Good hybrid crack

September 11, 2009

It’s interesting to see the Irish government seems to have been keeping a close eye on the hybrid debt fiasco, as it is now embracing the securities as a way to ensure the country’s banks don’t get an easy ride offloading dud property loans to NAMA, its bad bank scheme. I guess you could call it a form of payback.

Hybrid debt has played its own special role in creating the current mess.
Banks used hybrid debt to bolster their capital ratios even though the securities weren’t always very good at absorbing losses.

Investors kidded themselves that these risky capital securities were fixed income instruments that would always be supported by governments if a bank got into trouble, and so priced them as a form of debt.

But, now that banks have had to be bailed out, the European Commission is keen for hybrid investors to pay their pound of flesh by getting banks to defer coupons, not repay bonds at their expected maturity, or worse. CreditSights expects the EC to compel some Irish banks to stop paying discretionary coupons on their hybrid debt as part of the state-aid approval process.

The end result; nobody wins. Investors are sitting on losses, and regulators now want banks to be less reliant on hybrid debt.

Ireland, however, seems to have found a use for this kind of subordinated debt in its NAMA scheme. Ireland’s latest draft bill on NAMA suggests the agency pay banks for dodgy loans by issuing both senior and subordinated debt. If the loans perform worse than expected, the banks will bear the pain through the sub debt. 
CreditSights notes:

 It is not absolutely clear how this will work, but the implication is that, in the event of a loss, the subordinated debt would not be fully repaid when NAMA is eventually wound up, while the terms of the bonds might allow NAMA to suspend interest payments as well.

The draft bill also states:

(3) To the extent that the terms and conditions of the subordinated
debt securities (including the terms of subordination) are referenced
to or based on a measure of financial performance, the
measure shall be the financial performance of NAMA in totality and
not any part or parts of the acquired portfolio.

This last clause seems to suggest that banks would all share equally in the losses of NAMA, rather than being exposed to specific portfolios. That sounds like a headache – getting banks to work together and take equal ranking exposure to pooled credit assets is not easy . Witness, for example, the ill-fated Super SIV in the US. I guess the Irish banks don’t have much choice.

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