Hybrids and Capital Securities, Fitch 2006

7/23/2019 Hybrids and Capital Securities, Fitch 2006

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Hybrids and Capital Securities:

New Criteria for Equity Credit

Daniel R. Kastholm, CFADaniel R. Kastholm, CFA

Managing DirectorManaging Director

August 2006August 2006


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www.fitchratings.com 2

Hybrids and Capital Securities: Overview

> Basic Concepts and Fundamental Approach

> Analyze Hybrid Features

> Examples of Applying Criteria

> Impact on Credit Ratios and Notching


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Basic Concepts and Fundamental Approach

> Underlying credit philosophy Equity is needed when companies experience stress

Products are analyzed for their ability to provide financial flexibilityto the issuer regardless of the probability a stress will occur

> Basic building blocks

Loss absorption

Cash flow Flexibility, i.e. no fixed servicing costs

Qualities of these features determine specific equity credit


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Basic Concepts and Fundamental Approach

New Debt to Equity Continuum

100%0Class E

75%25%Class D

50%50%Class C

25%75%Class B

0100%Class A

DebtEquity


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Analyzing Features: Role of Subordination

Senior debt

Subordinated debt for banks (and

bank holding companies)

Class E - 0%

n.a.Class D - 25%

n.a.Class C 50%

Junior subordinated and

subordinated debt for corporates

and less regulated insurance

companies

Class B 75%

Preferred and preference shares

Junior subordinated debt for banks

(and bank holding companies)

Class A 100%

Equity Class Caps Level of Subordination

Source: Fitch


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Analyzing Features: Role of Maturity

Less than 5 yearsClass E - 0%

5 to 10 yearsClass D - 25%

Class C 50%

10 to 20 yearsClass B 75%

Perpetual/20 years plusClass A 100%

Maximum Equity Class Effective Matur ity

Source: Fitch


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Analyzing Deferral Features: Non-Cumulative vs Cumulative

Cumulative five years or more

Cumulative five years or more with constraints, partially

offset by exceptionally strong mandatory feature

Non-cumulative with constraints, but

offset by strong mandatory featureClass B 75%

Cumulative five years or more with constraints, butoffset by strong mandatory feature

Cumulative three to five years

Cumulative three to five years with constraint, but

partially offset by exceptionally strong mandatory

feature

Non-cumulative with constraints


with weak mandatory feature

Class C 50%

Cumulative five years or more with constraints

Cumulative five years or more with constraints, butweak mandatory feature

Cumulative three to five years with constraints, but

offset by strong mandatory feature

Class D 25%

Cumulative three to five years with constraints

Cumulative three to five years with constraints ,but

weak mandatory featureCumulative less than three years

Class E 0%

Non-cumulative


offset by exceptionally strong

mandatory feature

Class A 100%

Equity Classes Non-Cumulative Cumulative


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Analyzing Deferral Features: Optional & Mandatory

> Constraints on optional deferral, such as a look-back clause, can reduce

the equity assignment

Equity credit limited to a maximum of Class C (50%)

If deferral is constrained by over 12 months, instruments generally

receive no equity credit, i.e. Class E

> Mandatory Deferral may offset the effect of the constraint, depending onthe mandatory deferral feature

Class E (no offset to

Constraint)

Reporting is delayed; triggers take

effect only after severe financial

stress

Weak.

Limit is Class BTriggers are effective and monitored

reasonably often.

Strong

Limit is Class ATriggers kick-in early and are very

frequently monitored

Exceptionally Strong


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Analyzing Features: Mandatory Convertibles

Over five years senior or non-

deferrable/non-loss absorbing sub

Class E - 0%

Between three and five years to

conversion, senior or non-deferrable/non-

loss absorbing sub

Class D - 25%

Three years or less to conversion, senior

or non-deferrable/non-loss absorbing sub

Class C 50%

Between three and five years to

conversion, junior subordinated note

Class B 75%

Three years or less to conversion,junior subordinated note

Class A 100%

Equity Classes Type of Mandatory Convertible

Source: Fitch

Note: An instrument whose conversion is more than five years forward may

qualify for equity credit based on its other features (subordination, loss

absorption, deferral mechanism.)


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Examples: Non-cumulative Preferred Shares

40 years initial, 7years remaining

(Max Class: D)

40 years initial, 30years remaining

(no cap)

Perpetual (no cap)Maturity/

Permanence

Class A (100%

Equity)

No cap

Max Class: A

Max Class: A

Preferred Shares

(Bank)

Max Class: AMax Class: ACash Payments

Max Class: AMax Class: ALoss Absorption

No capNo capOther (Covenants,

Step-Ups)

Class D (25% Equity)Class A (100%

Equity)

Assign

Equity Class

Preferred Shares

(Corporate)

Preferred Shares

(Corporate)


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Examples: Trust Preferred

Optional non-cum:

Mandatory upon reg. capital

breach.

Max Class: A

Optional cumulative for 5

years, no constraint.

Max Class: B

Cash payments

Jr. Subordinated, Going-

concern loss absorption

Max Class: A

Jr. Subordinated,

Max Class: B

Loss Absorption

60 years remaining (no cap)30 years remaining (no

cap)

Matur ity/ Permanence

No capNo capOther (Covenants, step-up)

Class A (100% Equity)Class B (75% Equity)Equity Class

Tier 1 Innovative Capital

(Bank)

Std. Trust Preferred Security

(Corporate)


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Examples: Other Deferrable Securities

Class B (75% Equity)Class E (Debt)Equity Class

no capno capOther (Covenants,

step-up)

Non-cum optional, no look-

back; Also reasonable

mandatory deferral

Max Class: A

Cum. Optional 5 years, with

Look-Back in excess of 12

months; Weak mandatory

deferral

Max Class: E

Cash payments

Jr. Sub, Max Class: BJr. Sub, Max Class: BLoss Absorption

60 years;60 years;Maturity/ Permanence;

5 years call, + 100 bp;

Acceptable replacement;(no cap)

10 years call, + 100 bp;

Acceptable replacement;(no cap)

Call & replacement

Enhanced Capital Securi ty

(Corporate)

Enhanced Capital Securi ty

(Corporate)


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Examples: Convertibles

No deferral

Max Class: E

Cum. Deferrable for 3 years

(no cap)Pre-exercise Cash

Payments

No capNo capOther (covenants,

cross defaults)

Class E (Debt)Class A (100% Equity)Equity Class

Optionally Convertible; cash

settlement

Max. Class: E

Mandatory exercise in 3

years or less at defined

range of equity prices.

Max Class: A

Convertibility

Jr. Subordinated (no cap)Jr. Subordinated (no cap)Pre-exercise Loss

Absorpt ion

Optionally Convertib le Jr. Sub

Notes

Mandatory Convertible Jr.

Subordinated Units


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Impact on Credit Ratios: Leverage

> Limit of 30% Adjusted Eligible Capital

> Flat limitation, no difference for rating levels or sectors

> Limits are applied because hybrids are not equally equity-like in allscenarios

Generally are somewhat debt-like when issuer is weakening but not

yet in distress (i.e. continue to be serviced and have effectivematurities)

Companies can generally sustain up to 30% of total capital from thesesources without materially changing the risk profile

> Constitutes a soft cap for corporate and industrial sectors wherecash flow measures are more relevant than balance sheet capital


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Impact on Credit Ratios: Debt Service

> Hybrid instrument segmented into adjusted debt and adjusted

equity components for capitalization and balance sheet ratios> Capital Ratios

Banks: Eligible Capital ratios (defined as core equity plus up to 30%

hybrids) are calculated on a risk weighted basis.

Insurance Holding Companies: Adjusted Debt/Total Capital Corporates: Adjusted Debt / Cash Flow and Adj. Debt /EBITDA for

corporate leverage ratios.

> Interest or dividends

Corporates and Insurance: Coupon is NOT allocated into different

components; 100% of interest expense is used in coverage and fixed

charge calculations; in stress cases, maximum deferrals are applied.

Banks: Hybrid dividends are included in interest expense when calculating

net interest margins.


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Impact on Notching

> No change from existing notching criteria, based on IDR and RR

approach, with recovery of deeply subordinated instruments ordinarilyassumed to be RR6.

> We DO NOT apply extra notching for the existence of deferral feature.

> We DO move to the widest permitted notching if deferral has occurred,is imminent, or if a mandatory deferral trigger is very severe.

-2 or -3-1 or -20-10%RR6

-1-111-30%RR5

0031-50%RR4

+1+151-70%RR3

+2+271- 90%RR2

+3+291-100%RR 1

Speculative GradeInvestment Grade


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Fitch Ratings

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Hybrids and Capital Securities, Fitch 2006

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Transcript of Hybrids and Capital Securities, Fitch 2006