Oh dear. RBC Capital Markets’ credit analysts have taken an axe to Moody’s proposed reform of its ratings-methodology for hybrid debt.
The agency suggested earlier this month that it is considering altering its approach to assigning debt capital ratings. Currently Moody’s assumes that the hybrid or subordinated debt has implicit state support. However, several subordinated instruments have recently been allowed to suffer losses during the crisis — hence the Moody’s rethink, which in its current proposal would remove the support assumption within Tier 1 debt ratings.
Fair enough, you might say. Hybrid debt, which has characteristics of both equity and debt, has already been suffering of late with some Tier 1 debt trading at about 40 per cent of face value, according to this Reuters report.
Nevertheless, RBC credit analysts Hank Calenti and Alastair Whitfield see a boatload of potential problems with proposed reform. Here’s their note, published on Monday:
From our perspective, the proposed revisions result in an issuer accommodative rating methodology, whereby certain systemic measures remain part of the fundamental rating methodology. This irony of this proposal is the suggestion that systemic risk is removed when in fact it remains embedded within the methodology. . . .
While the possibility of future systemic support will be excluded, existing systemic or bank-specific support measures will remain a component of the individual intrinsic financial strength ratings. For example, the UK governments’ proposed Asset Protection Scheme is a critical component of the intrinsic financial strength rating (BFSR) of Lloyds, HBOS and RBS, according to Moody’s. As such, a winners-curse is the reward for UK banks that were strong enough to avoid extraordinary government support measures in the proposed rating scale, such as Barclays, as their BFSRs do not benefit from the ‘existing’ government-support rating boost. Nonetheless, in our view, the market imputes a discount for indirectly government-supported hybrid debt capital. As such, basing equity-like debt ratings on an ‘intrinsic-except’ methodology is unlikely to be of value for investors except in the cross-over area between investment and non-investment grade ratings.
Poor Barclays.
But it gets worse, according to the analysts. Not only could the reform induce potential punishment for banks that haven’t received state support — like Barclays — it could also be negative for UK banks in general (and Danish ones too):
The UK and Danish governments’ authority to impose selective losses on creditor classes, ex-post facto, will be a factor in the proposed rating methodology revision. We applaud the rating agency for the courage to implicitly condemn these practices by factoring them in the ratings process. This authority is an unmitigated credit negative and is likely to raise the cost of financing for UK and Danish banks relative to institutions operating in banking systems with less legal uncertainty, in our view.
The rating agency notes that the UK Banking Act of 2009 enables the UK government to impose losses on all types of hybrids in a government imposed restructuring of a bank. The Act was used in the case of debt issued by Dunfermline, a UK building society. Investors should take note that the usurpery powers of the Act remain in force and create a precedent, which in our view, are an unmitigated credit negative.
Moody’s also cites the effective expropriation of certain preferred securities in the nationalization of Northern Rock and the imposition of losses on all subordinated creditors of Bradford & Bingley in 2008. Taken together these represent cases where the UK government restructured troubled banks at the expense of hybrid debt holders and imposed losses on these securities via a process beyond the original provisions of the debt contracts. In addition, Moody’s notes that the Danish government relied on authority gained in the 1990′s to impose losses on all subordinated creditors of Roskilde Bank in 2008 and Fionia Bank in 2009.
We applaud the rating agency for the courage to implicitly condemn these practices by separating the potential impact of these actions from the intrinsic financial strength assessment process. This should make the discount for legal uncertainty more transparent. All other things equal, the result should be lower ratings for UK and Danish bank hybrids relative to intrinsically equal institutions that are headquartered in more certain legal operating environments.
There’s also the issue of Tier 1 debt with net loss coupon deferral triggers, explained below, which would face harsher ratings revisions under the proposal:
Tier 1 debt with income statement net loss coupon deferral triggers would face harsher rating revision treatment and may suffer a potentially unjustified, and completely arbitrary, ratings cap, in our view. Moody’s proposes to place these securities four notches below the A-BCA, and also proposes to cap ratings of these securities at Baa1.
The incentive alignment potential of net loss triggers is something that we expect regulators to add to their tool-kit of loss-absorbing capital for going-concern entities. We also question the imposition of an arbitrary cap on the rating level for these securities as it is conceivable that the positive benefits associated with the existence of these securities outweighs the probability of breaching the coupon deferral trigger. As such, we are of the view that they should not be subject to an arbitrary rating cap.
Net loss coupon deferral is triggered when net profits in the fiscal year are not sufficient to pay coupons on parity-securities with a net loss trigger. Furthermore, net loss coupon deferral, when triggered, forbids the institution from making dividend payments and share buy-backs.
As such, net loss triggers help to create the necessary condition of incentives for positive corporate governance, in our view, albeit these incentives are not always sufficient to forestall poor judgment. For example, a net loss trigger can create incentives for management to take care when considering acquisitions, as the future impairment of goodwill could produce a coupon deferral trigger. Nonetheless, this incentive did not prevent BBVA from paying almost 4x book value for U.S.-based Compass Bancshares at the height of the credit bubble.~
In addition, a net loss trigger also creates incentives for banks to accumulate loan loss reserves as lending increases or in advance of economic cycle changes in order to absorb increasing losses when earnings are in decline without triggering coupon deferral. However, this incentive alone may not always result in a prudent risk- reward balance. Nonetheless, the incentive alignment potential of net loss triggers is something that we expect regulators to find of value and we believe that the existence of these securities can outweigh the probability of breaching the coupon deferral trigger.
In return for providing these positive corporate governance incentives, security holders with net loss triggers are likely to require a premium relative to other debt from the same issuer, should Moody’s rating revision be adopted as proposed. As part of the rating revision, however, currently outstanding Tier 1 debt with net loss triggers may be severely downgraded and land close to the noninvestment grade threshold.
Australian and Spanish banks have net loss triggers in their Tier 1 debt and are the prime candidates to see large downward rating adjustments, in our view.
Got that? So that’s UK banks — especially ones that haven’t yet received government support (eg Barclays) — Danish, Australian and Spanish banks that could suffer most from the Moody’s reform, according to RBC.
The offshoot of all this is that those banks affected will probably just buy back or exchange any subordinated debt that’s at risk of a downgrade. But, that would probably raise their borrowing costs.
Banks of Britain, Denmark, Spain and Australia — you know who to write to.
Related links:
Hybrid Capital, a simple introduction – PwC blog
Uncertainty grips hybrid debt owners – FT
Banks face debt downgrades in Moody’s reform – FT