Hybrids and Capital Securities:

New Criteria for Equity Credit

Daniel R. Kastholm, CFA

Managing Director
August 2006

Hybrids and Capital Securities: Overview

> Basic Concepts and Fundamental Approach
> Analyze Hybrid Features
> Examples of Applying Criteria
> Impact on Credit Ratios and Notching

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Basic Concepts and Fundamental Approach

> Underlying credit philosophy
Equity is needed when companies experience stress
Products are analyzed for their ability to provide financial flexibility
to the issuer regardless of the probability a stress will occur

> Basic building blocks

Loss absorption
Cash flow Flexibility, i.e. no fixed servicing costs
Qualities of these features determine specific equity credit

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Basic Concepts and Fundamental Approach

New Debt to Equity Continuum

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Equity

Debt

Class A

100%

Class B

75%

25%

Class C

50%

50%

Class D

25%

75%

Class E

100%

Analyzing Features: Role of Subordination

Equity Class Caps
Class A 100%

Level of Subordination
Preferred and preference shares
Junior subordinated debt for banks
(and bank holding companies)

Class B 75%

Junior subordinated and

subordinated debt for corporates
and less regulated insurance
companies

Class C 50%

n.a.

Class D - 25%

n.a.

Class E - 0%

Senior debt
Subordinated debt for banks (and
bank holding companies)

Source: Fitch
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Analyzing Features: Role of Maturity

Maximum Equity Class

Effective Maturity

Class A 100%

Perpetual/20 years plus

Class B 75%

10 to 20 years

Class C 50%
Class D - 25%

5 to 10 years

Class E - 0%

Less than 5 years

Source: Fitch

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Analyzing Deferral Features: Non-Cumulative vs Cumulative

Equity Classes

Non-Cumulative

Cumulative

Class A 100%

Non-cumulative
Non-cumulative with constraints, but
offset by exceptionally strong
mandatory feature

Class B 75%

Non-cumulative with constraints, but

offset by strong mandatory feature

Cumulative five years or more

Cumulative five years or more with constraints, partially
offset by exceptionally strong mandatory feature

Class C 50%

Non-cumulative with constraints

Cumulative five years or more with constraints, but

offset by strong mandatory feature
Cumulative three to five years
Cumulative three to five years with constraint, but
partially offset by exceptionally strong mandatory
feature

Non-cumulative with constraints, but

with weak mandatory feature

Class D 25%

Cumulative five years or more with constraints

Cumulative five years or more with constraints, but
weak mandatory feature
Cumulative three to five years with constraints, but
offset by strong mandatory feature

Class E 0%

Cumulative three to five years with constraints

Cumulative three to five years with constraints ,but
weak mandatory feature
Cumulative less than three years

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Analyzing Deferral Features: Optional & Mandatory

> Constraints on optional deferral, such as a look-back clause, can reduce
the equity assignment
Equity credit limited to a maximum of Class C (50%)
If deferral is constrained by over 12 months, instruments generally
receive no equity credit, i.e. Class E
> Mandatory Deferral may offset the effect of the constraint, depending on
the mandatory deferral feature
Exceptionally Strong

Triggers kick-in early and are very

frequently monitored

Limit is Class A

Strong

Triggers are effective and monitored

reasonably often.

Limit is Class B

Weak.

Reporting is delayed; triggers take

effect only after severe financial
stress

Class E (no offset to

Constraint)

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Analyzing Features: Mandatory Convertibles

Equity Classes

Type of Mandatory Convertible

Class A 100%

Three years or less to conversion,

junior subordinated note

Class B 75%

Between three and five years to

conversion, junior subordinated note

Class C 50%

Three years or less to conversion, senior

or non-deferrable/non-loss absorbing sub

Class D - 25%

Between three and five years to

conversion, senior or non-deferrable/nonloss absorbing sub

Class E - 0%

Over five years senior or nondeferrable/non-loss absorbing sub

Note: An instrument whose conversion is more than five years forward may
qualify for equity credit based on its other features (subordination, loss
absorption, deferral mechanism.)
Source: Fitch
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Examples: Non-cumulative Preferred Shares

Preferred Shares
(Bank)

Preferred Shares
(Corporate)

Preferred Shares
(Corporate)

Cash Payments

Max Class: A

Max Class: A

Max Class: A

Loss Absorption

Max Class: A

Max Class: A

Max Class: A

Maturity/

Perpetual (no cap)

40 years initial, 30
years remaining
(no cap)

40 years initial, 7
years remaining
(Max Class: D)

Other (Covenants,
Step-Ups)

No cap

No cap

No cap

Assign

Class A (100%
Equity)

Class A (100%
Equity)

Class D (25% Equity)

Permanence

Equity Class

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Examples: Trust Preferred

Std. Trust Preferred Security
(Corporate)

Tier 1 Innovative Capital

(Bank)

Cash payments

Optional cumulative for 5

years, no constraint.
Max Class: B

Optional non-cum:
Mandatory upon reg. capital
breach.
Max Class: A

Loss Absorption

Jr. Subordinated,
Max Class: B

Jr. Subordinated, Goingconcern loss absorption

Max Class: A

Maturity/ Permanence

30 years remaining (no

cap)

60 years remaining (no cap)

Other (Covenants, step-up)

No cap

No cap

Equity Class

Class B (75% Equity)

Class A (100% Equity)

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Examples: Other Deferrable Securities

Enhanced Capital Security
(Corporate)

Enhanced Capital Security

(Corporate)

Cash payments

Cum. Optional 5 years, with

Look-Back in excess of 12
months; Weak mandatory
deferral
Max Class: E

Non-cum optional, no lookback; Also reasonable

mandatory deferral
Max Class: A

Loss Absorption

Jr. Sub, Max Class: B

Jr. Sub, Max Class: B

Maturity/ Permanence;

60 years;

60 years;

Call & replacement

10 years call, + 100 bp;

Acceptable replacement;
(no cap)

5 years call, + 100 bp;

Acceptable replacement;
(no cap)

Other (Covenants,
step-up)

no cap

no cap

Equity Class

Class E (Debt)

Class B (75% Equity)

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Examples: Convertibles
Mandatory Convertible Jr.
Subordinated Units

Optionally Convertible Jr. Sub

Notes

Convertibility

Mandatory exercise in 3
years or less at defined
range of equity prices.
Max Class: A

Optionally Convertible; cash

settlement
Max. Class: E

Pre-exercise Loss
Absorption

Jr. Subordinated (no cap)

Jr. Subordinated (no cap)

Pre-exercise Cash
Payments

Cum. Deferrable for 3 years

(no cap)

No deferral
Max Class: E

Other (covenants,
cross defaults)

No cap

No cap

Equity Class

Class A (100% Equity)

Class E (Debt)

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Impact on Credit Ratios: Leverage

> Limit of 30% Adjusted Eligible Capital
> Flat limitation, no difference for rating levels or sectors
> Limits are applied because hybrids are not equally equity-like in all
scenarios
Generally are somewhat debt-like when issuer is weakening but not
yet in distress (i.e. continue to be serviced and have effective
maturities)
Companies can generally sustain up to 30% of total capital from these
sources without materially changing the risk profile

> Constitutes a soft cap for corporate and industrial sectors where
cash flow measures are more relevant than balance sheet capital

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Impact on Credit Ratios: Debt Service

> Hybrid instrument segmented into adjusted debt and adjusted
equity components for capitalization and balance sheet ratios
> Capital Ratios
Banks: Eligible Capital ratios (defined as core equity plus up to 30%
hybrids) are calculated on a risk weighted basis.
Insurance Holding Companies: Adjusted Debt/Total Capital
Corporates: Adjusted Debt / Cash Flow and Adj. Debt /EBITDA for
corporate leverage ratios.

> Interest or dividends

Corporates and Insurance: Coupon is NOT allocated into different
components; 100% of interest expense is used in coverage and fixed
charge calculations; in stress cases, maximum deferrals are applied.
Banks: Hybrid dividends are included in interest expense when calculating
net interest margins.

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Impact on Notching
> No change from existing notching criteria, based on IDR and RR
approach, with recovery of deeply subordinated instruments ordinarily
assumed to be RR6.
> We DO NOT apply extra notching for the existence of deferral feature.
> We DO move to the widest permitted notching if deferral has occurred,
is imminent, or if a mandatory deferral trigger is very severe.

Investment Grade

Speculative Grade

RR 1

91-100%

+2

+3

RR2

71- 90%

+2

+2

RR3

51-70%

+1

+1

RR4

31-50%

RR5

11-30%

-1

-1

RR6

0-10%

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-1 or -2

-2 or -3
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