Is it wrong that a security can be classified as 75% equity by a borrower and yet is considered debt by insurance investors? That is the question that arises from the ruling of the National Association of Insurance Commissioners (NAIC) in the US that Lehman Brothers’ ECAP structure is equity.
When it appeared in August 2005 the ECAP was seen as a landmark deal as it was the first US hybrid to meet Moody’s basket D category [see Euromoney’s FIG Innovation of the Year, February 2006]. A year ago, Moody’s methodology for analysing hybrid securities evolved and it became possible to structure a security to receive 75% equity content from the rating agency. The bond would need to meet specified requirements involving such features as subordination, coupon deferral and permanence.
The bank capital-structuring teams immediately went to work to create a wave of new securities that would take advantage of this new paradigm. A flurry of deals appeared in Europe. In the US it was slightly more difficult to find an effective structure because, under US tax law, debt cannot be perpetual. But Lehman discovered that Moody’s would consider 60 years as permanent. Since then, a host of issuers have used ECAPs and other structures.
The NAIC’s decision surprised the market as it had been expected that ECAPs would be ranked as a preferred security (the third option is debt). This is significant. Insurance company investors now have to increase the capital charge against these hybrids from just 1% to 3% to something more like 40% to 50%. Furthermore, these investors would be required to shift ECAP structures into smaller equity security portfolios. Insurers are big buyers of this type of paper, accounting for about 25% of any normal deal. The NAIC’s verdict could increase the cost of raising this type of capital in the US – traditionally the deepest pool of capital.
Six months ago the NAIC had a Rabobank preferred deal classified as equity, only to change its mind a few weeks later. That had prompted expectations that it would do the same with the ECAP structure this time. But those hopes look to have been misplaced. Whereas with Rabobank the original ruling was made in the absence of proper documentation, that is not the case with ECAPs.
Lehman Brothers will no doubt argue with the NAIC that the decision lacks consistency with previous rulings on trust preferreds. ECAPs are senior to common equity and have various bells and whistles that support the idea that they are not equity. But one problem with hybrid capital structuring is the blurring of definitions. It is somewhat ironic, if not unfortunate, that a regulator has decided that if Moody’s thinks the issuer should receive 75% equity credit, maybe investors should also treat it as equity as well.
