Thursday, April 24, 2008

US banks opt for ‘hybrid’ securities

(FT) US banks have responded to the liquidity squeeze by issuing record amounts of preferred shares and other “hybrid” securities – a move that has bolstered their balance sheets but has caused concerns among credit ratings agencies.

Wall Street executives argue that preferred shares – and similar instruments that are a cross between bonds and equities – are in demand from retail investors and provide companies with a cheap and efficient way to replenish their capital reserves.

Hybrid securities, which give holders ownership of the company and pay a fixed interest rate, also enable banks to boost their regulatory capital requirements without diluting their existing shareholder base by issuing common equity.

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.

Ratings agencies do not rank hybrids on the same level as common equity in estimates of a company’s credit-worthiness.

“We tend to be uncomfortable if there are too many hybrid securities in the capital structure,” said Barbara Havlicek at Moody’s. “We don’t have a lot of experience on how they tend to react in a distressed situation”.

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