ANALYSIS-Ratings uncertainty stunts contingent capital growth

August 9, 2010

By Jane Merriman

LONDON, Aug 6 (Reuters) – Contingent capital, a breed of hybrid bond that could help capitalise banks in crisis, will struggle to grow into a mainstream asset class if rating agencies persist in refusing to rate it.

Contingent capital came into the spotlight nine months ago when Lloyds, converting existing hybrid debt, raised over 10 billion pounds as it raced to shore up its balance sheet.

The new form of hybrid bonds convert into equity capital when a bank hits trouble, topping up capital if it falls below a certain level, an attractive option for issuers especially as equity capital is expensive and scarce.

But contingent capital has been dead in the water since Lloyds and then Rabobank launched their pioneering deals. They look increasingly like one-offs, driven by these banks’ special needs.

Regulators are fans of the securities and more details are expected next month from the Basel Committee on Banking Supervision, which should publish a report on capital.

While the rating agencies assessed Lloyds’ bonds, Standard & Poor’s and Moody’s subsequently refused to rate Rabobank, reducing their appeal to some investors.

“The ratings agencies need to become an active part of this equation,” said Sandeep Agarwal, head of financial institutions, debt capital markets at Credit Suisse.

Borrowers find hybrid bonds, such as contingent, cheaper than equity partly because interest payments are tax-deductible.

If regulators give the green light, investment bankers see a potential pipeline of contingent capital deals.

But investor wariness of the newfangled instruments was not helped when Lloyds’ contingent bonds were excluded from key credit market indexes. Lloyds was also not allowed to include them in Europe’s recent “stress test” of capital levels.

“Investors want these instruments rated, but rating agencies have said there is too much discretion in the conversion trigger, so that they find it difficult to give a rating,” said Daniel Bell, director, product development at Bank of America Merrill Lynch.


“These bonds are clearly more risky than what went before. Bond investors want security, but with contingent capital there is a huge uncertainty whether you get all of your money back,” said John Anderson, head of credit at fund manager Gartmore.

Anderson also said investors are naturally suspicious if a new security lacks a credit rating.

Investors in Rabo’s contingent senior bond, for example, could face a writedown of their principal of 75 percent, with the rest repaid in cash, if the bank’s equity capital to risk-weighted assets ratio were to fall below 7 percent.

Moody’s will not rate newly issued contingent capital securities with regulatory capital triggers, which it said precluded it from rating Rabo’s contingent note.

The difficulty for the rating agencies is finding an acceptable mechanism as a trigger for writedown or conversion.

“The forms of contingent capital we are more likely to rate are those with clearly defined triggers, such as balance sheet triggers or net loss triggers,” said Matthias Ogg, analyst at Moody’s.

Fitch Ratings has issues with a conversion trigger that could be influenced by factors outside the borrower’s control.

“We rated the Lloyds contingent convertible securities under our hybrid securities ratings methodology,” said James Longsdon, managing director in Fitch Ratings’ financial institutions team. “Theoretically we can rate others. But not all types of contingent capital may be rateable.”

Fitch said it was not asked to rate the Rabo deal.

For S&P, which also rated Lloyds, but not Rabo, the challenge is to find a trigger that works at the right time.

“If the trigger is focused on capital ratios — these tend to be lagging indicators,” said Michelle Brennan at S&P.

“There is still no market standard for a contingent capital instrument. We don’t devise instruments, we respond to structures the market has produced. We’ve outlined our concerns, the question for the market now is to address is what will banks’ contingent capital look like.”

(Editing by Sitaraman Shankar)

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