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Fitch Launches New Hybrid Ratings

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Fitch Ratings formally unveiled its new rating criteria for hybrid securities that analysts here say will bring greater clarity to how these financial instruments are treated by the rating agency.

The new rating criteria, which take effect on Sept. 27, were explained during a press briefing. They apply to hybrids issued by all companies rated by Fitch irrespective of industry segment or geographic location. Previously, a two-pronged approach was used: one for banks, and a second for corporate issues, finance companies and insurers.

The new criteria break hybrids into 5 classes as follows:

– Class A, 100% debt.

– Class B, 25% equity and 75% debt.

– Class C, 50% equity and 50% debt.

– Class D, 75% equity and 25% debt.

– Class E, 100% equity.

The classifications would impact financial ratios and potentially the ratings of issuers of hybrid securities, says Keith Buckley, group managing director, global head of insurance in Fitch’s Chicago office.

Thus, for instance, if a security was valued at $1,000 and was classified as a ‘B’, then in its debt-capital ratio, $250 would be treated as equity and $750 as debt, Buckley explained.

Typically, he said, securities are issued at the insurer holding company level, but if a security was issued by an insurance subsidiary, then that unit’s financial ratios would be subject to the new classification.

For purposes of assessing financial ratios under Fitch’s new system, buyers of hybrids will be assessed using its PRISM system of risk assessment, an insurance capital model that Fitch introduced in June 2006.

Buckley said that comparability with other ratings is important to those looking at the ratings of hybrids and consequently, the new system attempts to make it easier to compare ratings with other ratings on a hybrid security.

Another change in the new hybrids rating approach is that the drop-off in the debt-to-equity treatment is less severe, says Ellen Lapson, managing director-global power in Fitch’s New York office. So, for instance, equity or debt treatment might drop from 75% to 50%, but would not drop from 75% down to zero, she explained.

Other modifications in the hybrids rating system include:

– A more detailed analysis of the effective maturity relating to call provisions, rate step-ups, and other factors.

– A reduced penalty to equity credit when a security includes a ‘look-back’ provision, and a refinement of the definition of ‘constraints’ on deferrals.

– Clarified treatment of optional versus mandatory coupon deferrals.

– A limited recognition of pre-bankruptcy loss absorption features.

Deferrals refer to an issuer’s right under terms of the hybrid contract to defer making interest or dividend payments on the security.

Some hybrids, Fitch explains, include a coupon step-up that typically coincides with an option date at which the issuer can call the security.

Look-back provisions, according to Fitch, are contractual restrictions in a hybrid contract that can effectively eliminate the deferral feature for an issuer.

In general, Fitch typically rates hybrids 1 to 3 rating notches lower than the senior debt of the same issuer to reflect lower expected recovery and greater risk for hybrid securities.

The rating agency says that if treated as debt, hybrids can increase financial leverage, so equity treatment is important to issuers of hybrids.

However, for investors, it is not as important an issue. What is important to investors, Lapson says, is that the security is issued by a highly-rated, stable company.

Sharon Haas, a managing director-financial institutions with Fitch’s New York office, says that as hybrids have added special features, the product has become more complex. As complexity has increased, liquidity for the product has decreased, she added. Attempts to standardize the product could help increase liquidity, according to Haas. So, rather than 40 flavors, bringing the number of flavors or varieties of hybrids down to a more reasonable number would help increase make the market more liquid, she explains.

The issue of liquidity has been raised in a separate discussion by Wall Street and insurers with state insurance regulators.

Hybrids have been under intense scrutiny over the last 6 months, following a decision by state insurance regulators to review whether they should be treated more as debt or more as equity. Those involved in the market said that the reclassification had caused the market to become illiquid.

At the fall meeting of the National Association of Insurance Commissioners, Kansas City, Mo., a temporary solution was reached and is being advanced through the organization’s process. The solution includes, among other points, treating all defined hybrids as preferred debt, and lowering by one SVO notch the designation for hybrids issued after Aug. 18, 2005 and those classified as common stock in 2006. The Securities Valuation Office, New York, is the securities rating arm of the NAIC.

In addition, work on a long-term solution that addresses issues such as transparency is currently underway.

Since the short-term solution has been reached, Fitch’s Lapson says Fitch has been told by some close to the hybrid market that liquidity is returning.


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