferraland settlement mechanism closely replicates common dividend deferral and is ranked strong on the No Ongo-ing Payments dimension of equity.

(3) A preferred security has a claim in liquidation that is only senior to equity and provides a cushion to absorblosses. As a result, it is ranked strong relative to equity on the Loss Absorption dimension.

Clarification on the Use of Baskets to Adjust Financial Statements

In our Refinements to Moody’s Tool Kit: Evolutionary, not Revolutionary!, a number of questions were raised about footnote4 on page 3. In that footnote, we describe how the baskets are used to adjust corporate financial statements. Specifically,the hybrid is classified on the balance sheet according to the debt and equity components assigned to the basket. Theincome statement is also adjusted with a certain percentage of the hybrid distribution classified as interest expense andthe remainder classified as preferred dividends20. Ratios are then computed based on the adjusted financial statements.

For financial institutions, the basket is used to classify the hybrid for balance sheet purposes only. The hybrid dis-tributions remain classified according to the GAAP or IFRS presentation. The rationale for this difference in classifi-cation treatment relates to what is emphasized in credit analysis for either corporates or financial institutions. In thecredit analysis of banks, the differentiation between interest and fixed charge coverage ratios is not particularly rele-vant21. As a result, the breakdown of hybrid distributions into an interest expense component and a preferred dividendcomponent does not provide additional useful information.

For insurers, fixed charge coverage is an important ratio to consider and since it incorporates both interest expenseand preferred dividends, it is less relevant to separate the interest expense component from the preferred dividendcomponent. However, for corporates, since both interest and fixed charge coverage ratios are important to consider,the use of baskets to allocate hybrid distributions is more relevant.

Summary and Conclusion

In this addendum, we have not presented any new thinking related to hybrid analysis, but instead clarified some of ourrefinements to hybrid analysis, specifically in the context of banks and insurers. More in-depth discussion is providedon our rationale for recognizing the benefit of regulatory oversight in hybrid analysis. We also covered how mandatorydeferral triggers, if set at a meaningful level, may result in cash flow relief at a time of financial distress, similar to theway that common equity acts. Finally, greater clarity is provided on the use of baskets to adjust financial statements,particularly in the context of hybrid distributions.

Features of Common Equity Ranking Relative to Equity

No Maturity (1) ModerateNo Ongoing Payments (2) Strong Loss Absorption (3) StrongBasket D

20. For example, if a Basket C security is issued, 50% of the hybrid distribution is classified as interest expense with the remaining 50% classified as preferred dividends. If a company refinances a Basket B security with a Basket C security, there will be a positive impact on interest coverage as the interest expense component drops while the preferred dividend component rises. However, there will be no impact on fixed charge coverage because both interest expense and preferred dividends are used in the calculation.

21. However, these ratios have more relevance for the liquidity analysis of bank holding companies.



Related Research

Special Comments:An Application of Moody's Tool Kit: The Analysis of Preferred Securities Issued by US Real Estate Investment Trusts(REITs), May 2005 (# 92580)Characteristics of a Basket E Mandatorily Convertible Security for Financial Institutions and Corporates, November2004 (# 89899)Aussie Hybrids: The Search for Equity-Like Instruments, March 2001 (# 64504)A Time to Unwind: Moody’s Views about the Use of Exchangeable Bonds by Insurers, March 2000 (# 54632)Rating Methodologies:Hybrid Securities Analysis: New Criteria for Adjustment of Financial Ratios to Reflect the Issuance of HybridSecurities, November 2003 (# 79991)Refinements to Moody’s Tool Kit: Evolutionary, not Revolutionary!, February 2005 (# 91696)Moody’s Tool Kit: A Framework for Assessing Hybrid Securities, December 1999 (# 49802)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.









Appendix

Refresher on Moody’s Approach to Hybrid AnalysisMoody’s published its Tool Kit for assessing hybrid securities, including preferred securities, in 1999. A comparativeframework was introduced, which ranks various hybrids on a relative basis and places them in different baskets on theDebt-Equity Continuum. The baskets range from Basket A (more debt-like) to Basket E (more equity-like). Throughthis analysis, the hybrid is broken down into its basic characteristics including maturity, call options, conversionoptions, deferral mechanics, and priority of claim in liquidation. To see how closely equity is replicated, these basiccharacteristics are compared to the features of equity including:

• No maturity.• No ongoing payments, the absence of which would result in a default.• Loss absorption for all creditors.The hybrid’s characteristics are scored in terms of their strength relative to common equity. The four gradations

of modifiers used are none, weak, moderate, and strong relative to common equity with none corresponding to mostdebt-like and strong corresponding to most equity-like. Once these scores have been assigned, the hybrid is comparedto hybrids already on the Debt-Equity Continuum for consistency purposes and is placed in a basket. The hybrid isthen considered within the context of each issuer’s overall credit fundamentals and its impact on the rating is left to therelevant rating committee.

Adjustment of Financial Statements to Reflect the Issuance of HybridsIn November 2003, Moody’s assigned a specific debt and equity percentage to each basket to improve consistency inthe interpretation of the baskets. The specific percentages assigned to each basket are:

To illustrate, a $100 million hybrid placed in Basket C will result in a $50 million increase in debt and a $50 mil-lion increase in equity on the balance sheet. For the income statement of corporate issuers, the hybrid distribution isalso broken down based on the basket with 50% of the distribution allocated to interest expense and 50% allocated topreferred dividends. Ratios are then computed based on the adjusted financial statements in the same manner for bothinvestment grade and non-investment grade issuers.

For financial institutions including banks, insurers, and REITs, the balance sheet is adjusted for the baskets, buthybrid distributions are captured according to GAAP or IFRS accounting. This means that distributions for a pre-ferred security in Basket C will be reflected fully in preferred dividends in the financial statements rather than adjustedfor the basket. Ratios are then computed based on the adjusted balance sheet and the hybrid distributions presentedon a GAAP or IFRS basis for both investment grade and non-investment grade issuers.

Basket A Basket B Basket C Basket D Basket E

100% debt 75% debt 50% debt 25% debt 100% equity25% equity 50% equity 75% equity


© Copyright 2006, Moody’s Investors Service, Inc. and/or its licensors and affiliates including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALLINFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED,FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, INANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained byMOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “asis” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitnessfor any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by,resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees oragents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect,special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of suchdamages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the informationcontained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY,EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHEROPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in anyinvestment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and ofeach issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated byMOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to $2,400,000. Moody’s Corporation(MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS’s ratings and ratingprocesses. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publiclyreported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder Relations — CorporateGovernance — Director and Shareholder Affiliation Policy.” Moody’s Investors Service Pty Limited does not hold an Australian financial services licence under the Corporations Act. This credit rating opinion has been prepared without taking intoaccount any of your objectives, financial situation or needs. You should, before acting on the opinion, consider the appropriateness of the opinion having regard to your own objectives,financial situation and needs.



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February 2007

Updated Summary Guidance for Notching Bonds, Preferred Stocks and Hybrid Securities of

Corporate Issuers

Notching refers to the general practice of making rating distinctions among the different liabilities of a single entity orof closely related entities. The conceptual framework underlying Moody's approach to notching was first laid out in aNovember 2000 rating methodology report, "Notching for Differences in Priority of Claims and Integration of thePreferred Stock Rating Scale." In September 2001, Moody's released a special comment "Summary Guidance forNotching Secured Bonds, Subordinated Bonds, and Preferred Stocks of Corporate Issuers" which outlined its notch-ing practices. This methodology updates the 2001 summary guidance to include hybrid securities and concludes theNovember 2006 request for comment "Rating Preferred Stock and Hybrid Securities."

Notching for Subordination

The guidance provided in this section for subordination-based notching applies to all corporate issuers, except thosespeculative-grade non-financial corporate issuers subject to Moody's Loss Given Default methodology.1 The guid-ance integrates a stylized definition of Moody's ratings, expressed in terms of expected-loss rates, with informationabout expected relative loss severity in the event of default for the various security classes of a single issuer.

Moody's notching guidelines are intended to ensure that two securities with the same rating have the sameexpected loss rate. An obligation's expected loss rate is defined as the product of the probability of default and theexpected severity of loss given default. Generally, it is assumed that the probability of default is linked to the issuer ofthe obligation and is consequently the same across all obligations of that issuer. Notching practices based on thisassumption are referred to as subordination-based notching.

Whenever possible, Moody's estimates issuer-specific expectations of relative expected loss severity upon default.However, relative loss severity estimates alone are insufficient to answer the following key questions:

• Are any differences sufficient to merit a rating distinction?• If so, should the differences be one notch, two notches, or more?• And do notching recommendations vary, depending where an issuer's benchmark rating is located on the

rating scale?As discussed in the September 2001 summary guidance document, in order to answer these questions, one needs

to know the percentage change in expected-loss rates as one traverses the long-term rating scale.Moody's benchmark expected loss rates define the meaning of Moody's ratings, both for structured finance trans-

actions and for fundamental corporate issuers. In particular, Moody's idealized expected loss (and default) rates exhibitthe following characteristics:

1. This includes US and Canadian issuers, as well as EMEA issuers from end of March 2007 on. Please see Moody's Rating Methodology "Probability of Default Rat-ings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate Obligors in the United States and Canada," August 2006 and the Novem-ber 2006 request for comment "Probability of Default Ratings and Loss Given Default Assessments for Corporate Obligors in Europe, Middle East and Africa: Recommended Framework."

• For rating categories Ba2 and higher, the percentage difference in risk, relative to one category higher, is45% or greater.

• For rating categories Ba3 and below, the percentage difference in risk, relative to one category higher, is lessthan 45%.

In order to translate these differences into notching guidance, we need estimates of differences in loss across debtclasses. The table below summarizes the percentage difference in average severity of loss, relative to an issuer's seniorunsecured rating, for a number of debt classes.

For those adjacent rating categories where the percentage difference in risk is greater than 45%, the percentagedifference in loss severity, relative to senior unsecured bonds, must be at least 45% to justify a rating notch. Twonotches would require a difference in loss severity of at least 110%. For rating categories where the percentage differ-ence in risk is less than 45%, a difference in loss severity in excess of 45% would justify possibly multiple ratingnotches.

For example, as shown in the table above, subordinated bonds recover on average 52% less than senior unsecuredbonds. Accordingly, they would be notched once if the senior unsecured rating is Ba2 or higher and perhaps twice oreven three times at lower rating levels.

Using this logic, we developed the following, simplified guidelines for subordination-based notching. As men-tioned previously, speculate-grade corporate issuers subject to Moody's LGD methodology are not covered by theseguidelines. Also note that no distinction is made between cumulative and non-cumulative preferred stock.

Average Loss Severity Rates for Various Debt Classes

(relative to the historical loss severity on the same issuer's senior unsecured bonds)Secured bonds -30%Senior unsecured bonds n/aSenior subordinated bonds 40%Subordinated bonds 52%Junior subordinated bonds 62%Preferred stock 85%

Guidance on Notching for SubordinationNumber of Notches

("+" greater than; Security Class "-" less than) Reference Rating

If Sr. Unsecured or Corporate Family Rating

is Ba2 or higher

Secured Bonds +1 Sr. UnsecuredSr. Unsecured 0 Sr. Unsecured

Sr. Subordinated -1 Sr. UnsecuredSubordinated -1 Sr. Unsecured

Jr. Subordinated -1 Sr. UnsecuredPreferred stock -2 Sr. Unsecured

Number of Notches("+" greater than;

Security Class "-" less than) Reference Rating

If Sr. Unsecured or Corporate Family Rating

is Ba3 or lower

Secured Bonds +1 CFR or Sr. UnsecuredSr. Unsecured 0 CFR or Sr. Unsecured

Sr. Subordinated -2 CFR or Sr. UnsecuredSubordinated -2 CFR or Sr. Unsecured

Jr. Subordinated -2 or -3* CFR or Sr. UnsecuredPreferred stock -3 or -4# CFR or Sr. Unsecured

*Junior subordinated debt is rated 2 notches below senior unsecured (or the corporate family rating), unless a company has a substantial amount of senior subordinated or ordinary subordinated debt outstanding; then it is rated 3 notches below the senior implied rating.#Preferred is rated one notch below the lowest rating assigned to any type of subordinated debt.


Notching Hybrid Securities

Modern hybrid securities — combining features of debt and equity and usually ranked as either subordinated debt orpreferred stock in terms of priority of claim — pose a unique set of risks that may not be adequately captured in theguidelines above. In particular, issuers may be allowed — or, in some cases, required — to omit dividends (or otherpayments) without triggering a broader default. In order to justify incremental notching beyond subordination-basedoutcomes, we must address the following questions:

• Is the risk of payment deferral material?• If so, are the expected losses due to deferral large enough to warrant a rating notch?To compare the relative potential loss rates on hybrids and ordinary debt securities, one needs to consider not only

any differences in loss on principal, but also the possibility that the hybrid security will go into "default" under circum-stances in which the non-hybrid security does not default, or if it does, it enters default at a later date.2 Given, how-ever, the lack of empirical data on hybrid losses, we are not suggesting incremental notching for deferral risk wheredeferral is optional, since anecdotal evidence to date suggests that the option to defer is very rarely exercised. Where"meaningful" mandatory deferral features are present, however, the following guidance holds:

As a general rule, notching should not exceed guidance for preferred stock. For example if a hybrid security werealready notched twice because it is deeply subordinated, no further notching would be warranted.

Meaningful mandatory deferral triggers are defined in footnote 8 of Moody's December 2006 Rating Methodol-ogy "Supplemental Comments on Rating Preferred Stock and Hybrid Securities":

Meaningful triggers are those set at a level such that they would be breached when: 1) the issuer isjust beginning to experience financial distress (before it is in severe financial distress); and 2) at a timewhen the issuer may cut or eliminate its common dividend.

Typically for non-financial corporate issuers, Moody's rating committees have set triggers to be activated whenfinancial measures correspond to a mid-Ba rating. For financial issuers, the January 2006 Rating Methodology"Refinements to Moody's Tool Kit: An Addendum for Banks and Insurers," provides further guidance:

Moody's general concept behind meaningful mandatory deferral triggers is, if breached, they resultin the deferral of hybrid distributions and provide cash flow relief in a deteriorating financial situa-tion. The triggers should be based on publicly available financial and/or operating parameters thatbest capture an issuer's deteriorating financial condition and not be set at a level that is too tight,thereby creating the very market access disruption that they were meant to protect against. More-over, they should not be set at such a low level that they are breached only when the financial institu-tion is in such a severe state of financial distress that it is taken over by regulators. Our view is thatthe appropriate level for a trigger breach is close to the time that a financial institution would con-sider suspending or cutting its common dividend payments.

Moody's ranks instruments with meaningful mandatory deferral triggers and an acceptable settlement mechanismas "strong" on the "No Ongoing Payments" dimension of its equity credit methodology.3 Such triggers are typicallyset at a level that would be crossed before the issuer experiences severe financial stress. The probability of tripping isconsidered to be material enough to warrant a rating notch.

2. Payment deferral on hybrid securities usually cannot trigger either a default on the hybrid itself or a cross-default on the issuer’s other obligations. In rating hybrid secu-rities, Moody’s assumes hybrid investors expect to receive payments as scheduled.

Hybrid Notching GuidelinesA hybrid security with a meaningful mandatory trigger and a priority of claimabove preferred stock will be rated one notch below the subordination-based (orLGD derived) rating.

A hybrid security with a preferred stock (or equivalent) priority of claim will haveno additional notching.

3. An acceptable settlement mechanism is one that is viewed as effectively non-cumulative, according to Moody's hybrid basket methodology.


The financial metrics used in setting meaningful mandatory deferral triggers usually vary from industry to indus-try. Furthermore, hybrid securities with mandatory deferral provisions may use a combination of more than onefinancial ratio test for Moody's to consider the triggers meaningful. Some common financial ratio tests used in hybridswith meaningful mandatory deferral triggers include:

• Negative GAAP income for four consecutive quarters combined with a decline in book capital and a cureperiod which allows the capital base to be restored

• Gross cash flow less than X% of consolidated sales• Interest coverage ratio less than or equal to X times• Retained cash flow-to-debt ratio of less than X%• Tangible equity below X% of assets under management (for an asset manager)

Global Application of Notching Guidelines

The guidance presented here is global and applies to all industries. It is expected that the vast majority of corporateratings will conform to these guidelines. Certain exceptions, however, will be made where Moody's believes the termsof a security materially increase an investor's expected loss beyond established norms. Consequently, some securitiesmay be subject to an additional notch. In particular, examples will be found in the case of certain European non-finan-cial corporate issuers, banks, and reinsurers in certain countries (e.g. Germany and Switzerland).

European Non-Financial Corporate IssuersWhile many European countries allow the issuance of preferred stock, the practice is rare due to a lack of investorappetite. In addition, some issuers either lack a board resolution authorizing issuance of preferred stock, or have cove-nanted not to do so. For such firms, hybrid securities can act as a substitute for preferred stock. Hybrids issued byEuropean firms are typically classified as "deeply subordinated" notes, senior only to common stock. Moody's consid-ers the junior position of such European corporate hybrid obligations as increasing an investor's expected loss to levelstypically associated with preferred stock, and therefore ratings on such hybrid instruments typically follow guidancegiven for preferred stock. For example, a deeply subordinated hybrid instrument issued by a European corporate witha senior unsecured rating at Ba2 or above would be rated two notches below the issuer's senior rating.

BanksMoody's notching guidance uses an issuer's senior unsecured rating as a benchmark, or reference point, for determin-ing the ratings on subordinated obligations. The rating methodology for banks first determines deposit ratings, thenin most cases sets senior unsecured debt ratings equal to the deposit ratings. Moody's does not believe, however, thatbank deposit ratings are always an appropriate notching benchmark.

Notching between a bank's deposit rating and more junior bond ratings may be wide in cases where Moody'sexpects the sovereign government to support the depositors and senior debt holders of a failing bank, but may not pro-vide the same support to junior bond holders. That is, Moody's believes that certain governments will try to pushdown the losses of a failing bank on junior debt holders, while protecting depositors and other senior debt holders. Fora bank in such jurisdictions, these relatively higher levels of investors' expected loss may lead to wider notching forhybrid ratings than indicated by the above guidelines.

ReinsurersFor reinsurers in certain countries (e.g. Germany and Switzerland), unlike primary insurers, senior debt holders are notsubordinate to policyholders, reflecting the regulatory protection that exists for primary insurance policyholders, but notfor reinsurance policyholders. As a result, while senior debt ratings for primary insurance operating companies arenotched below the Insurance Financial Strength Rating (IFSR), a reinsurer's senior unsecured debt will typically be ratedat the same level as the IFSR. However, this preferential parity status does not extend to subordinated or more juniorobligations, and such instruments are expected to bear a substantially greater loss in default than senior creditors (policy-holders and senior debt).


Hence, Moody's rates subordinated debt in such cases two notches below senior - in line with the IFSR/subordi-nated debt notching differential for primary insurers. Consequently, the existence of a meaningful mandatory triggerfor the subordinated debt of a reinsurer with a senior rating of Ba2 or above, under the revised guidelines, would berated one notch lower than other subordinated debt and at the relevant preferred security rating level (three notchesbelow senior).

This was the rationale underlying Moody's February 2007 rating action which placed the hybrid ratings of tworeinsurers - Allianz SE (the holding company and reinsurer for the Allianz Group) and Swiss Re - on review for possi-ble downgrade.4

4. Please see "Moody's Set to Issue Revised Guidelines for Hybrid Securities," February 2006, available on moodys.com.


Related Research

Special CommentsNotching for Differences in Priority of Claims and Integration of the Preferred Stock Rating Scale, November 2000 (61680)Summary Guidance for Notching Secured Bonds, Subordinated Bonds, and Preferred Stock of Corporate Issuers,September 2001 (70456)Rating MethodologiesRating Preferred Stock and Hybrid Securities, November 2006 (100692)Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade CorporateObligors in Europe, Middle East and Africa: Recommended Framework, November 2006 (100673)Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade CorporateObligors in the United States and Canada, August 2006 (98771)Refinements to Moody's Tool Kit: Evolutionary, not Revolutionary!, February 2005 (91696)Moody's Tool Kit: A Framework for Assessing Hybrid Securities, December 1999 (49802)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this reportand that more recent reports may be available. All research may not be available to all clients.









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