Hybrid capital spreads across the board blew out 10bp on news that the $300m deal Lehman Brothers issued last August, introducing a structure it called Enhanced Capital Advantaged Preferred Securities (Ecaps), had been redesignated as an instrument equivalent to common equity.
The decision was made by the NAIC's Securities Valuation Office after the New York State insurance regulator had referred the deal to the SVO.
The ruling threatens to disrupt the complicated regulatory and credit architecture of the hybrid capital market. Issuers, investors and bankers fear the SVO may now reclassify other deals, but have very little information on which to judge how likely that is.
Lehman's deal was the first US corporate hybrid capital issue that achieved tax deductibility for its interest payments, but in other respects was a fairly debt-like structure.
The redesignation means insurance companies holding the Ecaps paper will have to give it an onerous 30% risk weighting, rather than the 0.3% risk weighting stipulated by the SVO for all preferred stock and debt instruments.
In December Zurich Financial Services issued a $1.3bn Ecaps structure, which market participants now fear may also be reclassified. A week later Lehman rolled out the structure again, for aircraft lessor International Lease Finance Corp, with a $1bn issue.
And there have been many other transactions with some similar characteristics. "Any of the deals issued since August last year until the recent deals by Washington Mutual and US Bancorp could be affected," said one structured products official. "You just never know."
Hybrid capital specialists say the NAIC has made a bizarre decision that rubs against its logic in classifying other hybrid structures.
Lehman's Ecaps deal is senior to preferred and common equity in the bank's capital structure. The deal has other debt-like features — a 60 year maturity, a coupon step-up in year five and cumulative dividend/coupon payments.
Yet the SVO has decided Ecaps are more equity-like than the billions of dollars of perpetual, non-cumulative preferred stock issues it has for years designated as preferred stock.
The Ecaps transaction also gives creditors the right to make Lehman raise cash through an equity issue to pay them dividends in an event of financial stress. If it cannot issue equity, those dividends are cumulative.
"It is hard for any of us associated with the industry to look at these Ecaps-like structures and see them as anything but a senior instrument to a preferred stock, let alone common equity," added a structured products head on Wall Street.
Bankers' best guess is that one of the sticking points for the SVO may be the mandatory deferral trigger obliging Lehman to defer coupon payments if it hits certain financial stress indicators.
No explanation
The biggest frustration is that the SVO, despite repeated attempts by brokerage firms, has not shed any light on what exactly it is about the Lehman Ecaps deal that has made it consider it common equity. "Is there something specific to this deal, or is the whole market at risk of review and redesignation?" asked one banker.
Bankers said the SVO offered little explanation other than that it applies certain criteria in such procedures and that according to those, Ecaps came out on the side of common equity.
The decision will almost certainly be appealed by one or a group of insurance company investors. Broker-dealers cannot appeal against the SVO's decisions.
The only precedent for an appeal occurred last year, when the New York State insurance regulator had asked the SVO to review a perpetual, non-cumulative preferred issue by Rabobank.
The SVO erred on the side of caution and considered it common equity. The decision was appealed, and the issue was quickly and easily resolved — the NAIC simply requested extra information it needed to complete its review and concluded that the deal was preferred stock after all.
"This time it's different," said one banker. "It seems the SVO had all the information it needed. It's completed its review and it seems comfortable with the decision its made."
In a rare occurrence, firms that have been competing fiercely with each other in this market are
joining forces to help insurance companies that want to appeal against it.
Merrill Lynch invited Lehman Brothers to join it on a conference call with investors yesterday (Thursday). The firms said they would share information and work together on the issue.
Citigroup held a conference call too and Morgan Stanley is said to be willing to help.
Merrill Lynch led the Rabobank deal and is considered to have the most experience in dealing with the SVO on such matters.
Danielle Robinson
