Hybrid thoughts

Hybrids are hot. Many banks have opted to use securities falling between senior debt and common stock to bolster their balance sheets. We have seen both perpetual and dated prefs, mandatory convertibles, optional convertibles, and much else besides. As the FT points out, the use of hybrids avoids dilution to common stockholders, at least for now. Let them take up the story:

But credit ratings analysts believe that the surge in issuance could increase risks for bondholders and other investors and weaken the long-term health of banks’ balance sheets.

Last week, Moody’s warned it might downgrade the credit rating of Merrill Lynch, which recently raised $2.5bn in preferred shares, unless the bank reduced the percentage of hybrid securities on its balance sheet.

Just this month, banks including Merrill, Citigroup, JPMorgan Chase and Lehman Brothers have issued about $18bn in preferred shares – more than the total issued for the whole of 2006.

This year’s issuance of preferred shares by US companies is on course to exceed the record $52.6bn touched last year, according to figures from Dealogic.

Ratings agencies usually want companies to have less than 25-30 per cent of their total capital in hybrid securities. But the latest bout of issuance has pushed some banks above that limit. At Merrill, for example, hybrid securities account for more than 44 per cent of total capital, according to estimates by Sanford Bernstein analyst Brad Hintz. Merrill declined to comment.

Analysts say that less sophisticated retail investors are attracted to the high interest rates offered by preferred shares and are less aware of provisions allowing companies in later years to exchange them for ordinary shares with no interest. “Firms achieve better prices selling to retail than they ever could get by selling in the institutional community,” Mr Hintz said.

So they are cheap and common stockholders like them. Are they any good?

The problem is that it is hard to say. Structurally hybrids have features that make them equity-like: the ability to defer coupons, subordination, eventual conversion into equity, long life; all of these help to give the hybrid some loss absorption capability. However in practice this flexibility is rarely used. Issuers do not defer their coupons and perpetual securities are not just usually callable: they are usually called.

One insight into the real utility of hybrids is given by banks' economic capital calculations. They are permitted to use a certain percentage of hybrids to meet regulatory capital requirements (aka 'non-core Tier 1' and 'Tier 2'). But for economic capital banks can assess both the capital required and the capital available however they choose. There is a great diversity of models for the calculation of economic capital requirements as a result. However there is little diversity in how those capital requirements are met: banks overwhelmingly take no credit for hybrids in their assessment of available economic capital. Telling, that.