Watch out for those Moody’s hybrid debt downgrades!
They are coming:
Sydney, November 17, 2009 — Moody’s Investors Service has published its revised methodology on the way it rates the hybrid securities and subordinated debt instruments issued by banks. The new methodology is in line with changes proposed by the rating agency earlier this year and largely removes previous assumptions of systemic support for these securities. In addition, the ratings will differentiate among hybrid instruments based on certain features that affect the risk to investors. The ratings of securities potentially affected by this methodology change will be placed under review for possible downgrade and announced via a separate press release within the next two days.
Before the current financial crisis, Moody’s had assumed that any support provided by national governments and central banks to shore up a troubled bank and restore investor confidence would not just benefit the bank’s senior creditors but — at least to some extent — investors in its subordinated and preferred securities.
That, of course, hasn’t proved to be the case. The European Commission is (rightly or wrongly) enamoured of the concept of `burden-sharing‘ for bondholders — making hybrid, or subordinated, debt investors take their share of the `pain’ involved in state-sponsored bank bail-outs. Bailed-out banks are thus being pressured not to make certain coupon payments on, or not to call some of, their hybrid bonds.
Meanwhile, those clever finance types have come up with a new type of capital to replace hybrids — CoCo bonds.
But that’s before the fallout from the hybrid controversy has yet to really come to pass.
To wit, Citi analysts’ forecasts that about 40 per cent of the hybrids Moody’s covers will be downgraded by a notch as a result of the revised methodology. A quarter could go down by three or four notches, and 10 per cent could go down by five levels or more. That’s something that will have a big impact on the holders of such subordinated debt: Fixed income funds and, curiously, many insurance companies.
US insurer Aflac reportedly had a “large amount of exposure” to hybrids, which triggered concern among analysts earlier this year. Meanwhile, Legal & General has about £2.2bn of hybrid bonds on its books, much of that from banks, according to Citi estimates. In early 2009, Munich Re said it had €600m of hybrid debt holdings.
A ratings downgrade would presumably trigger the need for more capital for companies with large holdings of the subordinated stuff.
But of course, this isn’t a blanket thing.
As the Moody’s report notes, “the ratings will differentiate among hybrid instruments based on certain features that affect the risk to investors” — things like geography. Thus the hybrid bonds from banks in one country may end up worse off than those in others under the new methodology. And, perhaps it’s no surprise which country looks set to get the thinnest end of the Moody’s hybrid downgrade wedge.
From Gary Jenkins at Evolution Securities:
One feature of the new methodology is that it provides flexibility to position ratings based on country specific considerations, – following the change in terms on Bradford & Bingley’s LT2 debt earlier this year, this could mean UK banks see a relatively harsher treatment of LT2 debt than banks in other jurisdictions.
Related links:
`Non-toxic’ investments may hit European insurers’ capital base – Insurance ERM
Banks face debt downgrades in Moody’s reform – FT
SELL: Insurers – FT Alphaville
Hybrid debt attack! – FT Alphaville