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Hybrid capital: all things to all men?

The US hybrid market has suffered a setback following a recent NAIC ruling.

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.

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