Note: This article supercedes the one that was published on March 28, 2006. We have subsequently decided not to implement the possible, alternative approach discussed at that point. (See separate release.) This write-up also provides additional guidance on our methodology for assessing the risk posed by mandatory deferral triggers, among other matters.
In the Corporate and Financial Services sectors, Standard & Poor's Ratings Services assigns two types of credit ratings—one to issuers and the other to individual issues. The first type is called an issuer credit rating (ICR), counterparty credit rating, or corporate credit rating. It is our current opinion of an issuer's ability and willingness to meet its financial commitments on a timely basis. In contrast, while issue ratings address timeliness, they also address the potential for recovery of principal in the event of a bankruptcy or liquidation of the issuer—that is, the ranking of the issue.
Conventional preferred stock and certain other forms of equity hybrids, such as trust preferred, afford equity benefit to issuers in part by having ongoing payment requirements that are more flexible than interest payments associated with conventional debt and by being contractually subordinated to such debt. Obviously, these characteristics make the instruments more risky for investors than debt. In assigning issue ratings to equity hybrids, we seek to assess the incremental risks associated with the issue in terms of payment timeliness and principal recovery compared to the ICR and to debt. We reflect these risks in the issue ratings of equity hybrids by assigning them ratings that are "notched down" from the ICR. Owing to the unpredictable nature of some of the risks to which hybrid capital issue ratings are subject, the ratings are potentially more volatile than the ratings on conventional debt issues.
This article discusses our methodology for assigning issue ratings to equity hybrids. (For a broader discussion of issue ratings, see "Rating Each Issue: Distinguishing Issuers and Issues, " published on RatingsDirect on Oct. 24, 2004.)
We utilize a common framework across our Corporate and Financial Services practices and across regions. However, the rating dynamics can work differently. For example, in the banking sector most instances of companies deferring payments on trust preferred have reflected the intervention of regulators. In theory, given the high funding needs of banks and the importance of maintaining confidence in the specific bank and the entire financial sector, the regulatory order to defer may occur when the credit quality of the company is still stronger than the point where most corporates would consider such an action. So, in certain circumstances, where a bank is experiencing a trend of deteriorating credit quality, we may decide to widen the gap between the ICR and hybrid equity issue rating at an earlier point than for a corporate on a similar trajectory.
We also utilize this framework across the rating spectrum. In the case of highly rated issuers, the prospect of financial distress is, by definition, extremely distant. Still, issue ratings reflect our relative assessment of how different instruments in the issuer's capital structure might fare, should the downside case materialize.
Subordination
Subordination adversely affects the ultimate recovery prospects of subordinated obligation holders in a bankruptcy, since claims of priority creditors must be satisfied first. For issuers with ICRs that are investment grade, we take away one notch from the ICR for issues that are subordinated (but not deferrable). In the case of issuers with ICRs that are speculative grade, we take away two notches from the ICR for issues that are subordinated (but not deferrable). We do not distinguish in the notching between gradations of subordination: junior subordinated issues and senior subordinated issues are rated the same. Experience has shown that, in bankruptcy, ultimate recoveries for different classes of subordinated instruments tend to be similar—and poor. (Likewise, other things being equal, we don't distinguish between hybrid capital issues that are cumulative versus those that are noncumulative, since there is little reason to suppose recovery prospects of the two are materially different.)
Deferral
Payment risk is heightened in the case of equity hybrids due to:
The right of optional deferral, where management has the option under the terms of the instrument to suspend or cancel distributions without triggering a legal default;
The requirement of mandatory deferral, where, with the breaching of one or more predetermined triggers, the issuer is required to suspend payments and;
The ability of regulators, in certain cases, to order companies to defer payments.
Our objective is to fully reflect payment deferral risk in equity hybrid issue ratings, whatever the potential driver of the deferral.
Optional deferral
We assume that issuers will be loath to exercise their right of optional deferral, given the negative reaction this evokes among investors and hence the ramifications it can have for the issuer's future access to capital markets. Deferral risk is heightened when the issuer faces increased prospects of financial distress, such that management's reluctance to defer may ultimately be overcome in favor of the need to conserve cash. As referred to above, the "pressure points" may differ for different types of issuers, meaning the consideration of deferral may come at earlier or later stages in the course of credit deterioration. One danger sign is when a company curtails or eliminates its dividend on common stock: This is sometimes a precursor to a deferral on equity hybrids. (Most equity hybrids have a "dividend stopper" that prevents the company from making any distributions to its common stockholders while it is deferring distributions on the hybrid.)
If a corporate has an unusually large proportion of equity hybrids in its capitalization, this may give it an added incentive to defer, due to the significance of the cash flow savings that would result. However, in the case of large, regulated financial institutions, we believe this could cut both ways: The greater the amount of outstanding hybrids, the greater the potential for a systemic disruption or a backlash in the capital markets. This could result in more of an incentive for the issuer to continue payments under all circumstances.
Mandatory deferral
Triggers for mandatory deferral vary. Some consist of earnings-, cash flow-, or capitalization-based financial ratio tests; others refer to the issuer's incurrence of a loss over a defined period or the failure to meet specified minimum regulatory capital requirements. Still others tie the payment of the distribution on the equity hybrid directly to the company's payment of the common stock dividend.
Obviously, the payment deferral risk for the equity hybrid investor is higher when the likelihood that the trigger will be breached is greater. If, for example, it would take only a minor and temporary shortfall in profitability to cause the deferral, then risks to the equity hybrid investor could be dramatically higher than they would be for debtholders. On the other hand, if it would take circumstances so dire for the trigger to be breached that the issuer would likely be on the brink of bankruptcy, then the payment risks for the equity hybrid investor would not be materially different than they would be for debtholders.
Regulatory deferral
In some regulated financial services sectors, regulators have the authority to direct companies to defer payments on equity hybrids based on the regulators' own assessment of what is prudent. In certain cases, banks have been ordered to defer even when they met all regulatory capital requirements (for example, Riggs National Corp., a bank holding company that was required to defer payments on trust-preferred securities in December 2004). Assessing the risk of deferral in the case of a regulated company requires careful consideration of sector- and country-specific factors, including precedents of deferral ordered by the regulatory body in question. Especially important is the identification of financial measures to which the regulator is particularly sensitive.
The authority and intent of financial regulators to order deferral of payments in circumstances—whether or not clearly defined—means that most hybrid capital securities of regulated financial institutions can be viewed as having de facto mandatory deferral. Regulated financial institutions structure hybrids according to rules established by national regulators for regulatory capital measures. This includes the definitions of the capital ratios or performance measures that would trigger payment deferral if breached. The triggers for deferral—typically the regulatory minimum capital ratio for banks and insurers—are usually made explicit in the covenants of the hybrid security. Less often, the trigger is not explicit in the document but is understood by both issuer and regulator. In most cases, the regulator has the authority and intent to intervene and order deferral under defined circumstances.
Factoring payment risk into issue ratings
In reflecting payment/deferral risk in hybrid capital issue ratings, we evaluate the different sources of deferral risk that are present and seek to assess their combined significance. Where deferral is possible but we believe the prospect of a deferral is relatively remote over the foreseeable future, we take away at least one notch from the ICR in setting the issue rating, whether the ICR is investment grade or speculative grade. A one-notch differential is the typical treatment for issues that have optional deferral alone. For example, the subordinated and optionally deferrable issue of an issuer rated 'BBB+' would generally be rated 'BBB-'—one notch for subordination and one notch for payment deferral risk. If the issue were senior and deferrable (a rare but not unheard of combination), the issue would be rated 'BBB'. We take the same approach even at the highest rating levels. A subordinated and deferrable issue of a 'AAA' rated issuer is rated 'AA'.
In defining "remote," we use the hypothetical test that the ICR would have to decline by more than three notches (i.e., a full rating category) for the issuer to be in such a condition that deferral would be considered. When we have heightened concerns that the issuer may defer—whether due to the exercise of its right to defer optionally, the breaching of a mandatory deferral trigger, or the exercise of the prerogatives of a regulator—we increase the gap between the ICR and the issue rating, and we do not impose any arbitrary limit on the size of the gap. So, in an extreme example, if the ICR of an issuer was investment grade but we believed that there was a substantial risk that the payment on the issuer's trust-preferred securities could be deferred within a few quarters, the issue would have a low speculative-grade rating.
Combinations of different forms of deferral may or may not increase deferral risk. For example, if an issue has mandatory and optional deferability, and the mandatory triggers are defined in such a manner that they could be breached without there necessarily having been fundamental erosion in the issuer's credit quality, then the risks to investors would be greater than if there were optional deferability alone. The same would be true if the triggers were more reflective of fundamental credit quality, but could be breached in advance of the point where the issuer would contemplate optional deferral. In either of these cases, a lower issue rating would be warranted than if there were optional deferability alone. On the other hand, if the mandatory trigger were sufficiently remote that we believed it would be unlikely to be breached before the company would otherwise have optionally deferred, then we would not take away additional notches for the mandatory deferability compared to what would be appropriate for the optional deferability alone.
For example, MetLife Inc. (A/Negative/A-1) issued $2.1 billion of noncumulative perpetual preferred in 2005 that was rated 'BBB', or three notches below the ICR. The issue has both optional and mandatory deferral. The mandatory deferral is breached by the triggering of either of the following:
Consolidated net income during any consecutive four quarters is zero or less AND shareholders' equity declines 10% or greater over the most recent eight quarters AND MetLife cannot reduce the decline in shareholders' equity within the subsequent two quarters to less than the 10% threshold through equity issuance; or
The risk-based capital ratio of Metlife's largest U.S. life insurance subsidiaries falls below 175% of the company action level.
Analytically, it was deemed reasonably possible, while not expected, that MetLife could have an atypical earnings event or a decline in its GAAP equity that would cause the first trigger to be breached, even while the company remained financially strong. Furthermore, and more importantly, the second trigger relates only to measures of solvency for a portion of Metlife's U.S. life insurance operations, while the ICR reflects the diversity afforded by the company's U.S. property and casualty operations as well as its growing presence outside the U.S.
We have rated a number of mandatory deferrable issues where, as in the first trigger in the MetLife transaction, triggers are defined in such a way as to give the issuer the chance to make up for a decline in shareholders' equity by issuing new equity. Some issuers of these instruments have argued that this completely mitigates mandatory deferral risk, since it would always be their company's intention to take whatever actions were necessary to forestall the breach of the trigger. However, we must be skeptical about such assertions, just given the remoteness of the prospect of deferral, and the adverse changes the issuers might have undergone by the time that point was reached. In such a case, if we did somehow come to be convinced that the company, however dire its situation, would always avail itself of whatever financial resources were available to avoid having to defer--optionally or mandatorily--we would not notch down for deferral risk. However, there would then be little basis for ascribing equity credit to the issue.
In the case of regulated financial institutions, explicit mandatory deferral triggers do not add to deferral risk stemming from regulation if--as is generally the case--the triggers just replicate the capital standards that a regulator applies in determining whether to order a deferral. Also, in the case of banks, we consider it to be particularly unlikely that a company would exercise unilaterally its right to defer optionally. Moreover, we would generally presume that bank regulators would act preemptively to force banks to raise capital (or divest some activities) to prevent regulatory capital guidelines from being breached. Thus, in most instances we take away only one notch for deferral risk in rating hybrid capital issues of investment-grade banks, even where there is a combination of optional deferral and regulatory deferral risk--although, as indicated above, we still notch to a greater extent in cases we view as exceptional.
Default And Distress
(Note: this discussion supplements Standard & Poor's published rating definitions.)
In the case of equity hybrids where distributions are deferrable, the 'C' issue rating is assigned where we expect the next scheduled distribution to be deferred. The 'C' rating is also used in cases where the distributions are cumulative and the issuer has resumed distributions following a deferral, but where an arrearage still exists.
An equity hybrid issue is rated 'D' if a deferrable distribution has been deferred. (The 'D' rating is also assigned if there is a payment default on a nondeferrable distribution or principal repayment or if the issuer has filed for bankruptcy.) The deferral is not a legal default if the option to defer is provided for under the terms of the instrument. However, the deferral is viewed as tantamount to a default in our rating system, and the risk of deferral occurring is addressed by the issue rating. (Note: The issuer credit rating would not be changed to 'D' or 'SD' in such a case if the nonpayment on the hybrid were permitted under the terms of the instrument. Still, the nonpayment would in virtually all cases be symptomatic of problems at the company—problems that would need to be reflected in the issuer credit rating, along with the cash savings resulting from the deferral.)
Where the terms of the equity hybrid provide the issuer with the option to make interest/dividend payments by delivering more of the same equity hybrid, shares of common stock, or some other security, in lieu of cash, we do not view use of the alternative as a form of default, as long as the consideration distributed can be readily monetized by investors and the value approximates that of the cash that otherwise would have been paid out. Even if the consideration were not in a readily monetizable form and/or if the value fell short, we would not view it as a default if we believed it is widely understood by investors at the time of issuance that the issuer will utilize the in-kind option to make payments initially (and perhaps continuing for an indefinite period). However, if the payment is with cash at the outset and the issuer later reverts to in-kind payments due to perceived financial stress, then distribution of the in-kind payments would be treated as a default, even when permitted under the terms of the instrument.
Some issues with mandatory deferability have clauses that require the issuer to undertake the sale of common or preferred stock and utilize the proceeds to make the distribution. If the payment can be made on a timely basis, we would not view this as a default. In such circumstances, we believe a grace period of up to 30 calendar days is appropriate -– equivalent to the grace period commonly found in conventional debt issues. However, there is the risk that the company would be unable to complete the required share issuance, depending on the company's circumstances and conditions in the capital markets. In the case of corporates, we have not notched down for mandatory deferability in cases where "best efforts" share issuance (or issuance of other securities) would then be immediately required. However, we could reassess this approach as we gain more insights into the practicability of this requirement. In any event, we will notch down in cases where we believe that under the most likely scenario where a deferral could occur the issuer's financial strength and share price would have declined so precipitously that the issuer's ability to complete even a modest-size common stock issuance (or issuance of other securities) could be dubious.
Government Support
The policy for rating the hybrid equity securities of government-supported entities deserves particular mention. When Standard & Poor's expects that the government would act to support a government-supported entity's debt obligations but has less confidence that the support would be extended to the government-supported entity's equity hybrids, then the base for the notching of the equity hybrid issue rating is not just the ICR (which factors in the imputed government support). The issuer's stand-alone profile (absent government support factors, including extraordinary intervention and rescue) is also a relevant rating factor in these situations.
This indeed was the case in Japan in the late 1990s and the early years of the current decade, when the government of Japan provided massive support to the private banking sector to maintain confidence and prevent the failures of many institutions. The government support did not extend to all hybrid capital securities of Japanese banking groups during that period, however, and some of the bank hybrids, notably the operating company (OPCO) preferred securities, deferred payments. Two prominent cases of deferral were those of Resona Bank and UFJ Bank (through OPCO Tokai Preferred Capital Co.). During this period, Standard & Poor's widened the notching of hybrid equity securities, including OPCO preferred securities, up to six notches below the ICR of the issuing groups. In the cases cited, the banks avoided liquidity problems after the payment deferrals: UFJ was merged with higher-rated Mitsubishi Tokyo Financial Group, and Resona Bank was under the direct control of the government.
Our approach would be similar in the case of an entity whose ICR benefited from support of a strong parent, but where we doubted whether parental support would be extended to hybrid capital of the subsidiary.
Standard & Poor's is hosting a Hybrid Securities Hot Topics Conference on May 25, 2006, in New York. The conference will provide attendees with an overview of Standard & Poor's criteria for assessing and rating hybrid securities issued by corporate and financial services companies. For more information please log on to www.events.standardandpoors.com/hybrid.
