Criteria & Methodologies

We formed our New Instruments Committee (NIC) in early 2006, primarily to centralize our criteria-setting with respect to hybrid capital-related matters. The NIC is comprised of senior analysts across all relevant sectors and regions. Analysts closely involved in our hybrid capital criteria development activities are listed in Table 1.

Table 1

Hybrid Capital Criteria Analysts
Analyst	Location	Telephone	Email	Sector
Vincent Allilaire**	London	(44) 20-7176-3628	vincent_allilaire@standardandpoors.com	Corporates
David Anthony**	London	(44) 20-7176-7010	david_anthony@standardandpoors.com	Insurance
Michelle Brennan**	London	(44) 20-7176-7205	michelle_brennan@standardandpoors.com	Financial Institutions
Scott Bugie*	Paris	(33) 1-4420-6680	scott_bugie@standardandpoors.com	Financial Institutions
Mark Button**	London	(44)20-7176-7045	mark_button@standardandpoors.com	Insurance
Terry Chan*	Melbourne	(61) 3-9631-2174	terry_chan@standardandpoors.com	Financial Institutions
Paul Draffin**	Melbourne	(61)3-9631-2122	paul_draffin@standardandpoors.com	Corporates
Emmanuel Dubois-Pelerin*	Paris	(33) 1-4420-6673	emmanuel_dubois-pelerin@standardandpoors.com	Corporates
Anthony Flintoff*	Melbourne	(61) 3-9631-2038	anthony_flintoff@standardandpoors.com	Corporates
Gail I. Hessol*	New York	(1) 212-438-6606	gail_hessol@standardandpoors.com	(general)
Rob Jones*	London	(44) 20-7176-7041	rob_jones@standardandpoors.com	Insurance
David A. Kaplan**	New York	(1) 212-438-5649	david_a_kaplan@standardandpoors.com	(general)
Rosaleen Manzi**, Esq.	New York	(1) 212-438-6609	rosaleen_manzi@standardandpoors.com	Legal
Solomon B Samson*	New York	(1) 212-438-7653	sol_samson@standardandpoors.com	Corporates
Jacob L Schlanger*	New York	(1) 212-438-7238	jacob_schlanger@standardandpoors.com	Insurance
Scott Sprinzen*	New York	(1) 212-438-7812	scott_sprinzen@standardandpoors.com	Financial Institutions
Calvin R Wong**	New York	(1) 212-438-7495	calvin_wong@standardandpoors.com	Structured
Takamasa Yamaoka*	Tokyo	(81) 3-4550-8719	takamasa_yamaoka@standardandpoors.com	(general)
*New Instruments Committee member. **New Instruments Committee adjunct member.

Anyone with questions about our hybrid capital criteria should feel free to contact any of the individuals listed. In addition, the NIC offers feedback to investment bankers and issuers who are developing new instrument structures. We provide a preliminary and generic assessment of the equity content, and the notching that would be applied in rating the issue, on a confidential basis. Such feedback is subject to our review of the final terms and conditions of the issue, if there is an actual transaction, as well as to consideration of issuer-specific factors.

To have a new structure assessed, investment bankers and issuers should contact any of the individuals listed. It facilitates the discussion if the instrument is described in the form of an indicative term sheet. The NIC seeks to provide feedback expeditiously. The NIC routinely meets twice per month, but additional meetings can generally be convened to address pending priority matters, as necessary. In the overwhelming majority of cases, we communicate our conclusions informally; however, we provide formal, written feedback in certain circumstances, as appropriate. If an issuer is proposing an issue of a structure for which close precedents already exist, it is most efficient if they contact the primary analyst responsible for the credit, or others on the coverage team. Members of the NIC will be involved, as necessary, in assisting with the review of the instrument terms and to ensure the consistent application of criteria.

If the issuer is contemplating financing strategies involving issuance of different hybrid capital instruments, and wants to have definitive formal feedback regarding the potential rating ramifications, this exercise lends itself to our Rating Evaluation Service. The issuer can obtain information about this service by contacting their respective Client Business Manager or the following regional contacts:

• North America: Terrence Streicher, VP-Rating Evaluation Service Product Manager; New York; (1) 212-438-7196; terrence_streicher@standardandpoors.com
• Europe, Middle East, Africa: Ian Byrne, Director, Commercial & Product Management; London; (44) 0 207 176 3633; ian_byrne@standardandpoors.com
• Asia-Pacific: Denis O'Sullivan, Vice President, Client Relationship Group Asia Pacific; Hong Kong; 852 25333522; denis_osullivan@standardandpoors.com

What constitutes equity in the first place? Traditional common stock--the paradigm equity instrument--sets the standard. But equity is not a monolithic concept; rather, it has several positive characteristics:

• Equity requires no ongoing payments that could lead to default;
• It has no maturity or repayment requirement, and is expected to remain as a permanent feature of the enterprise's capital structure; and
• It provides a cushion for creditors in case of bankruptcy.

Equity hybrids possess some--or all--of these characteristics to some degree. Yet, because equity has these several defining attributes, a specific security can have a mixed impact. Hybrid securities, by their very nature, can be equity-like in some respects and debt-like in others. Moreover, the specific features may provide the positive characteristic only to a limited extent.

In any event, the security's economic impact is most relevant; its nomenclature is a secondary consideration. A transaction labeled debt for accounting or tax purposes may still be viewed as equity for rating purposes, and vice versa.

In the case of regulated banks and insurance companies, aside from our own analytical views about the characteristics of a given hybrid capital instrument, we must also take account of the regulators' views. Indeed, this can be a key consideration. In many jurisdictions regulators have the authority and power to intervene in the operations of a bank or insurance company, and they determine whether to do so based, in part, on their own assessment of capital adequacy. Regulators' capital policies strongly influence bank hybrid capital issues' terms--and this is increasingly the case in insurers' issues. Not only will the structure of a hybrid instrument be influenced by regulatory treatment, but the redemption of hybrid capital instruments typically is also subject to regulatory review. Regulators can intervene to enforce the suspension or nonpayment of hybrid coupon payments, restrict the amount of hybrids that an entity can issue, and require any redeemed hybrid to be replaced with an instrument of equivalent equity content. Thus, as explained below, our analytical assessment of regulated issuers' hybrid capital instruments is typically anchored in the regulator treatment.

A company generally pays dividends on its common stock only at its discretion: There is no fixed requirement to do so that could lead to default and bankruptcy if the common dividend were cut or eliminated.

In practice, though, once a company has established a record of paying a common dividend, it will be loathe to reduce the payment, given management's likely concerns about capital markets perceptions. Common dividend reductions are seen as a signal that the company's prospects are clouded, and market perception can be a powerful consideration in management's decision making. As a consequence, some distressed companies continue paying their common dividends, even though they arguably have more pressing uses for the cash. In this way, the common dividend can act like a fixed charge, draining the company, over time, of funds needed to bolster operations. Yet, whatever the pressure to pay common dividends, the company always retains some discretion, whatever the pressure to pay common dividends.

Most types of hybrid capital instruments have a stated dividend or coupon rate, but the payment either may be deferred or forgone at the discretion of management or a regulator, or must be deferred or forgone with the breach of a predefined trigger, or both. We assume that management or a regulator would always have greater reluctance to pass on the hybrid payment than to reduce or eliminate the common dividend. This is the hybrid capital market's clear expectation, as reflected in issue pricing, and borne out by historical experience. Accordingly, this distinguishes hybrid capital issues from common equity, in terms of the benefit to the issuer.

The longer a company can defer or skip payments, the better. An open-ended ability to defer or skip payments until financial health is restored is optimal. As a practical matter, the ability to forgo payments for up to five years or so is most critical in helping to prevent a general default. If the company cannot restore financial health in five years, it probably never will.

In addition, the fewer restrictions imposed on the company's ability to defer or forgo payments, the better. For example, some issues include a "look-back" provision under which the company can only defer or forgo payments after some minimum period of time has elapsed since the last common dividend was paid. In other instances, there is a requirement-–for example, under the corporate charter or the national corporate legal framework-–that any dividend changes be approved at the annual shareholders' meeting. Or there may be other preconditions that must be satisfied, such as the breach of certain financial tests. With any such restrictions, the company's ability to react to worsening circumstances by deferring or forgoing payments can be considerably hampered, and so such features undermine equity content. (See section "Issue Features: Dividend Stoppers, Look-Backs, And Pushers.") (Note: It is typical for a hybrid capital issue to include a so-called "common dividend stopper"--a provision under which the company is prohibited from paying common dividends while it is deferring or forgoing hybrid issue payments. We generally view such a stipulation as a neutral factor from a credit perspective. On the one hand, eliminating both the common dividend and the hybrid payment together maximizes the overall cash conserved. On the other hand, the link between the two may increase the reluctance of the issuer to forgo paying on the hybrid. Thus, a common dividend stopper is not essential to our assessment of the equity content afforded the hybrid issue.)

In the case of hybrid capital issues with optional deferral provisions, we are generally indifferent to the choice between instruments with cumulative payments (which, when deferred, still accrue, and ultimately must be made up) and noncumulative payments (where there is no obligation to address missed payments). With noncumulative instruments, it may be easier for the issuer to recover after deferring, since there is no arrearage to be repaid. However, given the more severe consequences for investors, the company may be somewhat more reluctant to forgo payments on noncumulative instruments in the first place.

Naturally, any instrument feature that discourages the issuer from exercising the right to defer optionally is detrimental to equity content. This is one of the key aspects that we analyze when we assess hybrid capital securities' equity content. Such features include:

• Penalty rates. In the case of cumulative issues, if deferred payments accrue at a rate that is higher than the normal payment rate, we view this as clearly intended to discourage deferral.
• Alternative payment mechanisms (a.k.a., alternative coupon settlement mechanisms; see section "Issue Features: Alternative Payment Mechanisms/Alternative Coupon Settlement Mechanisms (APM/APSM)"). In the case of some cumulative issues, the company must issue stock--common or preferred--once it has deferred for a certain period of time. If this requirement only becomes effective after five years of deferring, we don't view this as a significant negative. When management (or a regulator) is first weighing the decision to defer, this limitation is unlikely to be a significant consideration. However, if the requirement becomes effective earlier–-especially if it is only after one or two years--companies might well want to avoid such a requirement, and so be even more reluctant than usual to defer in the first place.
• Nomenclature. In some cases, instruments with virtually identical credit features can be variously defined as debt or preferred stock. Although the distinction may be only one of nomenclature, we believe the identification of a security as debt constrains the company's practical discretion to defer payments, given the greater "headline risk" that may be associated with deferring payments on the debt form of the security. However, this does not necessarily preclude the instrument being viewed as having significant equity content if there are other mitigating features.
• Corporate structure. We view common equity issued by master limited partnerships and real estate investment trusts as possessing less flexibility over dividends than other types of issues. Investors expect, and tax rules may require, a payout of virtually all cash flow, and this is how the securities are marketed. Where hybrid capital issues of such entities have common dividend stoppers, there is less flexibility still--even less so if it could affect the issuer's tax status.

Finally, various case-specific considerations can enter into the assessment of payment flexibility. Other things being equal, a company with heavy ongoing funding requirements-–and hence a need to access the capital markets regularly–-might be more reluctant than others to pass on making payments for fear of the capital markets' reaction. Such a company's regulator could well have the same reservations. Also, if the amount of cash that would be conserved is small relative to the company's near-term cash requirements, the company might rationally chose not to defer or forgo payments, since little would be gained from doing so.

By removing the discretionary element, mandatory trigger mechanisms can increase confidence that payments will be deferred or forgone when the issuer's circumstances make this desirable from the creditors' perspective. (Historically, income bonds--i.e., where interest payment is contingent on achieving a certain level of earnings--were designed with this in mind. However, to the extent that cash flow diverges from earnings measures, income bonds tend to be imperfect instruments.) The equity content of such instruments is significantly influenced by the trigger levels used to determine when payments are eliminated. For example, if the level of cash flow that triggers payment curtailment is relatively low, reducing the likelihood of deferral, that instrument does not support high ratings. Credit quality might already have deteriorated drastically before the trigger would be breached. Conversely, though, if the trigger level is set close to the expected performance level, and at a level where the company is still very strong, we would have to consider the headline risk that forced deferral might pose.

A different mandatory approach entails linking interest payments to the company's common dividend, creating a common equity-mimicking bond. (A number of international financial institutions issued such bonds in the late 1980s.) Of course, a company having an inordinate amount of dividend-linked issues outstanding could ultimately be reluctant to curtail its common dividend.

Capital should be sufficiently permanent that it is available to preserve cash and absorb losses when needed. Obviously, retaining funds in perpetuity offers the company the greatest flexibility. Extremely long maturities are next best. Accordingly, 100-year bonds possess an equity feature in this respect (and only in this respect) until they get much nearer their maturity. (To illustrate the point, consider how much, or how little, the company would have to set aside today to defease or handle the eventual maturity.) However, in 100-year bonds, interest payments are not deferrable and cross-default provisions could lead to these bonds being accelerated.

Hybrid capital issues usually come with a maturity. Having a limited life is a clear shortcoming in terms of equity permanence. If the maturity happened to coincide with a period of stress for the issuer, the need to refinance could add to financial pressures. Even if we expect the issue to be refinanced successfully at maturity, the potential for using debt in the refinancing would concern us.

As a practical matter, we view an issue with a remaining time to maturity of 20 years (15 years for 'BB' rated issuers and 10 years for 'B' rated issuers) as sufficient to support credit quality. However, even 20 years is a very long time for many issuers and investors. Different features have been introduced that further limit the likely life of the issue--and thereby constrain the extent of the equity content the issue affords.

Thus, the ability to call always gives reason for pause (see section "Issue Features: Call Provisions"). Will the issue remain outstanding beyond the call date? It is common for hybrid capital issues to be callable, either starting on a certain date and continuing for a defined period (often referred to as an "American-style" call) or on certain specified, discrete dates (i.e., "European-style" call). Calls exercisable after five years are the most common in certain markets, and we would question the rationale for an issuer including a call date sooner than five years after issuance. We have not placed much emphasis on call features as limiting equity content-–that is, if we believe the issuer has good reasons for maintaining hybrid capital in its capital structure (e.g., to meet regulatory capital requirements, or because the issue is tax deductible and therefore is a cost-effective form of funding). Indeed, call provisions can even be beneficial from a credit perspective, because they afford the issuer the opportunity to refinance the issue at more favorable rates, market conditions permitting. Moreover, in many instances, the issuer could repurchase the issue on the open market or through a tender offer, even in the absence of a call provision.

Where an issue contains a call provision, the issuer has the option to redeem the issue, but no obligation to do so. Thus, in our assessment of equity content, we don't generally penalize instruments with call provisions, unless, in the case of unregulated issuers, the initial call date is less than five years after issuance–-which heightens our skepticism about the issuer's intentions with respect to the issue. Where an issuer is regulated and we believe it can rely on the regulator to ensure that any refinancing would not be credit-harming, we do not penalize issues with call dates earlier than five years. (See section "Issue Features: Call Provisions.")

In recent years, more hybrid capital securities have included terms whereby the issuer has the right to call the instrument at par on the same future date that the coupon rate increases, or steps up, by a preset amount. Step-ups (and similar penalty-rate provisions) question the permanence of issues that incorporate them, and so undermine the equity content of a hybrid capital security (see section "Issue Features: Step-Ups, Resets, Remarketing"). The call and step-up are expressly designed to prompt issuers to retire the issue. Moreover, in certain circumstances, the issuer could incur significant reputational fallout if it did not call. Indeed, investors strongly rely on step-up provisions to incentivize a call. We view these types of hybrid capital instruments as a form of long-term capital if:

• The amount of the step-up is limited, such that if the issuer chose, for whatever reason, not to refinance the issue, it would not be burdened by onerous financing costs; and
• There is a high degree of assurance that if the issue were called, it would be replaced with another issue warranting an equal or higher degree of equity content.

We see no need for any replacement provision (legally enforceable or otherwise) if the issue does not have a step-up, even if the issuer has call rights. The issuer's option to retire hybrid capital issues is similar to its option to repurchase common equity. But, if a hybrid issue has a significant step-up, we presume the issue will be called--either at the time of the step-up or before it. The presumed temporary nature of the issue begs the question of how it will be replaced. Legally binding replacement language reinforces the permanency of the capital raised by rendering replacement highly likely, particularly when the issuer would need the capital to maintain its creditworthiness. In our view, mere expression of intent regarding replacement is insufficient when there is a workable alternative that more strongly enforces the permanence of the equity. To be sure, legally enforceable replacement capital covenants (RCCs) can pose their own problems--especially those that are complex or unduly restrict a company's future choices (see section "Issue Features: Replacement Capital Covenants"). But we view RCCs as the lesser of two evils. RCCs offset the clear motivation to call and retire the hybrid security created by the step-up, and reestablish sufficient permanence to allow the security "intermediate" or "high" equity content under Standard & Poor's methodology. We believe that legally binding RCCs can be crafted to introduce flexibility and thus render them more acceptable to issuers.

At any time, a company can choose either to repurchase equity or to issue additional shares. However, some securities are more prone to being temporary than others. Our analysis tries to be pragmatic, looking for insights as to what may ultimately occur. For example, auction-rate or remarketed preferred stock is designed for easy redemption. Even though the terms of this type of preferred provide for its being perpetual, failed auctions or lowered ratings typically prompt the issuer to repurchase the shares. (They are sold as commercial paper equivalents, which heightens the potential for failed auctions if credit quality ever falls to 'A-3'--or even 'A-2'--levels, or if market conditions deteriorate. Although the company has no legal obligation to repurchase the paper--i.e., the last holder could be left with this "perpetual" security--the issuer sometimes bows to market pressures and chooses to repurchase the preferred. Accordingly, such frequently remarketed preferreds are treated as debt.)

Another important consideration is the issuer's tax-paying posture. It may be difficult for an issuer that is currently not paying taxes to assert that it will continue to finance with nontax-deductible preferred stock once it becomes a taxpayer, and that it can lower its capital cost by replacing the preferred with debt.

Other clues can come from who invests in the issue (e.g., money market, as opposed to long-term fixed-income investors) and the mode of financing that is typical of the company's peer group. For example, U.S. utilities traditionally finance with preferred stock, and industry regulators are comfortable with it; therefore, the usual concern that limited-life preferred stock will be refinanced with debt is less of an issue for utilities.

There is always the risk that tax-deductible instruments' favorable tax status could be overturned by tax authorities, or through legislative changes. If we had particular concerns about the continuation of favorable tax treatment, and loss of tax deductibility would make the economics unfavorable for the issuer, we would have significant reservations about viewing the instrument as permanent, unless we had reason to believe that the issue would be refinanced in another equity-like form.

In assessing any issuance's degree of permanence, management intent is always an important consideration. Through discussion of financial policy with senior management, we seek insight into potential future retirement and replacement of hybrids. We also take into account a company's track record in this regard. We always must be aware that management intent can become diluted over time-–for example, as there are changes in management.

What happens in bankruptcy also pertains to the avoidance of bankruptcy and default, albeit indirectly. That is, companies' access to debt capital depends on providers feeling secure about the ultimate recovery of their loans in the event of a default. Debt-holders' claims have priority in bankruptcy, while equity holders are relegated to a residual claim on the assets. The protective cushion created by such equity subordination can facilitate the company's access to capital, helping enable it to stave off a default in the first place. (In the case of some European bank, insurance, and corporate issues, mechanisms exist that can result in loss absorption outside of bankruptcy or reorganization by reducing the principal owed to investors-–for example, following the recording of a net loss, when directed by the regulator.)

Regulators virtually always insist that instruments be subordinated to qualify for capital treatment. Apart from this consideration, in our framework subordination typically is a secondary factor compared with other beneficial aspects of equity, although lack of subordination would always weigh somewhat on equity content. Thus, if an instrument is senior, but ongoing payments are deferrable and it has a long-dated maturity, we could well view it as having meaningful equity content. On the other hand, if an instrument is subordinated, but lacks the other equity-like traits, it would be viewed as predominantly debt-like.

The distinction between subordination and deep subordination generally is not significant in our analysis, although deep subordination incrementally is somewhat more supportive of credit quality. However, many U.S. securities--to meet IRS guidelines for tax deductibility--may be termed subordinated while providing pari passu status to trade creditors. This is a shortcoming--albeit not one that we view as significant.

To facilitate our analysis, we classify qualifying hybrid capital issues into three categories, based on our assessment of their equity content: "high," "intermediate," and "minimal." In our financial institutions practice (excluding insurance), where matters pertaining to quality of capital assume particular importance, we further distinguish between "intermediate-strong" and "intermediate-adequate." As discussed more fully in the section "Equity Content Categories: Financial Institutions," for regulated U.S. financial institutions, we only give equity credit to issues that qualify for Tier 1 regulatory capital treatment.

Different attributes of equity hybrids are relevant to different dimensions of our analytical methodology. The aspect of ongoing payments is considered in fixed-charge coverage and cash-flow adequacy; equity cushion is considered in leverage, capital adequacy, and asset protection; the need to refinance upon maturity is considered in liquidity; and the potential for conversion is considered in financial policy. The before- and after-tax cost of paying for the funds also is a component of both earnings and cash flow analysis.

In our analytical methodology, we take account qualitatively of a hybrid capital issue's varied effects on the issuer's credit profile. We have also developed techniques for factoring in hybrid capital in our calculation of certain financial ratios-–knowing, though, that any such adjusted ratios represent a simplified view, and certainly do not tell the whole story.

In assessing hybrid capital issues' equity content, we use a common framework across our Corporate and Financial Services practices and across regions. In applying our conclusions, though, there are significant differences, reflecting the different nature of the companies and in our rating methodologies among sectors.

In our analysis of corporates, we have found that among all the possible ways to represent "intermediate" issues in financial ratios, the most effective is to split hybrid-related amounts 50%-50% between debt and equity.

Compared to the norm for corporates, most types of financial institutions (aside from insurance companies) are highly leveraged and have heavy funding appetites. In our analysis, the quality of capital is an important consideration. In considering regulated financial institutions (including insurance companies), we must pay particular attention to the matter of capital adequacy relative to regulatory capital requirements. In turn, the hybrid methodology does not follow the "partial credit" approach used for corporates; rather, for capitalization ratio calculation purposes, it grants full equity content within certain threshold limits, which are set depending on the degree of equity content.

Under our corporate methodology:

• Hybrids with "minimal" equity content are treated entirely as debt for ratio purposes;
• Amounts relating to "intermediate" category hybrids are split into 50% debt and 50% equity; and
• Hybrids with "high" equity content are treated entirely as equity for calculating ratios.

This approach is followed in our analysis of capital structure, as well as of cash flows and fixed-charge coverage. That is, for "minimal" equity content instruments, all related dividend or interest payments (however defined legally) are treated as a fixed charge; for "intermediate" equity content instruments, 50% of the related payment is treated as a fixed charge and 50% as the equivalent of a common dividend; and for "high" equity content instruments, all related payments are treated as if they were the equivalent of a common dividend—i.e., they are not included in fixed charges. (See also "Standard & Poor’s Encyclopedia of Analytical Adjustments for Corporate Entities," published July 9, 2007, on RatingsDirect.)

As discussed above, in assessing a hybrid capital instrument's equity content, we consider the financial reporting treatment of the issue, since this can influence management's actions and the market's perception. However, in performing our ratio calculations, we reallocate as necessary between debt and equity, and between interest expense and dividends, in accordance with our analytical methodology, and our treatment is not driven by the accounting treatment.

We know our approach to calculating ratios is a simplified one, inevitably leading to some distortions. So, for example, as discussed above, we don't view "minimal" equity content issues as fully debt-like, nor do we view "high" equity content issues as the exact equivalent of common stock. And, for intermediate issues, there are cases where the 50%/50% allocation will skew ratios in a positive or negative direction (depending on the initial financial profile of the issuer and the use of proceeds), where our overall analytical interpretation of the hybrid issuance would be the opposite. Moreover, in the case of "intermediate" issues, the company will generally either pay the stipulated amount or defer it; it is rare for there to be a partial payment.

These drawbacks speak to the limited value of financial ratios where hybrid capital issues are concerned. These instruments represent a bundling together of different features, which have a varied effect on the issuer's credit profile. We haven't devised a means of calculating financial ratios that better captures such subtleties.

Prior to mid-2006, for hybrids with intermediate equity content, we computed financial ratios both ways-—viewing them alternatively as debt and as equity, i.e., we calculated two sets of coverage ratios--to display deferrable ongoing payments entirely as ordinary interest and alternatively as an equity dividend. Similarly, two sets of balance-sheet ratios were calculated for the principal amount of the hybrid instruments, displaying those amounts entirely as debt and entirely as equity. For hybrids in the middle category, analytical truth lies somewhere between the two, and we sought to interpolate between the two sets of ratios to arrive at the most meaningful depiction of an issuer's financial profile. However, this methodology also had drawbacks, including the challenges for issuers in appreciating the potential impact on our view of their financial profile. Therefore--notwithstanding the issues mentioned above--we decided to calculate ratios with the amounts relating to intermediate category hybrids split 50%-50%. This is the set of ratios we now emphasize as the basic adjusted measures, and these are the ratios we publish in our reports. We believe this approach has greater transparency and ease of comparability-—thereby outweighing the negatives. We continue to encourage analysts to view hybrids from all perspectives.

Under our corporate methodology, there is no hard-and-fast limit to the amount of hybrid capital for which we recognize equity content. Nonetheless, without drawing any bright lines, we would, indeed, be sensitive at a certain point. That is not because the character of the security changes when a lot of it is issued. Rather, beyond a certain point, a company's nonstandard, complex, or over-engineered balance sheet begins to put its financial policies in a negative light. In turn, this could lead to market pressures to restructure or normalize company finances. This concern would be compounded to the extent that a company also uses various off-balance-sheet financing vehicles, derivatives, and long-term contracts, and/or other techniques that contribute to an overall opaque financing structure. The perception of financial aggressiveness--by us or by the investment community--would certainly overshadow any theoretical benefit from the equity content that might be afforded to hybrid securities. It helps to focus on measures that would indicate little or no concern. In simple terms, there should be no problem with issuing conventional hybrids in an aggregate amount up to 15% of capitalization. (Capitalization is defined as debt + hybrids + book equity, adjusted for goodwill and also making all our other standard adjustments.)

For corporates and financial institutions (excluding insurance companies), ratio calculations incorporate capital only after it is issued—or its issuance is mandatory within a relatively short period. Even though a company has contracted for the right to sell equity at its discretion and even has fixed a price, we do not include such contingent capital in advance. This treatment applies whether the contingent capital is provided by a financial counterparty or structured vehicle, whether prefunded or not.

That said, contracting for contingent capital can be very valuable as a credit support in specific situations. For example, a company might find its credit rating under pressure because of a potential acquisition or expansion; and management's stated intention to issue equity to finance such activity may not be entirely convincing. Arranging contingent equity capital in advance could be just what is needed to allay any concerns regarding a credit-harming outcome. The company would not want to issue equity prior to the transaction materializing. But locking in the availability and cost on a contingent basis makes sense as an "insurance policy." In the insurance sector, given the "lumpiness" of potential losses, we give formal recognition in capital ratios to certain contingent capital structures (see section "Applying Hybrid Capital Equity Content Assessment In Credit Analysis: Insurance Methodology").

In assessing financial institutions' hybrid capital securities, we employ the same broad equity content categories as with corporates-–"high," "intermediate," and "minimal." To reflect certain finer distinctions linked to regulatory capital, within the "intermediate" category we differentiate between "strong" and "adequate" issues.

Two sector-specific considerations significantly influence our approach to assessing equity content in the case of financial institutions.

First, in the case of regulated financial institutions, regulators have the power to intervene in companies' operations, and they typically determine whether to do so based, at least in part, on their own definitions of capital adequacy. Consequently, and due to the importance of regulatory capital, when assessing individual instruments and their specific features, we take account of the regulators' view. We don't follow the regulators exactly. Rather, we have developed generalized guidelines that vary somewhat from regulators' to facilitate cross-border comparisons.

Qualification as regulatory capital (Tier 1 or Tier 2) is a mandatory requirement for us to include a hybrid security in our total capital measures for regulated companies. If the regulator excludes an instrument from regulatory capital, the instrument provides no cushion between minimum capital and regulatory action, which could include closure. Whereas we are sometimes more conservative than regulators as to where we place a hybrid security in our hierarchy of equity content (compared to regulators' own classification hierarchy), we are rarely more liberal.

The home country financial regulators' capital policy is inscribed in the terms of most bank hybrid capital issues. Not only will the regulatory treatment influence the chosen structure of a hybrid instrument, but the redemption and refinancing of hybrid capital instruments typically is subject to regulatory review. Regulators typically can intervene to enforce the suspension of hybrid coupon payments, restrict the amount of hybrids that an entity can issue, and require any redeemed hybrid to be replaced with an instrument of equivalent strength. Regulators define and accept hybrid capital instruments to allow financial groups to build and manage regulatory capital. They seek instruments that rank below debt in liquidation and that absorb losses while permitting the financial institution to continue to operate. Bank regulators in mature and emerging countries around the world have adopted the Tier 1 and Tier 2 categories of hybrid instruments developed and defined by the Basel Committee on Banking Supervision to rank the instruments by relative capital strength and to regulate capital and leverage in the industry. Bank regulators distinguish between "plain vanilla" subordinated debt, which provides protection to depositors and senior creditors in liquidation, and stronger types of regulatory capital, which defer or eliminate coupon payment under defined circumstances. In many countries, and notably in the EU, regulators further define Tier 2, setting specific standards for eligibility as upper and lower Tier 2 capital. Consequently, when we review a financial institution's hybrid capital instrument, the regulatory intent with respect to the instrument is a dominant factor in our analysis of equity content and payment deferral risk.

The second sector-specific consideration that influences our approach to this sector is that financial institutions are typically characterized by a high degree of financial leverage and heavy ongoing funding requirements. The quality of capital and its ability to provide a cushion against insolvency and liquidity risks are of paramount importance.

Consequently, we apply varying limits to the inclusion of hybrid securities in our capital measures for financial institutions. This parallels the regulatory approach and best fits the highly leveraged nature of financial services companies. These limits vary by degree of equity content: high equity content hybrid securities are subject to higher limits than are intermediate-strong hybrid securities, which are subject to higher limits than are intermediate-adequate hybrid securities (see Table 2).

Table 2

Equity Content Categories - Financial Institutions
Equity content desgnation	Maximum included in adjusted total equity (ATE)*	Examples
High	Up to 50% of adjusted common equity (ACE)	Short-dated mandatory convertible securities (<3 years)
		Issues with participating coupons
Intermediate-strong	Up to 33% of ACE	Noncumulative, perpetual preferred stock
	Up to 18% or 33%** of ACE	Enhanced trust preferred
Intermediate-adequate	Up to 12% of ACE	Conventional trust preferred
Minimal	Not included in ATE	Issues that otherwise qualify for 'intermediate' or 'high' but have remaining lives of less than 20 years.
*Maximum amounts are cumulative of lower-designated securities. For example, an issuer that had already issued "intermediate-adequate" hybrids in an amount equal to 12% of ACE could get equity credit for additional "high" issuance up to 38% of ACE (thereby totaling 50%) or up to 21% of ACE in the form of noncumulative perpetual preferred stock (an intermediate-strong instrument, which, by itself, would receive equity credit up to 33% of ACE), thereby aggregating 33% of ACE. **Enhanced trust preferred of regulated N.A. financial institutions is limited to 18%.

Like the regulators, we limit the proportion of hybrid securities in our capital ratios because excessive reliance on hybrid securities increases financial leverage due to the fixed cost of servicing the hybrids and potential concentrations in the redemption dates of dated or callable instruments. The servicing cost of hybrids is less flexible than that of common equity, and many hybrids are less permanent than common equity. Investors expect hybrid securities to pay a fixed coupon. Hybrids often contain features that create incentives for management to retire the instrument, or to repurchase common shares that might be issued as a result of a conversion clause. Moreover, many hybrid securities include highly complex combinations of different features and are still relatively novel and untested, making it difficult to foresee how the securities would perform for issuers in different scenarios--and may cast doubt over how they would absorb losses on a going-concern basis. Thus, a prudent financial policy dictates a degree of caution about reliance on capital in this form.

In the same vein, banking regulators impose restrictions on call and step-up features to limit the incentives to retire regulatory capital that is intended to be permanent. In 1998, the Basel Committee on Banking Supervision issued a notification for regulators to limit acceptance of "innovative capital instruments" with calls and step-ups to a maximum of 15% of Tier 1 capital and to subject innovative hybrids to stringent conditions:

• The call option with step-up should be a minimum of 10 years after the issue date;
• The step-up should be less than or equal to 100 basis points (bps), less the swap spread between the initial index basis and the stepped-up index basis;
• The step-up should be less than 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis;
• There should be no more than one rate step-up during the life of the instrument; and
• The swap spread should be fixed as of the pricing date and reflect the differential in pricing on that date between the initial reference security or rate and the stepped-up reference security or rate.

Regulators in mature banking markets around the world generally have implemented the 15% Tier 1 limit on innovative hybrids broadly in line with the conditions suggested by the Basel Committee (although there are some exceptions based on the "grandfathering" of previous regulatory agreements).

The following are noteworthy points about our financial institutions methodology:

• As shown in Table 2, we express our caps in terms of percentages of "adjusted common equity" (ACE), as defined. In our capital measures, hybrid capital is included in "adjusted total equity" (ATE), which is a broader form of capital than ACE. Defining our caps in terms of ACE avoids the circularity that otherwise would result if the cap definitions were based directly on ATE.
• We differentiate the equity content of hybrid securities with deferrable payments limited to five years or less (such as conventional trust preferred) and instruments with longer deferral (such as enhanced trust preferred and noncumulative perpetual preferred). The former are typically "intermediate-strong" and the latter "intermediate-adequate."
• Given regulators' role in overseeing and authorizing any refinancing, we are not as concerned about call provisions as with unregulated issuers. Where an issuer is regulated and we believe the regulator will ensure that any refinancing would not be credit-harming, we do not penalize issues with call dates earlier than five years. And even where a call is coupled with a moderate step-up, we do not require a legally binding replacement capital covenant, unless the call date is less than 10 years from the date of th