IFR Definitive Guide

market intelligence
HYBRID CAPITAL SECURITIES:

A DEFINITIVE GUIDE FOR
ISSUERS AND INVESTORS
BY STEVE SAHARA
WITH ANNABEL DAWS-CHEW, Calyon, London
HYBRID CAPITAL SECURITIES:
A DEFINITIVE GUIDE FOR
ISSUERS AND INVESTORS
BY STEVE SAHARA
WITH ANNABEL DAWS-CHEW, Calyon London
About the contributors
Steve Sahara
Steve embarked on his investment banking career in 1991 at Merrill Lynch and has
successfully worked in a senior role managing the global hybrid capital and preferred
stock structuring efforts for leading firms such as Morgan Stanley, Lehman Brothers, ABN
AMRO and now Calyon, where he is Managing Director and Global Head of Hybrid Capital
Structuring. Steve has contributed greatly to the continued growth and innovation of this
dynamic and lucrative market segment which saw explosive growth among European
corporate issuers in 2005. Steve has an MBA from the University of Chicago, a BSC
Commerce and MAcc from DePaul University and is a CPA.
Annabel Daws-Chew
Annabel is an integral part of the Hybrid Capital Structuring team at Calyon, bringing over
six years of experience in debt capital markets including credit analysis and debt
origination for UK, German, and Benelux clients across corporate and financial sectors.
Annabel gained a BSc honours degree in Financial Economics from Liverpool University.
© Thomson Financial 2007

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First published 2007 by Thomson Financial Group, Aldgate House, 33 Aldgate High Street,
London EC3N 1DL, UK
Typeset by: Claire Taylor and Nicola O’Hara
ii
CONTENTS
Chapter 01 Interview with ING Structuring framework
01 Hybrid capital market Conclusion Technical foundations
overview Regulatory capital
What are hybrid capital Chapter 04: General characteristics of
securities? 47 Investor overview bank capital (based on BIS
The preferred stock paradigm Introduction guidelines)
Some bank regulatory history Investors in hybrid securities Tier 1 hybrid instruments
The Basel Capital Accord Institutional investors Tier 2 hybrid instruments
Rating agency impact Asset managers Tier 3 capital
Accounting, legal and tax Pension funds Legal
considerations Insurance companies Tax
Who are the issuers? Hedge funds SPV hybrids
Issuance trends Banks Typical SPV structure
The corporate hybrid Retail private bank market Summary rating agency
market has shown dramatic Key global investor trends guidelines
growth and structural innovation Profile of select UK investors How to achieve a Moody’s
Diversity and globalisation Profile of select German ‘Basket C’ or ‘Basket D’
prevalent in geographical investors Basket C
issuance trends Profile of select French Basket D
Who are the investors? investors Practical considerations
Evolution – historical milestones Profile of select US investors Addressing investor non-
and outlook Markets to watch payment risk
Japan Payment deferral conditions
Chapter 02: Canada Deferred payment
09 The market for hybrid Australia/New Zealand resolution
capital securities Middle East – market for Addressing investor extension
Introduction domestic placement risk
Hybrid market size, growth and Investor dynamics and Addressing investor event risk
structure motivation to buy hybrids Change of control clause
Investor markets Hybrids versus senior debt (COC)
The European investor market with similar credit quality Issuer protections
Bank Tier 1 sector Stronger credit quality Accounting guidelines
Insurance hybrid sector Liquid markets Rating agency approaches to
Corporate hybrid sector Strength of new issue hybrid capital
The US investor market performance in the secondary Moody’s approach
Bank Tier 1 sector markets Market precedent and
Insurance hybrid sector Market volatility application of the Moody’s
Corporate hybrid sector Dedicated hybrid funds methodology
The Asia-Pacific investor Hedging Mandatory deferral
market Investor risk factors Replacement language
Bank Tier 1 sector Structural conservatism Standard & Poor’s approach
Insurance hybrid sector Observing the secondary Fitch’s approach
Corporate hybrid sector market yield of hybrid capital Rating agency evolution
RPB versus institutional investor securities promotes increasing market
markets Observing spread sophistication
Issuer regions relationships for bank capital Interview with Fitch
Conclusion Spread observations for Eligible capital for insurance
corporate hybrid securities companies
Chapter 03: ‘Sample skew’ in average Introduction
31 Why issue hybrid capital rating quality of Basket C versus The current regulation
securities? Basket D population Capital buffer to be required in
Introduction Isolate sector champions the Solvency II framework
The rationale for issuance Isolate outliers Eligible elements in the
Who issues hybrid capital Multiples and spreads Solvency II framework
securities? Institutional True Perpetual and Tier 1 or core capital
Drivers for issuing hybrid capital step-up Tier 1 distinctions Tier 2 or supplementary
securities Reducing the cost of issuance capital
Michelin using a coupon floor Insurance Tier 3 capital
Linde Analysis and rationale Limitations
Suedzucker, Vattenfall and Interview with SGAM FSA position in the UK
DONG Capital resources for insurers
Henkel Chapter 05:
Porsche 73 Structuring hybrid Chapter 06:
Glencore capital securities 115 Structural
CEMEX Introduction considerations – focus on
Interview with Vattenfall Background issues select countries
iii
Introduction Italy Table 2.2: European investor
UK Current innovative Tier 1 market bank Tier 1 supply –
UK termsheets structuring opportunities select issues by size, 2006–H1
L&G Tier 1 debut packs a Hybrid structuring in Italy 2007
punch Italy termsheets Table 2.3: European investor
L&G's sparkling debut Smooth operator Generali market insurance hybrid supply
Barclays shows human side Twin-sets in fashion – select issues by size, 2006–H1
FIG hybrids get a new look Italian job 2007
Rexam's hybrid paves way for Lottomatica picks right Table 2.4: European investor
UK corporates number market corporate hybrid supply
Ireland Recent developments – select issues by size, 2006–H1
Ireland termsheets Italy hybrid capital limit 2007
Anglo Irish spreads wings increases to 20% of total capital Table 2.5: US investor market
New issues defy secondary Two key issues hybrid capital volumes,
widening USA 2005–H1 2007 (US$m)
France US termsheets Table 2.6: US investor market
The French ‘TSS’ structure for AIG tests market bank Tier 1 hybrid supply –
hybrid securities Europe FIG Wrap select issues by size, 2006–H1
Some history CVS rings up year’s largest 2007
Operating subsidiary Tier 1 Table 2.7: US investor market
Evolution Chapter 07: insurance hybrid supply – select
More recent French bank 163 The future of the hybrid issues by size, 2006–H1 2007
capital developments market Table 2.8: US investor market
Commission Bancaire sets a Introduction corporate hybrid supply – select
maximum limit of 25% on Growing the investor base issues by size, 2006–H1 2007
hybrid capital Expansion of the issuer pool Table 2.9: Asia-Pacific investor
France termsheets Tax, accounting, rating agency market hybrid capital volumes,
AXA calms Tier 1 nerves and regulatory 2005–H1 2007 (US$m)
French first Conclusion Table 2.10: Asia-Pacific investor
Vinci against the odds market bank Tier 1 hybrid
Hybrid volatility Appendix 01: supply – select issues by size,
Germany 167 Tax deductible equity 2006–H1 2007
Bank Tier 1 issued via an SPV and other hybrids in the US Table 2.11: Asia-Pacific investor
Tier 1 issued via a Stille – a brief history and current market insurance hybrid supply
Einlage and German GmbH developments – select issues by size, 2006–H1
Tier 1 via a Stille Einlage and Early attempts to create 2007
Jersey Limited Partnership deductible equity Table 2.12: Asia-Pacific investor
German termsheets Revenue Ruling 85-119 market corporate hybrid supply
Munich Re debuts MIPS, etc. – select issues by size, 2006–H1
Allianz takes the plunge Treasury department and 2007
Commerz advances on two legislative responses Table 2.13: Global hybrid
fronts Regulatory developments market supply, by issuer sector,
Siemens sees record demand Current tax developments 2006–H1 2007 (€, %)
Some German tax influences on Tax treatment of new (and
hybrid structures old) equity-like features Table 3.1: A selection of major
Overview Mandatory deferral hybrid capital deals
Some important German Replacement covenants
hybrid capital characteristics Longer maturities Table 4.1: Select UK investor
Maturity Scheduled maturities profile
Payment discretion/ Interest caps Table 4.2: Select UK investors
obligation Current structures Table 4.3: Select German
Participation in profits Enhanced trust preferred - investor profile
Participation in liquidation CENTs, etc. Table 4.4: Select German
Obtaining a tax ruling WITS and HITS investors
Withholding tax Hybrids issued by foreign Table 4.5: Select French
considerations issuers in the US investor profile
Switzerland Table 4.6: Select French
Switzerland termsheets 217 Appendix 02 investors
Overwhelming demand for Table 4.7: Select US investor
Swiss Re feedback
Credit Suisse gets Tier 1 in List of Tables and Figures Table 4.8: Select US investors
dollars Table 4.9: Hybrid capital –
Spain Table 1.1: The preferred stock considering equity features
The Preferentes structure paradigm Table 4.10: Select dual-tranche
Spain termsheets Table 2.1: European investor transactions, 2006
Tweak for BBVA market hybrid capital volumes, Table 4.11: Risk dynamics –
Fenosa prefers retail 2005–H1 2007 (€m) investor perspective
iv
Table 4.12: Example of Figure 2.4: European investor investor market bank Tier 1
structural conservatism market hybrid supply, by issuer supply, by currency, 2006–H1
Table 4.13: Spread analysis – region, 2006–H1 2007 (%) 2007 (%)
bank capital Figure 2.5: European investor Figure 2.24: Asia-Pacific
Table 4.14: Corporate hybrid market hybrid supply, by investor market insurance
spreads – CDS multiples and currency, 2006–H1 2007 (%) hybrid supply, by issuer region,
rating agency equity credit Figure 2.6: European investor 2006–H1 2007 (%)
Table 4.15: Example of step vs. market hybrid supply, by sector, Figure 2.25: Asia-Pacific
non-step premiums 2006–H1 2007 (%) investor market insurance
Figure 2.7: European investor hybrid supply, by currency,
Table 5.1: Hybrid securities – market bank Tier 1 supply, by 2006–H1 2007 (%)
summary primary foundations issuer region, 2006–H1 Figure 2.26: Asia-Pacific
Table 5.2: Notching for hybrid 2007 (%) investor market corporate
securities Figure 2.8: European investor hybrid supply, by issuer region,
Table 5.3: Development of the market bank Tier 1 supply, by 2006–H1 2007 (%)
‘meaningful’ mandatory deferral currency, 2006–H1 2007 (%) Figure 2.27: Asia-Pacific
trigger, 2004–06 Figure 2.9: European investor investor market corporate
Table 5.4: Classification of market insurance hybrid supply, hybrid supply, by currency,
hybrid securities for financial by issuer region, 2006–H1 2006–H1 2007 (%)
services companies 2007 (%) Figure 2.28: European investor
Table 5.5: Fitch debt-to-equity Figure 2.10: European investor market supply, 2006–H1
continuum market insurance hybrid supply, 2007 (%)
Table 5.6: Summary - corporate by currency, 2006–H1 2007 (%) Figure 2.29: US investor
hybrid transactions Figure 2.11: European investor market supply, 2006–H1
Table 5.7: Tier characteristics market corporate hybrid supply, 2007 (%)
defined in Solvency ll by issuer region, 2006–H1 Figure 2.30: Asia-Pacific
Table 5.8: Elements eligible for 2007 (%) investor market supply,
the guarantee fund Figure 2.12: European investor 2006–H1 2007 (%)
Table 5.9: Additional elements market corporate hybrid supply,
eligible for the ASM by currency, 2006–H1 2007 (%) Figure 3.1: The cost of
Figure 2.13: US investor common equity (expected
Table 6.1: UK termsheets market hybrid supply, by issuer market return), by country (%)
Table 6.2: Ireland termsheets region, 2006–H1 2007 (%) Figure 3.2: WACC calculation –
Table 6.3: France – total Tier 1 Figure 2.14: US investor common equity vs. hybrid debt
capital breakdown market hybrid supply, by sector, (%)
Table 6.4: France termsheets 2006–H1 2007 (%) Figure 3.3: Evaluating equity
Table 6.5: Germany termsheets Figure 2.15: US investor alternatives - hybrid is low cost
Table 6.6: Switzerland market bank Tier 1 supply, equity
termsheets by issuer region, 2006–H1 2007 Figure 3.4: Issuer motivations
Table 6.7: Spain termsheets (%) Figure 3.5: Issuance rationale
Table 6.8: Italy termsheets Figure 2.16: US investor for select corporate issuers
Table 6.9: US termsheets market bank Tier 1 supply, by
currency, 2006–H1 2007 (%) Figure 4.1: Illustrative investor
Table 7.1: Select new entrants Figure 2.17: US investor distribution for an institutional
to the hybrid capital market market insurance hybrid supply, global hybrid transaction (%)
by issuer region, 2006–H1 2007 Figure 4.2: Illustrative investor
(%) distribution (Perp nc 10
Figure 1.1: Sectoral differences Figure 2.18: US investor structure) (%)
in the rationale for hybrid market corporate hybrid supply, Figure 4.3: Example
issuance by issuer region, 2006–H1 distribution for a Euro-
Figure 1.2: Growth of next 2007 (%) denominated hybrid capital
generation European hybrid Figure 2.19: Asia-Pacific issue, by region (%)
issuance, 2003 to date (€m) investor market hybrid supply, Figure 4.4: Example
Figure 1.3: Institutional hybrid by issuer region, 2006–H1 distribution for a Euro-
investors – illustrative global 2007 (%) denominated hybrid capital
breakdown (%) Figure 2.20: Asia-Pacific issue, by region (%)
investor market hybrid supply, Figure 4.5: Example
Figure 2.1: Global hybrid by currency, 2006–H1 2007 (%) distribution for a Euro-
supply, by market, 2002–H1 Figure 2.21: Asia-Pacific denominated hybrid capital
2007 (US$m) investor market hybrid supply, issue, by region (%)
Figure 2.2: Global hybrid by sector, 2006–H1 2007 (%) Figure 4.6: Example
supply, by investor market, Figure 2.22: Asia-Pacific distribution for a US$-
2006–H1 2007 (%) investor market bank Tier 1 denominated hybrid capital
Figure 2.3: Global hybrid supply, by issuer region, issue, by region (%)
supply, by issuer sector, 2006–H1 2007 (%) Figure 4.7: Corporate hybrid
2006–H1 2007 (%) Figure 2.23: Asia-Pacific spread performance, 2006 to
v
date paradigm Figure 5.10: Global hybrid Tier
Figure 4.8: Hybrid performance Figure 5.3: Hybrid Tier 1 1 capital origins
vs. other asset classes, Apr 2006 structuring considerations Figure 5.11: Available solvency
to date Figure 5.4: Simple SPV margin: Solvency l minimum
Figure 4.9: Unrated/low-rated structure solvency level
issuers targeting the hybrid Figure 5.5: Hybrid example 1 – Figure 5.12: Capital limitations
market, 2006–07 interest payment mechanics
Figure 4.10: Spread differential Figure 5.6: Hybrid example 2 – Figure 6.1: German Tier 1 SPV
analysis, by rating interest payment mechanics structure
Figure 4.11: True Perpetual vs. Figure 5.7: Hybrid example 3 – Figure 6.2: German Stille
step-up hybrid securities, interest payment mechanics Einlage structure
Jan–Sep 2007 Figure 5.8: Hybrid example 3 – Figure 6.3: German Stille
optional early redemption Einlage structure with Jersey LP
Figure 5.1: Primary technical mechanics Figure 6.4: Italian hybrid Tier 1
foundations for structuring a Figure 5.9: New hybrid structure via a US trust
hybrid security transaction – time and Figure 6.5: Italian hybrid Tier 1
Figure 5.2: Preferred stock responsibility schedule structure via an EU SPV
vi
GLOSSARY
ACSM Alternative coupon satisfaction mechanism

ACT Advance Corporation Tax
ARPS Adjustable rate preferred securities
ASM Available solvency margin
BIS Bank for International Settlements
CAGR Compound annual growth rate
CAPM Capital asset pricing model
CDO Collateralised debt obligation
CDS Credit default swap
CEIOPS Committee of European Insurance and Occupational Pensions Supervisors
CMS Constant maturity swap
COC Change of control
DRD Dividends received deduction
ECR Enhanced capital requirement
FASB Financial Accounting Standards Board
GAAP Generally accepted accounting principles
ICA Individual capital assessment
ICG Individual capital guidance
IFRS International financial reporting standards
LBO Leveraged buy-out
LBRL Legally binding replacement language
LLC Limited liability company
M&A Mergers and acquisitions
MAPS Market auction preferred stock
MCR Minimum capital requirement
MPD Mandatory payment deferral
NAIC National Association of Insurance Commissioners
P&L Profit and loss
PCDS Preferred credit default swap
PIK Payment-in-kind
RCC Replacement capital covenant
RCI Reserve capital instruments
REIT Real estate investment trust
RMM Required minimum margin
ROE Return on equity
RSM Required solvency margin
RWA Risk-weighted assets
SCR Solvency capital requirement
SEC Securities and Exchange Commission
SPV Special purpose vehicle
TAC Total adjusted capital
TSS Titres super-subordonnés
WACC Weighted average cost of capital
vii
CHAPTER HYBRID CAPITAL MARKET OVERVIEW
01 What are hybrid capital securities?

The term ‘hybrid’ is often referred to in a wider context and can be applied to a number of
varying situations – with the term often applied when discussing the breeding of plants or
animals of different varieties or races. However, the basis remains the same and a hybrid at the
most basic level can be said to derive from two component entities which are dissimilar.
Evaluating the complex and arcane hybrid capital security market is best achieved by beginning
with a framework of analysis from which to operate. One useful framework is the ‘preferred
stock paradigm’, which compares a hybrid security directly with the classic preferred stock
structure.
The preferred stock paradigm

Hybrid capital securities can be thought of as ‘synthetic preferred stock’. This framework is most
useful in establishing the equity characteristics that regulators, rating agencies and other market
constituents may use as a benchmark to measure the merits of a hybrid as a common stock
substitute to strengthen the balance sheet and provide financial flexibility.
Table 1.1: The preferred stock paradigm
Preferred stock Paradigm
Perpetual
Discretionary non-cumulative
payments
Deeply subordinated and senior

only to common
Source: Compiled by CALYON
Where possible, the terms of classic preferred may be altered to reduce the desired equity charac-
teristics just enough to produce a hybrid security that achieves tax deductibility while
maintaining the desired regulatory and/or rating agency benefits. Alternatively, one could start
with simple senior debt and ‘layer on’ the desired equity features and ‘strip away’ the typical
senior investor protections to achieve the same result. People seem to ‘get’ the preferred stock
metaphor more readily. In practice, hybrids include preferred, subordinated bonds and various
combinations which may utilise special purpose vehicles (SPVs) to deliver the intended issuer
benefits and investor protections.
Before hybrid Tier 1 capital for banks took off in 1998 and the first corporate hybrids in 1993,
classic preferred stock was used to obtain the many benefits of a quasi-equity mezzanine layer of
capital that would be cheaper than common stock. Although there are different types of preferred
stock or preference shares, for purposes of evaluating hybrids a classical preferred stock format
can be observed. The hybrid securities which are now issued by most major industry sectors are
usually debt instruments that are therefore tax efficient (deductible) and emulate classic
preferred stock but retain their ultimate debt ‘essence’. In some jurisdictions specific laws enable
hybrid security issuance (Spain, France, Germany, for example).
Preferred securities exhibit elements of debt and elements of equity. Residing at the meeting
point of debt and equity the various types of preferred securities that exist such as market auction
preferred securities (MAPS), or adjustable rate preferred securities (ARPS) and fixed rate
perpetuals (FRP) were historically rooted in financial engineering where neither pure debt nor
pure common equity was adequate to strike the desired balance of risk allocation, sharing
reward/returns, control via voting rights etc.
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ifrintelligence reports/Hybrid Capital Securities: a definitive guide for issuers and investors
The term hybrid is increasingly stretched – sometimes including classic preferred stock, which is
still issued by banks when they have reached the regulatory limit on ‘innovative’ hybrid Tier 1
but have capacity for more low-cost quasi-equity for regulatory capital purposes. Some types of
preferred securities also had/have tax benefits associated with them such as the UK ACT (Advance
Corporation Tax) preference shares, US DRD (Dividends Received Deduction) preferred stock, and
QDI (Qualified Dividend Income) eligible securities. The issuer could pay a lower dividend rate on
such securities since the investor enjoyed a higher tax-adjusted return on their dividends
received. So while most modern hybrid securities seek tax efficiency primarily via a tax deduction
on the payments, it is historically consistent that quasi-equity securities may also provide the
issuers with lower cost due to tax benefits.
Some bank regulatory history

Banks and other regulated financial institutions are required to maintain prudent levels of capital
to keep them solvent, even in the event that they suffer losses on their asset portfolios. A
summary of the major bank capital guideline – the Basel Accord – provides some insight into the
role of bank regulatory capital requirements in motivating banks to issue lower cost preferred
stock (and later hybrid Tier 1) for part of their regulatory capital requirements.
The Basel Capital Accord

1988 – In 1988, the Basel Capital Accord was constructed by the Basel Committee organisation of
central banks for the G10 countries to effect a uniform level of capital adequacy requirements.
The Accord was introduced to create regulatory capital requirements in line with the particular
risks that bank portfolios could bear and to incentivise holding lower risk assets or more risk
capital. Additionally, the Accord was meant to rationalise eligible capital definitions across the
jurisdictions of the member countries to foster fair competition.
It was in fact the 1988 Basel Capital Accord which introduced to the industry the notion of tiered
capital, with Tier 1 representing core capital and Tier 2 representing supplementary capital
respectively.
Tier 1 is defined in the 1988 Basel Capital Accord in the following terms:
0 Common stock and perpetual non-cumulative preferred stock, preference shares;
0 Reserves (through appropriations of retained earnings or other surplus);
0 Less than wholly-owned minority interests in operating subsidiary equity where there are
consolidated accounts.
1998 – The evolution of the Basel Capital Accord1, was progressive in its allowance of ‘innovation’
with regard to capital instruments. The Basel Committee press release in October 1998 stated that
such hybrid innovations in bank capital securities including non-operating SPV instruments
would be allowed if they met the new guidelines and were subject to a limitation rule, whereby a
non-common equity Tier 1 instrument feature with a step-up and call which may incent
redemption of the security is capped at 15% of a bank’s Tier 1 capital. Step-ups were limited to the
higher of 100bp or 50% of the Libor equivalent spread at issue. The Committee allowed national
regulators to endorse new criteria for financial instruments which would qualify as Tier 1 capital
without too large a reliance on such instruments to meet capital ratio requirements.
The acceptance of hybrid Tier 1 capital was an improvement in the approach by the Committee
from the 1988 Accord. That was a direct result of industry globalisation and a response to various
disparities between national regulators where some jurisdictions were benefiting from fiscal
and/or other benefits which other jurisdictions did not allow.
In line with the 1998 guidelines, hybrid Tier 1 was required to exhibit the following characteristics:
0 Issued and fully paid up (to the bank);
0 Non-cumulative payments at the bank/regulator discretion;
0 Support going-concern status (loss absorption);
0 Subordinate to deposits, creditors, senior debt, other subordinated debt (Tier 2 capital);
1 Press release: ‘Instruments eligible for inclusion in Tier 1 capital’, 27th October 1998
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These guidelines shaped hybrid capital over the past decade and help us understand the
structures of many outstanding bank capital instruments. Many of these instruments will be
eligible for redemption in 2008 and beyond. Work on Basel II, Solvency II and IFRS will no doubt
continue to refine the landscape of capital securities in the coming years.
The impact of these guidelines on structuring hybrid structures is further detailed in Chapters 5
and 6. Further information can also be sourced on the Bank of International Settlements (BIS)
website www.bis.org, CEBS at www.c-ebs.org, FSA at www.fsa.gov.uk, and the Fed at www.federal-
reserve.gov
Rating agency impact

The rating agencies have always been a key constituent when considering the issuance of
preferred-type securities since there has always been a desire to gain maximum ratings benefit
from any preferred in the capital structure. The release of the Moody’s Toolkit in 2005 made it
clear how to structure hybrid securities to gain the optimal mix of equity credit considering the
pre-tax and post-tax cost of hybrids and classic preferred. The Moody’s Toolkit2 also provides a
useful framework that is analogous to the preferred stock paradigm basic concepts, but is
developed into a more complete methodology. The three primary drivers to obtain a high level of
equity credit from the rating agencies as stated by Moody’s are:
1 – No Maturity (permanence);
2 – No Ongoing Payments;
3 – Loss Absorption.
These criteria dovetail with the bank regulatory guidelines and preferred stock paradigm
framework in distinguishing the equity essence of a security. The extensive works by the three
major agencies should be studied in their entirety to fully appreciate the depth of their thinking
on hybrids from both issuer and investor perspectives.
Regulated bank entities had sufficient motivation to issue low-cost hybrid capital securities. The
clarification of the rating agency evolution toward increased equity credit for hybrids was
analogous stimulus for the insurance and corporate sectors (as shown in Figure 1.1). The rationale
for corporate issuers is covered in summary later in this section and in detail in Chapter 3.
The published works by the rating agencies also did a tremendous amount of good for promoting
the hybrid security asset class among investors since all the investors could access the same publi-
cations and evaluate the different perspectives of Moody’s, Standard & Poor’s (S&P) and Fitch.
While the publications were aimed at the potential hybrid issuers in terms of how to achieve
corporate finance objectives and support their ratings, the lucid discussion of which equity
features could enhance financial flexibility was instructive to investors considering hybrid
investments. Rating agencies also sought to signal various amounts of hypothetical investor risk
by ‘notching’ the ratings of the hybrid securities down from the plain vanilla senior ratings. An
issuer with senior debt rated BBB might have a hybrid rated BB+, for example, to signal hybrid
equity feature risks such as subordination and optional payments.
Rating agencies also referenced historical data on the payment performance and loss statistics on
preferred securities (again a proxy for the new hybrids). By providing an unbiased and thorough
framework for evaluating hybrid equity securities the three rating agencies helped issuers and
investors come to understand the essentials of hybrid securities in a very short period of time so
that a critical mass of corporate issuance occurred and a ‘new’ asset class was born.
Accounting, legal and tax considerations

In the early days of the Basel guidelines, accounting took on a more significant role than is does
now. The US was the first nation to experience massive issuance of tax-efficient Tier 1 capital by
adapting the then current corporate hybrid structure to a format suitable to the US bank
regulators. At that time, ‘minority interest’ equity accounting treatment was accomplished via a
wholly-owned SPV bank subsidiary issuing preferred securities that would consolidate with the
bank and meet the requirements of bank capital in the US. Minority interest satisfied Basel and
Federal Reserve (FED) guidelines so it was supportive to the regulatory lobbying for the adoption
of hybrid Tier 1 to note that the accountants record Hybrid Tier 1 as ‘equity’ via minority interest.
Financial Accounting Standards Board (FASB) changes no longer provide SPV minority interest,
but US regulators no longer care about this cosmetic aspect.
2 Refinement to Moody’s Tool kit: Evolutionary, not revolutionary!’ (February 2005)
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Many variations of this SPV capital theme were used globally (and still are) to provide global
banks with various versions of hybrid Tier 1 capital. This is discussed further in Chapters 5 and 6.
The adoption of international financial reporting standards (IFRS) has had sweeping impact on
the hybrid security market. Many companies found that they lost accounting equity treatment for
securities that counted as equity under their prior generally accepted accounting principles
(GAAP) systems. Another major implication is that ‘equity’ securities do not allow for the
application of IFRS hedge accounting and can result in more profit and loss (P&L) volatility than
they would have under GAAP.
For these reasons some structuring efforts have been applied to modify hybrid structures to be
recorded as debt for accounting purposes so that hedge accounting can be applied and P&L
volatility limited. More recently there have been securities issued into the ‘hybrid market’ which
have few of the capital or rating agency equity features but are designed only to achieve
accounting equity on the balance sheet. So again the hybrid definition evolves to meet another
set of issuers’ objectives.
The fact that the US led the first wave of explosive growth in hybrid corporate and Tier 1 bank
capital issuance in the 1990s had an impact on the early developments of the structures globally.
Since the US had a well defined legal classification of preferred stock and the tax regulations for
deductible debt conflict significantly with the characteristics of regulatory capital there were very
clever but somewhat awkward SPV/REIT (real estate investment trust) structures that emerged to
reconcile the conflicting perspectives. Key problems were the inability of perpetual and/or fully
non-cumulative instruments to qualify as deductible debt for US tax purposes. Use of the SPV
helped overcome these issues (as discussed in Chapters 5 and 6) but in many European jurisdic-
tions there has been a migration to direct issues as the need for SPV issuance is diminished, and in
response to a general sense of displeasure with SPV issuance (particularly from tax havens) on the
part of some European regulators.
Who are the issuers?

Regulated financial institutions such as banks and insurance companies are the key issuers of
hybrids, but the explosive growth in corporate hybrid issuance has grabbed significant attention
in the financial press. The key issuer rationale for the three main issuer groups – banks, insurance
and corporates – is summarised below and also covered in greater detail in Chapter 3.
Figure 1.1: Sectoral differences in the rationale for hybrid issuance
Regulated Unregulated
Banks Insurance Corporates

Accounting
Regulatory tier 1 capital Regulatory tier 1 capital
Ratings
Ratings
Ratings
Usually Depends - some Mostly

non issues have both non-cash
cumulative cumulative
Structures are getting more debt- like as regulators/rating agencies allow ACSM features
Issuance trends
M&A is one of the key drivers for recent global hybrid issuance growth, particularly in the
insurance sector, which increased by 60% to €15.9bn (equiv.). By contrast, while issuance from
banks continues to account for the majority of overall supply, contributing to 69% of the total
volume of the market, bank issuance growth in recent years has been relatively stable and
consistent.
4
CHAPTER01
The corporate hybrid market has shown dramatic growth and structural innovation
Recent years have seen corporate hybrid structures become increasingly used to fund M&A,
increase return on equity (ROE) and reduce weighted average cost of capital (WACC) with low-cost
quasi-equity. The corporate sector saw significant activity from German blue chips such as
Siemens, Porsche and Linde, which further stimulated interest in corporate hybrid strategies in
2006. This followed the explosion of corporate issuance seen in 2005 (see Figure 1.2), when rating
agencies first clarified their newly evolved methodologies and the hybrid securities were deemed
more beneficial to corporate and financial issuers alike.
Figure 1.2: Growth of next generation European hybrid issuance, 2003 - 2007 (€m)
Cumulative issuance
volume (€m)
18,000
16,000
14,000
Rating Agency
12,000 Publications
10,000
8,000
6,000
4,000
2,000
0
Jul
Oct
Jul
Oct
Jul
Oct
Jul
Oct
Jan
Jan
Jan
Jan
Apr
Apr
Apr
2003 2004 2005 2006 2007
Diversity and globalisation prevalent in geographical issuance trends

Issuance from the US, Asia and Europe continues to dominate but several new growth areas
are emerging.
In the European investor market, French, German and UK financial issuers dominate, accounting
for half of recent supply. Germany also continues to lead issuance in the European corporate
sector, including the largest corporate deal (Siemens), inaugural Sterling corporate hybrid deal
(Linde), and some of the most interesting and structurally innovative transactions to date. This
dominance in the European investor market is, however, lessening, driven by stronger supply
from other European countries, renewed flows from Asia-Pacific and also new and developing ju-
risdictions such as Kazakhstan, India and Korea. US financial institution issuers also tapped into
the European investor market with Euro and/or Sterling-denominated transactions. The CEMEX
US dollar dual-tranche issue found European diversification and was partly distributed to
investors in Europe and Asia.
The US investor market has also grown in recent years. The majority of supply continues to be
driven by US-domiciled financial institution and corporate issuers. However, the US investor
market is also finding greater international appeal and providing low-cost diversification and
market capacity for many European issuers. This has been most noticeable for the larger
European banks (particularly from the UK), but also for some of the European insurance issuers
(for example Axa, Swiss Re). Asia-Pacific financial institutions have also been active, with Japanese
banks issuing infrequently but in large size, and LatAm issuers have also tapped into demand in
this market.
In the Asian investor market, Japanese issuers contributed to a significant level of the overall
hybrid supply. Japanese retailer Aeon also broke new ground and issued the first corporate hybrid
sold into Japan’s domestic market. However European and US issuers (most notably the larger
banks and insurers) are becoming an increasing presence, diversifying and tapping into retail and
institutional investor demand in the region.
New and developing hybrid investor markets such as Canada and Australia were also tapped and
should provide increasing opportunities for issuers going forward.
5
CHAPTER01
Who are the investors?

Investors have been attracted to hybrids in a quest for yield in a low rate, tight spread
environment where the credit profiles have been improving, companies had been de-leveraging
and the economic outlook was positive. As structural conservatism adds investor-friendly features
to corporate hybrids the universe of eligible issuers expands and more investors enter the asset
class globally for exposure.
Figure 1.3: Institutional hybrid investors – illustrative global breakdown (%)
20%
35%
Asset manager
10% Banks
Insurance
Pension fund
Hedge fund
15%
20%
The continued growth and evolution of the global hybrid market has seen issuers tap into
increasing demand from institutional, retail and private bank (RPB) investors.
Institutional hybrid investors (as summarised in Figure 1.3) are comprised primarily of asset
managers, banks, hedge funds, insurance and pension funds, and these investors have
increasingly utilised the hybrid market as a method to maximise returns.
These investors have become more familiar with assessing the structural risks of hybrid
securities, and one of the key motivations for many investors has been the spread/yield pick-up
versus senior debt with a similar credit quality. Spread multiples or differentials are now utilised
by many institutional investors as a method for assessing the relative value and pick-up in
investing in the hybrid versus the senior security.
RPB investors (pure retail ‘mom-and-pop’ investors and high net worth individuals targeted
through private bank networks) have also become increasingly active and benefited from the
yield pick-up of hybrid securities. They have also provided important investor diversification to a
number of issuers who are more active in the institutional investor market. This investor base is
of particular significance in the US, European and Asian markets and has facilitated hybrid trans-
actions from both domestic and overseas issuers in recent years.
Evolution – historical milestones and outlook

Diversity is a prevalent theme as the hybrid market follows the path of globalisation – more types
of issuer are active in hybrids and more countries are entering the market as home to either the
hybrid issuers, the hybrid investors or both.
The hybrid capital securities market has recently experienced record new issue volumes. Bank
Tier 1 supply provides the greatest amount of new issue volume, although the insurance and
corporate sectors were a key driver for recent growth and structural innovation following rating
agency stimulus. Corporate and insurance issuance was largely driven by M&A-related funding
requirements and characterised by jumbo multi-tranche, multi-currency transactions in the
global hybrid market.
As more investor markets develop globally, hybrids also offer a source of funding diversification –
particularly important for issuers seeking historically large total amounts of cash. The ability to
choose from different instruments and investor bases including common equity, converts,
hybrids and senior debt in the European, US and Asian markets and tapping investors in the RPB
and institutional sectors has been a key component of the contemporary acquisition war chest.
6
CHAPTER01
The milestones of the 1990s, including the first generation of corporate hybrids and the adoption
of hybrid Tier 1 capital for banks, are now being challenged in significance as the next generation
of hybrid structures have stimulated the next wave of issuance from corporates and expanded the
pool of marketable issuers to include more sectors and countries than ever before.
The rating agencies have been the key catalyst for the recent hybrid structural enhancements, but
this would not have been as possible without the extremely constructive market conditions
which compressed the pricing of ‘risky’ structural features that provide equity credit.
Structures have become more conservative to attract more investor types and allow for more
diverse credit profiles to tap the hybrid market (low rated and unrated issuers). The market has
seen a ’new renaissance’ of hybrid capital structuring, and massive M&A funding needs have been
well supported by evolutionary developments in the sector. M&A also provided the purpose to the
hybrid product for many corporate issuers that do not need regulatory capital.
The current period is now reminiscent of the 1990s, when banks around the world were rapidly
innovating country specific variants of tax-efficient capital and issuance volumes surged. Investors
were attracted by yield, but wary of structural nuances and the potential for ‘embedded risk’
within the emerging hybrid asset class. Over time, structural details faded from significance, as
greater outstanding issuance volumes and liquidity led to understanding, commoditisation and
market efficiency.
The structural innovation rate of change may vary and the new issue volumes will rise and fall
with the business cycle but the continued use of hybrid capital securities in the capital structures
of sophisticated issuers seems as certain as ‘perpetual change’.
7
CHAPTER THE MARKET FOR HYBRID CAPITAL
02 SECURITIES
Introduction
Hybrid capital issuance in the global debt markets has been at its most dynamic in recent years,
exhibiting expansion, innovation, diversity and the emergence of several new growth areas. A
number of factors have led to the recent explosion of issuance. One of the most influential events
in the market occurred in 2005 when the lead rating agencies gave clarification to their method-
ologies for assessing hybrid capital securities. This opened the hybrid markets to a number of new
sectors and issuers and the market has been building on this momentum ever since. Organic
growth and M&A activity have, however, remained the primary drivers for market supply,
although more and more issuers look to further adapt hybrids for their own unique objectives.
Issuer aspirations have been supported by strong market conditions, which have attracted new
investors to hybrids and also a greater diversity of issuer credits.
Investor markets around the world are becoming deeper and more established. Institutional, retail
and private bank investors have all played a key role in the market expansion. While in many cases
domestic investors provide the backbone to the market, issuers are increasingly looking outside
their local investor base, tapping into new investor markets and achieving diversification. Within
the global hybrid markets, bank issuers raising Tier 1 regulatory capital continue to contribute the
majority of supply seen in the market today. Insurance and corporate hybrid volumes have,
however, seen significant growth in recent years and increased volumes look set to become a key
trend of the sector in years to come. As the market further opens, smaller mid-cap issuers have also
been able to access this important source of capital funding. This has led to the increasing
appearance of transactions below a typical benchmark size, and has also paved the way for issuers
with low or no credit ratings, as global investors become increasingly educated about the structure
of hybrid securities and issuers from emerging regions.
This chapter provides an overview of the global hybrid markets and some of the developments
which have driven rapid growth and expansion in recent years. A summary is given of the key
trends of the market, from both an investor market and issuer region perspective. Issuer
motivation is further analysed in Chapter 3, and the investor base for hybrid securities is
discussed in detail in Chapter 4. Looking forward, demand for these innovative securities,
continuing product development and increased issuer focus on balance sheet management are all
expected to result in the continued innovation and growth of the market going forward, both
from a supply and demand perspective.
Hybrid market size, growth and structure

Looking back, the last five years have been a growth period for the global hybrid capital markets.
In 2005, the market saw a significant boost of issuance as supply increased by 80% to over US$80bn.
Then in 2006 the global hybrid markets saw further expansion, reaching over US$120bn by the
year-end (a 45% increase from 2005). 2007 has already seen significant activity, with H1 volumes of
over US$80bn already surpassing 2005 year-end volumes, as shown in Figure 2.1.
The growth rate in recent years has also been significant, averaging 42% for the period 2002–06.
The insurance and corporate sectors have led this expansion (with 2002–06 growth rates of 100%
and 47% respectively).
9
CHAPTER02
Figure 2.1: Global hybrid supply, by issuer sector, 2002–H1 2007 (US$m)
Volume
(US$ equiv. m)
140,000
Corporate hybrid
120,000 Insurance hybrid
Bank T1
100,000
80,000
60,000
40,000
20,000
0
2002 2003 2004 2005 2006 H1 2007
So the global hybrid markets have experienced significant change in recent years, not only in
terms of size but also structure. A number of factors shaped the development of the market over
this period and have led this sector to be of such significance in the market today:
0 Rating agency methodology clarification – One of the defining moments for the market was
when the lead rating agencies gave significant clarification and improvement in equity credit
to their hybrid methodologies. This resulted in an explosion of supply, particularly from the
more rating agency focused corporate and insurance sector issuers. Global hybrid markets have
subsequently continued their rapid growth and expansion, with volumes hitting record levels
in 2006;
0 M&A activity – The increase in M&A activity has had a strong impact on this growth level in
recent years. As funding requirements for some issuers (particularly via these M&A-related
financings) have increased, this has in turn led to larger ‘jumbo’ deals and multi-tranche deals
as issuers have looked to tap multiple investor markets to achieve funding requirements while
at the same time optimising pricing;
0 Multi-tranche transactions – These have also become more prevalent and have proven a
popular route for larger funding needs. The search for investor diversification, coupled with
larger funding requirements for many issuers, has resulted in the launch of an increasing
number of large multi-tranche transactions in the hybrid capital market and hybrids in new
currency markets. This targeting of different maturities and currencies has enabled issuers
to attract different investor bases into the same deal, which was particularly relevant for the
larger funding exercises now seen in the market. These multi-tranche transactions have been
multi-currency (targeting different investor bases), and maturity (targeting different investor
types), or have had varying structures (for example, step-up and true perpetual, or subordinated
and Tier 1);
0 Expansion of the market to include new issuer regions and investor markets – Hybrid supply
from new issuer regions has grown significantly in recent years. Issuers from these new regions
(select LatAm, Eastern European, Asian countries) are now a more frequent occurrence in the
market and provide investors with diversification away from the more frequent hybrid supply
seen from US and Western European issuers. Investor markets are also expanding away from
the traditional US and European investor bases, broadening the overall demand for hybrid
securities, and also offering issuers a greater number of hybrid investors to tap into.
Global hybrid supply at present is sold primarily into three distinct investor markets – the US,
Europe and Asia. Figure 2.2 highlights the comparative size of each of these investor markets.
Approximately 48% of total global hybrid supply is sold into the US investor market. The majority
of this supply comes from domestic issuance from US-domiciled institutions; however, a significant
volume (over 20%) comes from cross-border issuance from Europe, with most of the remaining supply
coming from Asia.
10
CHAPTER02
The European investor market is also significant in size, absorbing approximately 42% of total
global hybrid volumes, and is the main focus of many of the cross-border flows seen in the market
today.
Approximately 10% of total global hybrid volumes are sold into the Asia-Pacific investor market,
with supply primarily from Asian and Australian banks, and also European institutions targeting
the region for diversification purposes.
Figure 2.2: Global hybrid supply, by investor market, 2006–H1 2007 (%)
10%
42%
Europe
US
Asia-Pacific
48%
The global market can also be discussed in the context of issuer sector. Figure 2.3 splits the hybrid
market into three distinct groups – bank Tier 1, insurance hybrid and corporate hybrid:
0 Bank Tier 1 – This sector is the most dominant, contributing to approximately 69% of the total
global supply of hybrid securities. Tier 1 capital issuance from regulated financial institutions
has reached record volumes in recent years, with the leading international banks returning
frequently and tapping multiple markets to benefit from a diverse and developing hybrid
investor base. This issuance has been driven primarily by M&A and the growth of banks’ risk-
weighted assets as the majority of banks have been fully capitalised up to hybrid limits. The
continued dominance of the bank Tier 1 sector has also been supported by increased supply
from issuers in new jurisdictions where regulatory capital guidelines are either being clarified
or established for the first time;
0 Insurance hybrid – This sector contributes approximately 21% of the total global supply of
hybrid securities. Insurance hybrid supply has become a growing presence in recent years,
which can be attributed to both regulatory and rating agency developments, with the growth
in M&A activity also playing a key role. This has resulted in often-significant financing needs
within the sector, resulting in many of the transactions structured as large €1bn+ multi-tranche
multi-currency transactions, as issuers have sought to maximise diversification and achieve
tight pricing;
0 Corporate hybrid – While hybrid capital has traditionally been a financing vehicle for regulated
financial institutions, changes to the treatment of hybrids by the rating agencies has increased
the attractiveness of the product to the corporate sector. As a result, corporate hybrid supply
today contributes approximately 10% of the total volume of global hybrid securities. This
supply has often been intermittent, and much less frequent than for bank and insurance
issuers, with some months seeing a slew of supply. This has in the past been strongly correlated
to execution conditions and timing. The provision of low cost equity remains a key driver for
the majority of corporate hybrid transactions. Corporate hybrid structures have also become
increasingly used as a cost-effective financial tool to reduce the weighted cost of capital and
de-leverage. This, together with the development of rating agency hybrid methodologies
(which is discussed in Chapter 5) has resulted in the explosion of global corporate hybrid supply
seen in recent years.
11
CHAPTER02
Figure 2.3: Global hybrid supply, by issuer sector, 2006–H1 2007 (%)
10%
69%
21%
Bank tier 1
Insurance hybrid
Corporate hybrid
Investor markets
From the perspective of investor markets, hybrid market supply can be split into three groups, as
has already been highlighted – Europe, the US and Asia-Pacific.
The European investor market

Table 2.1 provides a summary of hybrid capital supply into the European investor market in 2006
and H1 2007. The European investor market grew to over €42bn equivalent in size in 2006.
Average deal sizes have also increased to €486m, and this has risen again in 2007, increasing by
7% to approximately €517m. The largest single-tranche transaction during H1 2007 was a €1.5bn
insurance hybrid transaction from Munich-Re, issued in June 2007. The largest deal of 2006 also
came from the insurance sector – a €1.275bn insurance hybrid transaction from Generali, issued
in June 2006.
Table 2.1: European investor market hybrid capital volumes, 2005–H1 2007 (€m)
European investor market size
2006 2007 H1
Total issuance (€ equiv. m) 42,746 21,185
No. deals 88 41
No. multi-tranche currency deals 8 4
Largest size (€ equiv. m) 1,275 1,500
Average size (€ equiv. m) 486 517
The shape of the European investor market for hybrid securities can be seen in Figure 2.4, and
analysed by the region of the issuer. European-domiciled issuers account for approximately 86% of
supply into the European investor market, with French, German and UK issuers the most active
(these three jurisdictions dominate, contributing to half of all supply in the European investor
market). The majority of these transactions have been from banks and insurance companies with
large capital requirements, which has required them to issue on multiple occasions and with
varying structures, currencies and target investor bases.
The dominant presence of France, Germany and the UK is, however, beginning to lessen. This
shift in the market has been driven partly by stronger supply from some of the other European
issuer regions such as Italy (10%), Netherlands (6%) and Iberia (5%), which in total account for 34%
of European market volumes. Supply from Central and Eastern Europe is also expected to become
an increasing presence going forward, which will further add diversity to the European investor
market.
12
CHAPTER02
Supply from non-European issuer regions into the European investor market has also become
more established, with the most significant volumes seen from the US (6%) and Japan (5%), with in-
ternational banks again dominating. New and developing issuer regions in Asia-Pacific and LatAm
account for a relatively low proportion of supply into the European investor market, although
bank capital supply from many of these jurisdictions has already been seen in Tier 2 format,
which will likely pave the way for more Tier 1 supply in the future, and Mexican issuer Cemex has
recently opened the European investor market for LatAm corporate hybrid issuance.
Figure 2.4: European investor market hybrid supply, by issuer region,

2006–H1 2007 (%)
6%
1%
2% 17% United Kingdom Iberia
8% Germany
Switzerland
1%
4% Scandinavia France
15% 1% Other Benelux

1%
Austria
5% Mexico
Australia
Japan
United States
Italy
10%
Ireland
20%
4%
5%
From a currency perspective, European investor market hybrid supply remains focused on either
Euros or Sterling, as highlighted in Figure 2.5.
Euros continue to be the key currency to be issued into the European investor market, accounting
for almost 60% of the total supply.
Sterling hybrid issuance has grown rapidly in recent years and now accounts for just over 40% of
total hybrid volume. The key growth area here has been increased volumes from non-UK issuer
regions, primarily from the continent (65% of total sterling hybrid volumes). These continental
issuers have targeted the currency as a diversification play away from Euros, with the proximity
of the investor base often making this the first choice from a marketing (and often documenta-
tion) perspective. Non-European issuer regions in Asia-Pacific and the US have also tapped into
this deep and mature investor market (7% of total sterling hybrid supply), with transactions often
part of a larger dual tranche Euro-Sterling financing.
Figure 2.5: European investor market hybrid supply, by currency, 2006–H1 2007 (%)
1%
57%
42%
Euros
Sterling
US$
13
CHAPTER02
Figure 2.6: European investor market hybrid supply, by sector, 2006–H1 2007 (%)
12%
57%
31%
Bank tier 1
Insurance hybrid
Corporate hybrid
Bank Tier 1 sector

Bank Tier 1 accounts for approximately 57% of supply into the European hybrid investor market.
Figures 2.7 and 2.8 and Table 2.2 analyse the split of this supply by issuer region and currency, and
also highlight some of the largest bank Tier 1 transactions to be issued in the European investor
market in 2006 and H1 2007.
Bank Tier 1 supply into the European market consists primarily of transactions from the
European banks (85%) tapping into their natural investor market, one which has in recent years
established itself as a deep and sophisticated investor base able to absorb hybrid supply from
repeat and frequent issuers. Japanese banks have been quite active, contributing to 9% of supply
(e.g. MUFG, Mizuho, SMFG). US banks have been less active (5%), with bank Tier 1 issuance still
remaining low relative to Tier 2 supply.
Many of the larger banks have also successfully repeat issued in the European investor market.
These transactions have targeted both multiple investor bases such as institutional and retail
private bank (RPB) (e.g. Lehman, Helaba), structures such as step-up, true-perpetual (e.g. BPVN)
and currencies such as Euros, Sterling, US Dollars (e.g. Commerzbank, BNP Paribas, MUFG). Crédit
Agricole has also been one such issuer, targeting both Sterling and Euros, and also institutional
and RPB investor bases in Europe and Asia in recent years.
Smaller European banks have also been active in numbers, although deal sizes have on average
tended to be smaller. Some of these institutions have also been progressive in their approach,
either in issuing a non-step structure or in the targeting of the RPB investor base.
Over 50% of this supply is denominated in Euros. Sterling has contributed to 45% of bank Tier 1
supply and continues to be used by continental and non-European issuers looking to access the
UK institutional investor base (62% of Sterling bank Tier 1 supply is from non-UK banks).
14
CHAPTER02
Figure 2.7: European investor market bank Tier 1 supply, by issuer region,
2006–H1 2007 (%)
3% 6%
5%
Benelux Other
13%
France Scandinavia
20%
Germany Spain
Ireland United Kingdom
15% Italy United States
Japan Austria
8%
7% 8%
2%
4% 9%
Figure 2.8: European investor market bank Tier 1 supply, by currency,

2006–H1 2007 (%)
1%
54%
45%
Euros
Sterling
US$
Table 2.2: European investor market bank Tier 1 supply – select issues by size,
2006–H1 2007
Issuer Size Size
country Issuer Issue date Currency (m) (€ equiv. m) Coupon First call date Maturity
Germany Commerzbank Capital Funding Trust I 15 Mar 2006 € 1,000 1,000 5.012 12 Apr 2016 P
Germany Commerzbank Capital Funding Trust II 15 Mar 2006 £ 800 1,162 5.905 12 Apr 2018 P
France BNP Paribas SA 04 Apr 2006 € 750 750 4.730 12 Apr 2016 P
France BNP Paribas SA 05 Apr 2006 £ 450 645 5.945 19 Apr 2016 P
Netherlands ABN AMRO Bank NV 24 Feb 2006 € 1,000 1,000 4.310 10 Mar 2016 P
Germany HT1 Funding GmbH 21 Jul 2006 € 1,000 1,000 6.352 30 Jun 2017 P
Ireland Saphir Finance plc 17 Aug 2006 £ 600 891 6.369 25 Aug 2015 P
Japan MUFG Capital Finance IV Ltd 12 Jan 2007 £ 550 823 6.299 25 Jan 2017 P
France Credit Logement 01 Mar 2006 € 800 800 4.604 16 Mar 2011 P
Japan MUFG Capital Finance II Ltd 10 Mar 2006 € 750 750 4.850 25 Jul 2016 P
France BNP Paribas SA 29 Mar 2007 € 750 750 5.019 13 Apr 2017 P
United Kingdom HBOS Capital Funding No 3 LP 16 May 2006 € 750 750 4.939 23 May 2016 P
Source: Compiled by CALYON P=Perpetual
15
CHAPTER02
Insurance hybrid sector

Insurance sector supply accounts for approximately 31% of the European investor market. Figures
2.9 and 2.10 and Table 2.3 analyse the split of this supply by issuer region and currency, and also
highlight some of the largest insurance hybrid transactions to be issued in the European investor
market in 2006 and H1 2007.
European insurance companies account for approximately 86% of this supply, with France (21%)
and Italy (24%) the most active regions (Axa and Generali were noticeably active). US insurers
accounted for 12% of supply into the European investor market, with AIG particularly active. The
majority of insurance sector transactions sold into the European investor market have been
heavily focused on M&A-driven deals e.g. Axa, Generali, Allianz and Munich Re (which issued the
largest single tranche transaction of 2007 – €1.5bn – in June). Many transactions have also taken
the form of large multi-tranche financings to enable larger funding requirements to be met
(European issuers such as Generali and Axa, and US insurer AIG all issued in dual-currency Euro-
Sterling format). Supply from non-European/non-US insurance sector issuers was limited (2%).
Approximately 54% of supply has been in Euros, with European insurance companies contribut-
ing to the majority of the volume (90%). Approximately 45% of insurance sector supply has been
Sterling-denominated. Supply in this currency has been from a more geographically diverse set of
issuers, with 25% from UK insurance companies, 58% from continental insurance companies, 12%
from the US and 5% from Australia.
Figure 2.9: European investor market insurance hybrid supply, by issuer region,
2006–H1 2007 (%)
12%
24%
Italy
Netherlands
Switzerland
21%
UK
US
14%
Australia
2% France
12% 4% Germany
Source: Compiled by CALYON 11%
Figure 2.10: European investor market insurance hybrid supply, by currency,

2006–H1
1%
€
£
US$
45% 54%
16
CHAPTER02
Table 2.3: European investor market insurance hybrid supply – select issues by size,
2006–H1 2007
Size Size
Issuer country Issuer Issue date Currency (m) (€ equiv. m) Coupon First call date Maturity
Italy Generali Finance BV 07 Jun 2006 € 1,275 1,275 5.317 16 Jun 2016 Perpetual
Italy Generali Finance BV 07 Jun 2006 £ 700 1,021 6.214 16 Jun 2016 Perpetual
Italy Generali Finance BV 07 Jun 2006 £ 350 510 6.269 16 Jun 2016 Perpetual
United States American International 08 Mar 2007 € 1,000 1,000 4.875 15 Mar 2017 15 Mar 2067
Group Inc - AIG
United States American International 08 Mar 2007 £ 750 1,103 5.750 15 Mar 2017 15 Mar 2067
Group Inc - AIG
Germany Munich Re 05 Jun 2007 € 1,500 1,500 5.767 12 Jun 2017 Perpetual
France CNP Assurances SA 12 Dec 2006 € 1,250 1,250 4.750 22 Dec 2016 Perpetual
Italy Assicurazioni Generali SpA 30 Jan 2007 € 1,250 1,250 5.479 08 Feb 2017 Perpetual
Italy Assicurazioni Generali SpA 30 Jan 2007 £ 495 750 6.416 08 Feb 2022 Perpetual
Netherlands ELM BV (Swiss Re) 04 May 2006 € 1,000 1,000 5.252 25 May 2016 Perpetual
France AXA SA 29 Jun 2006 € 1,000 1,000 5.777 06 Jul 2016 Perpetual
United Kingdom Legal & General Group plc 19 Apr 2007 £ 600 884 6.385 02 May 2017 Perpetual
Netherlands ING Groep NV 01 Mar 2006 £ 600 882 5.140 17 Mar 2016 Perpetual
Corporate hybrid sector

Approximately 12% of European market issuance is derived from corporate hybrid transactions.
Figures 2.11 and 2.12 and Table 2.4 analyse the split of this supply by issuer region and currency,
and also highlight some of the largest corporate hybrid transactions to be issued in the European
investor market in 2006 and H1 2007.
Western European issuers, as expected, dominate corporate supply into the European investor
market (over 90% of total volumes), with the larger blue chip companies embracing hybrids as a
mainstream corporate financing tool to reduce WACC with low-cost quasi-equity.
German corporates continue to lead, contributing over 50% of total volumes. This incorporates
the largest corporate hybrid deal in the European investor market, from Siemens (a €900m/£750m
dual-tranche deal issued in September 2006), a dual-tranche £/€ issue from Linde issued in July
2006, and also more recently a number of smaller sized deals (circa €100–250m) from lower rated
and non-rated issuers.
Other regions such as France (8%), Italy (10%) Austria (6%) and Belgium (6%) have also been active,
including more recently the UK (10%), with Rexam the first UK-domiciled corporate to issue in
hybrid format (€750m, issued in June 2007). Mexico contributed to 9% of supply, with Cemex
issuing €730m in May 2007. This deal offered investor diversification for the issuer, which had
previously targeted the US investor market with two dollar-denominated hybrid transactions.
Over 80% of corporate hybrid volumes in the European investor market have been Euro-
denominated, driven by strong supply from European issuer regions targeting their domestic
currency, and also all the recent supply seen from non-European issuer regions. European
corporate hybrid issuers have also issued in Sterling (19%) to diversify and tap into the UK institu-
tional investor base. German corporates Linde and Siemens have both been active in this
currency, with Linde the first corporate to issue a Sterling hybrid in July 2006. It is also interesting
to note that a single-tranche Sterling corporate hybrid has yet to be seen, with both the Linde and
Siemens deals part of larger dual-tranche Euro-Sterling financings.
17
CHAPTER02
Figure 2.11: European investor market corporate hybrid supply, by issuer region,
2006–H1 2007 (%)
8%
6%
Germany
6%
51% Italy
Mexico
10%
UK
Austria
Belgium
9%
France
10%
Figure 2.12: European investor market corporate hybrid supply, by currency,

2006–H1 2007 (%)
19%
€
£
81%
Table 2.4: European investor market corporate hybrid supply – select issues by size,
2006–H1 2007
Size Size
Germany Siemens Financieringsmaatschappij NV 08 Sep 2006 € 900 900 5.250 14 Sep 2016 14 Sep 2066
Germany Siemens Financieringsmaatschappij NV 08 Sep 2006 £ 750 1,115 6.125 14 Sep 2016 14 Sep 2066
Germany Linde Finance BV 07 Jul 2006 € 700 700 7.375 14 Jul 2016 14 Jul 2066
Germany Linde Finance BV 07 Jul 2006 £ 250 362 8.125 14 Jul 2016 14 Jul 2066
Italy Lottomatica SpA 10 May 2006 € 750 750 8.250 31 Mar 2016 31 Mar 2066
United Kingdom Rexam plc 20 Jun 2007 € 750 750 6.750 29 Jun 2017 29 June 2067
Mexico C10-EUR Capital Ltd (Cemex) 03 May 2007 € 730 730 6.277 30 Jun 2017 Perpetual
France Vinci SA 07 Feb 2006 € 500 500 6.250 13 Nov 2015 Perpetual
Belgium Solvay Finance BV 23 May 2006 € 500 500 6.375 02 Jun 2016 02 Jun 2104
Austria Wienerberger AG 25 Jan 2007 € 500 500 6.500 09 Feb 2017 Perpetual
The US investor market

The US hybrid investor market has experienced surging levels of issuance in recent years.
Investors have given strong support to new hybrid transactions, which has ensured record
issuance sizes and minimal new issue premiums in the process. A summary is given in Table 2.5.
US investor market hybrid issuance in 2006 was particularly strong, totalling almost US$45bn.
This volume was particularly impressive given the NAIC shock which chilled the market in the
first half. 2007 has also been a particularly noticeable year for hybrid supply into the US investor
market, with H1 2007 volumes reaching US$51bn from 80 deals – already surpassing those seen
in the US investor market for the entire year in 2006. The largest deal of 2006 came from
Wachovia, which issued a US$2.5bn single-tranche trust preferred issue in January. 2007 also saw
the bank Tier 1 sector provide the largest transaction, a US$1.75bn Tier 1 issue from Goldman
18
CHAPTER02
Sachs in May. Multi-tranche transactions have become increasingly used by both banks and
insurers to target different investor bases and increase funding sizes (either in fixed-floating or
dual-maturity format).
Table 2.5: US investor market hybrid capital volumes, 2005–H1 2007 (US$m)
US investor market size
2006 2007 H1
Total issuance (US$ equiv. m) 44,903 51,650
No. deals 60 80
Largest size (US$ equiv. m) 2,500 1,750
Average size (US$ equiv. m) 748 646
As highlighted in Figure 2.13, hybrid supply into the US investor market continues to be driven
primarily by US-domiciled institutions (both financial and corporate), accounting for approxi-
mately 55% of total issuance volumes. Non-US domiciled issuers have also been active in this
market, tapping into strong execution conditions and achieving additional diversification.
Approximately 6% of this supply has come from issuers in Asia-Pacific; however, the majority of
non-US supply has come from the European issuer regions, driven by Tier 1 capital raising
exercises from the larger European banks and insurers looking to diversify away from Euros.
Figure 2.13: US investor market hybrid supply, by issuer region, 2006–H1 2007 (%)
6% 2%
4%
2%
1% US Germany
3%
2% UK France
5% Switzerland Asia
Other European countries Other countries
8% Mexico
67%
Ireland
Figure 2.14: US investor market hybrid supply, by sector, 2006–H1 2007 (%)
9%
15% Bank tier 1

Insurance hybrid
Corporate hybrid
76%
19
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Bank Tier 1 sector

Bank Tier 1 supply accounts for approximately 76% of the total US investor market. Figures 2.15
and 2.16 and Table 2.6 analyse the split of this supply by issuer region and currency, and also
highlight some of the largest bank Tier 1 transactions to be issued in the US investor market in
2006 and H1 2007.
Almost two-thirds of this supply is derived from US-domiciled banks. These banks have been able
to issue into the domestic market for the majority of their Tier 1 financings, with the depth of
demand for these strong-branded names ensuring the market is deep enough to fund all their
capital requirements.
The European banks (e.g. Crédit Agricole, Deutsche Bank, Bank of Ireland, Santander), contribute
to 24% of bank Tier 1 into the US investor market. The UK region has been the most active in
tapping into this investor base, with Barclays, RBS, HBOS, Standard Chartered and Lloyds TSB all
issuing in 2006–H1 2007. Bank Tier 1 European supply into the US investor base often differs in
structure, with both step-ups and true perpetuals (Lloyds TSB, Standard Chartered, HBOS, BNP
Paribas) utilised. BBVA also recently issued a bank Tier 1 deal, with a coupon floor after the first
call date.
LatAm and Asia-Pacific issuers have also intermittently tapped into the US investor market (e.g.
BBVA Bancomer, Woori Bank). Japanese banks contributed to 5% of supply, with the large banks
issuing into the US investor market infrequently but in large size (the average transaction size has
been approximately US$2bn). Canada is another North American market to watch.
Almost 100% of bank Tier 1 volumes in the US investor market were US$-denominated. One such
non-US$ transaction was last year’s C$400m Tier 1 deal from Crédit Agricole, the first hybrid
structure to be issued into the C$ institutional investor market.
Figure 2.15: US investor market bank Tier 1 supply, by issuer region, 2006–H1 2007 (%)
3% 4%
2%
5%
US Ireland
8%
UK Germany
2% Switzerland France
3% Spain
Others
63%
10% Japan
Figure 2.16: US investor market bank Tier 1 supply, by currency, 2006–H1 2007 (%)
0.5%
US$
C$
99.5%
20
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Table 2.6: US investor market bank Tier 1 hybrid supply – select issues by size,
2006–H1 2007
Issuer Size Size
country Issuer Issue date Currency (m) ($ equiv. m) Coupon First call date Maturity
US Wachovia Capital Trust III 25 Jan 2006 US$ 2,500 2,500 5.8 15 Mar 2011 Perpetual
Japan MUFG Capital Finance I Ltd 10 Mar 2006 US$ 2,300 2,300 6.346 25 Jul 2016 Perpetual
US JP Morgan Chase Capital XXII 26 Jan 2007 US$ 1,000 1,000 6.45 - 02 Feb 2037
US JP Morgan Chase Capital XXI 26 Jan 2007 US$ 850 850 FRN 02 Feb 2012 02 Feb 2037
US Goldman Sachs Capital II 08 May 2007 US$ 1,750 1,750 5.793 01 Jun 2012 Perpetual
Japan SMFG Preferred Capital USD 1 Ltd 13 Dec 2006 US$ 1,650 1,650 6.078 25 Jan 2017 Perpetual
US BAC Capital Trust XIII 12 Feb 2007 US$ 700 700 FRN 15 Mar 2012 15 Mar 2043
US BAC Capital Trust XIV 12 Feb 2007 US$ 850 850 5.48 15 Mar 2012 15 Mar 2043
US Citigroup Capital XVI 15 Nov 2006 US$ 1,500 1,500 6.45 31 Dec 2011 31 Dec 2066
US Merrill Lynch & Co Inc 15 Mar 2007 US$ 1,500 1,500 5.85 24 May 2012 Perpetual
US Lehman Brothers Holdings Capital Trust VII 8-May-07 US$ 1,000 1,000 5.857 31 May 2012 Perpetual
US Lehman Brothers Holdings Capital Trust VIII 8-May-07 US$ 500 500 FRN 31 May 2012 Perpetual

Insurance hybrid supply accounts for approximately 20% of the US investor market. Figure 2.17
analyses the split of this supply by issuer region, and Table 2.7 highlights some of the largest
insurance hybrid transactions to be issued in the US investor market in 2006 and H1 2007.
US insurers account for approximately 62% of this supply. European issuer regions such as France
(10%) and Switzerland (16%) have also been active, with large European insurers such as Swiss Re,
Axa and Zurich FS all issuing (both Axa and Zurich FS issued in dual-tranche step-up/true perp
format and Swiss Re issued in US$ as part of a dual currency Euro-Dollar financing). The
Bermudan reinsurance sector has also played a significant role, contributing to approximately 8%
of hybrid supply into the US investor market.
Figure 2.17: US investor market insurance hybrid supply, by issuer region,

2006–H1 2007 (%)
8%
10%
US
4% Switzerland
Netherlands
France
16% Bermuda
62%
21
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Table 2.7: US investor market insurance hybrid supply – select issues by size,
2006–H1 2007
Size Size
Issuer country Issuer Issue date Currency (m)($ equiv. m)Coupon First call date Maturity
US ZFS Finance (USA) Trust I 03 May 2007 US$ 1,000 1,000 6.500 09 May 2017 9 May 2037
US ZFS Finance (USA) Trust I 03 May 2007 US$ 500 500 5.875 09 May 2012 9 May 2032
France AXA SA 04 Dec 2006 US$ 750 750 6.379 14 Dec 2036 Perpetual
France AXA SA 04 Dec 2006 US$ 750 750 6.463 14 Dec 2018 Perpetual
US MetLife Inc 14 Dec 2006 US$ 1,250 1,250 6.400 15 Dec 2036 15 Dec 2036
US XL Capital Ltd 12 Mar 2007 US$ 1,000 1,000 6.500 15 Apr 2017 Perpetual
US American International Group Inc - AIG 06 Mar 2007 US$ 1,000 1,000 6.250 15 Mar 2037 15 Mar 2087
US Travelers Companies Inc 05 Mar 2007 US$ 1,000 1,000 6.250 15 Mar 2017 15 Mar 2037
US Progressive Corp 18 Jun 2007 US$ 1,000 1,000 6.700 15 Jun 2017 15 June 2037
US ING Groep NV 06 Jun 2007 US$ 1,000 1,000 6.375 15 Jun 2012 Perpetual
Switzerland Swiss Re GB plc 04 May 2006 US$ 750 750 6.854 25 May 2016 Perpetual
US American International Group Inc - AIG 31 May 2007 US$ 750 750 6.450 15 Jun 2012 15 June 2047

Corporate hybrid supply is the smallest sector, contributing to approximately 10% of total hybrid
volumes into the US investor market. Figure 2.18 analyses the split of this supply by issuer region,
and Table 2.8 highlights some of the largest corporate hybrid transactions to be issued in the US
Supply from US-domiciled corporate issuers remains dominant (75%). Non-US issuers accounted
for 25% of the volume, with Cemex the most active of these issuers (both in terms of the number
of deals – three – and volume issued – US$2bn). The first of these deals from Cemex represented
the first issue from a LatAm corporate in hybrid format, which achieved 85% placement within
the US investor market, but also a significant 10% into the European investor market and 5% into
LatAm. Cross-border supply from European corporates into the US investor market has yet to be
established, and is set to be an area of growth for those corporate hybrid issuers with repeat
borrowing requirements who also want to diversify away from the European investor markets.
Figure 2.18: US investor market corporate hybrid supply, by issuer region,

2006–H1 2007 (%)
25%
US
Mexico
75%
22
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Table 2.8: US investor market corporate hybrid supply – select issues by size,
2006–H1 2007
Size Size
Issuer country Issuer Issue date Currency (m) ($ equiv. m) Coupon First call date Maturity
United States CVS Caremark Corp 22 May 2007 US$ 1,000 1,000 6.302 01 Jun 2037 01 Jun 2037
Mexico C5 Capital Ltd 11 Dec 2006 US$ 350 350 6.196 31 Dec 2011 Perpetual
Mexico C10 Capital Ltd 11 Dec 2006 US$ 900 900 6.722 31 Dec 2016 Perpetual
Mexico C8 Capital Ltd 06 Feb 2007 US$ 750 750 6.640 31 Dec 2014 Perpetual
United States Enterprise Products Operating LP 21 May 2007 US$ 700 700 7.034 15 Jan 2018 15 Jan 2068
United States Comcast Corp 03 May 2007 US$ 575 575 6.625 15 May 2012 15 May 2056
United States USB Realty Corp 18 Dec 2006 US$ 500 500 6.091 15 Jan 2012 Perpetual
United States Public Storage Inc 04 Jan 2007 US$ 500 500 6.625 09 Jan 2012 Perpetual
United States PPL Capital Funding Inc 16 Mar 2007 US$ 500 500 6.700 30 Mar 2017 30 Mar 2067
The Asia-Pacific investor market
Table 2.9: Asia-Pacific investor market hybrid capital volumes, 2005–H1 2007 (US$m)
Asian investor market size
2006 2007 H1
Total issuance (US$ equiv. m) 14,568 5,333
No. deals 30 13
Largest size (US$ equiv. m) 3,488 1,000
Average size (US$ equiv. m) 486 410
The most significant supply into the Asia-Pacific investor market has been from Japan, which has
contributed to approximately 44% of recent hybrid supply in the region (highlighted in Figure
2.19). This has comprised primarily of Tier 1 capital deals from the Japanese banks issuing in US$
and JPY format into both the institutional and RPB investor bases.
Other Asia-Pacific issuer regions have accounted for 29% of recent Asia-Pacific market supply.
These jurisdictions are becoming an increasingly important segment of the Asia-Pacific investor
market as regulatory frameworks evolve and new banks access the market. One example is India
(now 5% of the Asia-Pacific hybrid investor market), which has had a growing presence following
clarification of bank capital adequacy guidelines, making it clearer for the Indian banks to tap
into the institutional debt markets to raise tax-efficient Tier 1 capital.
European issuers account for 24% of the Asia-Pacific investor market. Many of these transactions
are targeted towards the Asia-Pacific RPB market (the RPB investor base is discussed in greater
detail in Chapter 4), which remains a popular method of diversification for both European
financial institutions (for example, NIBC Bank, CNCEP) and corporates (Glencore, Porsche).
23
CHAPTER02
Figure 2.19: Asia-Pacific investor market hybrid supply, by issuer region,

2006–H1 2007 (%)
1% 4%
2%
7%
7% Japan UK
India Thailand
2%
2% Germany Switzerland
3% France South Korea

44%
Australia Philippines
US Netherlands
9%
Malaysia
8%
6% 5%
Figure 2.20 highlights hybrid supply into the Asia-Pacific investor market, split by currency.
Approximately 57% of supply into the Asia-Pacific investor market is denominated in US$.
However a significant component (approximately 32%) of supply is also denominated in JPY,
driven by continued capital issuance from the international Japanese banks such as Mizuho,
Fukui and MUFG, and this currency continues to facilitate Tier 1 transactions of significant
size (for example Mizuho). Other currencies comprise a smaller component of the investor
market (11%), driven by domestic currency bank Tier 1 supply from issuer regions such as India
and Malaysia.
Figure 2.20: Asia-Pacific investor market hybrid supply, by currency, 2006–H1 2007 (%)
11%
US$
¥
Other
32%
57%
The sector split for hybrid supply into the Asia-Pacific investor market is highlighted in Figure 2.21.
Figure 2.21: Asia-Pacific investor market hybrid supply, by sector, 2006–H1 2007 (%)
9%
10%
Bank tier 1
Corporate hybrid
Insurance hybrid
81%
24
CHAPTER02
Bank Tier 1 sector

Bank Tier 1 supply accounts for over 80% of total supply into the Asia-Pacific investor market.
Figures 2.22 and 2.23 and Table 2.10 analyse the split of this supply by issuer region and currency,
and also highlight some of the largest bank Tier 1 transactions to be issued in the Asia-Pacific
Japanese banks account for over 50% of bank Tier 1 issuance into the Asia-Pacific investor market,
with deals from this issuer region typically in single-tranche format, and utilising both US$ (28%)
and JPY (72%). The Asia-Pacific investor market has provided opportunities for these banks to fund
in large size (Mizuho and Mitsubishi UFJ both issued US$1bn+ equivalent deals) and for repeat
issues (Mizuho and Shinsei).
Approximately 30% of bank Tier 1 supply comes from other Asia-Pacific banks in issuer regions
such as Australia, Thailand, Malaysia, the Philippines and South Korea, with deals denominated
either in US$ or the domestic currency.
The remaining supply comes from bank Tier 1 issuance from European issuers (14%), with US
banks relatively inactive, contributing to 3% of total volumes.
Figure 2.22: Asia-Pacific investor market bank Tier 1 supply, by issuer region,
2006–H1 2007 (%)
5%
1%
2%
8%
Japan Thailand
5%
India Switzerland
3%
France South Korea
2%
Australia Philippines
3% 59%
US Netherlands
5% UK Malaysia
6%
7%
Figure 2.23: Asia-Pacific investor market bank Tier 1 supply, by currency, 2006–H1 2007
(%)
3%
US$
38% ¥
Other
59%
25
CHAPTER02
Table 2.10: Asia-Pacific investor market bank Tier 1 hybrid supply – select issues by
size, 2006–H1 2007
Size Size
Japan Mizuho Capital Investment (JPY) 1 Ltd 22 Dec 2006 ¥ 400,000 4,744 2.960 Jun 2016 Perpetual
Japan MUFG Capital Finance III Ltd 10 Mar 2006 ¥ 120,000 1,586 2.680 25 Jul 2016 Perpetual
South Korea Woori Bank 25 Apr 2007 US$ 1,000 1,000 6.208 02 May 2017 2 May 2037
Japan Shinsei Bank Ltd 16 Feb 2006 US$ 775 775 6.418 20 Jul 2016 Perpetual
Japan Shinsei Bank Ltd 14 Mar 2006 US$ 700 700 7.160 25 Jul 2016 Perpetual
Japan Mizuho Capital Investment (USD) 1 Ltd 09 Mar 2006 US$ 600 600 6.686 30 Jun 2016 Perpetual
Japan STB Preferred Capital 3 (Cayman) Ltd 23 Feb 2007 ¥ 50,000 589 2.830 25 Jul 2017 Perpetual
India State Bank of India 08 Feb 2007 US$ 400 400 6.439 15 May 2017 Perpetual
United Kingdom Aberdeen Asset Management plc 11 May 2007 US$ 400 400 7.900 29 May 2012 Perpetual
France BNP Paribas SA 16 May 2007 US$ 600 600 6.500 06 Jun 2012 Perpetual
US Lehman Brothers UK Capital 15 May 2007 US$ 500 500 6.900 01 Jun 2012 Perpetual
Funding V LP

Insurance sector issuance into Asia remains undeveloped at present, but looks set to become a
growth area for the future as large insurance companies look to repeat issue in the market and
diversify into new investor bases. Figures 2.24 and 2.25 and Table 2.11 analyse the split of this
supply by issuer region and currency, and also highlight some of the largest insurance hybrid
transactions to be issued in the Asia-Pacific investor market in 2006 and H1 2007.
Figure 2.24: Asia-Pacific investor market insurance hybrid supply, by issuer region,
2006–H1 2007 (%)
31% 35% Switzerland

France
Australia
34%
Figure 2.25: Asia-Pacific investor market insurance hybrid supply, by currency,

2006–H1 2007 (%)
31% US$
A$
69%
26
CHAPTER02
Table 2.11: Asia-Pacific investor market insurance hybrid supply – select issues by size,
2006–H1 2007
Size Size
Switzerland ELM BV (Swiss Re) 20 Apr 2007 A$ 300 253 7.635 25 May 2017 Perpetual
Switzerland ELM BV (Swiss Re) 20 Apr 2007 A$ 450 379 FRN 25 May 2017 Perpetual
Australia QBE Capital Funding LP 25 Apr 2007 US$ 550 550 6.750 02 May 2017 Perpetual
France AXA SA 11 Oct 2006 A$ 300 253 7.500 26 Oct 2016 Perpetual
France AXA SA 11 Oct 2006 A$ 300 253 FRN 26 Oct 2016 Perpetual
France AXA SA 27 Oct 2006 A$ 150 126 7.500 26 Oct 2016 Perpetual

Corporate hybrid issuance in Asia is also a new area for development. Figures 2.26 and 2.27 and
Table 2.12 analyse the split of this supply by issuer region and currency, and also highlight some
of the largest corporate hybrid transactions to be issued in the Asia-Pacific investor market in
2006 and H1 2007. Most recently, Japan saw the first corporate hybrid transaction from
supermarket chain Aeon, which was placed domestically within the institutional investor base.
Figure 2.26: Asia-Pacific investor market corporate hybrid supply, by issuer region,
2006–H1 2007 (%)
15%
Germany
Australia
Japan
26%
59%
Figure 2.27: Asia-Pacific investor market corporate hybrid supply, by currency,

2006–H1 2007 (%)
15%
US$
A$
¥
26%
59%
27
CHAPTER02
Table 2.12: Asia-Pacific investor market corporate hybrid supply – select issues by size,
2006–H1 2007
Size Size
Germany Porsche International Financing plc 19 Jan 2006 US$ 1,000 1,000 7.20 01 Feb 2011 Perpetual
Australia Woolworths Ltd 10 May 2006 A$ 600 506 FRN 15 Sep 2011 Perpetual
Japan Aeon Co Ltd 20 Sep 2006 ¥ 26,500 312 FRN 29 Sep 2011 29 Sep 2056
Japan Aeon Co Ltd 20 Sep 2006 ¥ 4,500 53 3.25 29 Sep 2011 29 Sep 2056
RPB versus institutional investor markets

The investor base for hybrid securities can be split into two groups: institutional investors (asset
managers, pension funds, insurance companies, hedge funds, banks) and retail private bank (pure
retail ‘mom-and-pop’ and private banks). This is further discussed in chapter 4.
Figure 2.28: European investor market supply, 2006–H1 2007 (%)

12%
Institutional
Retail private bank
88%
Figure 2.29: US investor market supply, 2006–H1 2007 (%)
41%
Institutional
Retail private bank
59%
28
CHAPTER02
Figure 2.30: Asia-Pacific investor market supply, 2006–H1 2007 (%)
22%
Institutional
Retail private bank
78%
Issuer regions
Table 2.13: Global hybrid market supply, by issuer sector, 2006–H1 2007 (€, %)
% split by investor market
US European Asian
Issuer jurisdiction Volume (€. equiv) % investor market investor market investor market Total
US 55,947 37 92 7 1 100
Europe 74,071 49 21 74 5 100
Asia-Pacific 19,332 13 22 22 56 100
Other 2,979 2 73 27 0 100
Total 152,329 100 – – – –
Conclusion
So what can be expected for the shape of the hybrid market going forward?
Hybrid issuance can be expected to continue to grow, with straight refinancing requirements and
risk-weighted asset (RWA) growth anchoring expected issuance volumes. Revisions to regulatory
guidelines for financial institutions could also lead to marginally greater issuance, and new
regulatory guidelines established in emerging and new jurisdictions will be key areas of growth
for these markets running forward. M&A-driven issuance will also continue to be a major variable
going forward.
Cross-border issuance, one of the key trends of the hybrid markets in recent years, looks set to
continue to expand, which will also support the issuance of multi-tranche multi-currency transac-
tions as issuers benefit from targeting multiple investor bases.
New markets will continue to be established and it can be expected that more ‘firsts’ from new
jurisdictions. The Middle East, Latin America and Asia are likely to be the key players, particularly
in bank capital where regulatory frameworks are becoming increasingly transparent and interna-
tional investors gain diversification for an attractive spread.
The drive for innovation, balance sheet optimisation and evolution of the rating agencies’
methods have increased the sophistication of market participants. The product is becoming in-
creasingly complex, as new issuers and rating agency revisions lead to some new structural
nuances with certain product features.
We expect even more and better opportunities in 2007, as new markets open and an ever broader
range of issuers benefit from hybrid security equity features. This is the exciting and challenging
aspect of hybrids – they defy limiting definitions and are adaptable to evolving objectives.
29
CHAPTER WHY ISSUE HYBRID CAPITAL
03 SECURITIES?
Introduction
Hybrids are low cost equity! The growth and evolution of hybrid securities is due to the many
‘equity benefits’ that hybrid securities provide. The bottom line is: if you need equity – hybrids are
typically the lowest cost form of equity or quasi-capital. A clear illustration of the benefits is via
the weighted average cost of capital (WACC) calculation, as will be demonstrated.
The Bank for International Settlements (BIS) bank capital guidelines have played a key role in the
beginnings of the asset class now called hybrid capital securities. The need for prescribed
amounts of capital to support risky assets drives the behaviour of financial institutions that are by
far the most active issuer group for hybrid capital securities. Preferred stock (also called
preference shares) are an example of the lower cost alternatives to common equity for meeting
bank Tier 1 capital requirements. Hybrids are an evolution of preferred stock – engineered to be
more investor friendly and tax efficient for the issuer. Other forms of more debt-like subordinated
securities are permissible to form Tier 2 and Tier 3 capital. Since the late 1990s billions of hybrid
capital securities were issued by banks to satisfy their regulatory capital requirements. As
insurance companies also look to meet capital requirements under the developing solvency rules
(which are converging with the bank capital rules) they too have turned to hybrid capital
securities. Hybrid capital securities provide the most cost-effective way to raise regulatory capital
for banks and insurance companies.
A key catalyst to recent hybrid new issue volume growth was the publication of hybrid security
equity credit guidelines from all of the major rating agencies (Moody’s, S&P, Fitch). These
guidelines made it clear that rating agencies view the financial flexibility and equity-like charac-
teristics of hybrid securities very favourably when conducting their financial analysis of the
issuer’s balance sheet and key financial ratios such as debt/equity leverage ratios. As hybrids
provide these benefits they strengthen the capital structure of the issuer and provide support for
the ratings at their current level. Issuing a hybrid capital security instead of senior debt is a low-
cost way to complete a debt financing in a ‘leverage light’ fashion because the hybrid adds some
equity to the issuer’s balance sheet in the rating agency ratio calculations but costs the issuer far
less than issuing common stock. Although these benefits were often pursued via hybrid issuance
prior to the publication of the guidelines, the black and white prescription for equity credit in the
guidelines gave potential issuers a greater belief in the rating agency conviction toward the value
of hybrids in the capital structure.
The rating agency publications coincided with an explosion in debt-financed M&A activity and the
use of hybrid capital securities in M&A was a key feature of many of the major deals that were
completed. In addition issuers used hybrids for accounting equity, currency hedging, and pension
liability funding. The list of possible issuer rationales continues to grow and in some cases has
nothing to do with the original catalysts of regulatory capital or rating agency equity. Logically
the types of issuers have gone beyond regulated financial institutions to include corporate issuers
from a variety of sectors such as utilities, manufacturing, REITS, gaming, travel/leisure, energy
and consumer products.
The rationale for issuance

Hybrids are low-cost equity from a WACC perspective. The academic framework of the capital
asset pricing model (CAPM) can be borrowed to demonstrate how hybrids can be a smart way to
reduce the WACC and increase ROE which should add value to the common shareholders
invested in the hybrid issuer. In this example it is assumed that a hypothetical issuer rated in the
BBB level needed to raise funds and a hybrid is evaluated compared to a combination package of
part senior debt and part common stock. Using the Moody’s terminology of Basket C (50% equity)
and Basket D (75% equity) Figure 3.2 shows the added value and cost savings (calculated in basis
points) provided by using a hybrid capital security instead of the debt/equity combo package.
31
CHAPTER03
Figure 3.1: The cost of common equity (expected market return), by country (%)
Europe USA United Kingdom
Risk premium : 6.94 Risk premium : 5.52 Risk premium : 6.10

Risk free rate : 4.39 Risk free rate : 4.55 Risk free rate : 5.03
Market return : 11.33 Market return : 10.07 Market return : 11.13
Japan Hong Kong Canada

Denmark Sweden Australia

Expected market returns range between 9-12%
Source: Bloomberg L.P.
Figure 3.2: WACC calculation – common equity vs. hybrid debt (%)
Cost before tax (%) Cost after tax (%)
Equity 10.25 10.25

10-yr senior debt 4.92 3.44
50% Equity + 50% 10-yr senior debt 7.585 6.845

-242bp
100% Hybrid (basket C) 6.310 4.42
75% Equity + 25% 10-yr senior debt 8.917 8.548

-390bp
100% Hybrid (basket D) 6.63 4.65
Hypothetical assumptions (all numbers illustrative only)

1 - Senior Spread of +75bp over Mid-Swap giving a cost of 10yr Debt of 4.92% before tax
2 - Corporate Tax Rate of 30%
3 - Cost of Equity (Refer to Cost of Common Equity Figure 3.1)
4 - Hybrid Costs are based on Corporate Hybrid secondary trading levels which are subject to change
5 - Methodology used: Capital Asset Pricing Model
When comparing the gross fixed annual cost of the hypothetical hybrid security to a debt/equity
combo package it is clear that both the Basket C and Basket D scenario produce a significant cost
benefit (approximately 120 to 230bp) for the hybrid issuer.
What is even more compelling is the after-tax comparison, where the hybrid payments are
structured to achieve tax deductibility and savings of 242bp and 390bp respectively are achieved
by issuing the hybrid instead of the debt/equity combo.
In this hypothetical example where it was assumed that a hybrid annual cost of about 6.5%
(average cost between Basket C and Basket D) and an after-tax cost of about 4.5% it should be clear
that this also compares favourably to the current common dividend yield of some issuers. When
the current and future higher common dividends and their dilutive impact are considered the
fixed hybrid cost looks very good indeed.
32
CHAPTER03
For issuers that expect the market value of their common equity shares to continue to increase
over the forecast future period (such as issuers engaged in share buybacks) it is much cheaper to
issue the fixed cost non-dilutive hybrid now and retain all the upside of the common stock for the
current common shareholders (the hybrid inflicts no new share issue dilution). For the same
reason the issue of a fixed cost hybrid will most often be less expensive than a convertible or
equity-linked security if the potential dilution of the convert is taken into account as shown in
Figure 3.3 for an issuer with average or greater forecast annual growth (expressed as the
Compound Annual Growth Rate – CAGR).
Figure 3.3: Evaluating equity alternatives - hybrid is low cost equity
Cost of equity %
20 Common equity
Convertible Sec.
Hybrid Capital Sec.
15
10
-5
-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
CAGR
Recent hybrid security issuance has also been stimulated by clarity in the published methodolo-
gies used by the three major rating agencies on the overall impact of hybrid capital in capital
structure and on the issuers’ senior debt ratings. This has allowed both issuers and investors to
make better informed assessments of the risks and benefits involved.
The increased dialogue with investors and financial engineers is leading to product evolution and
enhancements that will bring the hybrid security benefits to an ever larger population of
investors and issuers globally. Since the latest methodologies in use by the rating agencies can
give a high level of equity credit for specific instruments there is fresh stimulus for corporate
issuers and financial institutions that value the ratings support. In general the motivations for
issuance across sectors can be summarised as in Figure 3.4. Banks are predominantly focused on
the regulatory aspects but the ratings benefits are taking on increased import. Insurance
companies also focus on the regulatory capital aspects of hybrid securities but have shown a more
rapid adoption of the ratings methods that should ensure high rating agency equity credit. For
unregulated corporate issuers the benefits are predominantly ratings driven but can sometimes
be driven by a desire to book accounting equity either alone or in addition to ratings agency
equity. The accounting equity motivation has even been exhibited by not-rated corporates where
there is zero concern for the rating agency perspective. Given the strong market conditions and
the attractive pricing of hybrid securities, some issuers just view the addition of hybrid capital as a
cheap long-term funding and/or a way to diversify the investor base.
Figure 3.4: Issuer motivations
Banks Insurance Corporates

Accounting
Regulatory Tier 1
Regulatory Tier 1 Capital
Capital Ratings
Ratings
Ratings
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Who issues hybrid capital securities?

Recently, the hybrid capital securities market experienced record new issue volumes. The market
has seen a ‘new renaissance’ of hybrid capital structuring, and insurance companies' funding
needs have been well supported by structural developments in the sector. With bank Tier 1
supply remaining stable, the insurance sector was a key driver for growth, fuelled largely by
M&A-related funding requirements and characterised by jumbo multi-tranche multi-currency
transactions in the global hybrid market.
Hybrid capital securities remain the most efficient way to optimise the capital structure, and the
market’s focus has led to continued evolution beyond a static definition along the debt-equity
continuum. Hybrid securities can be compared to classical preferred stock and this ‘preferred
stock paradigm’ serves a basis for defining quasi-equity. With the terms of classic preferred stock
tweaked to reduce the equity characteristics just enough to enhance tax efficiency while
maintaining regulatory and/or rating agency benefits, hybrid capital securities can be considered
as ‘synthetic preferred stock’ or equity-rich deeply subordinated debt capital. This approach
provides a useful framework for evaluating this growing fixed income asset class.
The current period is now reminiscent of the mid-1990s, when banks were rapidly innovating
country-specific variants of tax-efficient capital and issuance volumes surged. Investors were
attracted by yield, but wary of structural nuances and the potential for ‘embedded risk’ within the
emerging hybrid asset class. Over time, structural details faded from significance, as greater
outstanding issuance volumes and liquidity led to understanding, commoditisation and perhaps a
degree of complacency.
The major issuers therefore include:
0 Regulated financial institutions:

- Bank Tier I regulatory capital;
- Insurance Tier I equivalent regulatory capital;
0 Corporate hybrid (rating agency or accounting equity, quasi-capital).
Banks – The banks led the dynamic global development of hybrids (cheap regulatory Tier 1
capital) and early investors took comfort from generally high credit quality, the importance of
market liquidity/reputation, and assumed regulatory support for major banks. The ‘belief’ is that
generally major banks will make payments, will call at the first call date and if failing, the banks
considered ‘too big to fail’ will be bailed out or supported and smaller banks may be merged by
the national regulator for the sake of the overall financial system. History supports this for the
majority of banks and bank capital securities are often more ‘equity-like’ than other sectors.
Most banks around the world have typically been obliged by their national banking regulators to
maintain a certain amount of equity capital to support their business risks. This regulatory capital
serves as a protection for depositors and creditors against unexpected losses as these can be
absorbed by the capital, thereby cushioning the claims of depositors or the repayment of debt.
Capital security features also provide financial institutions with flexibility.
The global hybrid funding opportunity is one of the major themes set to continue in the capital
markets. Hybrid issuance via multi-tranche, multi-currency transactions in markets around the
world has allowed for increased product capacity, which has helped to facilitate very large M&A
funding requirements. New and developing markets have also been targeted by issuers to
diversify the investor base and maintain overall price tension.
Insurance companies – Hybrids have been used by insurance companies for both capital and
rating agency equity in the past. They have been issuing hybrid capital in anticipation of the
convergence of bank capital regulation under Basel II with the insurance capital regulation under
Solvency II and also to support the strategically important credit ratings of the issuer. The benefits
of hybrid issuance are heightened in an M&A scenario.
On the Insurance side one such issuer was Axa, which successfully raised €3.8bn equivalent of
Tier 1 capital in 2006 – the largest annual hybrid funding exercise from a European insurer at that
time. This was achieved via a number of multi-tranche transactions worldwide – the proceeds of
which were to be used to refinance the €7.9bn acquisition of Winterthur from Credit Suisse. The
first transaction in June comprised three tranches, a £500m Perp nc 10, £350m Perp nc 20 and
€1bn Perp nc 10.
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Axa also achieved further diversification and successfully tapped ‘new world’ hybrid markets
including the Australian dollar market (the first to issue an Australian dollar Tier 1 Basket D
security), followed by a dual-tranche long duration US dollar transaction in December.
Clarification of the Italian fiscal and regulatory classification of hybrid Tier 1 securities paved the
way for the first insurance sector hybrid Tier 1 deal from Italy, with Generali issuing €2.8bn
equivalent in June. Generali also benefited from the three-pronged approach, pricing a Euro-
Sterling array comprising three tranches, a €1.275bn perpetual nc 10, £700m perp nc 10 and
£350m perp nc 20.
Further cross-border issuance was also seen from Swiss Re, which tapped the US dollar market via
a dual-tranche Euro–US dollar issue in May. This was in spite of the NAIC chill in the US market at
the time. This followed the reassessment of the Lehman ECAPS issue and other US dollar hybrid
securities by the NAIC, which had a profound effect on the market in the second quarter, causing
wider Tier 1 US dollar spreads and severe but temporary limitations to US market access (see the
NAIC website: www.naic.org).
For insurance companies the business risks differ from banks, the credit quality is on average
lower than major banks, there is less historical data, regulation is less developed and market
liquidity is less essential. Investors require increased structural protection in insurance hybrids,
given the relatively higher business risks of insurance companies and less regulatory oversight.
The issuers have complied to reduce hybrid issue costs and optimise the equity benefits. German
insurers were among early hybrid pioneers and some of the quirks of the German tax code
shaped the development of the current insurance hybrids as discussed in the structuring section
of this publication.
Non-regulated corporate/industrial companies – These hybrid issuers are usually seeking rating
agency or accounting equity at a lower cost than common stock or equity-linked issuance. In
general, non-dilutive hybrid capital securities are the cheapest form of equity capital for
companies that are regulated, or fast growing, or have an average or higher equity cost. Corporate
hybrid issuers exhibit the least systemic support (unregulated, lower liquidity/reputation motives,
perhaps less market sophistication/financial dexterity). Therefore more heterogeneous features
and a faster reversion back towards the certainty of traditional debt in structuring corporate
hybrids can be observed– particularly where rating agency equity is not a key driver.
Figure 3.5 gives an overview of some of the corporate issuers and an indication of what their issuance
rationale may be in deciding to issue hybrid securities. Some issuers have multiple overlapping rationales.
Figure 3.5: Issuance rationale for select corporate issuers
Strengthening capital structure Pension Non dilutive

M&A
(including debt refinancing) obligations capital
SOLVAY CASINO HENKEL OTTO
LOTTOMATICA DONG VATTENFALL
TUI MICHELIN
GLENCORE
VINCI
SUEDZUCKER
REXAM
BAYER
WIENERBERGER
UNION FENOSA Foreign Currency Hedging
M&G THOMSON
VOESTALPINE LINDE CEMEX
PFLEIDERER PORSCHE
EUROGATE IVG
CLAAS
EUROFINS SCIENTIFIC
BEHR
SIEMENS
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Drivers for issuing hybrid capital securities

Hybrids can help support a number of strategic initiatives, including but not limited to the
following:
0 Raise regulatory capital;

0 Strengthen rating agency credit metrics;
0 Finance M&A activity;
0 Balance sheet optimisation;
0 Reduce WACC, increase ROE;
0 Enable common equity buyback;
0 Make special dividend payments;
0 Refinance pension or other liabilities.
There are also opportunistic reasons to issue hybrids, including:
0 Attractive pricing;
0 Permanent funding;
0 Tapping new investor base.
In sum, financial flexibility is a key benefit to ‘equity’ and hybrids are very low-cost equity.
Below, some of the landmark corporate hybrid deals are discussed to give some insight into the
commercial rationalisation for their issuance. Among the pioneering issuers were Linde and
Michelin, which helped develop the market well ahead of the release of the Moody’s Toolkit and
subsequent rating agency publications.
Michelin
A landmark deal in European hybrid capital was Michelin's subordinated offering launched in
2003. The 30-year nc 10 structure proved popular with investors at issue and it pre-dated the
release of clarifying comments from the rating agencies on how to get more equity credit.
Michelin Finance, the issuing entity, was rated Baa1/BBB+, so the notched subordinated bond was
rated Baa3/BBB-. The hybrid security strategy, allowed Michelin to increase its long-term capital
base without diluting its common equity share capital and dilution was something the major
shareholders (the Michelin family) wanted to avoid. This is a common theme among family-
owned businesses.
Linde
German industrial gas and engineering group Linde issued hybrid securities to refinance senior
debt via its finance arm, Linde Finance, which issued €400m in perpetual nc 10 subordinated
bonds. Linde’s deal was considered the first undated Euro-denominated subordinated offering by
a European corporate targeted to the European institutional market, and opened up a new
market in hybrid capital for the non-financial corporate universe. By using the proceeds to
refinance senior debt, Linde will be able to strengthen its capital base and demonstrate its
commitment to its credit ratings.
The surge of corporate issuance which heralded the ‘next generation’ of corporate hybrids
included Südzucker, Vattenfall and DONG. These well known and high-quality issuers provided
large, liquid institutionally targeted ‘benchmark’ hybrid transactions within a short span of time
– commanding the attention of investors and the financial media for an emerging new asset class.
Among these deals the variety of terms within the structures demonstrated the diversity of
features that could differentiate quasi-equity hybrids in accordance with the new rating agency
guidelines while allowing for differences in national legal and tax regimes. Linde later issued the
first Sterling corporate hybrid.
Südzucker, Vattenfall and DONG

German sugar manufacturer Südzucker priced its €500m perpetual nc 10 and the Swedish state-
owned utility Vattenfall opted for a similar structure for its €1bn deal. Vattenfall managed to
generate a higher level of equity treatment from S&P with 60% equity credit and Basket D
treatment (75% equity) from Moody's. Südzucker also achieved Basket D treatment with Moody's
but was assigned 50% equity from S&P. All issuers looking at the hybrid security market are
attracted by the more generous ratings treatment now assigned to such structures and for state-
owned entities – for which issuing equity is more difficult – the hybrid security structure offers a
new solution for generating equity credit.
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“Due to the government ownership structure, we have restricted access to equity capital and we
saw this as an interesting alternative. We have been working on the transaction for 10–11 weeks,
but did not make the decision to launch a transaction until this week, when we had the feedback
from the roadshow. Vattenfall has been looking at the hybrid capital market for quite some time,
but has previously disregarded it since volumes obtainable were not meaningful within the
context of our balance sheet and the ratings agencies were less clear on their treatment of such
transactions," said Anders Lidefelt, treasurer of Vattenfall at the time in discussion with IFR.
Danish state-owned utility Dansk Olie Og Naturgas (DONG) generated more than €3bn of demand for
its €1.1bn hybrid. The choice of a 1,000 year maturity rather than perpetual reflects the differing tax
requirements across jurisdictions, making a Danish perpetual less efficient from a tax perspective.
"We viewed the hybrid as a way of raising equity capital for an issuer with limited access to equity.
The decision came from some recent M&A activity where we had the option of paying in shares
and by selling the hybrid we were able to exceed our equity requirements," said Morten
Buchgreitz, head of treasury and risk management at DONG in discussion with IFR.
Although the DONG transaction follows the basic structure seen for the two earlier transactions,
there are some structural differences, with the DONG hybrid achieving a slightly lower level
equity treatment with Moody's (50% or Basket C). The issuer chose a more bond-like structure that
did not have the mandatory deferral mechanism and was quasi-cumulative. While the Moody’s
Basket C equity credit is lower, the investor pricing was more attractive for DONG and required a
lower premium to the senior bonds than a Basket D would have. "We were initially looking at 75%
equity treatment, but chose 50% as a trade-off between the equity credit we could achieve and the
price we had to pay," said Buchgreitz.
"The hybrid product has applicability for a broad range of sectors and is a long-overdue development
for European corporates. We are currently in a sweet spot where it makes sense for a lot of issuers
and is probably cheaper now than it might be in the future," said Steve Sahara at the time of the deal.
Henkel
German consumer products company Henkel issued a €1.3bn 99-year nc 10 hybrid to fund its
pension liabilities. The Fortune Global 500 company used the hybrid security proceeds to
establish a contractual trust arrangement (CTA) for the benefit of the employees owed a pension.
The pension trust will provide for investment to meet pension obligations when they come due.
Henkel used the hybrid very effectively to fund the employee pension liability, thereby further
enhancing employee morale and meeting socially important commitments. The payment
flexibility of the Henkel hybrid considered in the overall capital structure was far more ratings
friendly than if the pension liability were to be funded with senior debt issuance and the hybrid
provided a far lower cost than an issuance of common equity. If Henkel were to suffer financial
distress the hybrid can absorb losses and allow for cash conservation. Senior debt would not do
this and nor would the employee pension liabilities. So replacing the inflexible pension liability
with the more flexible hybrid should be a real positive factor for the issuer’s credit profile. As
more companies come under pressure to address large and growing unfunded employee pension
schemes the Henkel example may provide an alternative for many other issuers to consider.
Porsche
German car manufacturer Porsche issued a US$1bn perpetual nc five hybrid sub-debt. The strong
name recognition overcame the lack of a credit rating. The structure includes optional deferral of
payments if no common equity dividend is paid, and deferred coupons are cumulative. The dollar-
denominated hybrid generated global demand driven by Asian RPB investors who have tradition-
ally purchased subordinated bonds from the global banking sector. For Porsche, the transaction
provides a currency hedge against US dollar receivables. Despite the subordinated, cumulative
structure, the hybrid achieves full equity accounting treatment under IFRS because of the
payment discretion provided. Porsche’s hybrid was a market leader ahead of the now increasing
number of corporates that are using hybrids to benefit from an accounting perspective.
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Glencore
Like Porsche, Glencore also visited the Asian RPB markets with a US$700m perpetual nc five
senior issue. The bonds were also placed primarily with Asian and Swiss Private Banks. Since
there is no ratings benefit intended or accounting equity credit assigned, the issuance rationale
comes down the fact that Glencore is a privately held company that has not tapped capital
markets to raise common equity capital. Although there is no equity credit assigned to the paper
from an accounting standpoint, as a perpetual security, Glencore obtains low-cost, long-term
quasi-capital with no incentive for calling the issue at the call date after the first five years.
Furthermore, the hybrid security is non-dilutive allowing the common equity owners to retain all
upside and voting control in the privately held company.
CEMEX
CEMEX, the Mexican cement company, issued a US$1.25bn hybrid security in 2006. The unique
dual-tranche (US$900m perp nc 10 and US$350m perp nc 5) transaction was driven by the
motivation to hedge FX exposure from some Asia business units with an equity-like instrument
issued in dollars and euros, and to gain accounting equity treatment. CEMEX was not specifically
seeking to improve the capital structure of the company, nor to upgrade its existing rating.
CEMEX followed up its successful hybrid debut with another issue in May 2007, this time tapping
the Euro market for a €730m hybrid perp nc 10 transaction.
Interview
The following Q&A interview is with Johan Gyllenhoff, President of Vattenfall Treasury AB and Group Treasurer
for the Vattenfall Group. Based on 2006 figures, Vattenfall is the fourth largest generator of electricity and the
largest generator of heat in Europe. The company both produces and delivers electricity throughout Europe,
and provides a wide range of additional energy solutions and services, in addition to add-on services such as
telecoms.
Vattenfall is also a pioneer in the European debt markets, achieving significant success with their €1bn hybrid
issue, one of the first corporate hybrid transactions to be issued after the rating agencies gave clarification to
their guidelines in 2005.
This interview provides an interesting insight into the main drivers for issuing hybrid securities, and also
highlights the subsequent benefits achieved from such a transaction.
What have been the main drivers of your decision to issue hybrids?
As Vattenfall is a government-owned company its access to capital through issuing new equity is more limited
than for its listed peers and competitors. Therefore, seeking a substitute instrument geared to the rating
agencies that would provide us with significant equity credit is very interesting, especially as we have a very
strong management commitment to a single A rating. In general, you can say that hybrids work well for
companies that operate in a stable and profitable business and also want to grow and take market share
through acquisitions, which is the case for Vattenfall.
How has the issuance of hybrids delivered the intended benefits or failed to do so?
The issue of the hybrid security immediately lowered our average cost of capital and at the same time gave us
greater financial flexibility, i.e. improved our capital base. An alternative for us could of course have been to
create the same base for growth by ‘sitting and waiting’ for operating cash flow to accumulate. That would
have taken us about one-and-a-half years, so effectively we bought ourselves ‘time’.
What advice, tips, or warning would you give a first-time hybrid issuer?
Our experience is that you have to have many dialogues open at the same time in order to explain, convince
and/or educate your different stakeholders. One important party that is not mentioned in your question is the
auditors. You need them ‘on the boat’ too. But the key is of course to educate and convince your Board of
Directors and have a close dialogue with the rating agencies.
How might the new imposition of legally binding replacement language from S&P have impacted your
evaluation of issuing hybrids, if that requirement had existed at the time of your initial analysis of the
hybrid opportunity?
That is difficult to say. I believe we would have issued, but it would probably have looked different, as we have
difficulties in accepting a legally binding replacement language.
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In general, does the perception of frequent shifting of rating agency requirements decrease the attrac-
tiveness of hybrids as a corporate finance tool?
In general, yes, but I guess that is something we will have to live with to at least some extent. The reason for this
probably lies in the very nature of this mezzanine product and the problem of ‘pleasing many masters’, i.e.
rating agencies, issuers, investors, tax authorities, auditors etc.
What changes, if any, would you like to see in future hybrids?

Less change.
Interview
The following Q&A interview is with Johannes D. Wolvius, Head of Corporate Treasury at ING Group. ING
Group is a global financial services company, providing a wide array of banking, insurance and asset
management services in over 50 countries. Based on market capitalisation, ING is one of the 20 largest
financial institutions worldwide, ranked in the top 10 in Europe and the number one financial services
company in Benelux.
ING is a frequent and prominent issuer in the global hybrid markets. Most recently in September 2007, ING
launched a US$1.5bn hybrid capital transaction which was a notable success from both from a size and
pricing perspective.
1) Can you describe the ING hybrid capital budgeting process you undertake each year to determine
the amount of hybrid capital you might raise in the next year (asset growth, business changes, hybrid
redemptions, etc)?
On a yearly basis in December we draw up next year's funding plan, which is directly derived from ING's
Medium Term Plan for the next three years. With the funding plan we try to make sure that by the end of
each year, ING's hybrid capacity is fully used to optimise our capital structure. We try to co-ordinate all
capital markets activities for the Group and this plan is then used throughout the year and updated on a
quarterly basis, taking into account factors such as our growth rate, the potential for acquisitions and the
state of the market.
Although we have quite a stringent plan set up at beginning of the year, we have a flexible approach and
adjust it according to market circumstances and also time it well – throughout the year – if spreads are good
at the start of the year, we try to do more at that point and vice versa.
2) Can you tell us about the ING project you undertook to start with a ‘clean piece of paper’ and structured
your own capital security? What were the benefits and/or challenges of this unique approach?
Hybrid capital structuring has almost become an industry in itself. There has been a race among investment
banks, rating agencies and regulators to include more and more features which adds to the complexity but, in
our view, does not always improve the instrument. It is our responsibility and decision to stay the AA rated
company that we are. From our perspective hybrid capital should be about maximising financial flexibility. We
think that it is not desirable to build future behaviour into hybrid capital through features such as
replacement covenants, certain mandatory deferral triggers or caps.
Earlier in the year, we conducted an independent review of our hybrid capital in order to maximise the
financial flexibility that these instruments provide, make the instruments more equity-like from our
perspective, simplify the terms and conditions used and align the structures that we use in the European and
US markets. Two law firms (one international and one Dutch) were hired and we had extensive discussions on
how each of the features would work out in stress scenarios. Based on this, some adjustments to the
structures were made and we achieved our objectives. While we believe that we have optimised our structure
to help us overcome any form of financial distress, from a Moody's perspective we are still only getting a 'B'
qualification, which we see as a curious outcome of their methodology.
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3) ING is an example of a bank/insurance issuer that successfully balances the dual requirements of
two regulatory constituents simultaneously. Can you highlight the way you approach this complex
task (any difficulty in reconciling regimes etc)?
Our main objective is to make sure that ING Groep NV, ING Bank NV and ING Verzekeringen NV are capitalised
according to the AA standard independent of each other. We have one issuing entity for our hybrid tier 1 transac-
tions – the top holding company ING Groep NV – in order to achieve the maximum flexibility in the deployment
of the capital. In this way it can be assured that all terms and conditions of our hybrid capital are well aligned.
Hybrid tier 1 raised by ING Groep NV is on-lent to either ING Bank NV or ING Verzekeringen NV where it can be
used to support the business. This is done on the same conditions as it was placed in the market.
In terms of how we optimise the structure while reconciling the requirements of both sets of rules for banks
and insurers, we have so far focused mainly on the guidelines for Bank Tier 1 Capital which are very specific,
and have then applied this for insurance capital purposes. We primarily manage our business according to our
own economic capital models and then try to achieve ensure that rating agency credit and the rating agency
assessment of capitalisation follow suit.
4) You expressed a desire to "keep your hybrid capital simple" and have also chosen not to pursue the
complexities of the high equity rating agency ‘baskets’. We have also seen this choice from highly
rated Banks that issue ‘pure Tier 1’ only. However many large insurance groups including other
Benelux bank/insurers have gone for Basket C and Basket D hybrid structures - what are the key
drivers of ING's decision?
We are concerned about basket treatment and, in principle, we would be inclined to strive for a higher basket.
But in order to achieve that, rating agencies require us to add features which we think would limit our
financial flexibility. For example, in the case of mandatory deferral and replacement capital covenants there
are instances when it would limit our ability to deal with financial distress. We would only change our hybrid
terms if it would result in a structural improvement. Our strategy is to be consistent and transparent towards
our hybrid capital holders; not to change our hybrids according to the flavour of the day.
5) What is your thinking about the hardening of S&P's new requirement for legally binding
replacement language for unregulated step up hybrids?
ING values its AA rating and aims to maintain that rating because we think it's important for our clients and
other counterparts. From that perspective, we think that the rating agencies should not be overly focused on
the permanence of our capital. If we were to choose to reduce our overall capitalisation, there are many more
ways to do this such as entering into large acquisitions or share buybacks. In this context, we are unsure as to
why the rating agencies feel so strongly about replacement language when we have always had the flexibility
to utilise our own capital.
Conclusion
Market forces have conspired to create the perfect conditions for a boom in hybrid capital
security supply and innovation. Investors’ quest for yield and issuers’ need to fund asset growth
while also increasing ROE have produced a period of significant growth in hybrid issuance
worldwide. Regulators have become increasingly comfortable with the expanded use of hybrid
capital given the robust nature of structures now possible in most international jurisdictions.
Amidst this positive backdrop, however, credit should be given to the major rating agencies that
have invested significant time to develop their own thinking around the essence of equity and
how it can be practically distilled within a security class that is also fiscally beneficial to issuers
and marketable to fixed income investors. They have provided numerous educating publications
and support to this growing market. Looking back over the history of hybrid capital gestation, an
ever changing and improving asset class can be observed, and looking forward that evolution
looks set to continue from this rampantly fertile period.
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Table 3.1: A selection of major hybrid capital deals

Issue date Issue First
Issuer (year) Currency size (m) Coupon call date Maturity
Australia
ANZ Capital Trust I 2003 US$ 750 5.3600 Dec-13 Perpetual
ANZ Capital Trust I 2003 US$ 350 4.4840 Jan-10 Perpetual
ANZ Capital Trust III 2004 € 500 FRN Dec-14 Perpetual
CBA Capital Trust 2 2006 US$ 700 6.0240 Mar-16 Perpetual
Macquarie Capital Funding LP 2004 £ 350 6.1770 Apr-20 Perpetual
National Capital Instruments (Euro) LLC 2 2006 € 400 FRN Sep-16 Perpetual
National Capital Trust I 2003 £ 400 5.6200 Dec-18 Perpetual
National Capital Trust II 2005 US$ 800 5.4860 Mar-15 Perpetual
QBE Capital Funding LP 2006 £ 300 6.8570 Jul-16 Perpetual
QBE Capital Funding LP 2007 US$ 550 6.7970 Jun-17 Perpetual
Westpac Capital Trust III 2003 US$ 750 5.8190 Sep-13 Perpetual
Woolworths Ltd 2006 A$ 600 FRN Sep-11 Perpetual
Austria
Erste Capital Finance (Jersey) Tier 1 PC 2006 € 400 5.2940 Sep-16 Perpetual
Erste Finance (Jersey) 4 Ltd 2004 € 275 FRN Mar-09 Perpetual
Erste Finance (Jersey) 6 Ltd 2005 € 200 5.2500 Sep-10 Perpetual
Erste Finance (Jersey) Ltd 1999 € 100 6.6250 Feb-04 Perpetual
Hypo Alpe-Adria (Jersey) II Ltd 2004 € 130 6.5000 Oct-11 Perpetual
Kommunalkredit Austria AG 2006 € 150 5.4500 May-36 Perpetual
Oesterreichische Volksbanken AG 2004 € 250 6.0000 Sep-11 Perpetual
RZB Finance (Jersey) II Ltd 2004 € 200 6.0000 Jun-09 Perpetual
RZB Finance (Jersey) II Ltd 2003 € 100 5.8950 Jul-13 Perpetual
RZB Finance (Jersey) Ltd 2006 € 500 5.1690 May-16 Perpetual
Wienerberger AG 2007 € 500 6.5000 Feb-17 Perpetual
Belgium
Dexia Funding Luxembourg SA 2006 € 500 4.8920 Nov-16 Perpetual
Fortis Bank SA/NV 2001 € 1,000 6.5000 Sep-11 Perpetual
Fortis Bank SA/NV 2004 € 1,000 4.6250 Oct-14 Perpetual
Fortis Hybrid Financing 2006 € 500 5.1250 Jun-16 Perpetual
Solvay Finance BV 2006 € 500 6.3750 Jun-16 Jun-2104
Denmark
Danske Bank A/S 2004 US$ 750 5.9140 Jun-14 Perpetual
Danske Bank A/S 2007 € 600 4.8780 May-17 Perpetual
DONG A/S (Danish Oil & Natural Gas) 2005 € 1,100 5.5000 Jun-15 Perpetual
Nykredit 2004 € 500 4.9010 Sep-14 Perpetual
France
AXA SA 2006 € 1,000 5.7770 Jul-16 Perpetual
AXA SA 2006 £ 500 6.6666 Jul-16 Perpetual
AXA SA 2006 £ 350 6.6862 Jul-26 Perpetual
AXA SA 2006 US$ 750 6.3790 Dec-36 Perpetual
AXA SA 2006 US$ 750 6.4630 Dec-18 Perpetual
Banque Federative du Credit Mutuel 2004 € 750 6.0000 Dec-14 Perpetual
Banque Federative du Credit Mutuel 2005 € 600 4.4710 Oct-15 Perpetual
BNP Paribas Capital Trust 2000 US$ 500 9.0030 Oct-10 Perpetual
BNP Paribas Capital Trust III 2001 € 500 6.6250 Oct-11 Perpetual
BNP Paribas Capital Trust IV 2002 € 660 6.3420 Jan-12 Perpetual
BNP Paribas Capital Trust V 2002 US$ 650 7.2000 Jun-07 Perpetual
BNP Paribas Capital Trust VI 2003 € 700 5.8680 Jan-13 Perpetual
BNP Paribas SA 2005 US$ 1,350 5.1860 Jun-15 Perpetual
BNP Paribas SA 2005 € 1,000 4.8750 Oct-11 Perpetual
BNP Paribas SA 2006 € 750 4.7300 Apr-16 Perpetual
BNP Paribas SA 2006 £ 450 5.9450 Apr-16 Perpetual
BNP Paribas SA 2007 € 750 5.0190 Mar-17 Perpetual
BNP Paribas SA 2007 US$ 1,100 7.1950 Jun-37 Perpetual
CA Preferred Funding Trust 2003 US$ 1,500 7.0000 Jan-09 Perpetual
CA Preferred Funding Trust III 2003 € 550 6.0000 Jul-09 Perpetual
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Table 3.1: A selection of major hybrid capital deals (continued)

Caisse Nationale des Caisses d'Epargne 2003 € 800 5.2500 Jul-14 Perpetual
et de Prevoyance - CNCEP
Caisse Nationale des Caisses d'Epargne 2004 € 700 4.6250 Jul-15 Perpetual
et de Prevoyance - CNCEP
Casino Guichard-Perrachon SA 2005 € 500 7.5000 Jan-10 Perpetual
CL Capital Trust I 2002 € 750 7.0470 Apr-12 Perpetual
CNP Assurances SA 2006 € 1,250 4.7500 Dec-16 Perpetual
Compagnie Generale des Etablissements Michelin 2003 € 500 6.3750 Dec-13 03 Dec 2033
Credit Agricole SA 2005 € 600 6.0000 Feb-10 Perpetual
Credit Agricole SA 2005 € 600 4.1300 Nov-15 Perpetual
Credit Agricole SA 2006 £ 500 5.1360 Feb-16 Perpetual
Credit Logement 2006 € 800 4.6040 Mar-11 Perpetual
SG Capital Trust I 2000 € 500 7.8750 Feb-10 Perpetual
SG Capital Trust III 2003 € 650 5.4190 Nov-13 Perpetual
Societe Generale 2005 € 1,000 4.1960 Jan-15 Perpetual
Societe Generale 2007 US$ 1,100 5.9220 Apr-17 Perpetual
Thomson SA 2005 € 500 5.7500 Sep-15 Perpetual
Vinci SA 2006 € 500 6.2500 Nov-15 Perpetual
Germany
Allianz Finance BV 2005 € 1,400 4.3750 Feb-17 Perpetual
Allianz Finance II BV 2006 € 800 5.3750 Mar-11 Perpetual
Bayer AG 2005 € 1,300 5.0000 Jul-15 29 Jul 2105
BayernLB Capital Trust I 2007 US$ 850 6.2032 May-17 Perpetual
Commerzbank Capital Funding Trust I 2006 € 1,000 5.0120 Apr-16 Perpetual
Commerzbank Capital Funding Trust II 2006 £ 800 5.9050 Apr-18 Perpetual
Depfa Funding IV LP 2007 € 500 5.0290 Mar-17 Perpetual
Deutsche Bank Capital Finance Trust VII 2006 US$ 800 5.6280 Jan-16 Perpetual
Deutsche Bank Capital Funding Trust I 1999 US$ 650 7.8720 Jun-09 Perpetual
Deutsche Bank Capital Funding Trust IV 2003 € 1,000 5.3300 Sep-13 Perpetual
Deutsche Bank Capital Funding Trust VI 2005 € 900 6.0000 Jan-10 Perpetual
Deutsche Postbank Funding Trust II 2004 € 500 6.0000 Dec-09 Perpetual
Deutsche Postbank Funding Trust IV 2007 € 500 5.9830 Jul-17 Perpetual
Eurohypo Capital Funding Trust I 2003 € 600 6.4450 May-13 Perpetual
Fuerstenberg Capital GmbH II 2005 € 550 5.6250 Jun-11 Perpetual
Henkel KGaA 2005 € 1,300 5.3750 Nov-15 Nov-2104
HT1 Funding GmbH 2006 € 1,000 6.3520 Jun-17 Perpetual
HVB Funding Trust VIII 2002 € 600 7.0550 Mar-12 Perpetual
Landesbank Schleswig-Holstein 2002 € 500 7.4075 Jun-14 Perpetual
Girozentrale - LB Kiel
Linde Finance BV 2006 € 700 7.3750 Jul-16 Jul-66
Muenchener Rueckversicherungsgesellschaft 2007 € 1,500 5.7670 Jun-17 Perpetual
AG - Munich Re
Otto Finance Luxembourg A.G. 2005 € 150 6.5000 Aug-12 Perpetual
Porsche International Financing plc 2006 US$ 1,000 7.2000 Feb-11 Perpetual
Siemens Financieringsmaatschappij NV 2006 € 900 5.2500 Sep-16 Sep-66
Siemens Financieringsmaatschappij NV 2006 £ 750 6.1250 Sep-16 Sep-66
Suedzucker International Finance BV 2005 € 700 5.2500 Jun-15 Perpetual
TUI AG 2005 € 300 8.6250 Jan-13 Perpetual
Greece
Alpha Group Jersey Ltd 2005 € 600 6.0000 Feb-15 Perpetual
EFG Fiduciary Certificates 2004 € 325 6.5000 Apr-10 Perpetual
EFG Fiduciary Certificates 2004 € 75 6.5000 Apr-10 Perpetual
EFG Hellas Funding Ltd 2005 € 200 6.7500 Mar-10 Perpetual
EFG Hellas Funding Ltd 2005 € 400 4.5650 Nov-15 Perpetual
EFG Hellas Funding Ltd 2005 € 150 6.0000 Jan-11 Perpetual
EFG Hellas Funding Ltd 2005 € 50 6.0000 Jan-11 Perpetual
National Bank of Greece Funding Ltd 2003 € 350 FRN Jul-13 Perpetual
National Bank of Greece Funding Ltd 2004 € 350 6.2500 Nov-14 Perpetual
National Bank of Greece Funding Ltd 2004 US$ 180 6.7500 Nov-14 Perpetual
National Bank of Greece Funding Ltd 2005 € 230 6.0000 Feb-15 Perpetual
42
CHAPTER03

National Bank of Greece Funding Ltd 2006 £ 375 6.2889 Nov-16 Perpetual
Piraeus Group Finance plc 2004 € 200 FRN Oct-14 Perpetual
Ireland
AIB UK 2 LP 2006 € 500 5.1420 Jun-16 Perpetual
Allied Irish Banks plc 2001 € 500 7.5000 Feb-11 Perpetual
Anglo Irish Asset Finance 2002 £ 160 7.6250 Jul-27 Perpetual
Anglo Irish Capital (2) UK LP 2006 € 600 5.2190 Sep-16 Perpetual
Anglo Irish Capital Funding Ltd 2004 € 600 6.0000 Sep-10 Perpetual
Anglo Irish Capital Funding Ltd 2004 € 600 6.0000 Sep-10 Perpetual
Bank of Ireland UK Holdings plc 2001 € 600 7.4000 Mar-11 Perpetual
Bank of Ireland UK Holdings plc 2003 £ 350 6.2500 Mar-23 Perpetual
BOI Capital Funding (No 1) LP 2005 € 600 6.2500 Mar-10 Perpetual
BOI Capital Funding (No 2) LP 2006 US$ 800 5.5710 Feb-16 Perpetual
BOI Capital Funding (No 3) LP 2006 US$ 400 6.1070 Feb-16 Perpetual
BOI Capital Funding (No 4) LP 2006 £ 500 6.4295 Apr-17 Perpetual
Chess Capital Securities plc 2005 € 125 4.8300 Jul-15 Perpetual
Lambay Capital Securities plc 2005 £ 300 6.2500 Jun-15 Perpetual
Saphir Finance plc 2006 £ 600 6.3690 Aug-15 Perpetual
Italy
Assicurazioni Generali SpA 2007 € 1,250 5.4790 Feb-17 Perpetual
Assicurazioni Generali SpA 2007 £ 495 6.4160 Feb-22 Perpetual
Banca Popolare di Lodi InvestorTrust III 2005 € 500 6.7420 Jun-15 Perpetual
Generali Finance BV 2006 € 1,275 5.3170 Jun-16 Perpetual
Generali Finance BV 2006 £ 700 6.2140 Jun-16 Perpetual
Generali Finance BV 2006 £ 350 6.2690 Jun-16 Perpetual
IntesaBci Capital B 2001 € 500 6.9880 Jul-11 Perpetual
Lottomatica SpA 2006 € 750 8.2500 Mar-16 Mar-66
San Paolo IMI Capital Trust I 2000 € 1,000 8.1260 Nov-10 Perpetual
UniCredito Italiano Capital Trust 1 2000 € 540 8.0480 Oct-10 Perpetual
UniCredito Italiano Capital Trust 2 2000 US$ 450 9.2000 Oct-10 Perpetual
Unicredito Italiano Capital Trust 3 2005 € 750 4.0280 Oct-15 Perpetual
Japan
KUBC Preferred Capital Cayman Ltd 2007 ¥ 12,500 3.4600 Jul-12 Perpetual
Mizuho Capital Investment (€) 1 Ltd 2006 € 500 5.0200 Jun-11 Perpetual
Mizuho Capital Investment (US$) 1 Ltd 2006 US$ 600 6.6860 Jun-16 Perpetual
MTFG Capital Finance Ltd 2005 ¥ 165,000 2.5200 Jan-11 Perpetual
MUFG Capital Finance I Ltd 2006 US$ 2,300 6.3460 Jul-16 Perpetual
MUFG Capital Finance II Ltd 2006 € 750 4.8500 Jul-16 Perpetual
MUFG Capital Finance III Ltd 2006 ¥ 120,000 2.6800 Jul-16 Perpetual
MUFG Capital Finance IV Ltd 2007 € 500 5.2710 Jan-17 Perpetual
MUFG Capital Finance IV Ltd 2007 £ 550 6.2990 Jan-17 Perpetual
Resona Preferred Global Securities (Cayman) Ltd 2005 US$ 1,150 7.1910 Jul-15 Perpetual
Shinsei Bank Ltd 2006 US$ 775 6.4180 Jul-16 Perpetual
Shinsei Bank Ltd 2006 US$ 700 7.1600 Jul-16 Perpetual
SMFG Preferred Capital £ 1 Ltd 2006 £ 500 6.1640 Jan-17 Perpetual
SMFG Preferred Capital US$ 1 Ltd 2006 US$ 1,650 6.0780 Jan-17 Perpetual
(Sumitomo Mitsui)
STB Preferred Capital 3 (Cayman) Ltd 2007 ¥ 50,000 2.8300 Jul-17 Perpetual
Luxembourg
Banque Internationale a Luxembourg SA 2001 € 225 6.8210 Jul-11 Perpetual
Banque Internationale a Luxembourg SA 2001 € 275 6.8750 Jul-06 Perpetual
Netherlands
ABN AMRO Bank NV 2006 € 1,000 4.3100 Mar-16 Perpetual
ABN AMRO Capital Funding Trust II 1999 US$ 1,250 7.1250 Apr-04 Perpetual
ABN AMRO Capital Funding Trust V 2003 US$ 1,250 5.9000 Jul-08 Perpetual
ABN AMRO Capital Funding Trust VII 2004 US$ 1,800 6.0800 Feb-09 Perpetual
AEGON NV 2005 US$ 925 6.3750 Jun-15 Perpetual
43
CHAPTER03

ELM BV (Swiss Re) 2006 € 1,000 5.2520 May-16 Perpetual
Eureko BV 2006 € 600 6.0000 Nov-12 Perpetual
ING Capital Funding Trust III 2000 US$ 1,500 8.4390 Dec-10 Perpetual
ING Groep NV 2002 US$ 1,000 7.2000 Dec-07 Perpetual
ING Groep NV 2003 € 750 FRN Sep-13 Perpetual
ING Groep NV 2004 € 1,000 FRN Jun-14 Perpetual
ING Groep NV 2005 € 500 4.1760 Jun-15 Perpetual
ING Groep NV 2005 US$ 700 6.1250 Jan-11 Perpetual
ING Groep NV 2005 US$ 700 6.1250 Jan-11 Perpetual
ING Groep NV 2005 US$ 1,000 5.7750 Dec-15 Perpetual
ING Groep NV 2006 £ 600 5.1400 Mar-16 Perpetual
ING Groep NV 2007 US$ 1,500 7.3750 Oct-12 Perpetual
Rabobank Capital Funding Trust I 1999 € 650 7.0000 Dec-04 Perpetual
Rabobank Capital Funding Trust II 2003 US$ 1,750 5.2600 Dec-13 Perpetual
Rabobank Capital Funding Trust III 2004 US$ 1,500 5.2540 Oct-16 Perpetual
Rabobank Capital Funding Trust IV 2004 £ 350 5.5560 Dec-19 Perpetual
Norway
DnB NOR Bank ASA 2007 £ 350 6.0116 Mar-17 Perpetual
Portugal
Banif Finance Ltd 2004 € 75 FRN Dec-14 Perpetual
BCP Finance Co 2004 € 500 5.5430 Jun-14 Perpetual
BCP Finance Co 2005 € 500 4.2390 Oct-15 Perpetual
BES Finance Ltd 2004 € 150 5.5800 Jul-14 Perpetual
BES Finance Ltd 2003 € 450 5.5800 Jul-14 Perpetual
BPI Capital Finance Ltd 2003 € 250 FRN Aug-13 Perpetual
Caixa Geral de Depositos Finance 2004 € 250 FRN Jun-14 Perpetual
Caixa Geral Finance Ltd (Cayman) 2005 € 350 FRN Sep-15 Perpetual
ESFG International Ltd 2007 € 400 5.7530 Jun-17 Perpetual
Totta & Acores Financing Ltd 2005 € 300 4.1200 Jun-15 Perpetual
Spain
Banco de Sabadell SA 2006 € 500 5.2340 Sep-16 Perpetual
BBVA International Preferred SA Unipersonal 2005 € 550 3.7980 Sep-15 Perpetual
BBVA International Preferred SA Unipersonal 2006 € 500 4.9520 Sep-16 Perpetual
BBVA International Preferred SA Unipersonal 2007 £ 400 7.0930 Jul-12 Perpetual
BBVA International Preferred SA Unipersonal 2007 £ 400 7.0930 Jul-12 Perpetual
Bilbao Vizcaya International Ltd 1999 € 1,000 5.7600 Mar-04 Perpetual
BSCH Finance Ltd 1999 € 1,000 5.5000 May-04 Perpetual
Caymadrid Finance Ltd 1999 € 900 5.1500 Dec-04 Perpetual
Repsol International Capital Ltd 2001 € 1,000 FRN Dec-11 Perpetual
Union Fenosa Preferentes SA 2005 € 750 FRN Jun-15 Perpetual
Sweden
Nordea Bank AB 2004 € 500 FRN Sep-09 Perpetual
Svenska Handelsbanken AB 2005 € 500 4.1940 Dec-15 Perpetual
Vattenfall Treasury AB 2005 € 1,000 5.2500 Jun-15 Perpetual
Switzerland
Credit Suisse (Guernsey) Ltd 2007 US$ 1,250 5.8600 May-17 Perpetual
Glencore Finance Europe 2006 US$ 700 8.0000 Feb-11 Perpetual
Swiss Re 2007 £ 500 6.3024 May-19 Perpetual
Swiss Re GB plc 2006 US$ 750 6.8540 May-16 Perpetual
UBS Preferred Funding Trust I 2000 US$ 1,500 8.6220 Oct-10 Perpetual
UBS Preferred Funding Trust II 2001 US$ 500 7.2470 Jun-11 Perpetual
UBS Preferred Funding Trust V 2006 US$ 1,000 6.2430 May-16 Perpetual
ZFS Finance (USA) Trust I 2005 US$ 600 6.1500 Dec-10 15 December
2065
ZFS Finance (USA) Trust I 2005 US$ 700 6.4500 Dec-15 15 December
2065
44
CHAPTER03

UK
Abbey National Capital Trust I 2000 US$ 1,000 8.9630 Jun-30 Perpetual
Abbey National plc 2001 US$ 450 7.3750 Nov-06 Perpetual
AIB UK 1 LP 2004 € 1,000 4.7810 Dec-14 Perpetual
AIB UK 3 LP 2006 £ 350 6.2710 Jun-16 Perpetual
Anglo Irish Capital (3) UK LP 2007 £ 350 6.9490 Jun-17 Perpetual
Aviva plc 2004 € 700 4.7291 Nov-14 Perpetual
Aviva plc 2004 £ 500 5.9021 Jul-20 Perpetual
Barclays Bank plc 2000 € 850 7.5000 Dec-10 Perpetual
Barclays Bank plc 2000 US$ 1,250 8.5500 Jun-11 Perpetual
Barclays Bank plc 2001 US$ 750 7.3750 Dec-11 Perpetual
Barclays Bank plc 2002 £ 400 6.0000 Jun-32 Perpetual
Barclays Bank plc 2002 US$ 1,000 6.8600 Jun-32 Perpetual
Barclays Bank plc 2004 € 1,000 4.8750 Dec-14 Perpetual
Barclays Bank plc 2005 € 1,400 4.7500 Mar-20 Perpetual
Barclays Bank plc 2005 US$ 1,000 6.2780 Dec-34 Perpetual
Barclays Bank plc 2005 £ 750 6.0000 Dec-17 Perpetual
Barclays Bank plc 2006 US$ 750 6.6250 Sep-11 Perpetual
Friends Provident plc 2005 £ 500 6.2920 Jul-15 Perpetual
HBOS Capital Funding LP 2001 £ 600 6.4610 Nov-18 Perpetual
HBOS Capital Funding LP 2004 US$ 750 6.0710 Jun-14 Perpetual
HBOS Capital Funding No 1 LP 2003 US$ 1,000 6.8500 Mar-09 Perpetual
HBOS Capital Funding No 3 LP 2006 € 750 4.9390 May-16 Perpetual
HBOS plc 2005 £ 750 6.0884 May-15 Perpetual
HBOS plc 2005 US$ 750 5.9200 Oct-15 Perpetual
HBOS plc 2005 US$ 750 6.4130 Oct-35 Perpetual
HBOS plc 2006 £ 350 6.3673 Jun-19 Perpetual
HBOS plc 2007 US$ 750 6.6570 May-37 Perpetual
HSBC Bank Capital Funding (Sterling 1) LP 2000 £ 500 8.2080 Jun-15 Perpetual
HSBC Bank Capital Funding (Sterling 1) LP 2003 £ 700 5.8440 Nov-31 Perpetual
HSBC Capital Funding (Euro 1) LP 2000 € 600 8.0300 Jun-12 Perpetual
HSBC Capital Funding (Euro 2) LP 2003 € 1,400 5.3687 Mar-14 Perpetual
HSBC Capital Funding (Euro 3) LP 2004 € 750 5.1300 Mar-16 Perpetual
HSBC Capital Funding (US$2) LP 2003 US$ 1,250 4.6100 Jun-13 Perpetual
Legal & General Group plc 2007 £ 600 6.3850 May-17 Perpetual
Lloyds TSB Bank plc 2002 US$ 850 6.9000 Nov-07 Perpetual
Lloyds TSB Bank plc 2002 € 500 6.3500 Feb-13 Perpetual
Lloyds TSB Bank plc 2005 € 750 4.3850 May-17 Perpetual
Nationwide Building Society 2004 £ 400 5.7690 Feb-26 Perpetual
Nationwide Building Society 2007 £ 350 6.0240 Feb-13 Perpetual
Old Mutual plc 2005 £ 350 6.3760 Mar-20 Perpetual
Prudential plc 2003 US$ 1,000 6.5000 Dec-08 Perpetual
RBS Capital Trust 1 2003 US$ 850 4.7090 Jul-13 Perpetual
RBS Capital Trust A 2002 € 1,250 6.4670 Jun-12 Perpetual
RBS Capital Trust B 2002 US$ 750 6.8000 Mar-08 Perpetual
RBS Capital Trust C 2005 € 500 4.2430 Jan-16 Perpetual
RBS Capital Trust D 2006 £ 400 5.6457 Jun-17 Perpetual
RBS Capital Trust II 2003 US$ 650 6.4250 Jan-34 Perpetual
RBS Capital Trust III 2004 US$ 950 5.5120 Sep-14 Perpetual
Resolution plc 2005 £ 500 6.5864 Apr-16 Perpetual
Rexam plc 2007 € 750 6.7500 Jun-17 29 June 2067
Royal & Sun Alliance Insurance Group plc 2006 £ 375 6.7010 Jul-17 Perpetual
Royal Bank of Scotland Group plc 2001 US$ 1,200 7.6480 Sep-31 Perpetual
Royal Bank of Scotland Group plc 2005 € 1,250 5.2500 Jun-10 Perpetual
Royal Bank of Scotland Group plc 2007 US$ 950 6.6000 Jun-12 Perpetual
Royal Bank of Scotland plc 2004 € 1,250 5.5000 Dec-09 Perpetual
Society of Lloyds 2007 £ 500 7.4210 Jun-17 Perpetual
Standard Chartered Bank 2007 US$ 750 7.0140 Jun-37 Perpetual
Standard Chartered Capital Trust 1 2000 € 500 8.1600 Mar-10 Perpetual
Standard Chartered plc 2006 US$ 750 6.4090 Jan-17 Perpetual
45
CHAPTER03

UBS Preferred Funding (Jersey) Ltd 2005 € 1,000 4.2800 Apr-15 Perpetual
US
BAC Capital Trust X 2006 US$ 900 6.2500 Mar-11 29 March 2055
BAC Capital Trust XIII 2007 US$ 700 FRN Mar-12 15 March 2043
BAC Capital Trust XIV 2007 US$ 850 5.4800 Mar-12 15 March 2043
Citigroup Capital XIX 2007 US$ 1,225 7.2500 Aug-12 15 August 2067
Citigroup Capital XVI 2006 US$ 1,500 6.4500 Dec-11 31 December
2066
Citigroup Capital XVII 2007 US$ 1,100 6.3500 Mar-12 15 March 2067
Citigroup Capital XVIII 2007 £ 500 6.8290 Jun-17 Perpetual
Comcast Corp 2007 US$ 575 6.6250 May-12 15 May 2056
Countrywide Capital V 2006 US$ 1,300 7.0000 Nov-11 8 November 2066
CVS Caremark Corp 2007 US$ 1,000 6.3020 Jun-37 1 June 2037
Enterprise Products Operating LP 2007 US$ 700 7.0340 Jan-18 15 January 2068
Fifth Third Capital Trust IV 2007 US$ 750 6.5000 Apr-17 1 April 2037
Goldman Sachs Capital II 2007 US$ 1,750 5.7930 Jun-12 Perpetual
ING Groep NV 2007 US$ 1,000 6.3750 Jun-12 Perpetual
JP Morgan Chase Capital XI 2003 US$ 1,000 5.8750 Jun-08 Perpetual
JP Morgan Chase Capital XVIII 2006 US$ 750 6.9500 Aug-36 Aug-66
JP Morgan Chase Capital XX 2006 US$ 1,000 6.5500 Sep-36 15 September
2066
JP Morgan Chase Capital XXI 2007 US$ 850 FRN Feb-12 Feb-37
JP Morgan Chase Capital XXIII 2007 US$ 750 FRN May-12 15 May 2047
Lehman Brothers UK Capital Funding III LP 2006 € 500 3.8750 Nov-11 Perpetual
Merrill Lynch & Co Inc 2005 US$ 750 6.3750 Nov-10 Perpetual
Merrill Lynch & Co Inc 2007 US$ 1,500 5.8500 May-12 Perpetual
Merrill Lynch Capital Trust I 2006 US$ 1,000 6.4500 Dec-11 15 December
2066
Merrill Lynch Capital Trust II 2007 US$ 950 6.4500 Jan-12 15 June 2062
Merrill Lynch Capital Trust III 2007 US$ 750 7.3750 Sep-12 15 September
2062
MetLife Inc 2006 US$ 1,250 6.4000 Dec-36 15 December
2036
Morgan Stanley 2006 US$ 1,000 FRN Jul-11 Perpetual
Morgan Stanley Capital Trust IV 2003 US$ 575 6.2500 Apr-08 1 April 2033
Morgan Stanley Capital Trust VI 2006 US$ 750 6.6000 Feb-11 10 February 2046
National City Capital Trust II 2006 US$ 750 6.6250 Nov-11 15 November
2066
Progressive Corp 2007 US$ 1,000 6.7000 Jun-17 15 June 2037
Regions Financing Trust II 2007 US$ 700 6.6250 May-27 15 May 2047
Travelers Companies Inc 2007 US$ 1,000 6.2500 Mar-17 Mar-37
USB Capital IX 2006 US$ 1,250 6.1890 Apr-11 15 April 2042
USB Capital XI 2006 US$ 700 6.6000 Aug-11 15 September
2066
Wachovia Capital Trust III 2006 US$ 2,500 5.8000 Mar-11 Perpetual
Wachovia Capital Trust IV 2007 US$ 875 6.3750 Mar-12 15 March 2037
Wachovia Capital Trust IX 2007 US$ 750 6.3750 Jun-12 15 June 2047
Wells Fargo Capital XI 2007 US$ 1,000 6.2500 Jun-12 15 June 2067
XL Capital Ltd 2007 US$ 1,000 6.5000 Apr-17 Perpetual
46
CHAPTER INVESTOR OVERVIEW
04 Introduction
As new investor markets develop globally, hybrid securities offer a valuable source of investment
diversification, and the growth of investor demand for the product remains vitally important for
issuers seeking historically large total amounts of capital.
The ability to choose from different finance instruments including common equity, convertibles,
hybrid securities and senior debt in the European, US, UK and Asian markets, and tap into
multiple investor bases in the retail private bank and institutional sectors has become a key
component of the contemporary acquisition war chest for many issuers. Only through the
development of new investor markets can these issuer aspirations become reality.
One good example of this was seen in the US when institutional markets were affected by the
NAIC shock to insurance company investors. The temporary close of the institutional markets at
this point was buffered by continuing strong demand from the US retail investor base, which
enabled the continuation of hybrid new issue supply at this time.
In the EU zone, the UK sterling institutional investor base has also provided additional depth and
flexibility – primarily for financials but also now for corporate issuers, following the opening of
the market in 2006 with the inaugural sterling corporate hybrid transaction from Linde. This
market depth, coupled with the opportunity for diversification, has now also attracted supply
from overseas, which has resulted in an increasing volume of funds invested in transactions from
issuer jurisdictions such as Japan, Austral-Asia and the US. The US retail and institutional investor
base continues to provide the key source of funding for US corporates and financials, and
European financial institutions also continue to tap into this deep pool of liquidity for additional
diversification. New and emerging investor bases such as Asia, Canada and Australia are also
providing an important source of hybrid funding, particularly for European issuers that issue
frequently in the more traditional euro and sterling currencies.
The first wave of ‘next generation’ corporate hybrids were from strong, well known credits
(Burlington Northern, Stanley Works, Vattenfall) that passed the critical first step in the investor
decision process – credit risk. The pricing of these hybrids was considered attractive enough to
stimulate large order books for liquid benchmark-size deals. In some cases the hybrid spread was
3–4 times the senior or credit default swap (CDS) spread for similar tenors. Since the yields for
such strong credits looked attractive relative to senior or compared with risky high-yield and
emerging market (EM) alternatives, the hybrids performed well in secondary trading and were
well supported by dealers. The initial success of these issues can be summarised by:
0 Strong credit profile;

0 Attractive yield;
0 Benchmark size / index inclusion;
0 Good secondary price / spread performance;
0 Liquid secondary markets (tight bid/ask).
Within the overall hybrid capital security market, Bank Tier 1 issues are traditionally considered
the relative safe haven, albeit providing lower spreads for investors. While Tier 1 bank paper is
equally subordinate and truly non-cumulative, there is a much more compelling argument that
banks will respect the investor market place (not abuse the Tier 1 equity features) to preserve
their own market reputation, funding liquidity, and new issue pricing. Relatively higher bank
ratings, regulatory supervision and national significance of the larger banks (too big to fail)
provide further comfort to investors looking for yield pick-up in subordinated paper.
Attempts to model the investor risk factors of hybrid securities and assign a spread to each
structural feature have been mostly unsatisfactory and the entire topic of modelling security risk
where there is a limited universe of relevant historical data has been cast in shadow after the
recent meltdown in sub-prime and related structured securities. While models are imperfect,
they constantly improve and are one of the tools that can be useful to ‘try’ to address complex
scenarios.
47
CHAPTER04
The problem in such modelling is often due to the modeller’s need to make many assumptions as
critical inputs to the model, so the model results can then only be relied upon in a range of
scenarios that are far more limited than those encountered in ‘the real world’. The pricing of a
hybrid new issue is still more of an art than a science and many factors are taken into account
which cannot be modelled for universal application. This evaluation of the pricing ‘X factor’ is a
key part of the hybrid deal execution, including road-show marketing, investor price discovery,
syndication process, etc.
It is useful, however, to observe the trading history of the outstanding hybrids to see where
various credits and various structures trade in relation to one another and to think about why this
is so. It can be instructive to look at the layers of subordination in the issuance by financial institu-
tions and consider the difference in payment deferral among Tier 1, Upper Tier 2 and Lower Tier
2. By observing the secondary trading of hybrids from frequent issuers of step-up hybrids one can
build a ’maturity curve’ of sorts based on the call dates. By observing issuers that have both step-
up hybrids and True Perps it is possible to observe how the market is evaluating extension risk for
that credit at that point in time and how it changes over time.
Default studies are also a useful reference for the historical behaviour of company management,
performance of preferred hybrid securities and the observed occurrence of deferral and/or
default. Recent default studies from the leading rating agencies have, however, been instructive
and have noted that, overall, very few deferrals and defaults have occurred, and that this has been
particularly observed in the financial institutions sector.
Further details on these default studies can be found on the rating agencies’ websites:
Moody’s Investor Services - www.moodys.com

Standard and Poor’s - www.ratingsdirect.com
Fitch Ratings - www.fitchratings.com
Investors in hybrid securities

Institutional investors
The institutional investor universe continues to expand globally, with blue chip corporate issuers
and larger liquid deals from financial institutions encouraging greater investor focus and partici-
pation in hybrids.
These institutional investors have embraced hybrids as a way to gain yield pick-up from well-
known credits. Additionally, the quest for yield has opened the market to lesser known and lower
rated issuers as the hybrid market develops. Investors in general remain credit positive, which
has been reflective in the increasing demand for hybrid issuance from lower rated issuers further
down the credit spectrum. However, investors have also been structurally conservative, leading to
the continuation of features such as quasi-cumulative interest payments and alternative coupon
satisfaction mechanisms (ACSM).
Figure 4.1: Illustrative investor distribution for an institutional global

hybrid transaction (%)
20%
35%
Asset manager
10% Banks
Insurance
Pension fund
Hedge fund
15%
20%
48
CHAPTER04
The key institutional investor types can include the following:
Asset managers
Asset managers focus on the professional management of various securities (including fixed
income products such as senior and hybrid bonds), which meet specific investment criteria and
target investment returns for investors. These investors might be private investors, who will
invest via mutual funds or investment schemes, or institutions such as pension funds, insurance
companies or corporations that have asset portfolios they wish to invest to maximise returns.
Asset managers are viewed as high quality buy-and-hold investors. As such, they are the most
significant investors of fixed income product in the market today, and contribute to, on average,
half of the order-book for institutional hybrid transactions.
Pension funds
A pension fund is a type of asset manager which has been set up to invest pension contributions
from company plans in co-ordination with trustees. Those assets are invested on a consolidated
basis in a variety of different assets to ensure that sufficient income is generated to pay pensioners
once they reach the specified age and retire. By their nature, pension funds are relatively risk
averse so the demand for hybrid securities is typically lower than for senior unsecured product.
However, hybrid securities remain an attractive product from an asset-liability matching
perspective due to the longer maturities involved (10 years, 12 years, 15 years to call).
Insurance companies
Insurance companies offer risk management products to private individuals and institutions to
hedge against the risk of contingent losses. In return for receiving protection, a premium is paid
by the policyholder, which is then invested on a consolidated basis by the insurance company in
various assets to ensure any claims against insurance policies can be met.
The investment strategies for insurance companies are similar to those of pension funds in that
medium-low risk strategies are preferred, although the long-dated nature of the securities ensures
they remain attractive for liability matching purposes.
Hedge funds
Hedge funds are investment funds used by institutions and high net worth individuals, which
utilise complex investment strategies and securities, via a number of different asset classes
including fixed income. Hedge funds are characterised by their ability to short securities, use
higher leverage and derivatives and an increasingly diverse universe of assets and strategies. As
such, hedge funds support liquidity in hedging traditional asset managers and show a greater
openness in investment diversity and risk. This has in turn given further support to the explosive
growth of the sector, with funds able to pursue investment strategies to deliver optimal risk
adjusted returns.
Hedge funds have become a much larger proportion of the capital markets in recent years and for
new issues have become an important route for distribution. This differs from the early days
when hedge funds were viewed as fast-money accounts. Hedge funds are now viewed as an
integral component of the market and some are more closely compared with traditional asset
managers.
Banks
Banks can also invest directly in new hybrid security issues, primarily via their proprietary trading
books. Banks’ involvement in the bank capital securities market is typically low compared with
their involvement in senior unsecured transactions, as they are required to hold an identical
amount of capital to offset any bank capital they may buy (which makes buying into a bank
capital transaction relatively cost-inefficient). This constraint is not such a deterrent for other
hybrid sectors.
Retail private bank market

RPB investors can be split into two distinct groups, pure retail ‘mom-and-pop’ investors, versus
high net worth individuals who invest through private banks (PB).
49
CHAPTER04
Pure retail investor bases are primarily targeted by commercial banks which have access to large
often domestic retail banking networks as part of the larger consolidated banking group (several
Swiss, Benelux and German banks have used their domestic distribution capabilities for this
purpose). Distribution of this kind has also been supported through more simple distribution
methods such as advertising in the local press; however, in the majority of cases the transaction is
placed through the lead banks and their corresponding retail network and syndicate members,
which will include private banks (as below).
The second distinct retail group is that of high net worth individuals who invest through a PB that
is either independent or part of a commercial bank. This investor group comprises wealthy
individuals, often domiciled in jurisdictions such as Monaco, Switzerland and Singapore.
Investors with significant assets to be managed, and established financial sophistication, enables
greater access to a range of financial products and structures. This investment need is facilitated
mostly by PB’s that can provide wealth management services, personalised banking and financial
services to these individuals.
Figure 4.2 highlights the PB distribution achieved from a Euro-denominated bank Tier 1
transaction.
Figure 4.2: Illustrative investor distribution (Perp nc 10 structure) (%)
1% 4%
3%
4%
25%
5% United Kingdom Greece
5% Benelux Germany
France Monaco
6% Switzerland Portugal
Spain Singapore
Hong Kong Other European countries
7%
17%
8%
15%
While institutionally-targeted hybrid transactions are generally bigger and cheaper for issuers,
the RPB market also offers attractive diversification opportunities for hybrid issuers. At times,
certain issuers can also achieve a better transaction from a price and execution perspective by
targeting RPB investors, given their unique evaluation process.
RPB investor activity typically remains intermittent, with demand highly focused on two key
factors: first, the current rate environment, where private investors are focused on a high coupon
relative to the current rate environment (compared with institutional investors who are more
focused on credit spreads); second, private investors will also give consideration to the specific
name of the issuer. Strong name recognition, for example banks, insurance, consumer goods,
autos, retail, and pharmaceutical, are all well suited to target this investor base with a hybrid
security. In addition, companies which have a strong history of RPB demand for senior unsecured
bonds (e.g. Benelux, Austria, Germany) could also be well suited to this market.
RPB investors also increasingly participate in institutional deals where possible in the secondary
market, or primary market given Prospectus Directive compliant documents (smaller 1k denomi-
nations are used to stimulate retail investor participation in these transactions).
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RPB targeted transactions have different structures, as follows:
0 Structures are usually nc 5, not nc 10 (institutional);

0 No step-up coupon at the first call date;
0 Pricing is driven by the coupon, not the spread;
0 Transactions tend to be smaller in size and less liquid;
0 Fixed rate and structured CMS (constant maturity swap) varieties have been issued.
Therefore the RPB market can provide advantages to the institutional market for permanent
capital (non step-up non-innovative or unique structured issues).
Investor call options and other structural features can be ‘monetised’ by issuers if they sell the
embedded optionality in the swaption market. This can reduce the all-in cost by 10–40bp in some
cases.
The US RPB market has offered deep pockets of demand in recent years, facilitating transactions
from both domestic issuers (e.g. Citigroup, Morgan Stanley, Bank of America, Freddie Mac) and
overseas issuers (e.g. Aegon, RBS, Deutsche Bank) provided they are SEC registered. These transac-
tions have typically been distributed directly by the brokerage networks of the lead managers,
with the inclusion of regional US brokers to the syndicate group, which adds additional support to
the distribution.
European investors have been targeted through PBs (often private bank subsidiaries of larger
banking groups). Pure retail distribution in Europe has also been achieved through the networks
of local commercial banks where strong retail distribution platforms already exist (e.g. Benelux,
Germany, Switzerland). Asia has also facilitated a number of hybrid PB transactions from non-
Asian issuers, including Porsche and Glencore. Distribution to investor bases outside these three
key areas has been more modest in terms of overall volume, although local investor bases
continue to support domestic private-placement style hybrid issuance in many jurisdictions (e.g.
the Middle East).
Key global investor trends

The following is a brief analysis of key institutional investor trends, focusing on the three key
investor jurisdictions for hybrid securities in Europe (65% of the total European investor base), in
addition to the US.
Profile of select UK investors

Institutional:
0 The UK investor base is key to all Sterling-denominated transactions and continues to be one of
the leading regions for investment for Euro-denominated transactions in the European debt
markets. Investors are familiar with the hybrid product and asset class overall, and name,
credit, management and underlying business strength are all key criteria in the investment
decision making process;
0 Transactions with several bookrunners (we estimate this to be three or more) are preferred for
liquidity purposes, in addition to an investment grade rating and benchmark size. UK investors
are also supportive of liquidity, remaining active in secondary flows;
0 Some transactions from both the corporate and insurance sectors have seen strong demand
from the UK investor base. Investors have seen value in deals, attracted by the volatility and
spread;
0 Outstanding sector concerns, however, include hedging event risk and liquidity.
Retail private bank:
0 Investor interest can be variable in this jurisdiction and is typically limited to those transactions
with domestic name recognition.
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Table 4.1: Select UK investor profile

Client Investment issues
Asset managers Credit and underlying business are the most important criteria.
Active buy-and-hold investment strategy but also significant investment in trading accounts (hedge funds) that seek
liquid high Beta assets. Remain sceptical of event risk. Like clarity on the rationale, large repeat issuers, and regulated
entities.
Lower rated deals bought on a case-by-case basis subject to credit profile, structure and yield.
Insurance Very active in hybrid asset class. Prefer to invest in high quality, benchmark transactions. Will extend duration for
quality credits.
Preference for cumulative structures but will buy non-cumulative structures based on the name/sector of the issuer.
Can invest if security ratings are sub-investment grade on provision that senior debt is investment grade.
Pension fund Buy and hold investment strategy. More risk averse so prefer strong credit profile and investment grade security rating.
Hedge fund Can be significant buyers of hybrid securities – viewed as an integral part of the market. Sub-investment grade rating
could reduce demand but investment typically not restrained by rating.
Figure 4.3: Example distribution for a Euro-denominated hybrid capital issue,

by region (%)
Others
ia
As 7%
3%
Switzerland United Kingdom
7% 28%
Nordic
8%
Benelux
11%
France
20%
Germany
16%
Table 4.2: Select UK investors

Investor Investor type
ABN AMRO Fund manager
AIG Insurance
Deutsche AM Fund manager
ECM Fund manager
Fidelity Fund manager
Fischer Francis Fund manager
Gartmore Fund manager
Insight AM Fund manager
Invesco Fund manager
JPMorgan AM Fund manager
M&G Fund manager
Merrill Lynch IM Fund manager
Schroders Fund manager
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Profile of select German investors

Institutional:
0 Some of the larger buy-and-hold European investors for hybrid capital product are located in
Germany, particularly for domestic issuers – e.g. Bayer, Linde, Pfleiderer, Eurogate;
0 German funds have shown interest in global names and well-known industrial credits. Strong
name recognition remains a key part of the decision-making process, with well-known German
names and global utilities preferred;
0 Some asset managers remain restricted on lower rated securities due to internal investment
limits;
0 Some insurance companies view hybrid capital as a product which may help them meet
minimum return hurdles;
0 German investors have shown resilience and there has been less selling from German accounts
during volatile periods.
0 The RPB market has also played a role in institutional deals such as Otto and TUI.
Table 4.3: Select German investor profile

Asset manager Hybrid issues are part of their investment spectrum. Transaction maturity does not constrain investment decision.
Can buy sub-investment grade securities – some investors have special fund restrictions and need to apply an
internal credit process.
Insurance Investment strategy based on name-specific credit analysis, with focus on minimal risk with some spread return
(some application of coupon vs. return hurdles).
Strategy based on a name-by-name basis so rating is not an issue if the sector and the credit is stable and already
known to analysts.
Preference for higher step-up to give more certainty of maturity at first call date (liability matching purposes).
Deferral mechanism is also an important feature of the structure (cumulative vs. non-cumulative).
Pension fund Invest in hybrid securities, with preference for investment grade issuers with strong credit profiles.
Retail private bank Investment decision highly correlated to the issuer name and the security coupon (creating cyclical demand).
Rating not a decision point for retail investors if strong name recognition exists

by region (%)
Others
As
7%
ia
3%
Switzerland United Kingdom

7% 28%
Nordic
8%
Benelux
11%
France
20%
Germany
16%
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Table 4.4: Select German investors

Cominvest Fund manager
Deka AM Fund manager
DEVK Insurance
DWS DAM Fund manager
Frankfurt trust Fund manager
Gothaer Insurance
R+V Insurance
SI AM Insurance
Union invest Fund manager
Profile of select French investors

Institutional:
0 Strong name recognition and select sectors are the key buying criteria for French investors.
Benchmark liquidity and performance in the secondary market are also key considerations,
particularly in light of spread widening seen in the markets in the first half of 2006 and again
in 2007;
0 French asset managers have been key investors in hybrid transactions in the past (e.g.
corporates such as Vattenfall, DONG and Südzucker). Despite concerns surrounding market
volatility, and hedge funds using the asset class to short the market, investors remain active in
the more liquid bank and insurance hybrid sectors;
0 Strong performance (spread tightening) and increased liquidity have helped to improve market
perception of the asset class.
0 The RPB market in France can be deep and provide for significant funding sizes, particularly for
French issuers with strong brand and name recognition (Casino).
Table 4.5: Select French investor profile

Asset Manager Investors have been significant buyers in previous transactions.
Preference for a strong issuer rating – name recognition and strong sector characteristics are key for a non-
investment grade transaction.
Select investors are unable to invest in split-rating issues.
Insurance Investor preference for stable credits if a core holding and also for cumulative structures.
Strong focus on issuer rating and structure – cumulative/non-cumulative coupon deferral and deferral triggers
are key characteristics.
Accounts most focused on liquid benchmark-size transactions.
Retail Private Bank Continued focus on strong name recognition and sector. Continue to invest on the product but remain cautious
overall.
While the issuer name and sector are the primary consideration, high coupons are a strong incentive for investor
participation.
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by region (%)
Others
As
7%
ia
3%
Switzerland
7% United Kingdom
28%
Nordic
8%
Benelux
11%
France
20%
Germany
16%
Table 4.6: Select French investors

AGF Fund manager
Aviva Insurance
Axa Fund manager
CAAM Fund manager
Generali Insurance
IXIS IM Fund manager
Groupma Insurance
HSBC AM Fund manager
MACSF Fund manager
SGAM Fund manager
Sogeposte Fund manager
Profile of select US investors

Institutional:
0 Strong name recognition and an investment grade rating for a hybrid security will underpin
demand for the transaction. This remains particularly important for non-domestic issuers who
want to access the investor base in this market with a hybrid transaction;
0 Investors are open to investing in transactions which are smaller than a benchmark size.
Secondary market performance also remains a key consideration;
0 New funds invested in the sector by asset managers continue to drive the majority of demand
for hybrid securities in the US market. Investors have remained active in the sector in spite of
the volatility seen in the market recently and in March, in not only the more liquid bank and
insurance sectors and the corporate hybrid sector;
0 US investors take more types of risk, more complicated structures and longer duration.
US retail:
0 US retail remains a significant component of the total investor base for hybrid securities
in the US.
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Table 4.7: Select US investor feedback

Asset Manager Buy-and-hold investors key for the sector and underpinning hybrid demand in the market. Investors look at
issues on a case-by-case basis – credit and sector specific (investments not usually constrained by deal size or by
minimum rating).
Insurance Preference for longer-dated investments. Require spread but also want to minimise risk.
Focus on issuer rating and structure in decision-making process. NAIC risk weightings will be critical going
forward.
Hedge Fund Active investor in the hybrid market, with strong focus on spread return versus credit and structural risk.
Demand not typically constrained by the security rating.
Retail Strong demand for product driven by issuer name recognition, high coupon and sector preference.
High coupons continue to attract many investors to participate in new issues even if lower rated.
Figure 4.6: Example distribution for a US$-denominated hybrid capital issue,

by region (%)
15%
North East
10% International
50%
Mid West
South West
20% West Coast
5%
Table 4.8: Select US investors

Aegon Insurance
AIG Insurance
Black Rock Fund manager
Deutsche AM Fund manager
Dresdner Fund manager
Fidelity investments Fund manager
Hartford investment management Fund manager
ING Fund manager
JPMorgan Fund manager
Metropolitan life Fund manager
Moore capital Fund manager
Sailfish capital Fund manager
Sigma capital Fund manager
Markets to watch
Japan
The Yen hybrid investor market has been well established for many years and is more frequently
targeted by the larger international Japanese banks for bank capital transactions. This market
could be an important source of diversification for those Western issuers that have already
targeted the Asian market in US dollar hybrid format (and can avoid, or effectively hedge, the
currency exposure).
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Canada
The Canadian market was targeted with an international hybrid transaction for the first time in
August 2006 with a bank Tier 1 capital issue from Crédit Agricole. This was also an interesting
transaction at the time as the majority of other international markets were closed for the summer
break (in addition to providing a useful alternative to the US market due to the close correlation of
Canadian dollar to US dollar).
Australia/New Zealand
The Australian hybrid market has been open to domestic bank issuers issuing in the domestic
currency for some time, but has also been utilised by European issuers (including Rabobank and
Axa).
Middle East – market for domestic placement

The Middle East already provides a deep and diverse investor base for local currency transactions
for domestic issuers (with notable bank capital supply from the various jurisdictions).
Investor dynamics and motivation to buy hybrids

Hybrids versus senior debt with similar credit quality
Investors have become increasingly familiar with assessing the risks of hybrid security structures.
The hybrid institutional investor base overlaps the investor base for senior unsecured debt.
Primary to the decision-making process for many investors in terms of whether or not to invest in
a hybrid security is the investors’ view on the underlying credit. This credit component of the
hybrid spread is the most likely to lead to future performance of the security. Less differentiation
between senior and subordinated investors has also allowed issuers to better target institutional
investors, particularly those that have already issued senior debt. For some issuers the hybrid
proves investor diversity as new investors are attracted by the higher yield.
For many investors, hybrid capital securities offer a significant and attractive pick-up in spread
when compared to the credit spread they receive for buying senior unsecured debt. The spread of
a hybrid structure includes credit and structural risks – subordination, payment deferral and
maturity extension. The hypothetical spread premium for the various components of a hybrid
structure can therefore be contemplated and broken down looking at each component on an
individual basis. An additional premium might also be applied – the ‘X factor’ - which will be
added on a credit-specific basis to take into account any additional risk incurred (for example,
acquisition risk). These premiums are highlighted in the illustrative example given in Table 4.9.
Table 4.9: Hybrid capital – considering equity features

Hypothetical risk premiums (mid BBB credit)
Hybrid 10yr step-up Hypothetical risk premium
1 - Subordination 30-45bps Hybrid premium
2 - Non payment
3 - Extension
4 - X factor (M&A, etc.) - name specific
50-75bps
20-30bps
XXbps
} approximately
100-150bps
Senior 10yr bullet 50bps
Hybrid new issue spread: 150-200bp (plus the ‘X Factor’)

Source: Compiled by CALYON- July 2007
Hybrid spreads are usually a multiple of the issuers’ senior/CDS spread for the same tenor. The
magnitude of the multiple varies by issuer, deal and sector, and is volatile over time. The illustra-
tive example in Table 4.9 is not based on a model and should not be relied on. It merely shows
how the incremental hybrid spread could be associated with the major structural risks. One
completely reliable model for hybrid pricing is not available to the market since each deal is
unique and the X factor requires human judgment and interaction through investor price
discovery. Each deal has been unique and sometimes factors such as the issuer’s rationale (M&A
funding for example) may result in variance from where the issuer would otherwise be expected
to price.
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Stronger credit quality

For those investors searching for higher yielding investment products, hybrid capital can offer a
relatively more stable investment compared with other higher yielding products. The risk of loss
of the investment and of coupon payments is perceived by the market to be relatively low for a
hybrid security. This is particularly prevalent for financial institutions, which are perceived to be
somewhat protected by the oversight provided by national regulators (it is thought unlikely that
many large banks would be allowed to fall into liquidation).
Liquid markets
Over time, as investors have become more familiar with hybrid structures and their inherent
risks, the depth of the investor base for the product has facilitated larger size deals across all
currencies. Issuers have also been able to raise more capital through one single funding exercise
by targeting more than one investor base at a time via dual-tranche transactions – as highlighted
in Table 4.11.
With hybrid deal sizes increasing to a more liquid average size, hybrid indices are becoming in-
creasingly relevant for institutional investors in particular and stimulating demand from large
money managers as a result. One frequently referenced index is iBoxx, which applies a criterion
for hybrid debt which is similar to that for senior unsecured debt. With a minimum size
limitation of €500m and investment grade credit rating, more and more hybrid transactions are
able to be included, making hybrid indices larger and therefore a more prominent part of
investors’ portfolios. See www.indexco.com for further details on iBoxx.
Table 4.10: Select dual-tranche transactions, 2006

Issuer Issuer
Sector nationality Issuer date Currency Size (m) Coupon First call date Maturity
Financial France CNCEP 13-Jan-06 US$ 300 6.7500 27-Jan-12 Perpetual
Financial France CNCEP 18-Jan-06 € 350 4.7500 01-Feb-16 Perpetual
Financial Japan MUFG capital finance II Ltd 10-Mar-06 € 750 4.8500 25-Jul-16 Perpetual
Financial Japan MUFG capital finance III Ltd 10-Mar-06 ¥ 120,000 2.6800 25-Jul-16 Perpetual
Financial Japan MUFG capital finance I Ltd 10-Mar-06 US$ 2,300 6.3460 25-Jul-16 Perpetual
Financial Germany Commerzbank capital funding trust I 15-Mar-06 € 1,000 5.0120 12-Apr-16 Perpetual
Financial Germany Commerzbank capital funding trust II 15-Mar-06 £ 800 5.9050 12-Apr-18 Perpetual
Financial France BNP Paribas SA 04-Apr-06 € 750 4.7300 12-Apr-16 Perpetual
Financial France BNP Paribas SA 05-Apr-06 £ 450 5.9450 19-Apr-16 Perpetual
Insurance Switzerland ELM BV (Swiss Re) 04-May-06 € 1,000 5.2520 25-May-16 Perpetual
Insurance Switzerland Swiss RE GB pic 04-May-06 US$ 751.5 6.8540 25-May-16 Perpetual
Insurance Italy Generali Finance BV 07-Jun-06 € 1,2745 5.3170 16-Jun-16 Perpetual
Insurance Italy Generali Finance BV 07-Jun-06 £ 700 6.2140 16-Jun-16 Perpetual
Insurance Italy Generali Finance BV 07-Jun-06 £ 350 6.2690 16-Jun-26 Perpetual
Insurance France AXA SA 29-Jun-06 € 1,000 5.7770 06-Jul-16 Perpetual
Insurance France AXA SA 29-Jun-06 £ 500 6.6666 06-Jul-16 Perpetual
Insurance France AXA SA 29-Jun-06 £ 350 6.6862 06-Jul-26 Perpetual
Financial France BNP Paribas SA 04-Jul-06 € 150 5.5000 13-Jul-16 Perpetual
Financial France BNP Paribas SA 05-Jul-06 £ 325 5.9540 13-Jul-16 Perpetual
Strength of new issue performance in the secondary markets

The tightening of hybrid credit spreads in recent years resulted in hybrids being a top performing
asset class. Corporate spreads in particular have seen a strong performance, benefiting from
increased market liquidity and investor comfort with the risks of payment deferral and subordi-
nation. As highlighted in Figure 4.7, corporate hybrid spreads have tightened by 30bp over the
course of 2006 (senior spreads tightened marginally over the same time period), and in spite of
recent market widening, corporate hybrid spreads are 100bp tighter (at end-September 2007)
than the market wides seen in June 2006.
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Figure 4.7: Corporate hybrid spread performance, 2006 to Sep 2007
Euribor
spread (bp)
270
Corporates senior
220 Corporates sub
170
120
70
20
Jul
Sep
Nov
Jul
Sep
Jan
Mar
Jan
Mar
May
May
2006 2007
Market volatility
The secondary trading performance of a hybrid security can be compared not only with the
trading performance of comparable hybrid transactions, but also in relation to measures of other
‘high beta’ risky assets such as equities and high yield.
Figure 4.8 highlights the comparative performance of hybrid securities against these asset classes,
with hybrids showing a strong performance against both high yield and crossover securities.
Hybrid securities have also performed well and have shown strength against periods of increased
equity market volatility.
High market volatility from the equity and/or debt markets can, however, still effect hybrid
performance and cause increased execution risk and new issue price volatility, as investors charge
higher new issue premiums to hedge the poor secondary market performance of the new issue.
In addition, periods of heavy volume are sometimes followed by a sell-off as the market ‘digests’
the supply.
Figure 4.8: Hybrid performance vs. other asset classes, Jan-Sep 2007
ITRXEX56 currency
500 ITRXEX57 currency
ITRXEX58 currency
450
Banks T1
400 Corporates subordinated
350
300
250
200
150
100
50
0
01/02/07
07/03/07
12/04/07
16/05/07
20/06/07
24/07/07
27/08/07
28/09/07
Source: International Index Company, Bloomberg L.P.
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Dedicated hybrid funds

While institutional investors might distinguish their various portfolios by sector or credit rating,
they are not typically structured to allow for standalone dedicated hybrid or subordinated funds.
This leads to an interesting dilemma for investors who are caught between managing the risk of
the portfolio (buying the senior paper of a specific credit) and maximising the return (buying the
hybrid).
Pure credit funds approach this from the perspective of maximising returns. For many investors,
if they like the security from a credit perspective, they will typically choose to buy the hybrid for
the additional spread pick-up, as opposed to the senior paper with a lower spread. Hybrid
securities will typically be placed into generic credit funds which may also be sector specific – not
distinct hybrid or subordinated funds – then benchmarked within the fund against a generic
corporate index (e.g. Lehman Aggregate Index).
There are some specialist preferred and hybrid funds but these are still in a minority (albeit
growing).
Hedging
The hybrid CDS market has already developed in the US, with the establishment of the PCDS
(preferred credit default swap) and PDX index pioneered by Lehman Brothers. This derivative
product has allowed investors to more efficiently hedge the hybrid exposures in their portfolios –
buying protection is equivalent to synthetically shorting the underlying reference obligation,
offsetting price movements in their hybrid security portfolio. A PCDS is also efficient as it allows
the investor to achieve bullet exposure without extension risk.
The CDS markets overall are also becoming efficient from the perspective of liquidity, with
derivative markets not bound by the same physical supply constraints as the market in cash
bonds (a cash investor has to trade in a specific security with finite quantity and liquidity with
physical delivery – in the CDS market they simply trade a new contract and settle in cash). In
terms of structure, a PCDS is similar to senior unsecured CDS, with corresponding terms and
credit events. The differences in the two structures focus on the hybrid-related features of the
underlying deliverable obligation of the PCDS, which results in deferral being incorporated as a
credit event.
In Europe, the hybrid CDS market has yet to develop. In the absence of a single product which
provides a hybrid hedge, investors use alternatives to best offset the credit and equity-like
components of their hybrid exposure. A number of different assets are currently used for this
purpose. Some investors short other hybrid securities to offset the market risk (for example,
Vattenfall short/long versus Dong). Senior CDS, or taking a short position in senior debt directly
can also be used; however, this will only offset the investors’ credit exposure, not the subordina-
tion and payment deferral features typically included in a hybrid structure. Alternatives with a
high correlation to hybrid performance, such as the Itraxx crossover index, or common equity
can also be considered. The size of the hedge must also be adjusted to take into consideration the
variations in Beta, and the slippage as Beta changes during spikes in times of market volatility.
Therefore most hedging methods remain inefficient.
We are also aware of market participants that think about hybrids in building-block terms or
develop quantitative models to address hybrid optionality. Some of these models take the
approach of viewing the hybrid security as a series of separate financial components:
0 Zero coupon sub-debt (term equal to call);

0 Coupon strip (deferral possible, cumulative/non-cumulative);
0 Extension option.
The breakdown of a hybrid security into individual payment risk components could be a useful
tool for investors looking to more efficiently trade or hedge specific components of the hybrid (for
example, extension risk or payment deferral). Additionally, by looking at the individual risk
components and the potential cost of hedging each component (market price for the risk), the
investors can evaluate the total spread at which a hybrid is trading to determine if it is rich or
cheap. Hedge funds often utilise more innovative strategies to manage risk and optimise returns
and are most likely to take this approach. The development of actual liquid markets to trade in
these types of risk will increase the overall efficiency of the hybrid market.
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Investor risk factors

Investors are becoming more discriminating about the terms of hybrids they buy and the return
they require to take degrees of equity risk. For investors, the evaluation of hybrids involves
quantifying the key risks. Investment grade hybrids are bought initially on the credit and yield –
with key valuation considerations being the timing and probability of the return on and return of
invested capital. Security details have in the past been secondary. For higher yielding hybrids, the
perceived risk of non-payment causes a greater focus on the security in terms of investor
protection.
However, while investors are increasingly focused on hybrid structures, the real issues driving the
market continue to be M&A event risk, trading liquidity, the hybrid deal pipeline and the
rate/spread outlook.
In evaluating the spread differential between senior unsecured spreads and hybrid spreads, as
mentioned previously the incremental risk can be explained by breaking it down into its
constituent parts using the larger universe of hybrid capital securities. Investors also expect a
higher extension risk for corporate names, as there is a greater opportunity cost for a regulated
financial institution that does not redeem capital at the step-up/call date. Payment deferral risk is
also greater for corporates but this is partially mitigated since many corporate hybrids are quasi-
cumulative, unlike bank Tier 1.
Some key risks for investors in hybrid securities can be defined as follows:
0 Default risk – Hybrids are designed so that the deferral or elimination of payments will not
trigger a default. This means payment risk is higher on the hybrid capital securities – particu
larly for a mandatory deferral structure which requires the issuer to stop hybrid payments if a
financial trigger event (as defined in the prospectus) is breached. Therefore investors do not
have the right to sue for non-payment of the hybrid capital security coupon (or dividend). The
occurrence of an actual default would occur from non-payment on senior or other securities
and the hybrid investor would in turn assume their subordinated rank in the legal proceedings;
0 Recovery potential – Because of the subordinated status of the hybrid capital securities ranking
just ahead of common stock, there is a lower expected recovery rate than there would be for
senior debt;
0 Payment timing – Payment deferral features make periodic cash flows from hybrids more risky.
Since the hybrid securities can be structured as perpetuals (or with a very long dated maturity),
the ultimate repayment of hybrid capital security principal invested could be reduced to very
little in present value terms over such a long time horizon. To mitigate this, step-up interest
rate structures have been used to give institutional investors some comfort that they will be
called out when the issuer is required to pay the higher rate after 10 years. The step-up rate of
return paid after the issuer’s optional call date in year 10 is typically 100bp more than the asset
swap spread at issue (limited by rating agencies and regulators). In a higher rate/spread
environment, or if an issuer is suffering financial distress, the step-up rate may no longer be
high enough to motivate the call and refinancing of the hybrid. The investor is exposed to
‘extension’ risk because of this possibility.
0 Non-cumulative payments – Traditional preferred stock structures were frequently non-

cumulative to meet regulatory requirements and because this supports the essential equity
characteristics of fully discretionary payments. However, investors prefer to have some
protection that they could get paid at a later date, even if the issues do not pay currently. To this
end, the market has seen ‘non-cash cumulative’ features, which allow issuers the option (or
requirement) to pay arrears via:
0 Increases in principal;
0 The cash proceeds of a new sale of common stock;
0 By delivering an in-kind security.
These examples of non-cash cumulative structures are generically known as ACSM;
0 Beta – Hybrid beta is typically 3–4 times senior and CDS, and the beta change expands to 8–10
times (or more) during credit shocks and periods of high market volatility;
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0 Hedging – Investors have few good choices for hedging higher beta hybrids. With beta of three
or four times senior debt, the amount of senior or CDS shorted would be high – even if
available. Moreover the beta is not static and will create hedge slippage in volatile conditions.
Shorting equity could be disastrous if a leveraged buy-out (LBO) bid up the equity while the
bonds sold off;
0 Liquidity – Investors are typically looking for a minimum deal size of €500m when considering
a liquid ‘benchmark’ transaction and prefer €1bn with three or four banks acting as managers
to ensure secondary trading liquidity. Index inclusion is also helpful, so large benchmarks are
preferred;
0 Common stock dividend policy – Common dividend history is a major factor for investors. Most
hybrids follow the preferred stock model whereby if common dividends are paid, interest on
the hybrid must also be paid – and if common dividends are not paid, interest on the hybrid
might be deferred.
Table 4.11 summarises the general risk dynamics for investors when considering hybrid
securities.
Table 4.11: Risk dynamics - investor perspective

Stronger Weaker
Cumulative Non-cumulative
Compound No compound
Pusher/stopper in place No
Look back >12 months Look back < 12 months
Deferral time limited Deferral time unlimited
Mandatory payment Deferral trigger low probability/out of money MPD trigger high probability/in the money
ACSM Many security types ACSM Few security types
Must activate May activate
Short time frame Long time frame
Recovery relatively less senior debt (hybrid less subordinate) Recovery relatively more senior debt (hybrid more subordinate)
Capital structure subordination
High step-up Low / no step-up
Dated (loses equity credit below 50 years – more call incentive) Perpetual / undated
Weak replacement language Strong replacement language
Change of control No COC
Management, family owner, regulator(s) motives known/trusted Unknown, untested, distrusted
Make whole early redemption (tax, regulatory, accounting, rating Par call if early redemption event
agency – benefit lost)
So standard investment and trading risks remain – credit, liquidity, supply and event risk (buyer
and target) – but investors want more protection. The good news for issuers and investors alike is
that, following the 2005 release of the seminal Moody’s Hybrid Toolkit revisions (and subsequent
guidelines from other agencies), the market has already seen the flexibility to build in the
required investor protections for non-regulated and/or lower rated issuers that are tapping the
hybrid markets, as discussed in Chapter 5 and highlighted in Figure 4.9.
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Figure 4.9: Select unrated/low-rated issuers targeting the hybrid market, 2006–07
NR
3,500 B
BB
3,000 BBB
A
2,500
2,000
1,500
1,000
500
0
Mar
May
Nov
Mar
May
Jan
Jul
Sep
Jan
Jul
Sep
2006 2007
Issue date Maturity Size Issue ratings

Porsche 19-Jan-06 Perpetual US$1bn Not rated
Vinci 7-Feb-06 Perpetual €500m Baa3/BBB
IVG 27-Apr-06 Perpetual €200m Not rated
Lottomatica 10-May-06 31-Mar-66 €750m Ba3/BB
Solvay 23-May-06 2-Jun-04 €500m Baa1/BBB+
Linde 7-Jul-06 14-Jul-66 £250m Ba1/BB
Linde 7-Jul-06 14-Jul-66 €700m Ba1/BB
Siemens 8-Sep-06 14-Sep-66 £750m A2/A–
Siemens 8-Sep-06 14-Sep-66 €900m A2/A–
Behr GmbH & Co 15-Dec-06 Perpetual € 100m Ba1/NR
Wienerberger AG 25-Jan-07 Perpetual €500m Ba1/BB+
IVG Immobilien AG 1-Feb-07 Perpetual €200m Not rated
Pfleiderer Finance BV 13-Apr-07 Perpetual €250m B1/NR/BB–
Eurofins Scientific 11-May-07 Perpetual €100m Not rated
Eurogate GmBH 11-May-07 Perpetual €150m Not rated
Rexam plc 20-Jun-07 29-Jun-67 €750m Ba2/BB+
Voestalpine 15-Oct-07 Perpetual €1bn Not rated
In particular, quasi-cumulative payments – originally included for issuer tax reasons – now also
give investors the incremental comfort needed to participate in insurance and corporate hybrid
transactions. Without this evolution, the hybrid market would be restricted to a much smaller
universe of issuers. These evolving hybrid features are investor friendly in that they provide a
more debt-like instrument than most bank Tier 1 by allowing or requiring issuers to satisfy hybrid
payments via one or more ACSM. This addresses one of the major concerns expressed by critical
investors evaluating many of the corporate hybrid transactions in the market.
Structural conservatism
There are several structural trends that have resulted in a ‘structural conservatism’ in the latest
hybrids in order to comfort investors, increase investor demand and reduce issuer cost.
In France, the TSS legal form of hybrid is a very elegant hybrid capital security in that it is a direct
issue, tax deductible, perpetual, non-cumulative instrument that meets bank Tier 1 capital re-
quirements. The TSS hybrid bank capital structure was sold successfully by high-quality banks to
institutional and RPB investors for several years.
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As other credits used the TSS structure for more diverse purposes (i.e. ratings) institutional
investors noted the standard TSS format as used by banks is more equity-like than other corporate
or insurance structures that have quasi-cumulative payments and ACSM features. Some French
insurance companies have subsequently issued hybrids with these enhancements included.
In Table 4.12 a few variations in corporate hybrids are used to identify the more investor-friendly
features that are becoming more common as the hybrid market develops, such as:
0 Quasi-cumulative payments vs. non-cumulative;

0 ACSM payment resolution and ‘fast pay’ ACSM;
0 Dated vs. perpetual format;
0 Higher step-ups;
0 Change of control (COC) clause.
The Vinci hybrid is a traditional TSS format and non-cumulative, whereas the Solvay and
Lottomatica structures which were issued subsequently have the more investor-friendly quasi-
cumulative coupon structures. The Lottomatica issue is also dated, which provides some comfort
on extension risk since the equity credit decreases as the maturity approaches (creating an
incentive to call after 10 years). Lottomatica also has a ‘fast pay’ ACSM which reduces investor
deferral risk and avoids the third notch down in ratings from S&P.
Some other issuers have included larger step-up rates to reduce extension risk but this can reduce
equity credit and increase the need for strong replacement language.
Increasingly, COC clauses are used for senior debt issues where there is a meaningful risk of the
issuer being taken over and being downgraded by the rating agencies due to significantly
increased leverage post acquisition. Given the subordination, long tenure and potential for
payment deferral or cancellation, hybrid investors are even more vulnerable than the typical
senior bond holder. Therefore hybrid securities have also started to include these COC protective
features. The COC clause protects the existing creditors by providing for an exit or increased com-
pensation if the issuer ratings suffer a significant downgrade following a change of control.
This structural conservatism has helped attract a wider and deeper investor universe since the
investor-friendly features mitigate the primary investor risks. This also has allowed issuers with
higher credit risk to successfully tap the hybrid market.
Table 4.12: Examples of structural conservatism

Vinci €500m 6.250% Lottomatica €750m 8.250% Solvay €500m 6.375%
Perp nc 10 (issued Feb-06) 60 nc 10 (issued May-06) 98 nc 10 (issued May 2006)
Issuer Vinci SA Lottomatica SpA Solvay Finance
IssuerType Direct Direct SPV
SecurityType Undated Deeply Subordinated Subordinated Interest-Deferrable Deeply Subordinated Fixed to
Fixed to Floating Rate Bonds Capital Securities Floating Rate Bonds
Status / Subordination Direct, unconditional, unsecured, The securities will rank pari passu Direct, unconditional, unsecured
and lowest ranking subordinated among themselves and with parity and deeply subordinated
obligations (titres subordonnes de securities, junior to all other obligations of the Issuer. The Bonds
dernier rang) of the Issuer. The unsubordinated and subordinated will rank pari passu among
Bonds rank pari passu among creditors, and senior to ordinary themselves and with all other
themselves and with all other shares of the Issuer, financial present and future parity
deeply subordinated obligations, instruments (strumenti finanziari), securities of the Issuer, and
and subordinated to all prêts any savings shares and preference subordinated to titres participatifs
shares, and any other equity interest and prêts participatifs, ordinary
or junior obligations of the Issuer. subordinated and unsubordinated
obligations of the Issuer.
Maturity Perpetual 31-Mar-2066 2-Jun-2104
First Call Date 13-Nov-2015 31-Mar-2016 2-Jun-2016
Step-Up at First Call Date +100bps +100 bps +100 bps
Early Redemption Yes (Tax / Accounting Event). Bonds Yes (Withholding Tax Event / Tax Yes (Tax Event). Bonds redeemed at
redeemed at their principal amount Event / Change of Control Event). the higher of principal or B+75.
(Tax Event - additional amounts). Securities redeemed at their principal
Bonds redeemed at higher of amount (Withholding Tax Event), or
principalor Bunds+75 (Tax Event - at the higher of principal or Bunds+75
change to tax deductibility / (Tax Event / Change of Control Event).
Accounting Event). Mandatory Redemption Event -
mandatory redemption at 101% of
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Table 4.12: Examples of structural conservatism (continued)

Vinci €500m 6.250% Lottomatica €750m 8.250% Solvay €500m 6.375%
Perp nc 10 (issued Feb-06) 60 nc 10 (issued May-06) 98 nc 10 (issued May 2006)
principal at the earlier of the
termination of the merger agreement
(Lottomatica/GTECH), and October 10th
2006 (if acquisition not completed).
Replacement Clause Intent-Based Replacement of Intent-Based Replacement of Intent-Based Replacement of
Redeemed Bonds. Replacement RedeemedSecurities. Replacement Redeemed Bonds. Replacement
with common equity, pari passu/ with ordinary shares or securities with parity/ junior securities or
junior securities with same terms with similar terms and conditions. ordinary shares.
and equal/greater equity content.
Dividend Pusher / Stopper Dividend Pusher Dividend Pusher / Stopper Dividend Pusher
Optional Deferral Interest payments are optionally Interest payments are optionally Interest payments are optionally
deferrable and non-cumulative. deferrable. Maximum 10-year deferrable. Maximum 5-year
deferral period (cumulative). deferral period (non-cash
Deferred payments to be settled cumulative). Deferred interest to
with cash (first 5-year period) be settled via ACSM.
or via ACSM (next 5-year period).
Rating Agency n/a Interest payments mandatorily n/a
Mandatory Deferral deferrable. Trigger - Coverage Ratio
is less than 1.35. No deferral if issuer
has available cash proceeds raised via
equity issuance in prior 6-month
period. Issuer to pay deferred payments
promptly via ACSM. Maximum 10-year
Deferred Payments Non-Cumulative Mandatory Deferral (Non-Cash Non-Cash Cumulative
Cumulative) / Optional Deferral
(Cumulative - first 5 years / Non-
Cash Cumulative - next 5 years)
ACSM n/a Settlement of deferred interest Settlement of deferred interest
payments immediately, via issuance payments via issuance of
of Issuer Equity (ordinary shares). ordinary shares (2% limit) or
Issuer undertakes to keep available eligible securities (25% limit).
authorised shares to enable payment Issuer shall use all
of deferred interest via ACSM. reasonable measures to settle
Deferred payments not settled after deferred interest payments.
10 years will constitute an event of Deferred payments cancelled if
default. not settled within 5 year period.
Additional Features/ – Fast Pay ACSM avoided typical third –
Comments notch from S&P. Mandatory
Redemption Event - mandatory
redemption at 101% of principal at
earlier of termination of Merger
Agreement, and October 10th 2006
(if acquisition not completed).
Source: Transaction Offering Circulars
Observing the secondary market yield of hybrid capital

securities
Observing spread relationships for bank capital
The bank capital market provides the best universe for looking at how investors may evaluate hybrid equity
risk factors. The spread differential between senior unsecured spreads and subordinated bank capital can be
shown by breaking the incremental risk down into its constituent parts using the larger universe of hybrid
capital securities for banks. A snapshot illustrative example of spread differentials is summarised in Table 4.13.
This example is illustrative only, since actual market relationships vary dramatically over time. While
inconclusive, the relationships are noteworthy when considering the market trading of hybrid risk.
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Table 4.13: Spread analysis - bank capital

Bank capital (%) Comment
1 – Subordination Risk 15-25 LowerTier 2 vs. Senior Unsecured
2 – Extension Risk* 30-40 UpperTier 2 vs. LowerTier 2
3 – Payment Risk** 40-50 Non-Cum. Tier 1 vs. Cum. UpperTier 2
Source: Compiled by CALYON - July 2007
Spread observations for corporate hybrid securities
Table 4.14: Select corporate hybrid spreads – CDS multiples and rating agency equity
credit
Moody’s Current hybrid 10yr CDS Spread to
Issuer Issuer rating basket Moody’s S&P trading (“CS”) interpol. (“CDS”) 10yr CDS CS/CDS (%)
Michelin Baa3/BBB A Ba1 BB+ 116 34.0 82.0 341
TUI B1/BB– B B3 B 388 327.7 60.3 118
Linde (old) Baa1/BBB B Ba1 BB 85 36.5 48.5 233
Linde (new) Baa1/BBB C Ba1 BB 190 52.3 137.7 364
Vinci Baa1/BBB+ C Baa3 BBB–(neg) 178 48.4 129.6 368
DONG Baa1/BBB+ C Baa3 BBB– 76 22.8 53.2 333
Thomson Baa2/BBB– C Ba1 BB 276 97.8 178.2 282
Solvay A2/A C Baa1 BBB+ 104 24.4 79.6 426
Wienerberger Baa2/BBB C Ba1 BB+ 205 – – –
Siemens Aa3/AA– D A2 (pos) A– 72 25.0 47.0 288
Bayer A3/BBB+ D Baa2 BB+ 145 37.1 107.9 391
Vattenfall A2/A– D Baa1 BBB– 72 18.8 53.2 383
Suedzucker Baa2/BBB D Baa2 BBB– 201 49.9 151.1 403
Henkel A2/A D Baa1 BBB– 128 23.8 104.2 539
Rexam Baa3/BBB D Ba3 BB 204 78.7 125.3 259
Lottonatica Baa3/BBB- Ba3 BB 243 - - - -
Source: Compiled by CALYON - July 2007
‘Sample skew’ in average rating quality of Basket C versus Basket D population

The current population sample of more liquid corporate hybrid securities included in Table 4.14 highlights
this difference – there is ‘sample skew’ in that more of the Basket C securities are rated in the BB range and
more of the Basket D securities are BBB or A. Also, there has not been an issuer of both a Basket C and Basket
D security where the required yield premium could be observed for a single credit. So the table requires close
analysis to adjust for the sample skew when looking past CDS multiples as indications of how hybrids trade
and how the market seems to be pricing hybrid risk at a point in time.
Looking at the current sample, it can be observed that the average credit quality and therefore rating of
issuers of Basket C securities has tended to be lower than the Basket D security issuers. This has been partly
driven by the desire of some of the Basket C security issuers to avoid additional Basket D notching by S&P
which could result in a sub-investment grade security rating and negatively impact transaction execution
(marketing and cost of the hybrid). We can look deeper to better understand the data.
Isolate sector champions

Within the sample, the utility sector stands out as a leader in terms of credit quality perception – issuers such
as DONG and Vattenfall have the lowest CDS levels in the sample (+23 and +19, respectively), reflective of the
high perceived quality of the utility sector, national significance and ownership structure. Spreads on the
hybrid securities are also some of the lowest in the sample (+76 and +72), partly reflective of the strong
expectation that a strong utility will make interest payments and call the securities at the first call date.
The hybrid/CDS spread differentials (53 in both cases) are also some of the lowest differentials in the sample.
Therefore these credits should only be given significant weight in comparison to other very highly perceived
credits (such as utilities) that trade beyond their rating levels.
Isolate outliers
When using the data in the sample it is helpful to isolate any outliers that could distort the results of
comparison.
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The CDS spreads of some issuers in the sample trade at levels which are relatively wide to the sample average.
TUI (trading at +328) and Thomson (trading at +98) are two examples of this.
These securities are less comparable to most of the others in the sample and should be isolated for use in
specific comparisons with like companies not prevalent in the current sample.
Multiples and spreads

The cost of basic credit risk – CDS spreads have been referenced for each of the hybrid securities to reflect
the basic market pricing of credit risk for each of the issuers.
CDS spread/hybrid multiples are a ‘quick and dirty’ way to gauge and communicate the trading levels
observed in hybrid securities relative to senior or CDS. Multiples provide one starting point for further analysis
but they must be carefully interpreted. This need for close interpretation is driven by the relatively wide
ranges of the multiples generated. This is highlighted in Table 4.14, where CDS multiples for Basket C
securities range from 282–486% (204% differential), and for Basket D securities 259–539% (280%
differential). These ranges can also still remain wide even when outliers are removed from the sample.
The various CDS levels observed in the market can have a distorting effect on multiples. ‘Noise’ in the calculations
can be in either the numerator or denominator or both. Very low CDS spreads for certain issuer names may result
in optically larger hybrid spread multiples and likewise some issuers which have a relatively high CDS spreads
could result in a lower CDS multiple. Multiples have limits in accurately capturing the market perception of
investment risk in specific hybrid since the multiplier approach can exaggerate differences. The absolute amount
of hybrid spread must be considered in relation to other relevant hybrid credits in addition to the simple multiples.
Hybrid spreads – The spread of a hybrid security can be assessed in relation to other hybrid securities by making
distinctions based on the differing security ratings (issuer credit quality), hybrid structure (deferral optionality,
cumulative versus non-cumulative, ACSM or not, dated versus perp, amount of step-up, level of subordination,
etc) and rating agency equity credit (Basket designation and corresponding risks) and market profile of the issuer.
Spread differentials – By observing the sample of hybrid securities, hybrid spread differentials (the bp
difference between the CDS spread and hybrid spread) can be observed. By observing these rating differen-
tials across the different issuer credit ratings, some broad spread differential ranges emerge at a given point in
time – 50–80bp for A rated issues, 100–150bp for BBB rated issues and 120–180bp for BB rated issues.
The average spread differential for each ratings band can then be broken down into individual components,
assessing each of the features of a hybrid security in turn and applying the following illustrative breakdown:
0 Subordination: 30% (25–35% range);

0 Extension: 20% (15–25% range);
0 Deferral: 50% (45–55% range).
These relationships are highlighted in Figure 4.10 below, but will vary over time and as markets and credits change.
Figure 4.10: Spread differential analysis, by rating

Spread
differential
160
Deferral
140 Extension
Subordination
120 Deferral risk
(50% average)
100
80
60 Extension risk
(20% average)
40
Subordination risk
20 (30% average)
0
A BBB BB
Security rating
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Spread differentials between Baskets – Observing the sample data in Figure 4.10, it can be noted that
Basket D securities on average trade at a wider spread compared to Basket C securities:
0 Basket D (BBB-rated issue): 120–200bp;

0 Basket C (BBB-rated issue): 100–180bp.
When a new hybrid security is priced, syndicate managers will often indicatively price both a Basket D security
and a Basket C security. For a typical blue chip European corporate with BBB ratings, the estimated
incremental spread required for a Basket D security compared to a Basket C has averaged 25–50bp. This
additional spread is associated with the payment deferral feature of the Basket D security, and more specifi-
cally relates to mandatory payment deferral which is a feature unique to most Basket D securities (subordina-
tion and extension risk is similar for both types of security).
Institutional True Perpetual and step-up Tier 1 distinctions

Institutional True Perpetual securities are securities which have a call date, but no step-up coupon at this
date. At the call date the payments typically switch to floating rate from fixed. Regulated financial institutions
avoid the BIS limits on innovative step-up capital issuance by issuing non-step up securities and are therefore
willing to pay an additional premium to issue a True Perp structure.
However, investors expect the issuer to call for ‘reputation maintenance’ and still require a premium to buy
these high beta instruments.
The RPB market can also be used as an alternative to the institutional True Perp market (either for diversification,
price benefits or if the institutional market is closed). This could also benefit those issuers who want to issue in non-
step True Perp format that stays fixed coupons in perpetuity – retail investors place no value on the step-up coupon,
so a step-up does not need to be applied and pricing can vary significantly from the institutional investor market.
Figure 4.11: True Perpetual vs. step-up hybrid securities, Jan–Sep 2007
Euribor
BA CR 4.75% 20 (non-step)
spread (bp)
A IB 4.781% 14 (non-step)
400 BA CR 4.875% 14 (non-step)
DRES 6.352% 17 (non-step)
350 A IB 7.5% 11 (step)
300 BA CR 7.5% 10 (step)
BANCOPOP 6.756% 10 (non-step)
250 BANCOPOP 6.156% 10 (step)
200
150
100
50
0
02 May 07
02 Aug 07
02 Mar 07
02 Sep 07
02 Feb 07
02 Apr 07
02 Jun 07
02 Jan 07
02 Jul 07
Table 4.15: Example of step vs. non-step premiums

Issue Current spread differntial vs step-up Approximate spread premium - step vs non-step
AIB 4.781% 2014 +118bp (vs. AIB 7.5% 2011) +93bp
Barclays 4.75% 2020 +115bp (vs. BACR 7.5% 2010) +78bp
Source: Compiled by CALYON, September 2007
Reducing the cost of issuance using a coupon floor

One interesting True Perp variation in the US market in March 2007 was a non-call 10-year fixed-to-floating Tier
1 security with a coupon floor after the call that was said to save the issuer money (see below). TruePerpFloor
featured a yield of 5.919% as they priced at T+134bp, (equivalent to 82bp over Libor). After the call, the
securities will float at the equivalent of the new issue spread over three-month Libor, and the coupon floor will
equal the initial yield of 5.919%. This seems like a very good idea that could have broader applicability for other
financial institutions (subject to regulatory approvals) and perhaps even more so for corporate hybrids where
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extension risk is a key investor concern. While this deal was a non-step up or True Perp, the same logic should
apply to a step issue – the floor will add value to investors and improve execution for issuers.
Analysis and rationale

A floor on the floating rate after year 10 provides investors with greater certainty of their return if the issuer
does not call the securities in 10 years. In a future lower interest rate environment, the investor would enjoy a
minimum coupon (5.919%) equal to today's rate – therefore receiving a higher return against the traditional
floater if rates are much lower beyond year 10. So in a low rate environment, the investor is in the same
position as owning a traditional Fixed Rate Perp. In a higher interest rate environment, the investor would
enjoy a coupon increase if rates increase on a floating basis in relation to Libor above the floor. This is the
same position they would be in if they held a traditional True Perp.
At the time of issue a similar Tier 1 step-up would have priced in the T+145bp area in the US – so the floor
may have saved 10bp or more (for reference, step-ups from similar credits priced around T+128 or mid-
swaps+75bp at around the same time).
Comparing with Europe, a similar issued a PNC10 step-up would have traded at mid-swaps+95bp, which had
tightened to mid-swaps+79bp when the new US deal was marketed. Also, BNP had recently priced a Euro
PNC10 step-up at m/s +72bp. Therefore the US TruePerpFloor may have achieved very attractive pricing
compared with European step-ups, considering the usual spread premium between a step-up and True Perp
structure is 50–60bp on average, within a range of approximately 35–120bp. When compared to the then-
current Euro True Perp secondary levels below, the value is apparent:
0 AIB True Perp PNC 2014: m/s+132bp;

0 Barclays True Perp PNC 2014: m/s+114bp, PNC 2020 m/s+162bp;
0 Dresdner True Perp PNC 2017: m/s+131bp;
Therefore, the True Perp floor structure priced a True Perp nearly flat to a Perp NC10 step-up and saved
approximately 30bp against the Euro market.
Interview
The following Q&A interview is with Marie-Suzanne Mazelier, Credit Portfolio Manager at Société Générale
Asset Management (SGAM). SGAM is a global fund management group with over £238bn in assets under
management worldwide (as at end-December 2006). This discussion was as of September 2007.
This interview provides an interesting perspective on the rationale for investing in hybrid securities. It also
provides a unique insight into the investor’s view on the key risks of a hybrid, how relative value is evaluated,
and the relative importance of the structural features and rating of the security.
What position do you normally take as an investor: long-term buy-and-hold or more trading focused,
or both?
We favour trading positions (three to six months), with buy-and-hold positions remaining low.
Which sectors (banks, insurance, corporate) do you prefer to invest in? Which sectors are best or worst
(e.g. utilities, retail)?
All investment decisions are a matter of risk/return, depending on market conditions and our view on credit
fundamentals. At present, we think that the financials sector (both senior and subordinated) offers good
relative value, especially on the primary market.
What is the process for deciding whether to invest in a hybrid security, in relation to a senior security
from the same issuer? Does the credit limit cover both types of security?
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It is often a pricing matter, combined with our global view for credit spread movements (beta). We size the
investment according to its risk (spread volatility). Hybrids are higher betas by nature. We also look at the
various features of the structure (for example, the step-up), prefer more liquid sizes, and deals which also have
a good correlation with the overall market. We have a separate limit for both senior and hybrid securities from
the same issuer.
Do you manage your portfolio against a specific index?
We manage both benchmark portfolios (investment grade/high yield/convertibles) against generic bond
indices, not hybrid/subordinated-specific indices and absolute return portfolios.
How important is the rating notching of the hybrid security versus the senior credit rating? Are you
limited to investment-grade?
The rating notching should reflect the subordination level. We are not limited to investment-grade except in
specific institutional mandates. We are also not limited to investing in rated transactions, in which case we will
assess the transaction internally on the basis of the implicit rating.
Maybe the most important factor is the real rationale for the company to issue a hybrid security as part of the
capital structure and aside from the covenant packages that are often regulatory or agency driven, the real
economics of the deal and the commitment of the company.
How do you decide what the spread should be? Do you look at the multiple of the CDS credit spread?
Or 'building blocks' (additional spread for extension risk, subordination, payment deferral) against the
senior credit spread? Do you also look at the hybrid spread versus returns from other asset classes
(high yield, equity)?
All of the above methods are utilised. What is important for us is to assess the return on the security relative
to the risk taken, and issuer credit risk as the first investment criteria to be considered.
We also look at the hybrid spread return versus other asset classes, and have several times bought hybrid
bonds (financials and corporates) on a relative value basis into our high yield funds.
Do you have any preference in terms of liquidity, i.e. minimum size for a deal?
Yes – we have very active management, so liquidity and the commitment of the dealers is very important to
us. We will, however, buy into less liquid deals (less than €500m in size) but for smaller amounts.
What do you view as the key risks for buying into a hybrid security? Payment deferral? Loss of
payment? Loss of principal? Liquidity? Mark-to-market risk?
The key risk for us will be mark-to-market risk because hybrid securities are high beta credits.
From an investment/pricing perspective, do you distinguish between maturities which are perpetual
versus very long dated (e.g. 60 years)? Do you distinguish between securities which are cumulative
versus non-cumulative, or non-cash cumulative (settlement via ACSM)?
We do not distinguish between very long dated and perpetual bonds. The form of subordination for us is
much more important in assessing the relative pricing perspective.
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How closely do you base your investment decisions on the recent secondary market performance of
the issuer? And of comparative hybrid securitites in the market?
Both of these criteria are important. Depending on the fundamentals of the issuer, we would weight these
criteria depending on the market conditions, technical aspects (liquidity, market making) and the
fundamentals.
What is your view of ACSM as a method of payment for deferred coupon payments?
The ACSM should reduce the risk of investor losses when settlement is immediate (or within one year).
What is the minimum step-up that you require at the first call date to view the security as being called
at the first call date?
The minimum step-up that we require at the first call date must be significantly higher than the initial spread
(in our view 100bp+ is acceptable for a T1 at the time being).
How do you hedge your position when you buy a hybrid security – senior? CDS?
We can go outright long, or use the CDS market to lessen our risk position (jump to default or spread
duration).
Are you a buyer of true perpetuals (i.e. no step-up)? What price premium do you require versus a step-
up security?
For the time being we do not invest in non-step bonds. The pricing rationale is not simple so it is not easy to
assess relative value. We are not convinced there are long-term investors on this type of structure.
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CHAPTER STRUCTURING HYBRID CAPITAL
05 SECURITIES
Introduction
The first step in a hybrid structuring project is to scope it out by asking: “What are the issuer’s
main objectives?” and “What constituents are they concerned with (i.e. regulators, rating
agencies, analysts, shareholders, etc.)?” Although hybrid issuers from all sectors share the
common goal of achieving ‘equity’, the hybrid structures are often different between sectors.
Difference derives from the constraints of local legal and tax regimes and from different issuer
objectives. Even within a sector structures differ by nationality of issuance. This confounds
investors and new issuers alike. The issuer’s objectives are shaped by the constituents they aim to
satisfy and this will drive the structures that result within the constraints of the legal, tax and
accounting regimes. These are the technical aspects of structuring hybrids.
Practical aspects must also be considered – such as selling the securities to investors! Marketing
the hybrid securities to investors is a key part of every successful hybrid transaction and some
structuring innovations evolved specifically to reduce perceived investor risks, increase investor
demand and thereby reduce issuer cost – particularly for non-bank issuers.
This chapter highlights some of the structuring challenges and explores some of the reasons for
the differences that can be seen in hybrid securities. A more detailed review of actual transactions
follows in Chapter 6. As will be seen, the hybrid security universe is far from commoditised at this
point.
Background issues
Regulatory requirements continue to drive the majority of hybrid security issuance in the market.
Many leading banks issue up to the maximum limits allowed by bank regulators for hybrid capital
and subsequently ‘top up’ as the asset base grows, to fine tune the balance sheet (via share
buybacks or hybrid security re-financing) or to fund M&A transactions. For banks in the major
world economies a form of hybrid capital exists and is well accepted and readily used by the
largest banks. In recent years further new issuance supply has been derived from emerging
economies and from smaller banks that are tapping the hybrid market either in their local
markets, internationally, and via hybrid collateralised debt obligation (CDO) structures which
aggregate smaller issues into a large marketable tranched pool. Structuring innovations have
often been required to tap these new sources of new issue supply and successfully market them to
investors in the formats they prefer.
Insurance companies have followed the banks’ lead by issuing hybrid capital to more efficiently
meet their capital requirements. However, the rating agency benefits of hybrid capital further
stimulated hybrid security innovation – particularly for insurance companies acting as consolida-
tors in the industry and buying smaller rivals. In many cases the hybrid structures of insurance
companies differ from banks of the same country either because banks had specific historical
issuance structuring advantages, or rating agency credit was not sought by the bank, or insurance
hybrids were viewed more sceptically by investors and additional investor-friendly features were
included to increase their attractiveness. The need to comfort hybrid investors is even more acute
for corporate hybrids. The growth in non-bank issuance has fuelled a trend of structural conser-
vatism in hybrid securities and most constituents have been constructive.
Corporate issuers have long been aware of hybrids but have not been significant issuers for about
10 years. Historically there was significant corporate issuance of preferred stock (particularly
from utilities) and then the first corporate hybrid (in a tax-efficient format) was issued for Texaco
in 1993 and a surge of corporate issues followed. At this time the low after-tax cost of hybrids
brought a wave of new first time corporate issuers and spurred a series of large-scale tenders and
exchange offers to refinance corporate preferred stock issues with the more tax-efficient
corporate hybrids. The preferred-for-hybrid exchanges worked well since the issuer could offer
investors a higher hybrid payment but the hybrid issuer still enjoyed a lower after-tax cost with
the hybrid than they had with the preferred.
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‘Next generation’ corporate hybrids have received significant market focus because corporate
issuance was so low for such an extended period. Since 2005, corporate hybrid new issue volumes
surged as changes to some accountancy regimes (IFRS) and the clarification of increased rating
agency benefits from hybrids combined with M&A motives, the desire to optimise capital
structure and very attractive credit markets.
Favourable market conditions have also supported new issuance across sectors but initially this
was only feasible for the more attractive credits and structures. The market pricing of the hybrid
equity features becomes very attractive in a low-rate, tight credit spread environment. Since
investors are taking long-term, subordinated positions the pricing of hybrids is at its best during
periods of strength in the business and economic cycle. Even so, the rebirth of the corporate
hybrid market began with large, liquid, benchmark-size deals from issuers that exhibited very
strong credit profiles, reputable management, high levels of institutional investor following and
credible issuance rationale. Over time the hybrid market also opened to lower rated and unrated
issuers globally.
However, when risk aversion increases and investors shed high beta assets, then hybrid issuance
prospects are likely to be harshly impacted and the market can close to some or all of the
potential issuers regardless of sector, structure or pricing (as discussed in the investor section,
Chapter 4). During these periods, investors that have studied the subtle differences in hybrid
structures can make better investment decisions for their portfolios. Diagrams have been
included in the form of decision trees that highlight some of the optional and mandatory
payment flows of select hybrid securities to illustrate distinctions that could matter.
Structuring framework
After scoping out a hybrid structuring project in accordance with the issuer’s objectives the next
step is to consider the details of the various technical areas that will constrain or enable the
hybrid security design. It is often said that “the Devil is in the detail” when navigating the
primary technical foundations that define capital security structuring.
The primary technical foundations can be illustrated as a Venn diagram (see Figure 5.1) and the
solution is found in the ‘eye of the needle’ which must be passed through to achieve the
objectives of the hybrid structuring project (tax-efficient quasi-equity). In addition, the practical
aspects of selling the resulting hybrid instrument require the project scope to include the require-
ments and constraints of the target investor market.
Figure 5.1: Primary technical foundations for structuring a hybrid security
Accounting
Tax
Investors
Hybrid capital
security
Legal
Regulators
Rating agencies
One of the most useful structuring frameworks that can be observed is the preferred stock
paradigm. A classic preferred stock is a deeply subordinated instrument (senior only to common
stock), can be non-voting, and can be non-cumulative with payments that are fully discretionary.
Although there are different types of preferred stock (or preference shares) for purposes of con-
structing hybrids, the existence of any preferred stock instrument within the jurisdiction in
question is a useful starting point.
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The structuring considerations that follow relate to how to make it more tax efficient or eliminate
any tax inefficiency. Hybrid capital can be constructed by evaluating the legal possibility for the
key instrument debt/equity characteristics:
0 Features of both debt and equity – Where is the dividing line in the jurisdiction for legal, tax
purposes?
0 Subordinated to all other debt, senior only to common – In some places there is no legal
concept of subordination, preference;
0 Maturities that are long dated or perpetual – What is permitted legally, and what is the tax
impact?
0 Payment discretion – What is permitted legally, and what is the tax impact:
- Mandatory and optional deferral;
- Cumulative or non-cumulative?
By analysing what preferred type security is legally available in the local system a hybrid
structuring professional can determine how feasible it will be to strike a balance on the safe side
of the apex or tipping point between debt and equity. Alternatively, if there is no legal concept of
a preferred security in the security law of the jurisdiction of the issue, the options include:
0 Constructing the hybrid from the bond side;
0 Considering issuance from a jurisdiction offshore from the issuer’s home jurisdiction (if
permissible) or considering a combination of multiple securities that may be bundled to
provide the features required (such as stapled or convertible securities).
Hybrid capital securities are positioned between debt and equity and positioned in terms of their:
0 Legal classification;
0 Subordination;
0 Payment characteristics;
0 Accounting classification;
0 Tax treatment;
0 Investment return.
Figure 5.2: Preferred stock paradigm

«
Ordinary shares (equity)

«
Increasing equity-like characteristics
Preference shares
«
Hybrid capital
Senior bonds
«
Bank loans
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As illustrated in Figure 5.2, hybrid capital securities are instruments like preferred stock which
exist between ordinary debt and equity as a hybrid of the two distinct instruments. While hybrid
securities combine features of both debt and equity, specific capital instruments defined as
‘hybrid’ can differ greatly because of the jurisdiction of the issuer and the approach required to
construct the hybrid structure. Structuring will focus on which point of the debt/equity
continuum to start at and how feasible it will be to ‘stretch’ the various boundaries toward the
centre zone of the hybrid security Venn diagram – to ‘thread the needle’.
Technical foundations
Figure 5.3: Hybrid Tier 1 structuring considerations
Tax Regulatory Investor risks

- Deductibilty - BIS guidelines - Credit
- Witholding tax - Definition of tier 1 (national) - Subordination
- Stamp duties - NAIC - Deferral
- DRD - Solvency 2 - Extension
- Linkage/ triggers - Event risk
«
- Limits on hybrid tier 1 - Liquidity

- Index inclusion
«
«
«
Accounting Hybrid structure Issuer objectives

- Debt vs. equity distinctions - Maturity - Direct/SPV - Strategy
- Minority interest accounting
« - Ratings - Debt vs. equity
« - Foreign exchange risk
- Consolidation/de-consolidation
- Hedge accounting « - Step-up/trueperp - Cumulative vs
- Retail/inst. non cumulative
« - Asset efficiency
- Execution (price/size)
- Replacement - Call features - Investor diversity
language - US/Euro/Other - WACC/ROE
- ACSM - Mandatory deferral - M&A
- COC
«
«
Rating agencies Legal

- S&P, Moody’s, Fitch - Debt vs. equity definitions - PFIC/PTP
- Equity content/financial flexibility - Preferred stock definitions - SEC registration
- Ongoing rating concerns - Disclosure (144A/SEC) - ERISA
- Cash flow & fixed charge coverage - 1940 act issues
- Assigning ratings (notching relative to senior) - Prosperous directive
Regulatory capital
Banks issue the greatest volume of hybrid securities in the global market and provide the widest
universe to look at in making distinctions about hybrid capital securities for regulatory purposes. The
purpose of bank regulatory capital is to provide a cushion to absorb the potential losses of a deposit-
taking financial institution. The regulatory capital takes the first losses before general creditors are
impacted and without damaging the interests of depositors since safety of pubic deposits is
paramount to a sound financial system. Furthermore, the equity investors providing regulatory
capital are seen to be risking their ‘own funds’ before those of the depositors and creditors.
The establishment of bank capital guidelines and monitoring adherence to guidelines for bank
capital management by bank regulators is accomplished in part through capital ratios designed to
reflect how well a bank can support the asset risks in its business. Regulators in each jurisdiction
will set minimum capital ratios for individual banks.
General characteristics of bank capital (based on BIS guidelines)

0 No legal/contractual obligation to pay;
0 Ability to absorb losses;
0 Fully paid up (cash in bank);
0 Issued to independent external investors;
0 Permanent.
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Tier 1 hybrid instruments
0 Perpetual (undated in most jurisdictions, some exceptions);

0 Deep subordination – rank senior only to common stock;
0 Fully discretionary payments (non-cumulative if eliminated);
0 Loss absorbing;
0 Issuer call option permitted with regulator’s consent;
0 Step-up rates generally allowed (but limited amount of step-up);
0 ‘Innovative’ instruments (such as step-ups) limited to 15% of total Tier 1 capital.
Tier 2 hybrid instruments
Upper Tier 2:
0 Perpetual (undated in most jurisdictions);

0 Subordinated to senior creditors and depositors;
0 Interest deferral option (cumulative);
0 Loss absorbing;
0 Step-up rates allowed but limited.
Lower Tier 2:
0 Dated – minimum original maturity of five years;

0 Subordinated senior to Upper Tier 2, but junior to creditors’ deposits;
0 Interest cannot be deferred. Non-payment is an event of default;
0 Step-up rates allowed but limited;
0 Capital value amortises 20% per annum in last five years for regulatory purposes.
Tier 3 capital
0 Dated subordinated debt (minimum maturity two years);

0 Lock-in clause stops payment of interest and/or principal if capital too low;
0 Supports trading book (market risk not credit risk);
0 Does not amortise.
Insurance companies are also major issuers of subordinated capital securities and the capital rules
that they follow (Solvency) are similar but different to banks’ and are expected to continue to
converge with the capital rules of banks as Basel ll and Solvency ll evolve. Major global insurance
companies have been active in issuing Tier 1 eligible securities even while the regulatory capital
rules for Solvency ll are still developing. Several major insurance companies have also taken an
early interest in the opportunity to gain greater amounts of rating agency equity credit from the
regulatory capital hybrid Tier 1 securities they issue. This has been a catalyst for the evolution of
hybrids for banks and insurance companies.
Tier 1 securities always include common stock and in many cases classic preferred stock (where it
exists in the legal system). Hybrid Tier 1 is a synthetic equivalent to such preferred stock (or
preference shares) in terms of permanence, loss absorption, payment discretion (non-cumulative)
and other key features, but with some terms tweaked to achieve tax deductibility. The hybrid
structuring building blocks therefore include preferred stock equity securities (where it exists)
and/or Upper Tier 2 subordinated debt.
Upper Tier 2 subordinated debt is usually a tax deductible security and if one takes that as a
starting point to create hybrid Tier 1 then the challenge is to enhance its equity features enough
to increase its capital value without losing the tax status as deductible debt. For example,
cumulative Upper Tier 2 payments need to be structured as non-cumulative payments for the
instrument to have a possibility for qualification as Tier 1. The development of ACSM helps span
the gap by creating a quasi-cumulative payment. ACSM features allow deferred payments to be
satisfied with cash from a new sale of equity-rich securities (common, preferred, converts,
warrants) to raise the cash or other methods including payment in kind (PIK) with more hybrids.
This makes the security more like a cumulative security and therefore more debt like. This can be
a crucial difference to the tax analysis and to the investor marketing.
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ACSM features are an example of the ‘structural conservatism’ that has been exhibited in recent
hybrid product development. Fortunately, there has been a continued spirit of accommodation
and a more sophisticated approach from the rating agencies and other key constituents in
evaluating equity ‘equivalence’. This has expanded the eye of the needle in the hybrid capital
structuring Venn diagram and allowed for more hybrid structures that simultaneously:
0 Qualify as equity and/or capital;

0 Achieve tax deductibility;
0 Address investor risk factors.
For example, a hard-line approach to evaluating the equity essence of an instrument would ask:
“Is it perpetual or not?” However, there are more sophisticated ways to consider the question. If
an instrument in present value terms is considered (discounting future payments) a perpetual
instrument (with no maturity requiring payment at a specific date) is somewhat equivalent to an
instrument with a 1,000 year maturity (if you are able to get money today and you do not have to
repay for 1,000 years, or at an indefinite future date that you choose, or never – it is about the
same to you).
Working back toward today from 1,000 years to 100 years (60, 30, 20 and so on) the value of the
payment due starts to become more significant. Current thinking by rating agencies seems to be
that 50 to 60 years is long enough to get significant equity credit. Therefore you will see in
Chapter 6 that deal terms in corporate hybrids started as perpetual but there are more recent
examples of 1,000, 100 and 60-year maturities.
The evolution of international regulatory capital guidelines has historically aimed to create a level
playing field among financial institutions – particularly as multinationals become more
competitive with each other on a global basis. National tax and legal regimes have been one of
the binding constraints preventing this homogeneity across countries. In the US and some other
countries, hybrid Bank Tier 1 can be in the form of a dated security because the tax rules would
not allow deductions on perpetual Tier 1 instruments (see the US taxation perspective article later
in this chapter) but the regulator has taken the view that the overall qualities of the security meet
their hybrid Tier 1 standards and the use of such hybrids is limited within the capital structure.
Time will tell if various other regulators will also adopt a more constructive view of perpetual re-
quirements for hybrid Tier 1 versus a ‘perpetual equivalent’ long dated security and ACSM
resolved payment deferrals as effectively the same as non-cumulative payments.
Legal
In most major countries the legal form of distinct capital market instruments can be distin-
guished as debt or equity and the literal interpretation of ‘security’ can be reliably articulated to
ascertain the legal rights, obligations, recourse, penalties, claims and cures that form the contract
between the investor and the issuer. A long history of the actual resolution contested claim
further assists structuring new instruments with confidence. In such cases a debt security usually
has a specific format and an equity security has a specific format and a properly drafted set of
terms will tell a lawyer or a court what the security is meant to be and what obligations, benefits
and optionality are intended.
From a hybrid structuring perspective it is helpful if the legal system also has a clear definition of
preferred stock or preference shares in addition to debt and common equity. However, in many
emerging jurisdictions this is often not the case and other structural solutions must be
considered.
Generally, the legal aspects are fairly black and white. The legal perspective focuses to provide
properly drafted documentation at the time of the deal (debt/equity) as instructed by the parties
to the deal based on their negotiations. If the issuer maintains its credit and satisfies the terms of
the security there should be no legal contest over the term of the issue.
Tax
Contrast the clarity of issues in the legal documentation process with the opaqueness of most tax
law. There is real money at stake between the tax authority and the deal parties – yet the tax
authority is often not party to the deal terms when the deal is structured. However, the tax
authorities can take action any time after the deal is closed (deny deductions, impose withholding
tax, etc). Issuers should seek tax-efficient means of financing their businesses to produce optimal
shareholder risk adjusted returns.
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Taxes, like all business expenses, should be prudently managed and tax planning involves risk
management. Frequently where there is a quirky feature in the structure of a hybrid deal it is
driven by the tax optimisation of the structure within the context of the jurisdiction where it was
issued. International investors do not want to be exposed to the tax risk of the issuer’s home juris-
diction (where investors cannot hope to be experts), therefore tax risks are usually borne by the
issuer (i.e. gross-up clauses, redemption features).
The determination of expected tax treatment often comes down to reasoned judgment from legal
tax experts based on precedent and case law (which may not be available) on the specific
structuring nuances. The use of a strong tax counsel is imperative and where possible a strong tax
opinion from the lawyers or ideally a tax ruling from the local tax authority is advisable to ensure
best results. Some of the recent innovations in the US market have been accomplished through
advances in the application of the US tax law given the greater depth of legal context the industry
now enjoys as the hybrid security product proceeds through its second decade of existence. Please
refer to the US taxation perspective article at the end of this chapter for an in-depth look at the US
tax issues and their impact on the evolution of hybrid securities.
SPV hybrids
These are one of the most useful and prevalent structures employed in hybrid capital structuring.
The use of an SPV in hybrid structuring can assist in achieving many issuer objectives, including:
0 Accounting minority interest (quasi-equity) – consolidation of SPV onto parent financial statements;
0 Deconsolidation (orphan SPV);
0 Tax optimisation (withholding tax, stamp duty, deduction);
0 Elimination of voting rights;
0 Change characterisation (debt in, equity out or the opposite);
0 Payment deferral control – switching payment flows to investors ‘on’ or ‘off’ and providing a way to
overcome the rigid limits of the debt securities (tax) in order to meet the capital and equity requirements;
0 Investor tax reporting (Trust vs. Limited Partnership investor tax reporting);
0 Aggregating/splitting benefits – two or more securities may be input to the SPV and then an aggregation
or subset of the combined features can be provided to the investors with investors only needing to hold
one single security.
As the hybrid products have become more reputable globally the system has evolved in some countries to
streamline the available structures for achieving the benefits of hybrids.
For example, it is increasingly common to have direct issue hybrid securities replacing the more complicated
SPV issues which preceded them. This is the case in France, the Netherlands, the UK and Italy to name a few.
Sometimes this required a change in law (as in France), other times just a greater leniency from a regulator,
rating agency or other constituent that had previously resisted.
One of the catalysts has been the increased issuance by insurance companies and corporates that on
balance have a greater incentive to seek rating agency benefits. Banks did most of their hybrid development
during the late 1990s and in some case had exemptions they could use to balance the tax/regulatory
tensions. Since then they have been happily issuing on a frequent basis with fairly modest incremental im-
provements or changes to the bank capital structures.
Typical SPV structure

This can be established in three easy moves:
1) The bank establishes a wholly-owned SPV by investing a nominal amount of capital to acquire 100% of the
SPV common equity. The ideal conditions for the SPV include the following:
0 Bankruptcy remote;
0 The SPV begins as a clean ‘shell’ – a new pass-through entity, no contingent liability from past operations,
no other activities permitted;
0 The SPV can be consolidated as quasi-equity (such as minority interest);
0 Fiscally transparent (no/minimal SPV level tax leakage) usually based on jurisdiction of SPV (e.g. Cayman,
Delaware);
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0 The SPV will benefit from a ‘guarantee’ by the parent bank which allows it to benefit from the credit ratings
0 of the parent bank. The guarantee is a subordinated level of limited guarantee suitable to the capital nature
of the security (no senior guarantee on capital).
2) The bank issues an instrument (subordinated notes, deposit security) to the SPV in return for cash.
3) The SPV issues ‘capital securities’ to third party investors (cash proceeds are used to pay the bank for the
instrument it provided to the SPV and to get the cash to the bank as required for Tier 1 eligibility).
Figure 5.4: Simple SPV Structural Diagram
Issuer
Cash « Subordinated
proceeds notes (interest
payments tax
deductible)
«
SPV
«
Subordinated
«
guarantee
Cash Capital
proceeds securities
«
Investor
Because of the use of the SPV to issue the actual capital securities these structures are often referred to as
‘indirect issues’. At inception, the proceeds from the third party capital security investors are used by the SPV
to purchase the subordinated securities from the parent bank. It is important to note that the cash goes all
the way back to the parent bank providing it with the full benefit of the issuance of hybrid Tier 1. The
subsequent subordinated security payments from the bank to the SPV fund the SPV capital security
payments to investors.
If a capital event or regulatory event or other specified non-payment event occurs, capital security payments
to investors can be eliminated by either suspending payments at source on the subordinated security or
by retaining cash at the SPV and routing it back to the parent bank as an SPV common dividend payment
(since the parent bank owns all the common stock of the SPV). Since the capital security is the security
issued out of the SPV and not the security the SPV acquires from the bank the capital will show up in the
consolidated financial reports of the bank but will not be included on a ’solo’ reporting basis where
subsidiaries are excluded.
In the first phase of adoption of SPV hybrid Tier 1 by international regulators the accounting treatment
received significant focus but over time this has diminished in some jurisdictions. This is a very simplified
illustration of the US trust preferred security structure and many of the early SPV structures used in Europe
and Asia.
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There are also examples of SPV hybrid Tier 1 structures where the SPV is not owned or guaranteed by the
bank (issuer). In such cases the actual capital security is issued directly from the bank to the SPV. The SPV in
this case serves a different purpose – typically to make the bank capital security more marketable to the in-
ternational investors (e.g. management of withholding tax). The SPV in such case is owned by an independent
third party or is an ‘orphan’ not owned or consolidated by the bank. The SPV securities will provide a simple
pass-through of the capital security payments and the nature of the securities (debt/equity) is not typically a
major factor in the structuring for regulatory capital qualification since they are issued by an independent
entity. In Chapter 6 there are examples of German and Irish hybrid structures of this variety.
Deft hybrid structuring professionals demonstrated an ability to overcome most concerns the regulators
identified with hybrid securities. Good structuring led to SPV hybrid Tier 1 that was by most accounts
equivalent to what the regulators said they needed for a Tier 1 instrument. To the extent any one hybrid
structure was imperfect in its ability to completely satisfy 100% of the national regulators’ requirements there
were several examples of ’less perfect’ securities that were already accepted as Tier 1 in another country. The
international regulators desire to harmonise Tier 1 guidelines globally and to create a level playing field led to
compromise. Since adroit financial engineers seemed to overcome most roadblocks to the adoption of
hybrid Tier 1eventually it was accepted within broad guidelines that provided for national regulator discretion
and local tax needs. Instead of continuing to focus on the exact nature of Tier 1 instruments, limits were put
in place on the amount that could be included in the capital structure.
One criticism of SPV structures was the perceived complexity, potential complications in a liquidation
scenario and the perceived distance from the bank and its regulators. Capital should be pure, said some.
SPV structures were also unfairly cast in a negative light because completely unrelated schemes and
unrelated business entities sometimes used SPVs to accomplish unsavoury ends (such as money laundering)
particularly in countries deemed to be offshore ‘tax havens’. It was important that legitimate bank capital
should not be tarred with the same brush. Therefore the move to direct issues has increased over time. In
Chapter 6 there are numerous indirect issue SPV structures and also direct issue structures detailed from
various countries.
Summary rating agency guidelines

There is a summary later of the guidelines from the major rating agencies. There is a strong
correlation with the bank capital guidelines and the preferred stock paradigm, in that all concur
that equity is:
0 Permanent (no maturity or long maturity);
0 Has no ongoing payments that cause default;
0 Absorbs losses.
The primary structuring objective with regard to rating agency credit has been to achieve 50–75%
equity credit by including key features that the rating agencies consider adequate to meet these
major criteria. In the Moody’s terminology, for example, 50% is ‘Basket C’ and 75% is ‘Basket D’.
Achieving the high equity credit status of Basket D has been the innovation in most of the next
generation hybrids (see the text box below). To obtain even greater equity credit an issuer
typically would need to consider a mandatory convertible security linked to its common equity
and dilutive to its shareholders. Such securities are considered to be part of a different market;
they are sold to different investors and they require different issuer considerations and are not
addressed in detail in this report as a result.
Rating agencies studied the available historical data to evaluate the observable behaviour of capital
securities in prior periods when the issuing entity is under severe financial distress and in some
cases liquidation. The subordinated securities had low recovery rates in liquidation because they
are ‘loss absorbing’ and paid after senior creditors and depositors with any residual funds. The
rating agencies observe that optional payment deferral is often not used to conserve cash or is used
reluctantly by management. This review of the historical performance decreases the rationale for
high equity credit for optional payment deferral but could encourage investors that deferral is
actually somewhat unlikely. Greater equity credit is given by rating agencies if mandatory payment
deferral is included in the terms but this increases investor risk (as discussed below).
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How to achieve a Moody’s Basket C or Basket D

Assuming the subordinated (loss-absorbing) instrument is very long dated (60 years) or perpetual, the focus
shifts to eliminating payments and increasing permanence.
Basket C
A Basket C hybrid will normally include ‘Intent-based’ replacement language and optional payment deferral.
Optional deferral – Payment can be deferred/eliminated at the issuer’s discretion if no common dividend was
declared at the last Annual General Meeting.
There are several variations in the resolution of the payment deferral among different hybrid transactions:
0 The optionally deferred payments can be either cumulative or non-cumulative, depending on jurisdiction
(if non-cumulative, the payment is lost);
0 Optionally deferred payments can be cumulative for a specified or indefinite period of time;
0 Optionally deferred payments may be eligible for settlement via an ACSM, wherein the issuer could pay with
proceeds from the selling of existing or new ordinary shares, preferred shares or various benign/parity
securities;
0 The ACSM can be an intention from the issuer to attempt to issue stock (soft ACSM) or an obligation from
the issuer to use such a mechanism to satisfy deferred coupons (hard ACSM).
Basket D
A Basket D hybrid will also include optional deferral but will add either mandatory payment deferral or legally
binding replacement language (LBRL).
Mandatory payment deferral: At the occurrence of a ‘meaningful deferral trigger’ hybrid payment is
mandatorily deferred (similar payment deferral resolution alternatives to optional payment deferral). As an
example, the Moody’s original standard of reference is the MetLife trigger, which includes either of the
following:
0 Four quarters of net loss and shareholders’ equity down by more than 10% compared to prior 8 quarters;
0 Covered insurance subsidiaries’ risk based capital ratio is less than 175%).
This is seen to increase the hybrid equity content with reference to ‘no ongoing payments’ and mitigates the
agency concerns that issuer management will continue to make optional payments when cash conservation
would be better for the senior creditors’ risk exposure.
Replacement language – To increase the hybrid permanency for more equity credit, LBRL can be included
instead of mandatory payment deferral. If the hybrid securities are called, the issuer must replace them with
instruments of equal or greater equity content.
The replacement issue is not as critical for issuers that are deemed to be strictly regulated (since the bank
regulator will monitor capital needs) but has been important for insurance and corporate hybrids.
Practical considerations
There are structural deviations from the preferred stock paradigm necessitated by the practicali-
ties of the markets:
0 Investor protections – It is no good creating a structure that cannot be sold to investors.

Investors seek structural enhancements that strike a balance between risk and reward that
justifies investment in the hybrid asset class;
0 Issuer protections – What if it all goes horribly wrong? Issuers need the flexibility to unwind or
make a special redemption if all the intended benefits are eliminated.
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To comfort investors, some structural features such as the ACSM have become increasingly
popular. As discussed in the investor overview (Chapter 4) there are two major market segments
(institutional and retail, private bank or RPB) and each has a different approach to evaluating
hybrid security investment decisions. As the M&A boom has driven the need for larger hybrid
transactions the institutional market has been the primary market for execution. Institutional
investors tend to put greater focus on the detailed terms of hybrids and the potential risks they
contain, such as:
0 Non-payment;
0 Subordination;
0 Extension risk.
To increase the investor universe willing and able to buy hybrids and to lower the issuers’ cost of
capital funded via hybrids, more debt-like features have been included in contemporary hybrids
(which also helps the tax analysis in some countries).
Addressing investor non-payment risk

Investor payment risk is different across various hybrid structures. Hybrid payments can be
deferred on an optional and/or mandatory basis. The deferred hybrid payments can be either:
0 Cumulative;
0 Quasi-cumulative via ACSM;
0 Non-cumulative, depending on jurisdiction and the structure.
Therefore investors should always focus on these distinctions when comparing hybrid securities.
Payment deferral conditions

Optional payment deferral – Hybrid payments can be deferred at the issuer’s discretion if no
common dividend was declared (within a specified look back period). This preserves the hybrid
equity position in ‘preference’ to common equity so that common does not get paid when
preferred or hybrids do not.
Mandatory payment deferral – Hybrid payments must be deferred if a specified financial trigger
(included in the offering documents) is breached. Regulatory capital securities will also be subject
to solvency or capital adequacy triggers and to discretion of the national regulator. In some
structures there may be additional conditions such as the availability of distributable profits
and/or reserves.
Deferred payment resolution

If the securities are truly non-cumulative like classic Tier 1 (preferred stock, common stock),
payments that are not made will be lost forever. Deferred payments can alternatively be
cumulative for an indefinite or a specified maximum period of time (such as five or 10 years). At
the end of the specified period, payments may either become due or in other structures will be
lost forever.
While non-cumulative payments are ideal in ‘equity’ instruments, both fixed income investors
and certain tax regimes are more comfortable with the more debt-like cumulative payments. Non-
cash cumulative payments achieved via ACSM reconcile the two divergent constituents and
stretch the ‘eye of the needle’ to fit more deals through. Therefore in many recent hybrids the
issuer may satisfy deferred payments through the ACSM by paying the coupons with cash
proceeds from the sale of new common/ordinary shares, preferred shares or parity securities or
PIK. The ACSM can be an intention from the issuer to attempt to issue stock (soft ACSM) or an
obligation from the issuer to use such a mechanism to satisfy deferred coupons (hard ACSM). The
investor risk is derived in part from these structural differences as shown in the payment flow
decision trees which follow. By comparing these illustrative example, subtle but potentially
important differences can be observed that are typical in the universe of hybrid securities.
Remember, every hybrid security needs to be examined in relation to the full terms and
conditions of the offering circular and insight can often be gained from the rating agency write-
ups on specific transactions. Differences may exist within sector, within country and even among
several hybrids issued by the same company.
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Insurance hybrid, example 1

This structure has three primary events that could result in payment deferral or elimination:
1) Optional payment deferral – This is possible if no common dividends have been paid during the
12-month look-back period. If the issuer’s option is exercised by company management, then
payments are lost (non-cumulative);
2) Solvency event – Payments are stopped and lost forever (non-cumulative);
3) Mandatory payment deferral – If this is breached payments are deferred and may be settled via
ACSM.
Figure 5.5: Hybrid, example 1 - interest payment mechanics
Payment of common stock Solvency event Mandatory deferral event Payment outcome
Coupon is paid
Is there a Is there a « (dividend pusher)
Yes « solvency
event?
No « mandatory
deferral event?
No
Has a dividend Yes

Yes «
«
been declared
or paid? Coupon is lost Mandatory deferral: coupon
is deferred ACSM applied
«
«
Yes
No « Yes «
Lookback Is there a Is there a
=12 month
period
solvency
event? No « mandatory
deferral event? Optional deferral: coupon
No « paid/cancelled at option of
issuer

This structure has three primary events that could result in payment deferral or elimination:
1) Optional payment deferral – This is possible if no common dividends have been paid during the
payments are deferred and may by settled via ACSM (quasi-cumulative);
2) Solvency event – Payments are deferred and may be settled via ACSM (quasi-cumulative);
3) Mandatory payment deferral – If this is breached, payments are deferred and may be settled via
ACSM.
Payment of common stock Solvency event Mandatory deferral event Payment outcome
Coupon is paid
Is there a Is there a
No « (dividend pusher)
Yes « solvency
event?
No
« mandatory
deferral event?
Yes
Has a dividend
been declared
Yes «
or paid? « Mandatory deferral: coupon
« is deferred ACSM applied
« No « Yes
«
Yes
Lookback Is there a Is there a
=12 month
period
solvency
event? No « mandatory
deferral event?
No « Optional deferral: coupon is
deferred ACSM applied
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This structure has only optional payment deferral, which may be settled via ACSM:
0 Optional payment deferral – This is possible if no common dividends have been paid during the
payments are deferred and may be settled via ACSM (quasi-cumulative).
Payment of common stock Optional deferral Payment outcome
Are payments
No
Yes « optionally
deferred?
« Coupon is paid
Has a dividend
been declared
or paid?
« No « Yes « Optional deferral: coupon is

deferred ACSM applied
Lookback Are payments
=12 month optionally
period deferred? No
« Coupon is paid
NO
MANDATORY DEFERRAL:
MOODY’S BASKET D ACHIEVED WITH
LEGALLY BINDING REPLACEMENT
LANGUAGE
Dividend stopper - if interest payments are optionally deferred, no dividend payments on any shares of capital stock can be made, and no payment of principal or interest on any
pari passu/junior securities can be made (including securities issued of subsidiary level)
Addressing investor extension risk

Fixed income institutional investors prefer a known maturity and principal repayment certainty –
a step-up rate at the hybrid call date increases certainty. Both regulators and rating agencies limit
the size of the step-up since they think that an excessive step-up will motivate early redemption
and decrease the ‘permanence’ of the hybrid capital in the capital structure. Therefore step-ups
are generally limited to 100bp (with several exceptions). The 100bp step-up amount is added to
the original fixed rate spread at the pricing date (expressed as a Libor spread or equivalent). The
step-up occurs after the call date (usually in year 10) when the coupon changes from fixed rate to
floating rate.
Because banks rely on frequent access to the capital markets for liquidity most market partici-
pants expect banks to call the securities and refinance at the call date in order to satisfy investor
preferences and maintain low-cost access to the capital markets. Some high-quality banks with
very reputable management teams have successfully issued perpetual hybrids with no step-up at
all. These hybrid securities are referred to as True Perps to distinguish them from step-up hybrids.
For insurance companies and corporate issuers the liquidity incentive is less evident and investors
have greater concerns over the extension risk presented by a step-up which is considered too low.
Lower rated issuers further stress the investors risk analysis since there is greater possibility that
the credit will deteriorate and the hybrid will not be economical for the issuer to refinance. If the
hybrid security has a maturity (as seen in several corporate hybrids) this may give some comfort
that eventually the principal will come due, even if the securities are not called when the step-up
rate kicks in. Hybrid issues that are not intended to provide regulatory capital or high levels of
rating agency equity (such as those for accounting equity or just long-term low-cost quasi-capital)
have used higher step-up to increase the demand from investors by reducing their perceived risk
of extension at the call date.
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Addressing investor event risk
Change of control clause (COC)

Event risk – such as LBO takeover risk – is sometimes addressed via very high rate step-ups
(500bp) linked to a rating downgrade threshold (typically below investment grade) that results
from a change in control (merger, takeover). The company can pay or accrue at the higher interest
rate or tender to redeem the impacted securities benefiting from the COC. The step-up
mechanism is less effective in a truly non-cumulative instrument. The key risk to investors
without the COC clause is that a company is taken over via a highly leveraged financing that
leaves the company highly geared. Potentially common stock dividends could be cut by the new
company owners to service senior debt payments. Once the common dividends are cut, the
hybrid payment discretion comes into play and hybrid payments could also be deferred or
eliminated to service senior debt. Under such a circumstance the hybrid investor could be stuck in
a radically different (worse) credit and be holding a zero coupon perpetual subordinated security –
ouch!
Issuer protections
Issuers pay a yield premium when they issue hybrids compared to what a similar term plain
vanilla senior issue would cost. The incremental cost is justified by the various benefits hybrids
can provide, but the main benefit is low cost equity. One of the essential features of equity,
according to many market constituents, is permanence. Therefore hybrids are structured long
dated or perpetual. Even the scheduled optional call date is usually five or 10 years after the date
of issue. So the issuer is making a long-term commitment when they decide to issue hybrids. If
the rules change and the key benefits are lost or a new adverse condition arises, the issuer
obviously would like the flexibility to redeem (or modify) the hybrid securities. Typical early
redemption events to protect the issuer in the event a change of rules diminishes the hybrids
benefits are as follows:
0 Accounting event;
0 Capital event;
0 Tax event;
0 Additional amounts event (typically withholding tax);
0 Acquisition event.
Figure 5.8 illustrates the potential functioning of a hybrid security with various early redemption
options for the issuer’s protection.
However, investors could suffer a loss due to an early redemption at the issuer’s option, since the
hybrid security may be trading at a premium or the investor may have ’locked up’ the asset by
matching it against specific liabilities or hedged it or be prevented by charter from selling. A
‘make whole call’ is designed to comfort investors that they should be fairly paid if the issuer
needs to redeem ahead of the scheduled call date. A make whole call price is normally derived
from discounting the remaining cash flows by a low discount rate that will provide a premium
price that is in excess of what the investor might reasonably expect the bond to be at. With a
make whole call and a generous call price investors should be interested in allowing a call at any
time, as shown in the structure in Figure 5.8.
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Figure 5.8: Hybrid example 3 - optional early redemption mechanics
Standard features:
Change of Accounting event Acquisition event

control event
capital event tax event
«
Yes additional amounts
event minimum Issuer option to
Issuer option to redeem securities
outstanding principle redeem securities - in whole but not in
No Has early redemption
Scheduled call date? « event occurred
amounts event - in whole but not in
part
part
- at 101% of principle
Issuer option to - at special make - amount + accrued
redeem securities whole redemption interest
- in whole, but not in price (higher of
part principle amount or
- at principle amount + price equiv. of Bunds
accured interest + 100) + accrued
Yes interest
«
No
Issuer option to redeem
securities
- in whole but not in
part «
-at principle amount + Issuer option to redeem securities
accrued interest - in whole but not in part
-at make -whole redemption price (the higher of principle amount or
price equivalent of Bunds +25 + accrued interest
Accounting guidelines
Defining equity instruments under IFRS:
“Under IFRS an instrument is classified as equity if there is no contractual obligation to deliver

either cash or another financial asset or exchange financial assets and financial liabilities at
potentially unfavourable terms to the issuer.”
“Equity represents a residual interest in the assets of an entity.”
“If there is a contractual obligation to deliver cash, the instrument is debt (financial liability).“
According to §16 IAS 32, a hybrid capital instrument issue can be treated as equity if and only if it
does not bear any contractual obligation to:
0 Pay cash or any other financial asset;
0 Exchange financial assets or liabilities with a counterparty according to conditions that would
be unfavourable for the issuer.
Therefore, if a security includes no obligation of financial reimbursement or cash payment, the

security should be accounted as equity. The main characteristics of hybrids compatible with an
equity treatment according to §17 are as follows:
0 Any call feature is in the hand of the issuer (no investor put);
0 The payment must be discretionary – solely the decision of the issuer (like dividends);
0 The past dividend paying payment track record is not deemed an obligation to pay cash;
0 Cumulative feature of payments is allowed (like common stock ‘retained earnings’);
0 Step-up at call date is allowed. The typical 100bp will not prevent the instrument from being
treated as 100% IFRS equity. Most reasonable step-ups measured in relation to the coupon and
market norms should be allowed since economic incentive is not the same at a contractual
obligation.
The equity classification of the hybrid instrument ultimately will be determined by the issuer’s
auditors and this is a subjective and evolving practice area where divergent judgements of
different firms and individuals may occur.
The IFRS classification of an instrument as equity can also prohibit the use of hedge accounting if
an issuer intends to swap the transaction. Therefore if the characteristics of the security provide
for equity treatment under IFRS rules, swapping the issue will not allow for hedge accounting.
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Table 5.1: Hybrid securities – summary primary foundations

Regulatory Rating agency Accounting Legal Taxation Investors
Issuer aim Tier 1 Regulatory Rating agency Equity accounting Structure permissible Tax Investor-friendly
capital equity credit under IFRS under legal framework deductibility structure to achieve
achieved of issuer jurisdiction achieved wider placement/
tighter
pricing
Equity-like/ More equity - like More equity - like More equity - like Either Equity or Debt More debt - More debt - like
Debt-like (however, some like (if
issuers want debt deduction
treatment) desired)
Permanence -Permanent (perpetual) -Permanent -Perpetual (no -Perpetual or long -Overall -Limits to duration
-Limits to minimum (perpetual/ long maturity) dated natureof to reduce cost
call date dated) -Long call date security -Prefer shorter
-Limits on maximum -Limits to -Reasonable considered call date
step up minimum call date step-up taking into -Prefer higher
-Limits to account all step-up
maximum step-up features and
-Replacement case row
language precedent
-In some
cases,
specific
security types
are deemed
deductible
under local
law
(Preferentes,
TSS, Stille
Einlage, etc.)
Sub- -Deeply subordinated- -Deeply -Not required for –Case law referred to -Jurisdiction -Price premium
ordination senior only to common subordinated- IFRS equity for precedent dependant required for
equity senior only to classification -Legal and subordination
-Loss absorption common equity accounting
-Loss absorption treatment
may be
Ability to -Non-cumulative -Non-cumulative -Non-cumulative -Civil code referred to observed -Cumulative or
defer -ACSM where allowed best -Can be quasi -Exchange/other for support quasi-cumulative
payments -Can be quasi cumulative- but rules applied better
cumulative (ACSM) payments must -Non-cumulative
remain fully requires premium
discretionary
Rating agency approaches to hybrid capital

The three major credit rating agencies (Moody’s, S&P and Fitch) contemplate hybrid capital
securities from two angles:
0 The credit rating allocated to the specific security signals risk to investors;
0 The balance sheet equity content allocated in determining the issuers overall rating.
Therefore, the following two perspectives of the rating agency methodologies will be discussed
for each of the key rating agencies:
0 Methodology for the allocation of equity credit;

0 Notching practice for banks, insurance and corporate hybrid structures.
To generalise a metaphor, it could be said that Moody’s published framework for analysis seems
more focused on the hybrid ‘tool’ while S&P publications seem to consider also the ‘craftsman’
that will use the tool and the ‘task at hand’. Clearly, the work completed by the rating agencies
accelerated the adoption of hybrids by issuers and investors alike and will continue to shape the
future of the hybrid security market.
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Until the release of a seminal series of 2005 publications, the rating agency methodology for
hybrids was viewed as opaque and lacking clarity, leaving issuers and investors wary. Increased
transparency at the rating agencies, accompanied by clarification around their methodologies,
gave rise to increased levels of issuance and innovation – particularly from the corporate sector.
Investors also benefited from these publications as they helped highlight the potential
risk/reward trade-offs of hybrid investment, both in the narrative and via a system of ratings
notches to visually flag the potential incremental risks. Generally, for investment grade issuers,
both Moody’s and S&P apply one notch down for subordination and one notch down for possible
payment deferral. If mandatory deferral is included in the structure, S&P may apply a third notch.
Lower rated issuers may be notched further.
Rating agencies continue to refine their methodologies for assessing hybrid securities, with an
increasing focus on the structural detail. However, continued refinements to their methods have
sometimes put unwelcome volatility into the system, frustrating issuers and investors grappling
for stability and clarity in their understanding of the emerging asset class. Given the huge contri-
bution of the rating agencies this criticism seems a bit unwarranted and market participants
should expect changes as the market collectively learns more about the hybrid asset class.
Table 5.2: Notching for hybrid securities

Corporate Hybrid Insurance Tier 1 Bank Tier 1 Upper Tier 2 Lower Tier 2
Moody’s (FSR C and above) + 2 notches + 2 notches + 2 notch + 1 notch + 1 notch
S&P (Senior above BBB-) + 2/3 notch + 2/3 notch + 2 notches + 2 notches + 1 notch
Fitch (Senior above A-) + 1 notch + 1 notch + 1 notch + 1 notch + 1 notch
Table 5.3: Development of the ‘meaningful’ mandatory deferral trigger, 2004 - 06

Issue Date Transaction Mandatory deferral trigger
20-Feb-2004 Allianz €1.5bn Perp nc 2014 1 - Net loss
26-Jan-2005 AGF €400m 4.625% Perp nc 2015 1 - Net loss with a 4-quarter look-back at capital formation
9-Jun-2005 Metlife US$1.5bn 6.5% Perp nc 2010 1 - 4-quarter Net loss AND Shareholder’s equity has fallen by more than
10% compared to prior 8 quarters (with 2 quarter cure period), OR
2 - Covered insurance subsidiaries risk-base ratio is less than 175%
28-Feb-2006 Allianz Finance II BV 5.375% Perp nc 2011 1 - Net income in preceding year is less than or equal to zero, AND
2 - Adjusted shareholders equity amount as at the end of the most recently
completed and published quarter of the Guarantor and as at the end of the
quarter that is two quarters before the most recently completed and
published quarter of the Guarantor has declined by 10% or more, as
compared to the adjusted shareholders equity amount as at the end of the
quarter of the Guarantor that is ten quarters prior to the most recently
completed and published quarter of the Guarantor.
4-May-2006 ELM BV (Swiss Re) 5.252% Perp nc 2016 1 -Consolidated net income for the two consecutive Reporting Periods
ending on the Lagged Reporting Date is less than zero, AND
2 - Adjusted Equity Amount as at the Lagged Reporting Date has declined
by more than 10% as compared to the Adjusted Equity Amount as at the
Reporting Date that is 24 months prior to such Lagged Reporting Date (the
“Benchmark Adjusted Equity Amount”), AND
3 - Adjusted Capital Amount as at the Current Reporting Date has declined
by more than 10% as compared to the Benchmark Adjusted Equity
Amount.
7-Jun-2006 Generali €1.275bn 5.317% Perp nc 2016 1 - Aggregate Net Income of the Guarantor for two consecutive Reporting
Period ending on the lagged Reporting Date is less than zero, AND
2 - Adjusted Equity Amount of the Guarantor as at the Lagged Reporting
Date has declined by more than 10% as compared to the Adjusted Equity
Amount as at the Reporting Date that is 24 months prior to such Lagged
Reporting Date, AND 3 - Adjusted Capital Amount of the Guarantor as at
the Current Reporting Date has declined by more than 10% as compared to
the Adjusted Equity Amount as at the Reporting Date that is 30 months
prior to such Current Reporting Date.
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Table 5.3: Development of the ‘meaningful’ mandatory deferral trigger, 2004 - 06 (cont.)
Issue Date Transaction Mandatory deferral trigger
29-Jun-2006 Axa €1bn 5.777% Perp nc 2016 1 - Accumulated Net Earnings of the Issuer for the two 6-month periods
ending on the Lagged Reporting Date is less than or equal to zero, AND
2 - Adjusted Shareholders Equity Amount as at the Lagged Reporting Date
has declined by 10% or more as compared to the Adjusted Shareholders
Equity Amount as at the end of the Benchmark Half-Year Period; AND
3 - Adjusted Capital as at the Current Reporting Date has declined by 10%
or more as compared to the Adjusted Shareholders Equity Amount as at the
end of the Benchmark Half-Year Period.
Source: Transaction Offering Circulars
Moody’s approach
Moody’s produced their seminal Toolkit publications in 2005, which first gave clarity to the
rating agencies methodology for assessing hybrid securities. To many market participants,
Moody's have led in the development of the recent thinking on hybrid capital securities, the
distinction of debt from equity and how to craft a fixed income security that provides financial
flexibility and capital structure benefits like common equity. Indeed, the Moody's Toolkit
framework has been the most articulate and transparent summary of rating agency methodology
and it sparked a surge of new issuance and increased issuer and investor dialogue.
The essential features of an instrument are assessed compared with the key features of equity,
which according to Moody’s include the following:
0 Permanence (no maturity or long dated);
0 No ongoing payments (which could trigger a default);
0 Loss absorption.
The features are scored according to their strength relative to equity using four grades:
0 ‘Strong’ (most-equity-like);
0 ‘Moderate’;
0 ‘Weak’;
0 ‘None’ (most-debt like).
A more detailed description of this framework for classification is given in their January 2006
publication ‘Refinement to Moody’s Tool kit: An addendum for Banks and Insurers’.
After these three essential attributes are evaluated individually, the instrument’s aggregate score
is considered relative to the debt-equity continuum and the hybrid instrument is placed in one of
five baskets on the debt-equity continuum.
The amount of equity credit related to the basket of the particular hybrid security will impact
positively on the issuer’s overall credit metrics, provided the proportion is within the ‘tolerance’
for total hybrid issuance for the particular senior rating level.
In summary:
0 Essential equity features are scored according to four grades – ‘strong’ (most equity-like),
‘moderate’, ‘weak’ and ‘none’ (most debt-like);
0 The instrument is put in one of five baskets in along the debt/equity continuum based on the
essential equity features;
0 Each basket corresponds to a fixed amount of equity content to be used in balance sheet ratios;
0 Issuers should not use excess amounts of hybrid in the capital structure.
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Market precedent and application of the Moody’s methodology

One of the key features to have evolved from the Toolkit to enhance the ‘no ongoing payments’
criteria is mandatory payment deferral. In order to increase the equity credit from Moody’s via
mandatory payment deferral the term must be legally binding within the hybrid security terms
subject to ‘meaningful deferral triggers’. This feature provides an important structural element
which has been applied by many recent hybrid issuers in order to achieve a Moody’s Basket D
weighting. A meaningful trigger should incorporate an income and capital trigger for insurance
companies, capital trigger for banks and a cash flow trigger for corporates. Recent insurance and
corporate hybrid transactions provide the most prevalent precedent for these features (see
examples in the text box). Since the issuers are legally required to defer payment if the trigger is
breached, investor risk is increased and market pricing is more costly for the issuer compared to a
Basket C transaction which is only optionally deferrable. However many issuers consider the extra
benefit to be worth the marginal incremental cost.
Mandatory deferral
Payment discretion is essential for the financial flexibility of equity as it is defined by most constituents.
However, some studies of historical bank hybrid payment behaviour suggest there could be a reluctance on
the part of managers to stop making optional payments. If this is true, the implication is that the value of
optional payment deferral could have limited value in the determination of the equity nature of an
instrument. Therefore mandatory payment deferral provides greater equity essence within an instrument.
Regulatory bank capital securities typically have a series of events which could cause the issuer to be forced
to stop making its otherwise discretionary payments. Most significant is the ability of the bank regulator to
stop payments should they deem it in the best interest of the banks depositors, creditors and/or the national
financial system. Other defined events, such as breach of required regulatory capital thresholds for capital
adequacy, could trigger payment elimination. The same concept exists within regulated insurance hybrids,
but solvency ratios are used. To achieve higher levels of equity credit from Moody’s one route is the inclusion
of ‘meaningful triggers’ that result in the legal requirement to stop making hybrid payments. Moody’s
considers these trigger points are set at indicators of financial conditions where cash is better conserved
internally (to protect the senior debt holders) rather than paid out on hybrids. For issuers that are not
regulated it is of even greater importance to Moody’s to achieve higher amounts of equity credit. Considered
in isolation the mandatory deferral feature raises the risk of the hybrid investor. To flag the investor’s risk
caused by this, S&P has at times provided a third notch on hybrid ratings where this Moody’s designed
mandatory deferral feature is included. For issuers with senior ratings on the cusp of non-investment grade
(low bbb) the extra notching could be a discouragement, as the notching into deep non-investment grade
could negatively impact investor demand and pricing of the hybrid. Some issuers avoid this mandatory
deferral feature and either settle for less equity credit or utilise the LBRL (as discussed above) to achieve the
same high level of equity credit. Another structural feature which has evolved to mitigate the negative
aspects of this feature is the ACSM.
Another important structuring aspect is replacement language in relation to the Moody’s criteria
of ‘permanence’. Because hybrids are typically callable (and often have a step-up payment rate at
the call date which could motivate redemption at the call date) it could be argued that such
callable securities are not significantly permanent within the capital structure. Replacement
language seeks to comfort the rating agencies that hybrids will be a permanent part of the capital
structure. Intent-based replacement language is the most common form thus far. In the offering
document the issuer states they intend to replace the hybrid with an equal or better equity
security. Intent-based replacement language has been included in all Basket C hybrids and if
mandatory deferral is included, then Basket D status can be achieved (if the other structural
aspects are appropriate). An alternative is the legally binding replacement capital clause.
With a legally binding replacement clause an issuer can achieve Moody’s Basket D without
including the mandatory payment deferral feature in the structure. This could provide a lower
cost Basket D hybrid issue since it subjects investors to less payment uncertainty. Also some early
hybrid issues were notched down one extra notch by S&P to signal the risk of mandatory deferral
(further increasing issuance cost) but legally binding replacement language would not attract this
additional notch. A stifling complication is the impossibility or impracticality of drafting a legal
contract of this type in certain jurisdictions. The contract is not with the hybrid investors or with
the rating agencies, but instead with and independent third party such as a class of senior bond
holders. Successful examples have, however, been observed in the US, UK and Australia.
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Replacement language
Rating agencies value true equity because of its perceived permanence – it has no defined maturity calls
(particularly with step-ups) or puts. These features bring hybrid permanence into question. Replacement
language provides some reassurance to the agencies, particularly for non-regulated issuers.
For a well regulated industry such as banking in the major world economies there is a belief that the national
regulator will prudently monitor the banks within its jurisdiction and guide the bank in its maintenance of
adequate capital. There is a long historical period which can be observed to confirm that major regulators have
behaved prudently in most cases over many years and in most major countries with advanced economies and
capital markets. So hybrid capital from well regulated banks is deemed to be as permanent as it needs to be
from the rating agency perspective without specific replacement language in the hybrid documentation.
Insurance regulation is deemed to be in a more developmental stage generally and for unregulated
corporates there is no oversight body to monitor, guide or enforce the capital structure decision process. In
these cases rating agencies require the inclusion of replacement language in order for the issuer to achieve
higher levels of equity credit. ‘Intention’ to replace is the minimum issuer commitment required, but even
greater equity credit can be achieved if the issuer is willing to be legally bound to replace the hybrid capital
with equal or better quality equity securities in future (ideally, prior to redeeming the hybrid in question).
Therefore hybrid transactions have been structured that seek to increase the permanency feature of the
structure to get more equity credit by including LBRL in the form of a replacement capital covenant (RCC)
with the following considerations:
0 If the securities are called, the issuer must replace them with instruments with same terms and conditions
that are ranked pari passu with existing securities;
0 The legal commitment is neither with the rating agencies nor with the hybrid security holders, but instead
with a third party set of investors identified outside the hybrid documentation in separate deed of
covenant. A specific class of senior bond holders could be parties to the RCC, for example.
One of the more recent methodology changes came from S&P in June 2007 publication. They have now
hardened their view on replacement language, requiring an RCC for new step-up hybrid securities issued by
non-regulated issuers such as corporates, to achieve ‘intermediate’ equity credit from S&P. Legally binding
replacement language is meant to restore the degree of permanence that the step-up rate destroys
according to S&P. Existing hybrid transactions with intent-based replacement language will be grandfathered.
S&P allow issuer flexibility via RCC termination events (carve-outs) usually where the hybrid security is no
longer necessary or desirable. For some issuers this will make legally binding language much easier to
rationalise and accept as part of the hybrid structure. In addition, if the issuer can convince S&P that it is not
possible/practical to include the RCC then they may be able to omit it, but S&P believe it should be possible
in most countries outside Japan. About half of the US hybrids include RCCs now and there have also been
Australian and UK examples (the UK has been used by English and Greek issuers).
Both Fitch and Moody’s take a different approach. Fitch evaluate the overall issuer credit and the value-add of
the hybrid to the issuer’s credit profile without giving additional equity credit to any form of RCC. Moody’s
have maintained a consistent approach to replacement language since a legally binding RCC was first applied
by First Tennessee Bank in March 2005. Intent-based language will suffice for Basket C or a Basket D with
mandatory payment deferral linked to a meaningful trigger. If Moody’s Basket D is attempted via legally
binding RCC the terms must provide for only limited termination events (carve-outs) and not the broader list
of carve-outs available for the S&P intermediate category. Carve-outs will therefore need to be selected
considering which are allowed by both rating agencies and which Moody’s basket.
This can also be viewed as a ‘belt and braces’ approach – intent-based replacement language and a legally
binding RCC with acceptable carve-outs will be required to reconcile the differing methods of the rating
agencies. Effectively, issuers must meet the typical Moody’s requirements and add a legally binding RCC for
S&P as needed.
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This is a developing area and one that issuers have been reluctant or unable to adapt to their needs. Not all
countries have an elegant way to make this work. Most early examples are in the US and Australia, but recent
deals have occurred in Greece (RCC under UK law) and the UK. Issuers that seek higher equity credit from
Moody’s but do not or cannot utilise the RCC have instead opted for the mandatory payment deferral
structure, which is potentially harmful to the hybrid investors and therefore requires a premium yield. In
contrast, the RCC does not require a premium from investors since payments (or deferral probability) are not
affected. This is the evaluation issuers need to make for this structuring detail.
Standard & Poor’s approach

S&P released several papers in 2006, including the restatement of their criteria for assessing
equity credit for bank, insurance and corporate securities, and clarification around their
assessment of optional deferral (viewed as affording significant equity benefit). Hybrid securities
are categorised by S&P into three categories:
0 Category 1 - High equity content;
0 Category 2 - Intermediate equity content (divided into two levels: Category 2: Strong, and
category 2: Adequate);
0 Category 3 - Minimal equity content.
An indication of how some different hybrid structures are categorised is given in Table 5.4.
Table 5.4: Classification of hybrid securities for financial services companies

Category Examples
Category 1: High Equity Content Shorter-dated Mandatory Convertible Securities (<3years)
High quality hybrids with participating coupons.
Category 2: Intermediate Equity Content
Category 2: Strong Perpetual preferred shares
Most bank and insurer undated deferrable Tier 1 instruments
Insurance long-dated hybrid instruments (residual maturity of 20 years or more)
with coupon deferability
Category 2: Adequate Most, but not all, bank UpperTier 2 instruments
Limited life preferred shares (e.g. U.S. trust preferred)
Insurance hybrid instruments with a residual maturity of less than 20 years, with
coupon deferability*
Eligible funded contingent capital for insurers
Category 3: Minimal Equity Content Dated hybrid instruments with a residual maturity of five years or less
Auction-preferred securities
Nondeferrable subordinated debt
Instruments with put options
Note: Reprinted with permission from the report ‘Revisions In The Risk-Based Insurance Capital Model’ (21 November 2006), published by Standard & Poor’s Ratings, a division
of The McGraw-Hill Companies Inc.
TAC--Total adjusted capital (for insurers). *Within 10 years of the repayment date, Standard & Poor's will gradually treat the instrument as more debt-like, using a five-year
amortization schedule whereby for each year under 10 years, an incremental 20% of the instrument is treated as debt until, at five years of remaining life, the issue is viewed as
completely debt-like
Source: Standard & Poor’s
S&P have also been active in reviewing their capital requirements for the insurance sector. This
began at the end of 2005, when S&P indicated that they would be updating their risk-based capital
model substantially, adjusting the total adjusted capital (TAC) ratio calculation and changing the
treatment of risk assets so that required capital may change up or down.
The new framework increases the TAC limit to 25% from 15%, which will allow insurers to use
more hybrid capital in the TAC calculations, provided the hybrid security is structured in at least a
dated Upper Tier 2 style format (such as 30 nc 10 sub-debt cumulative deferrable payment
structures) or better (but no Lower Tier 2).
S&P adopted a single minimum maturity standard, to be applied in all regions and sectors. In
order for a hybrid bond to receive an ’intermediate equity classification from S&P and capital
credit from S&P in their capital analysis, the issue will be required to have a minimum legal
maturity of 20 years.
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While this is not a problem for issues with a perpetual maturity, traditional European insurance
sector 20 nc 10 structures will no longer be particularly 'efficient' in S&P terms, as S&P will start
to amortise the credit they allow for it by 20% per annum starting in the year after issuance (i.e. 20
years before the final maturity). Consequently, a dated issue needs to have a 30 nc 10 structure to
get maximum equity credit for the first 10 years from issuance, after which it may be redeemed
on the call and step-up date at year 10, just before the 20% annual amortisation of the equity
credit is applied.
S&P seem to be hardening their position on replacement language and seem to be moving toward
legally binding formats wherever it is legally feasible.
Fitch’s approach
Fitch introduced the latest version of their hybrid securities criteria in September 2006, with the
aim of increasing the clarity and transparency of the rating agency’s approach and streamlining
their analysis of equity credit for hybrid instruments. The new methodology provides more
clarityand has similarities to Moody’s approach of assessing the key characteristics of a hybrid
transaction and the application of a debt-to-equity continuum. However, the application of a look-
back clause, coupled with Fitch’s ‘weak-link’ approach have caused a significant reduction of
equity credit to a number of corporate hybrid structures – a significant divergence from Moody’s,
S&P and the markets’ evaluation of these securities. Fitch published a unified methodology for
hybrids and other capital securities across all financial and corporate sectors. This superceded
previous hybrid equity credit methodologies in the financial and corporate sectors. Fitch apply a
debt-to-equity continuum consisting of five classes from A (100% debt) to E (100% equity), similar
to that of Moody’s (see Table 5.5).
Table 5.5: Fitch debt-to-equity continuum

Equity classes (%) Equity credit Debt credit
Class E - Superior Equity Content 100 0
Class D - High Equity Content 75 25
Class C - Moderate Equity Content 50 50
Class B - Low Equity Content 25 75
Class A - Debt; No Equity Content 0 100
Source: Fitch
The proportion of equity credit assigned to an instrument will depend on the evaluation of four
specific characteristics:
0 Loss absorption;
0 Ability to avoid ongoing cash payments;
0 Permanence/maturity;
0 Covenants and other features.
However, Fitch will apply a weak-link approach, with the security limited by its weakest characteristic.
The look-back provision for payment deferral is a key focus for Fitch in their new methodology.
Look-back links recent common dividend payments to hybrid payments by requiring hybrids to
pay if common was paid (dividend pusher), and assuring the preferred status of hybrids. For
example, an instrument with a high degree of equity content but with a six-month look-back for
payment deferral could result in only a Basket C classification, while a similar instrument with a
look-back of less than six months could result in a Basket D classification.
It is also interesting to note Fitch’s approach to regulatory oversight and the differentiation
between fully regulated financial institutions (generally banks, although jurisdiction dependant)
and insurance companies, which do not enjoy the same perceived degree of beneficial regulatory
oversight. As a result, the rating agency views the majority of Tier 1 bank transactions as a Basket
E (100% equity credit), but insurance sector structures are weighted on a much lower, more
structure-dependant basis as D or C.
For non-bank issuers, it is critical that the hybrid look-back is constructed to Fitch specification
(i.e. very short look-back – three months).
The Fitch framework also calculates the hybrid tolerance limit used in equity when calculating
equity-credit adjusted ratios. Fitch uses a basket approach and following this methodology now
allows inclusion of hybrids of up to 35% of a bank’s core equity in total capital credit (the amount
of capital used by Fitch for leverage calculations).
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Rating agency evolution promotes increasing market sophistication

Refinements to the rating agency methodologies for hybrid capital securities have continued to
evolve the market in recent years and this is likely to continue. Moody’s surprised the market and
proposed a change to its approach to the notching of approximately 300 non-cumulative hybrid
securities. The proposal (which was withdrawn) suggested these securities should be notched
down to signal payment ‘omission risk’, compared to other cumulative or quasi-cumulative (fast-
pay ACSM) securities. While further clarity around the rating agencies’ approach to hybrid
securities is always welcomed by the market, these changes create market volatility as they signal
potential risks associated with the various structural features and can impact an investor’s ability
to hold hybrid assets. The use of market sounding periods and requests for industry comment
help to mute the market shock that evolving methodologies can cause.
Interview
The following Q&A interview is with Ellen Lapson, Managing Director, Global Power and Chairperson of the
Hybrid Products Committee, and Gerry Rawcliffe, Managing Director, Financial Institutions and Member of the
Hybrid Products Committee, Fitch Ratings.
What is the internal process of Fitch’s hybrid products committee for assessing the equity
credit of a hybrid security?
“Fitch’s equity credit classification is governed by the criteria paper published on 27 September 2006 called
‘Equity Credit for Hybrids and Other Capital Securities’. This paper and subsequent clarifications papers form
the template that Fitch’s analysts employ for analysing equity credit. When a company decides to issue a
hybrid security, it is the role of the credit analyst to determine if the security is one that is readily analysed
from the existing criteria. If not, then the hybrid is brought before Fitch’s Hybrid Products Committee (HPC)
which is the ultimate arbiter on these matters.
“The HPC is comprised of six ‘regular’ members and six ‘alternate’ members. The six regular members
represent different sectors and geographies, namely one each from the US/Europe,
Banks/Corporates/Insurance. The six alternates represent similar areas. It is Fitch’s intention to add an
additional one or two members from the Asian region in the near term. Four out of a maximum of the current
six voting members (regular or the respective alternate) constitutes a quorum for making decisions.
Additionally, to be quorate, there must be at least one regular member voting, and there must be at least one
representative (regular or alternate) from each of the three product groups.”
Does Fitch apply different methodologies to hybrid issues from different sectors or different
jurisdictions?
“Fitch has a unified and consistent set of equity credit criteria that is applied for all hybrids irrespective of the
sector or jurisdiction. Nevertheless it is possible that two identical hybrid instruments may behave differently
in times of severe financial distress as a result of external factors, such is the influence that regulators may
exert on an issuing entity. As a result, it is feasible that two identical hybrid instruments may receive a differ-
entiated equity credit treatment.”
How does Fitch treat hybrid securities in their credit analysis of a company – are they treated in
the same way as common stock?
“From a rating perspective Fitch treats hybrids generally as being debt-like, albeit with lower recovery
prospects, which is why hybrids are generally rated one or more notches lower than any senior debt would be
issued by the same entity. From an equity credit perspective, for higher rated issuers we would not expect
hybrid issues to unfold their equity-like characteristics (i.e. deferral and loss absorption). These we would
expect to become active only in times of severe financial distress. However, in assigning equity credit (which
for our methodology presumes financial distress) the equity portion that is determined is treated equivalent
to common stock in terms of our leverage and capitalisation analysis.”
What is the primary focus for Fitch – issuer benefit or flagging risk to the investor?
“From a rating perspective the primary focus is flagging risk to the investor, although not all investor risks are
necessarily captured in the rating which focuses on default and recovery risks. Additional risks, such as
deferral or extension risk that are very important to investors, are not generally captured by the rating. From
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an equity credit perspective the primary focus is the benefit to the issuer in times of severe financial distress.
To put it another way, the extra financial flexibility that an issuer may have through a hybrid potentially being
able to defer or absorb loss (either on an ongoing or liquidation basis), in times of severe financial stress.”
What is the internal process at Fitch for assessing the notching of a hybrid security?
“Notching of hybrid securities is governed by separate criteria papers that each of the bank, corporate and
insurance sectors in Fitch have published. The HPC is not responsible for determining hybrid notching. This is
determined by traditional rating committees.”
Can notching really communicate the risks of such complicated securities? Is notching too dull
a tool?
“Clearly, with only around 20 rating notches from ‘AAA’ to ‘C’ to capture the full spectrum of credit risk from
US Treasuries to the riskiest of high-yield borrowers, there is a limit to the extent that notching can capture
every nuance of complicated hybrid capital securities, nor is it intended to do so. Nevertheless, the
combination of a clearly understood generic notching approach (to broadly signal to investors the presence
of increased loss given default through subordination), together with greater bespoke flexibility to adjust
notching in specific circumstances, does in Fitch's view add value to investors. An example of the latter would
be the wider notching that Fitch applies to banks whose senior debt rating is helped to a given level by the
potential for government support, as expressed in its Fitch Support rating. Fitch generally assumes, however,
that such support is unlikely to flow to deeply subordinated hybrid capital instruments, and these
instruments cannot, therefore, be simply notched off the ‘supported’ senior debt rating. Instead, the hybrid
rating must be referenced to the bank's standalone Individual rating.”
How does Fitch approach their analysis of a security – an overall ‘average’ view of how equity-
like the security is, or a specific review of the individual equity-like features of the security?
“Fitch undertakes a specific review of the individual equity-like features of the security and will apply a weak-
link methodology in determining the overall equity credit. The main reason for applying a weak-link
methodology as opposed to an ‘averaging’ approach is that in times of severe financial distress, it is Fitch’s
experience that if a hybrid security has a flaw from an equity credit perspective (i.e. a very debt-like feature), it
is this flaw that will ultimately constrain the issuer’s ability to gain financial flexibility from the instrument
when they most need it.”
Is the major focus on regulatory oversight justified? How does Fitch view regulatory oversight
for insurers? Does this vary across different jurisdictions?
“Fitch believes that regulatory oversight can play a key role in whether a hybrid behaves in an equity-like or
debt-like manner. It is our experience that management teams may be reluctant to activate some of the
equity-like features of a hybrid (e.g. defer a coupon payment) in order not to upset investors or generate
negative sentiment in general. A regulator may be less concerned about market perceptions and would in our
view be more likely to encourage/insist that management triggers the equity-like features of hybrids irre-
spective of market perception in times of severe financial stress. In terms of the effectiveness of regulatory
oversight across differing jurisdictions, Fitch has yet to formally opine on which insurance regulators would in
Fitch’s view be able to act in a timely manner based on the effectiveness of the regulatory measurements
both in terms of timeliness and usefulness of the metrics employed.”
What is the Fitch approach to assessing subordination?
“Fitch has a fairly binary approach to determining subordination. It either exists (i.e. the hybrid needs to be
subordinate to senior unsecured creditors) or it does not, in which case the hybrid would receive zero equity
credit.”
What is the Fitch approach to assessing effective maturity? What limits are applied in terms of
final maturity, the first call date and step-up?
“Fitch employs an effective maturity regime that can be summarised as follows:

0 Class E (100% equity credit) – Perpetual/20 years plus;
0 Class D (75% equity credit) – 10th to 20th years;
0 Class C (50% equity credit) – Eighth to ninth years;
0 Class B (25% equity credit) – Sixth to seventh years;
0 Class A (0% equity credit) – Less than five years.
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“Determination of an effective maturity can be summarised as follows:
0 No call = Perpetual/stated maturity;

0 Call only = Perpetual/stated maturity;
0 Call with step-up only = Call date;
0 Call with step-up plus replacement language acceptable to Fitch = Perpetual/stated maturity;
0 Call with step-up but replacement provisions do not satisfy Fitch concerns regarding
management intent = Call date.
“We do not impose step-up limits, since even a one basis step-up can be viewed as the effective maturity.
However, step-ups significantly above market conventions (notionally referred to by Fitch as threshold levels)
on cumulative instruments would be viewed by Fitch as carrying incremental risks to the company that we
would penalise by reducing the equity credit classification by one further class irrespective of other features.
“The above is a brief summary and more detailed guidance is available in our main criteria paper.”
What is the Fitch approach to assessing payment deferral?
“Fitch’s approach views that hybrids in order to be considered for equity credit must be able to avoid making
cash payments in periods of financial stress. Coupon deferral mechanisms (be they optional, mandatory or a
combination) and ACSM are structured to achieve this objective, but there is a wide variety in the types and
quality of coupon avoidance or deferral features present. Provided a coupon deferral mechanism is uncon-
strained and effective for at least five continuous years, hybrids are eligible for the highest equity credit under
Fitch’s methodology. Any mechanisms that constrain management’s ability to defer or erode the duration of
the deferral below five years will result in a reduction of the equity credit.
What is the Fitch approach to alternate settlement – ACSM – and PIK?
“A brief summary follows:
0 Non-cash ACSMs – Issuer settles deferred or omitted dividends with common stock. If the
underlying optional or mandatory deferral mechanism is cumulative, the effect of non-cash
stock settlement is to replicate a non-cumulative deferral, qualifying for a higher equity class
(absent a restraint on the class by another factor). If the underlying deferral was non-
cumulative, then the stock settlement is neutral (no change in equity class). Although from an
equity credit classification perspective this feature appears attractive, it is rarely seen, because
it is relatively unattractive to investors and in the US would result in the issue being categorised
as equity from a tax perspective. When the non-cash settlement is accomplished with junior
securities, similar to PIK settlement, this would be viewed by Fitch as a cumulative feature as
the accumulated PIK amount will ultimately have to be paid in cash. Also, if the hybrid gives
management discretion to settle in any of a variety of securities including common, preferred,
like hybrids, options, etc., it is Fitch’s view that the issuer is more likely to opt for settling with
hybrid securities rather than common, and this will be treated as a cumulative deferral;
0 Cash ACSMs via market issuance – Most ACSMs include a pledge by the issuer to attempt the
market issuance of new junior or equity securities (once or repeatedly) and to use the proceeds
of any issuance of junior securities or equity to settle the omitted coupon on the hybrid issue.
Although some may argue that such a settlement mechanism is cash neutral, in that payments
are only paid with new funds raised externally, Fitch views this as a burden on the issuer’s
financial flexibility at a time of financial stress. Such a provision provides debt-like protections
for hybrid holders and lowers the security’s equity quality. When a cash settlement mechanism
is merely an option available to the issuer, it is generally neutral to equity credit. When the
issuer must pursue cash settlement in connection with a nominally non-cumulative mandatory
or optional deferral, prior to resuming coupon payments and common stock dividends, this
feature may effectively turn the hybrid’s deferral from non-cumulative to cumulative and
thereby reduce the maximum equity class. If the same ACSM were associated with a
cumulative deferral, it would have a neutral effect on the equity class. If the issuer is unable to
successfully market equity-like securities to settle the coupon, a likely scenario in a stress
event, the consequences can vary. In some instances the issuer must continue to use its
reasonable efforts to sell equity-like securities until successful, or the unpaid coupons
accumulate and must be satisfied with cash whenever the company subsequently sells equity-
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like securities or pays a common dividend. In both these cases Fitch will view the feature as
equivalent to a cumulative deferral. However, in some cases, if the ACSM is unsuccessful, the
unpaid coupons are eliminated (as if non-cumulative). Fitch will view such a feature as
equivalent to a non-cumulative deferral.
What is the Fitch approach to the look-back?
“Fitch expanded its views on look-backs in a paper published on 10 April 2007 called ‘Hybrid Securities
Subject to a Look-Back Constraint’. The areas covered include:
0 The ‘effective’ duration of the look-back;

0 The impact of including parity securities in a look-back provision;
0 The interaction of look-backs with either mandatory or regulatory deferral mechanisms.
“A very brief summary of the effective duration guidelines would be:
0 < three months look-back period = Unconstrained;

0 > three months to six months = Minor constraint (constrains maximum equity credit classification by one
class);
0 > six months to 12 months = Major constraint (constrains maximum equity credit classification by two
classes);
0 > 12 months = Class A (100% debt, 0% equity).”
Does Fitch apply tolerance limits to the issuance of hybrid securities?
“Fitch has a limit for banks and insurers of 30% of eligible capital. This is applied both at the consolidated group
and unconsolidated entity levels, depending on the relevant rating analysis undertaken. The proportion of any
hybrids that exceed that limit will be treated as debt. Fitch’s precise definition of eligible capital can vary across
sectors, but typically the focus is on core shareholders’ equity, subject to various analytical adjustments (e.g. in
certain sectors the deduction of goodwill), plus the amount of eligible hybrid equity.
“For corporate issuers in sectors in which corporate liquidity far outweighs technical measures of capital as an
analytical concern, the hard limit on hybrids used for banks and insurers as a percentage of eligible capital
need not be strictly applied. For example, when an issuer’s book equity is extremely low or negative due to
prior write-downs, it would not be reasonable to limit the benefits of hybrid equity through excessive
attention to the formula. In these circumstances, a rating committee (as distinct from the HPC) may
determine that more capital can be accepted from this source, depending on individual circumstances; for
example, analysts have used normalised value in place of book value of equity, or considered the benefits of
the planned use of the capital infusion.
“Whatever the limit, Fitch is generally indifferent to the composition of the hybrids included within it,
although rating committees may review the qualitative composition of the hybrids and capital securities, par-
ticularly for low-rated companies.”
How does Fitch view the need for something like a hybrid ‘pre-sale’ report (especially useful for
the post-deal period, as a secondary resource for the market)?
“Fitch believes that a hybrid ‘pre-sale’ report could be of value to the market, particularly for more complex
hybrid issues, which would give Fitch more scope to address details that may not be readily covered in a
typical one-page ‘expected rating’ press release.”
How does Fitch anticipate the market might develop in the future? Where does Fitch see the
market in five years time? In 10 years time?
“Notwithstanding the recent market turmoil, we expect hybrid issuance to remain strong over the longer
term. Although many of the larger bank and insurance issuers may have already reached their limits of hybrid
equity issuance, we would expect the market to continue developing by growth in the corporate sector and
greater numbers of small and mid-sized financial issuers also tapping the hybrid market either through direct
issuance, or via structured vehicles that pool smaller hybrid issues (e.g. the Dekania transactions).
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“Furthermore, we believe that innovation will continue to be a feature of the hybrid market as hybrid
structurers at investment banks continue to try and address the disparate (and at times opposing) and
changing views of the various market participants (i.e. issuers, investors, tax authorities, regulators, rating
agencies, etc.). In addition, the changing regulatory landscape in insurance, particularly in Europe through
the advent of Solvency II, may provide further stimulus for change over the medium to long term although
the legislation is too early in formulation to determine whether the impact will be positive or negative.”
Does Fitch have any future plans for changing or clarifying its methodology for allocating
equity credit or rating notching for hybrid securities?
“Fitch intends to publish further papers on the following topics:
0 Mandatory deferral triggers and their impact on equity credit;

0 Insurance regulatory environments and their impact on equity credit.
“However, these papers will be giving more detailed guidance and not altering the criteria outlined in the
overarching piece published in September 2006.
“There are currently no plans to change notching methodologies.
“Periodically Fitch will consolidate its base criteria and subsequently published clarifications and detailed
commentary to continue to provide all market participants with a clear and comprehensive understanding of
our approach in what is a highly technical area. Overall Fitch has adopted a principles-based approach, with
these principles being informed as far as possible by empirical evidence. In the light of this, Fitch will only
engage in material changes to its criteria if, at some point in the future, new, and currently unforeseen,
empirical evidence requires it.”
Figure 5.9: New hybrid transaction – example time and responsibility schedule
Mandate awarded
Documentation Marketing Execution Documentation

«
Week 1 Week 2 Week 3 Week 4 Week 5 Week 6 Week 7 Week 8

«
«
«
Start Roadshow Books open Pricing and Settlement

documentation commmences launching
Consult with Red OC ready Final

rating agencies for distribution signing of
and/or documentation
regulator
Timeframe Action to be taken Role

Week 1-week 4 Documentation -Mandate letter signed (expense clauses, material adverse change) (week 1) Lead banks
-Termsheet is finalised based on agreed transaction structure Issuer/banks/lawyers
-Draft documentation/ Ts and Cs produced Banks/lawyers
-Appointment of counsels, fiscal, paying and listing agent Banks/lawyers
-Auditors comfort letter, legal opinions Banks/lawyers
-Start establishment of the SPV Banks/lawyers
Discussion with -Notification to rating agencies and regulator (week 1) Issuer
the regulator -Draft documentation and terms and conditions sent to rating agencies and/or Banks
and rating regulators for comments
agencies -Negotiations with rating agencies and/or regulators to discuss their comments Structuring advisor
-Confirmation of tier 1 qualification by the regulator Issuer/banks
-Confirmation of the rating of notes Issuer/banks
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Timeframe Action to be taken Role

Week 5-week 7 Marketing and -Roadshow, books open, pricing and launching Structuring advisor
execution Issuer/banks
Week 8 (after Finalisation of -Final signing of documentation –
the transaction documentation -Listing
has priced)
NB. Example for schedule only - the timeframe for structuring can vary significantly
Figure 5.10: Global hybrid Tier 1 capital origins
German
US Portuguese preferred
fixed/adjustable step-up (7)
rate preferrds (2) US capital preferred (4)
securities
Canadian
European preferred
offshore (6)
US REIT Australian step-up
preferred preferreds preferred (3)
Japanese LLC
French LLC step-up
step-up preferred (8)
preferred (5)
Sept Oct June July Aug Aug Jan Jan

«
1991 1992 1996 1996 1997 1997 1997 1997 1998 1998
Notes:
(1) Issuance via Cayman/Guemsey SVP during 1991-1993.
(2) 10 year cumulative approved 12/95, 5-year non cumulative approved.
(3) Original structure was approved by the RBA but later dis-allowed because of conflicts with BOE/BIS.
(4) Not BIS eligible.
(5) Real estate “OpCo” issues.
(6) Canada REIT and MIC.
(7) “Silent participation preferred stock”. Structure has 10 year term.
(8) Japanese bank issued LLC structures with credit linked notes as the LLC’s assets.
100
Table 5.6: Summary - corporate hybrid transactions
101
Suedzucker Vattenfall Dong Bayer Otto Thomson
Issue date 15-Jun-05 17-Jun-05 21-Jun-05 18-Jul-05 28-Jul-05 16-Sep-05
Market Institutional Institutional Institutional Institutional Retail Institutional
Equity credit (Moodys/S&P) Basket D / Intermediate Basket D / Intermediate Basket C / Intermediate Basket D / Intermediate – Basket C / Intermediate
CHAPTER05
Size (m) €700 €1,000 €1,100 €1,300 €150 €500

Maturity Perpetual Perpetual 1,000 years 100 yrs Perpetual Perpetual
First call 10 years 10 years 10 years 10 years 7 years 10 years
Step-Up + 100 bps + 100 bps + 100 bps + 100 bps + 175 bps + 100 bps
Senior rating Baa2/BBB/BBB A2/A–/AA– Baa1 /BBB+/A– A3/BBB+/BBB+ NR/NR/NR Baa3/BBB-/NR
Security rating Ba1/BB/BBB– Baa1/BBB–/A+ Baa3/BBB–/BBB+ Baa2 /BB+/BBB NR/NR/NR Ba2/BB/NR
Notching 2/3/1 2/3/1 2/2/1 2/3/1 –/–/– 2/2/–
Interest deferral
- Optional Cumulative Cumulative (due at redemption) Non-Cash Cumulative Cumulative (max 10 years then due) Cumulative Non-cumulative
(due at redemption) (due at redemption)
- Mandatory with a Trigger Non-Cash Cumulative (max 1 year) Non-Cumulative No Non-cash Cumulative No No
(max 1 year then lost)
Dividend pusher / stopper? Dividend Pusher Dividend Pusher/ Dividend Stopper Dividend Stopper Dividend Pusher Dividend Pusher Dividend Pusher
Replacement language Intent-Based Intent-Based Intent-Based Intent-Based No Intent-Based
Accountancy treatment Equity Debt Equity Debt Equity Equity
Source: Compiled by CALYON from the respective offering circulars
Table 5.6: Summary - corporate hybrid transactions (continued)
102
Henkel TUI Vinci Lottomatica Solvay Linde Siemens Wienerberger Rexam
Issue date 17-Nov-05 2-Dec-05 7-Feb-06 10-May-06 23-May-06 7-Jul-06 8-Sep-06 25-Jan-07 20-Jun-07
Market Institutional Institutional Institutional Institutional Institutional Institutional Institutional Institutional Institutional
CHAPTER05
Equity credit Basket D / Intermediate Basket B / [Intermediate] Basket C / Intermediate Basket D / Intermediate Basket C / Intermediate Basket C / Intermediate Basket D / Basket C / Intermediate Basket D /
(Moodys/S&P) Intermediate Intermediate
Size (m) €1,300 €300 €500 €750 €500 €700 £250 €900 £750 €500 €750
Maturity 99 years Perpetual Perpetual 60 years 98 years 60 years 60 years 60 years 60 years Perpetual 60 years
First call 10 years 7 years 10 years 10 years 10 years 10 years 10 years 10 years 10 years 10 Years 10 Years
Step-Up + 100 bps + 200 bps + 100 bps + 100 bps + 100 bps + 100 bps + 100 bps + 100 bps + 100 bps + 100 bps + 100 bps
Senior rating A2/A/A– B1/BB–/NR Baa1/BBB+/BBB+ Baa3/BBB–/NR A2/A/A Baa1/BBB/NR Aa3/AA–/AA– Baa2/BBB/NR Baa3/BBB/NR
Security rating Baa1/BBB/BBB+ B2/B–/NR Baa3/BBB–/BBB Ba3/BB/NR Baa1/BBB+/A– Baa3/BB+/NR A2/A–/A+ Ba1/BB+/NR Ba2/BB+/NR
Notching 2/3/1 1/3/– 2/2/1 3 / 2 /– 2/2/1 2/2/– 2/3/1 2/2/– 2/2/–
Interest deferral
Optional Cumulative (max 5 yrs Non-Cash Cumulative Non-Cumulative Cumulative (max 5yrs), ) Non-cash Cumulative Non-Cash Cumulative Cumulative (max 5yrs Non-Cash Cumulative Non-Cash
then due) (due at redemption) then Non-Cash (max 5 yrs then lost) (due at redemption) then due) (max 5 yrs then lost) Cumulative (max
Cumulative (max 10 yrs 5yrs then due)
Mandatory with a Non-Cash Cumulative No No Non-Cash Cumulative No No Non-Cash Cumulative No Non-Cash
Trigger (max 5 yrs then lost) (max 10 yrs) (max 5 yrs then lost) Cumulative (max
10yrs then due)
Dividend pusher / Dividend Pusher Dividend Pusher Dividend Pusher Dividend Pusher/ Dividend Pusher Dividend Pusher Dividend Pusher Dividend Pusher Dividend Stopper
Stopper? Dividend Stopper
Replacement Intent-Based Intent-Based Intent-Based Intent-Based Intent-Based Intent-Based Intent-Based Intent-Based Intent-Based
language
Accountancy Debt Equity Equity Debt Debt Debt Debt Equity Debt
Treatment

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Eligible capital for insurance companies

By Christophe Ollivier, Financial Institutions Group, CALYON
Introduction
The purpose of this note is to provide an update on the current discussion relating to the elements that
should be eligible for the solvency margin calculation for insurers in the EU.
The current regulation

Until Solvency II application, the solvency margin calculation is currently driven in the EU by two main
Directives:
0 Directive 2002/83/EC for life insurers (and its amendments);

0 Directive 73/239/EEC for non-life insurers (and its amendments).
Under Solvency I, the capital buffer required by the regulator to cope with the uncertainty of their business is
equal to the required minimum margin (RMM). The latter is equal to the maximum amount between:
The required solvency margin (RSM), with the following formula:
0 For non-life insurers, the maximum amount between:

0 The result of a function of a premium index;
0 The result of a function of a claim index.
For life insurers, the sum of:
0 A fraction of the mathematical provisions;

0 A fraction of the capital at risk (if positive).
0 The minimum guarantee fund, being equal to the maximum amount between:
0 One-third of the RSM;
0 A €2-3m floor amount for non-life and life respectively (reviewed annually since March 2002 on the basis
of the European index of consumer prices - Eurostat).
Figure 5.11: Available solvency margin: Solvency l minimum solvency level
Available
solvency
margin
Required
minimum
margin
Guarantee
(RMM)
fund
Under this minimum solvency level, the competent authorities have the power to require a financial recovery
plan for the insurance undertaking where competent authorities consider that policyholders' rights are
threatened.
Practically, most companies have tended to operate with capitalisation levels substantially in excess of
regulatory RMMs, two times the RMM being considered as a minimum threshold.
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Two directives define the elements that are eligible for the calculation of the guarantee fund:
Without limitation:
0 The paid-up share capital or the effective initial fund plus any member's account for mutual companies;
0 The statutory and free reserves;
0 The profit or loss brought forward;
0 The profit reserves appearing in the balance sheet (subject to national law).
With limitations and subject to the agreement of the competent authority of the member states:
0 The cumulative preferential share capital and the subordinated loan capital (up to 50% of the RSM, sub-
limited to 25% for subordinated loans with fixed maturity or fixed term cumulative preferential share
capital);
0 Securities with no specified maturity date and other instruments, including cumulative preferential shares
other than those mentioned above (up to 50% of the RSM for the total of such securities and the
subordinated loan capital referred to in the point above);
0 Any hidden reserves arising out of the valuation of assets.
The following are the elements acceptable for the calculation of the available solvency margin (ASM), in
addition to those eligible for the guarantee fund (subject to authority review):
For life insurers:

0 50% of the undertaking's future profits (not exceeding 25% of the lesser of the available solvency margin
and the required solvency margin until 31 December 2009);
0 The difference between a non-Zillmerised or partially Zillmerised mathematical provision and a
mathematical provision Zillmerised at a rate equal to the loading for acquisition costs included in the
premium (not exceeding 3.5% of the sum of the differences between the relevant capital sums of life
assurance activities and the mathematical provisions for all policies for which Zillmerising is possible).
For non-life insurers:

0 One half of the unpaid share capital or initial fund, once the paid-up part amounts to 25% of that share
capital or fund (up to 50% of the lesser of the available solvency margin and the required solvency margin);
0 In the case of mutual or mutual-type association with variable contributions, any claim which it has against
its members by way of a call for supplementary contribution, within the financial year (subject to a limit of
50% of the lesser of the available solvency margin and the required solvency margin).
'Revaluation reserves' and 'value adjustments' are not explicitly mentioned in the Insurance Directive but in
practice, they can be recognised as eligible by member states.
Note: Other specific limitations and/or restrictions are provided in the tables at the end of this section.
It is important to highlight the fact that national legislation may be stricter than the Directives. For example, in
a number of member states, the cumulative preferential share capital is not an eligible element.
Capital buffer to be required in the Solvency II framework

Under Solvency II, there should be two levels of capital buffer considered by the regulator:
0 The minimum capital requirement (MCR) should be the capital threshold defined under Solvency II below
which the insurer presents unacceptable risks to policyholders and an insurer will not be permitted to
operate below it. In such a case, an ultimate supervisory action would be triggered;
0 The solvency capital requirement (SCR) or target capital should be the threshold above which the company
solvency margin will be deemed to be comfortable (closer to an insurer's economic capital requirement).
Dropping below SCR would always be a plan of action but would not necessarily trigger an immediate
action. The SCR should be determined as the level of capital that reduces the likelihood of ruin to less than
0.5% on a one-year horizon.
The MCR could be calculated using a modular approach similar to that of the SCR but calibrated on a 10%
probability of ruin on a one-year horizon. Even simpler, it could be a proportion of the SCR or of required
capital in the Solvency I mode.
The MCR is expected to be approximately in line with the Solvency I RMM.
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The SCR is likely to take the overall capital requirement to a higher level than the Solvency I RMM but as
previously observed, this does not necessary imply a higher capital requirement since today many regulators
look to companies to hold a multiple of their RMM.
Eligible elements in the Solvency II framework

Compared to the Solvency I approach, the total balance sheet approach to be adopted by Solvency II should
appear less arbitrary, as the eligible elements of capital should be based on the economic ability to absorb risk.
Specifically, eligible capital should be assessed against the extent to which it can do either or both of the
following:
0 Reduce the probability of insolvency by absorbing losses on a going concern basis or in run-off;
0 Reduce the losses to policyholders in the event of insolvency or wind-up.
These eligible elements should also be assessed on the following general characteristics:
0 Permanence and availability in times of stress;

0 Servicing costs/repayment and their potential for deferral or even cancellation in times of stress;
0 Seniority on interest and principal amount.
Eligible capital could be divided between:
Basic own funds, representing:
0 The free assets (excess of assets over liabilities);

0 The subordinated liabilities.
Ancillary own funds, representing the assets other than own funds which can be called up to absorb the
following losses:
0 Unpaid share capital or initial fund that has not been called up;
0 Letters of credit;
0 Any other commitments received by the insurance and reinsurance undertakings;
0 For mutual companies, any future claims which it may have against its members by way of a call for
supplementary contribution, within the financial year concerned.
There have been a number of attempts to resolve the divergences in approach between the insurance and
banking sectors, whether these differences are both necessary and justified for prudential soundness or
sector-specific reasons.
In its November 2006 consultation paper (CP20), CEIOPS (the Committee of European Insurance and
Occupational Pensions Supervisors) suggested a more transparent classification of capital across all sectors,
inspired by the classifications used in the current banking accord but taking into consideration a relevant
difference, which is the timescale of their operations that influences the eligibility of capital as follows:
0 In the banking sector a greater emphasis is placed on liquidity of capital to protect against potential runs
on deposits, which rules out most forms of contingent capital;
0 For insurers, however, the longer term nature of their liabilities means that contingent capital is a much
more valuable resource as long as reliance can be placed on the counterparty's willingness and ability
to pay.
Basic principles regarding classification should be:
0 The better the loss absorbency of an element, the higher the tier it should be classified into;
0 Non-cumulative elements on a going-concern basis should be treated more favourably than cumulative
elements;
0 Perpetual elements should be treated more favourably than fixed-term elements.
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Table 5.7: Tier characteristics defined in Solvency ll

Tier 1 Tier 2 Tier 3
Characteristics to possess: Characteristics to possess : Any basic and ancillary own fund items
• Subordination • Subordination which do not match with Tier 1 orTier 2
• Loss-absorbency characteristics.
• Loss-absorbency • To a substantial degree : Perpetual, absence
• Permanence of mandatory costs
• To a substantial degree: Perpetual,
absence of mandatory costs.
Tier 1 or core capital

This should have the following optimal qualities to serve as a buffer:
0 Fully loss absorbent in both a going-concern and a winding-up situation, where:

On winding-up it ranks for repayment after all liabilities towards policyholders and any higher ranking debts
and liabilities;
0 Currently and permanently available;
0 No fixed costs (i.e. there is no inescapable obligation to pay dividends or interest).
It should therefore include:
For the highest quality core capital, the 'core Tier 1' (which could represent at least 50% of Tier 1 capital):
0 Paid-up voting common shareholders' equity, or paid-up initial or foundation fund, as appropriate;
0 Called-up voting common shareholders' equity, or called-up initial or foundation fund, as appropriate;
0 Retained earnings calculated using the accounting balance sheet;
0 Any net difference, net of tax, in the valuation of assets and liabilities under accounting standards and with
respect to the solvency evaluation (which serves as a reference standard), provided that these amounts
comply with the principles set out for Tier 1 capital.
For the ‘non-innovative Tier 1’ capital:
0 Subordinated members' accounts;

0 Subordinated liabilities which possess the characteristics of subordination, loss-absorbency in a winding-
up and going-concern situation, and substantively possess the characteristics of perpetuality, absence of
requirements or incentives to redeem the nominal sum and absence of mandatory servicing costs (e.g.
non-cumulative perpetual preference share capital).
For the 'innovative Tier 1' capital ( to be limited, either with respect to percentages of total Tier 1 capital or
with respect to the maximum of pre-specified percentages of Tier 1 capital and the SCR):
0 Hybrid capital which provides a better loss absorbency than that classified as Tier 2.
Deduction for investment in own shares, intangible assets (goodwill) existing in the current Directive should
be maintained.
Tier 2 or supplementary capital

This has certain flaws on all three criteria and therefore should be only countable as eligible up to certain limits:
0 Subordinated liabilities which possess the characteristics of subordination and loss-absorbency in a

winding-up situation, and substantively possess the characteristics of perpetuality, absence of
requirements or incentives to redeem the nominal sum and absence of mandatory servicing costs;
0 Letters of credit and guarantees, provided by credit institutions authorised in accordance with Directive
2006/48/EC, and held in trust for the benefit of insurance creditors by an independent trustee;
0 Members' calls by way of supplementary contribution from members of Protection and Indemnity
Associations;
0 Other contingent capital which possesses the characteristics of subordination, loss-absorbency in a
winding-up and going-concern situation and substantively possesses the characteristics of perpetuality,
absence of requirements or incentives to redeem the nominal sum and absence of mandatory servicing
costs, analysed between:
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0 Letters of credit and other commitments received;
0 Members' calls by way of supplementary contribution;
0 Other contingent capital which has the characteristics for inclusion in Tier 2 capital.
This tier should furthermore be subdivided with respect to permanence, as follows:
0 Upper Tier 2 capital, which should be perpetual, and could include perpetual cumulative preference
shares, perpetual subordinated debt and hybrid capital not eligible as Tier 1;
0 Lower Tier 2 capital, which would be dated, and may include dated subordinated debt and dated
preference shares.
Insurance Tier 3 capital

This should be limited for the capital items which are typical for insurers and not for banks due to the lower
volatility of insurance business, i.e. certain types of capital that is not yet paid in, such as potential members'
calls and unpaid elements of partly paid-in capital, subject to limits and the prior approval of the supervisory
authority:
0 Subordinated liabilities which do not possess the characteristics for inclusion in Tier 2 capital;
0 Contingent capital which does not possess the characteristics for inclusion in Tier 2 capital analysed
between:
0 Letters of credit and other contingent commitments received which do not possess the characteristics
for inclusion in Tier 2 capital;
0 Members' calls by way of supplementary contribution.
Regarding members' calls, mutual companies will assess their premium requirements for the forthcoming year
and issue a supplementary call to their members for the required amount. When this 'budgeted' supplementary
call is collected in a single advanced payment or part of it is deferred until a fixed date later in the year, this amount
can be accounted for as premium due in the profit and loss account at net realisable value and therefore feeds
into Tier 1 capital. This is the case under Solvency I and should continue to be so under Solvency II.
If the deferred part of a 'budgeted' supplementary call is not payable until after the relevant accounting
period and/or, for some reason, it is not recorded in the accounting books of the mutual company, the
amount should nevertheless still be treated as premium due and therefore contribute to Tier 1 capital.
(CEIOPS suggest that a prudential filter should normally apply for this purpose.)
By opposition, the 'unbudgeted' supplementary calls issued to cover unexpected events (e.g. claims and
changes in regulatory requirements) should be classified as insurance Tier 3 capital and eligible only subject
to specific principles and criteria such as:
0 Clear procedure for issuing supplementary calls (timing, amount, quorum for the vote);
0 Clear information on the calling procedure and the member's obligations;
0 Legal incentives (contract cancellation) to increase members' willingness to pay;

0 Legal framework for collection and arrangement for debt enforcement;
0 Assessment of the creditworthiness of members.
Limitations
There are still open discussions regarding the limitations to apply to Tier 2 and Tier 3 capital.
In the CP20, CEIOPS suggests a limit on the sum of Tier 2 and Tier 3 capital with respect to the available Tier 1
capital (only) instead of setting separate limits:
0 For Tier 2 capital , the maximum of Tier 1 capital and a pre-specified percentage of the SCR);
0 For Tier 3 capital, the maximum of the sum of Tier 1 and Tier 2 capital and a pre-specified percentage of
the SCR.
This proposal is currently tested in the Quantitative Impact Study 3 (QIS3).
If Tier 1 capital should not be subject to upper limits, CEIOPS suggests the introduction of minimum levels for
core Tier 1 capital and the overall level of Tier 1 capital to ensure that the quality is not diluted too much by
non-core Tier 1 capital, and that a sufficient amount of Tier 1 capital is available to cover the SCR:
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0 Tier 1 core capital should form at least 50% of Tier 1 capital;
0 An upper limit (a pre-specified percentage of Tier 1 capital) should be set for the percentage of innovative
Tier 1 capital. CEIOPS recommends that the results from its internal questionnaire regarding innovative
capital should be reviewed before fixing this limit.
Figure 5.12: Capital limitations
CORE TIER 1
Tier 1
Eligible NON CORE TIER 1 Max 50% of
Non-innovative Tier 1 - Innovative Tier 1** total tier 1*
Max 15%
SCR MCR of total
tier 1*
Eligible UPPER TIER 2
Perpetual Max 100% of

total tier 1*
Tier 2
Eligible LOWER TIER 2
Max 50%
Dated with at least a 5-years original maturity of total
tier 1*
Tier 3 Eligible TIER 3 Max 100% of

total tier 1*
* Total Tier 1 = Core Tier 1 + Non core Tier 1

To ensure that at least 50% of the SCR and 50% of the MCR is covered with Tier 1 capital, CEIOPS suggests to
limit the sum of Tier 2 and insurance Tier 3 capital with respect to the available capital.
CEIOPS also recommends that Tier 3 contingent capital elements are not eligible for covering the MCR.
Using the abbreviations t1, ct1, t2, lt2 and t3 for the amount of Tier 1, core Tier 1, Tier 2, lower Tier 2 and Tier
3 capital, the proposed limitation rules can be summarised as follows:
0 Minimum level of eligible capital:

t1 + t2 + t3 ≥ SCR
0 Minimum level of Tier 1 and core Tier 1 capital:
t1 ≥ 1/2 * SCR
ct1 ≥ 1/2 * t1
0 Minimum level of the sum of Tier 1 and Tier 2 capital:

t1 + t2 ≥ MCR
0 Limits for the sum of Tier 2 and insurance Tier 3 capital:
t2 + t3 ≤ t1
lt2 ≤ 1/2 * t1
FSA position in the UK

During 2003-04, the FSA decided to pre-empt the Solvency II regime and to implement a new risk-based
capital regime for insurance companies (applicable by 2005) with the publication of rules determining how
much capital life insurers’ with-profits funds, non-life insurance companies and reinsurers have to hold. These
rules are part of the ‘Integrated Prudential Sourcebook for Insurers’. It notably stipulates that:
0 Both non-life and life insurers have to provide the FSA with individual capital assesments (ICAs) based on a
confidence level equivalent to 99.5% over a one-year period;
0 A new risk-based minimum regulatory capital requirement, based on a separate calculation of capital
needs, carried out alongside the MCR (a similar approach to the one defined in the EU Directive, with a
floor being the 'base capital requirement' and a guaranteed fund), the enhanced capital requirement (ECR)
now applies for non-life and life insurers and must be communicated to the regulator. The FSA shall in
return provide the insurance companies with its own individual capital guidance (ICG):
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0 For non-life companies, the ECR calculation requires a firm to multiply the balance sheet values of its
assets and liabilities, and its net premium income, by appropriate percentage risk weights. The risk weights
vary for different types of assets and according to the different classes of insurance business undertaken
by the firm;
0 For life non-profit business, required capital would comprise current mathematical reserving and solvency
requirements based on EU Directives, subject to a few amendments such as reclassifying the resilience
reserve as a capital requirement;
0 For life with-profits business, firms with with-profits liabilities over £500m would hold capital based on the
higher of a regulatory peak and 'realistic' peak ('twin peaks' approach):
0 The regulatory peak - the sum of a 'prudent' actuarial assessment of the financial resources required to
meet only contractual guarantees (with implicit margins for adverse deviation from the expected position
included in the mathematical reserves), the EU solvency margin and a resilience requirement;
0 The 'realistic peak' - the sum of an assessment of 'expected' liabilities arising from contractual guarantees
and a fair provision for expected discretionary payments, such as future annual and terminal bonuses, plus
an explicit risk capital margin calculated on top of realistic provisions (for unexpected risks affecting assets
or liabilities).
Capital resources for insurers

Regarding capital resources for insurers, the FSA approach is not surprisingly very close to the one currently
published in the July 2007 EU Directive.
Tier 1 - Characteristics are the same as described above, with the same subdivisions:
0 Core Tier 1 capital - similar to the EU Directive definition but notably including a fund for future
appropriation (comprising all funds the allocation of which, either to policyholders or to shareholders, have
not been determined by the end of the financial year);
0 Non-innovative Tier 1 capital - perpetual non-cumulative preference shares;
0 Innovative Tier 1 instruments - precisely defined, notably regarding loss absorption issues, as:
0 A Tier 1 instrument that is redeemable;
0 And a reasonable person would think that:
(a) the firm is likely to redeem it; or
(b) the firm is likely to have an economic incentive to redeem it;
0 And the firm's obligations under the instrument (other than a share) either:
(a) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the
Insolvency Act 1986; or
(b) do constitute such a liability but the terms of the instrument are such that:
0 any such liability is not relevant for the purposes of deciding whether:
(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;
0 a person (including, but not limited to, a holder of the instrument) is not able to petition for the winding
up or administration of the firm or for any similar procedure in relation to the firm on the grounds that the
firm is or may become unable to pay any such liability; and
0 the firm is not obliged to take into account such a liability for the purposes of deciding whether or not
the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful
trading).
The FSA also stipulates that, to be admitted in the Tier 1 capital, step-up in instruments should be 'moderate', which
means it results in an increase over the initial rate that is no greater than the higher of the following two amounts:
0 100bp, less the swap spread between the initial index basis and the stepped-up index basis;
0 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up
index basis.
Deduction must be made for investment in own shares, intangible assets (goodwill) and other amounts
deducted from technical provisions for discounting and other negative valuation differences.
Tier 2 - This includes:
Upper Tier 2 capital, which can only include perpetual instruments such as:
0 Perpetual cumulative preference shares;
0 Perpetual subordinated debt;
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0 Other instruments that have the same economic characteristics (notably subordination, loss absorption
and perpetuality) as the one above.
Lower Tier 2 capital, which includes fixed/long-term instruments with the following maturity conditions:
0 An original maturity of at least five years; or
0 Redeemable on notice from the holder, but the period of notice of repayment required to be given by the
holder is five years or more.
Deduction must be made for inadmissible assets, assets in excess of market risk and counterparty limits,
related undertakings that are ancillary services undertakings and negative adjustments for related
undertakings that are regulated related undertakings (other than insurance undertakings).
Other capital resources - These are limited to:
0 Unpaid share capital or initial funds and calls for supplementary contributions;
0 Implicit items subject to the supervisory authority agreement (including future profits, Zillmerisation and
hidden reserves).
Regarding limitations:
0 Core Tier 1 must represent at least 50% of the eligible capital;

0 Innovative Tier 1 capital must not account for more than 15% of the Tier 1 capital resource of the insurer;
0 At least 50% of an insurer's MCR must be accounted for by the sum of Core Tier 1 capital and perpetual
non-cumulative preference shares;
0 An insurer carrying on long-term (or general) insurance business must meet the higher of:
0 One-third of the long-term (respectively general) insurance capital requirement;
0 The base capital resources requirement; with the sum of the Core Tier 1 capital, perpetual
non-cumulative preference shares, upper Tier 2 capital and lower Tier 2 capital .
Note: A regular check should be made regarding the validity of this information, as the FSA regularly updates
the 'Integrated Prudential Sourcebook for Insurers' to take into account the comments made by the market
and the global evolution of financial institutions' regulations.
Table 5.8: Elements eligible for the guarantee fund

Eligible elements Limitation Other restrictions
Paid-up share capital. None None
Or effective initial fund plus any The memorandum and articles of association must
member’s account for mutual stipulate that payments may be made from these
companies. accounts to members only in so far as this does not
cause the available solvency margin to fall below the
required level, or, after the dissolution of the
undertaking, if all the undertaking's other debts
have been settled;
The memorandum and articles of association must
stipulate, with respect to any payments referred to in
point (i) for reasons other than the individual
termination of membership, that the competent
authorities must be notified at least one month in
advance and can prohibit the payment within that
period;
The relevant provisions of the memorandum and
articles of association may be amended only after
the competent authorities have declared that they
have no objection to the amendment, without
prejudice to the criteria stated in points (i) and (ii).
The statutory and free reserves Not corresponding to underwriting liabilities nor
qualified as equalisation reserves
The profit or loss brought forward After deduction of dividends to be paid.
The profit reserves appearing In so far as authorised under national law.
in the balance sheet
The cumulative preferential Up to 50% of the RSM
share capital Sub limited to 25% for subordinated loans with
fixed maturity or fixed term cumulative
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Table 5.8: Elements eligible for the guarantee fund (continued)

preferential share capital;
Provided that binding agreements exist under
which, in the event of the bankruptcy or
liquidation of the assurance undertaking, the
capital element ranks after the claims of all other
creditors and is not to be repaid until all other
debts outstanding at the time have been settled.
Subordinated loan capital Only fully paid-up funds may be taken into account;
For loans with a fixed maturity, the original maturity
must be at least five years. No later than one year
before the repayment date, the assurance
undertaking must submit to the competent
authorities for their approval a plan showing how
the available solvency margin will be kept at or
brought to the required level at maturity, unless the
extent to which the loan may rank as a component of
the available solvency margin is gradually reduced
during at least the last five years before the
repayment date. The competent authorities may
authorise the early repayment of such loans
provided application is made by the issuing
assurance undertaking and its available solvency
margin will not fall below the required level;
Loans the maturity of which is not fixed must be
repayable only subject to five years' notice unless
the loans are no longer considered as a component
of the available solvency margin or unless the prior
required for early repayment. In the latter event the
assurance undertaking must notify the competent
authorities at least six months before the date of the
proposed repayment, specifying the available
solvency margin and the required solvency margin
both before and after that repayment. The
competent authorities shall authorise repayment
only if the assurance undertaking's available
solvency margin will not fall below the required level;
The loan agreement must not include any clause
providing that in specified circumstances, other than
the winding-up of the assurance undertaking, the
debt will become repayable before the agreed
repayment dates;
The loan agreement may be amended only after the
competent authorities have declared that they have
no objection to the amendment;
Securities with no specified Up to 50 % of the RSM for the total of such They may not be repaid on the initiative of the bearer
maturity date and other securities and the subordinated loan capital or without the prior consent of the competent
instruments, including referred to in point above. authority;
cumulative preferential shares The contract of issue must enable the assurance
other than those mentioned undertaking to defer the payment of interest on
above. the loan;
The lender's claims on the assurance undertaking
must rank entirely after those of all non-
subordinated creditors;
The documents governing the issue of the securities
must provide for the loss-absorption capacity of the
debt and unpaid interest, while enabling the
assurance undertaking to continue its business;
Only fully paid-up amounts may be taken into account.
Any hidden reserves arising With the agreement of the home member state;
out of the valuation of assets. In so far as such hidden net reserves are not of an
exceptional nature.
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Table 5.9: Additional elements eligible for the ASM

For life insurers
50% of the undertaking's future profits. Not exceeding 25% of the lesser of the available When an actuarial report is
solvency margin and the required solvency submitted to the competent
margin until 31 December 2009. authorities substantiating the
The amount of the future profits is obtained by likelihood of emergence of these
multiplying the estimated annual profit by a profits in the future; and In so far
factor (not exceed six) which represents the as that part of future profits
average period left to run on policies. The emerging from hidden net
estimated annual profit shall not exceed the reserves referred to in point (c)
arithmetical average of the profits made over has not already been taken into
the last five financial years. account.
The difference between a non-Zillmerised or Not exceeding 3.5% of the sum of the Where Zillmerising is not practised
partially Zillmerised mathematical provision and a differences between the relevant capital sums or where, if practised, it is less
mathematical provision Zillmerised at a rate equal of life assurance activities and the than the loading for acquisition
to the loading for acquisition costs included in the mathematical provisions for all policies for costs included in the premium.
premium. which Zillmerising is possible.
For non-life insurers
One half of the unpaid share capital or initial fund, Up to 50% of the lesser of the available solvency
once the paid-up part amounts to 25% of that margin and the required solvency margin
share capital or fund
References:
0 Directive 2002/83/EC for Life insurers (and its amendments).
0 Directive 73/239/EEC for Non Life insurers (and its amendments).
0 CEIOPS consultation Paper n°20 - Draft Advice to the European Commission in the Framework of the
Solvency II project on Pillar I issues - further advice.
0 Solvency II Directive Framework Directive Proposal.
0 FSA CP 190 & 195.

0 FSA Prudential Sourcebook for Insurers.
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CHAPTER STRUCTURAL CONSIDERATIONS –
06 FOCUS ON SELECT COUNTRIES

Introduction
This chapter is like an ‘alchemists cook book’ since the story of the evolution of hybrid capital
securities can be illuminated with a light hearted metaphor to alchemy – the art and science of
turning base materials such as lead into gold.
Alchemy was a study and experimentation into the true ‘nature’ of things with the hope that un-
derstanding will allow manipulation or transmutation to a different (i.e. better) state of nature.
Alchemists, were said to literally dissolve and deconstruct things to derive the essence of the
thing and subsequently sought to reconstitute or put it back together in a more valuable configu-
ration. Similarly, financial engineers focus on the essence of debt and equity to structure hybrid
securities that exhibit the desired proportion of the each component.
The alchemist's basic elements were earth, water, fire and air and these are replaced in the world
of hybrid capital security structuring with regulatory, ratings, accounting, tax and legal elements.
Hybrid alchemists sought to deconstruct equity to examine all its virtues and reconstituting those
virtues in a form that was also tax efficient and therefore better and more valuable to the issuers
of hybrids. The essence of bonds and the security provided to fixed income investors was reconsti-
tuted with elements of equity to create hybrid securities that gained for the issuer regulatory and
rating agency benefits far beyond basic bonds, and at a reasonable cost premium to senior debt
given the new protections that were included (step-ups, quasi-cum, ACSM etc). The evolution of
accounting, legal, regulatory and tax principles has influenced the process and the rating agencies
also helped to distil the ‘essence of equity’ in their useful publications.
But not all that glitters is gold and hybrids are not a replacement for common equity and so limits
on the use of hybrids have been put in place even by the regulators and rating agencies that have
championed their usefulness as equity substitutes. So while hybrids are not exactly up to the
‘gold standard’, that same pursuit of gold has led to the development of very useful, robust and
flexible alternatives to the purer elemental forms, just as alchemists developed alloys such as
steel from iron and carbon that are fundamental to the construction of our modern world. So too,
hybrids can play a role in the capital structure of modern companies. As CEBS and others review
the ‘essence’ of hybrid equity capital in future it may be useful to consider the evolution of
hybrids over the past 20 years and compare some of the major jurisdictions that successfully
employ hybrids.
Given the historical background provided on the forces that have led to the creation of hybrid
capital securities, it will now be instructive to look at summary terms of illustrative hybrid capital
securities in some major countries where they have flourished. In addition, the various catalysts
of growth that have driven new issue volumes and the expansion of the hybrid product's
usefulness to encompass an ever wider variety of issuers have been highlighted; therefore, in this
chapter the major issuer sectors within regions are detailed and some of the the features
illustrated so that they can be compared and contrasted at a high level.
This chapter aims to serve as a ready reference to readers who may want to see how some hybrid
structures compare at a high level within a particular country, or how structures compare across
sectors or countries. A sample cross-section only has been provided since the universe of hybrids
is too diverse to capture in its entirety and continues to evolve. Additionally, investors may find
this a useful catalogue to reference in search of a rapid overview of the country, sector, and/or
categorical comparisons for beginning to evaluate risk and relative value. These summaries are no
replacement for the complete offering circulars which should be read in their entirety before
making any decisions.
No doubt by the time this report goes to press there will be changes in the market that invalidate or make obsolete some
of the information or references herein. Also, since the chapter summarises and points out highlights, the original and
complete documents should be referenced for a full assessment of the risks and nuances of the structures.
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It is impossible to efficiently convey all the detail of the transactions that are summarised here, but
the summaries will bring to light some major features and allow for more easily processed identifi-
cation of similarities and distinctions so that some ‘risk factors’ might be compared and structural
trends may be observed. It is the case that old solutions may solve new problems, so this chronicle
of some structures that have evolved over time will also create a pathway back to older structuring
technology which can be useful in future development of the market. The extracted stories from
International Financing Review relating to these transactions offer additional insight into the
rationales behind their issuance and into their reception by the market.
UK
The UK FSA and UK banks have always been at the forefront of global regulatory capital develop-
ments. As a Basel committee member the UK FSA continues to provide thought leadership about
the definitions of regulatory capital and implementation of capital adequacy rules.
UK banks were among the first significant users of preference shares for bank capital purposes
and issued significant amounts of preference shares. While these early preference shares were
not tax deductible for the issuing banks some did provide a tax benefit called ACT to some
investors that could reclaim the ACT tax benefit (ACT benefits were eventually eliminated) which
effectively increased the investor’s tax adjusted return, thereby increasing the investor demand
for this type of security and effectively reducing the issuer’s cost.
During the late 1990s when regulators began to oppose SPV-oriented Tier 1 hybrids, a shift in
hybrid product development led to the first UK direct issue, tax-deductible hybrid Tier 1. Some of
the early structures had names like Reserve Capital Instruments (RCI), Tier One Notes (TONS), Tier
One Non-Innovative Capital Securities (TONICS) and Tier One Preferred InCome Securities
(TOPICS). The acronym war among banks was waged in real anger in those days! Some of the UK
structures have had a lasting impact on global hybrid structuring development.
The key advance in these early structures mostly involved the reconciliation of the tax requirement for
a cumulative payment, which clashed with the non-cumulative nature of bank capital Tier 1. The in-
troduction of various stock settlement mechanisms provided a non-cash cumulative instrument,
which is a predecessor to the ACSM structures widely seen today. Other variations followed, including
early True Perp structures with principal stock settlement features and designs to be counted outside
the 15% limit on ‘innovative’ step-up hybrids. The rate step-up at the call date is a fundamental charac-
teristic of what regulators deemed ‘innovative Tier 1’ and therefore limited to 15%. These new UK True
Perp structures had no rate step-up at the call date, but could optionally settle the principal amount of
the issue via common stock issuance (which could be deemed an incentive to call the security for cash
instead of incurring the expense and dilution of common settlement).
After a period of stringent FSA adherence to very conservative interpretations of BIS guidelines,
the approval of these structures by the FSA gave UK banks a chance to issue tax-efficient Tier 1 on
a competitive basis with other global banking players. However, the FSA was challenged by some
other national regulators who considered some of the new FSA-approved hybrid Tier 1 securities
to contain features that rendered the hybrids unworthy of the 1998 BIS guidelines for ‘core
capital’. It was an interesting point in time really. At that time, certain national regulators from
across the world were pitted against each other in a process of evaluating their own and each
other’s versions of capital to seek a now legendary ‘level playing field’. During the political
process of this reconciliation, national structures were often defended by the home regulator and
foreign structures challenged. The ACSM feature has been carried forward but not stock
settlement of principal at the call date in core Tier 1. As the definition of own funds is again being
considered by global regulators such political debates may again rage on but hopefully lessons of
the past and contemporary structuring advances will be exploited so that hybrid capital will
further evolve to better serve its many constituents.
While the UK led in the development of regulatory capital for banks and insurance companies
and the early issuance of preference shares by corporates in the 1990s, the UK corporates were
curiously absent from the next generation corporate hybrids until Rexam became for first UK
corporate to issue hybrids since the new rating agency rules were published in 2005. Surprisingly,
it was a Euro issue and the first Sterling corporate hybrid was previously issued by Linde of
Germany. The Rexam Basket D hybrid deal was however chock full of interesting features (early
redemption, structural modification flexibility) and could pave the way for more UK corporate
issuance.
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Similar levels of flexibility were included in the L&G preference securities issue which was also
structured to achieve Basket D. However, the perpetual preference securities issued by L&G got to
Basket D via the legally binding Replacement Capital Covenant (RCC) which improves
permanence rather than via the Mandatory Payment Deferral (MPD) used by Rexam in the 60 year
dated subordinated debt obligations to strengthen the ‘no ongoing payments’ dimension.
It is interesting to compare the wide range of features on L&G preference securities versus the
comparatively straightforward Barclays Non-Cumulative Preference Shares which do not seek
enhanced rating agency equity credit but rather are classic Tier 1 bank capital. A further
comparison is provided by summarising a Barclays RCI type issue for comparison to the Barclays
Preference Shares and the other UK examples. The inclusion of features such as the ACSM, the
types of securities available via any ACSM and any limits on the amount of those ACSM securities
are distinctions to make when reading the offering circulars of these types of hybrid transactions.
A common theme across geographies exhibited among these few UK examples is that while banks
were the early leaders in structuring hybrids to meet their regulatory objectives it can be observed
that corporate and insurance sector transactions are often cutting edge structures with features
that may influence future bank hybrids.
As noted the UK issues are direct rather than through SPVs and the use of ACSM mechanisms support
both the historical primary aim of achieving tax efficiency (i.e. RCI debt for tax purposes) but also in
some more recent cases across sectors ACSM provides additional investor comfort that improves mar-
ketability and lowers the issuer’s cost. Variations in the issuer’s early redemption options and the
discretion, duration and potential cure associated with potential payment deferral (or payment
elimination) are also key distinctions when looking at any hybrids for comparative purposes.
More information on the FSA is available on www.fsa.gov.uk
UK termsheets
L&G Tier 1 debut packs a punch
(Published in IFR, 21 April 2007)
In terms of credit, Legal & General is a no-brainer for investors. So when the conservative issuer, the third-
largest UK insurer by market capitalisation, brought to the market its inaugural Tier 1 issuance in the form of a
£600m perpetual non-call 10-year trade last week, the challenge was not to achieve the cheapest possible
funding, but to ensure secondary market performance.
Having issued in UT2 and LT2 format in 2004 and 2005, respectively, the innovative Tier 1, fixed-to-FRN,
100bp step-up trade (rated A3/A) rounded off the issuer's capital structure. In view of its relatively low gearing
versus peers, L&G opted for a structure designed to maximise ratings agency equity credit, becoming the first
European insurer to use legally binding replacement language (also known as a replacement capital covenant
or RCC, requiring that the issue can only be redeemed by either a similar or junior trade) rather than
mandatory deferral, taking a leaf out of National Bank of Greece's £375m Tier 1 issuance last October.
"On the basis that we believe that there should continue to be a place for innovative Tier 1 on our balance
sheet, we do not consider this covenant particularly burdensome and certainly preferable to a mandatory
deferral trigger based on P&L criteria as used by European insurers to achieve Basket D," said John Whorwood,
group treasurer at Legal and General.
The liberal sprinkling of structural tweaks built into the transaction by joint leads HSBC, Merrill Lynch and RBS
(sole structuring adviser) meant that the deal became the first European Basket D transaction (eligible for
75% equity credit on Moody's continuum) without mandatory deferral triggers. It is also the first UK
transaction to use preference shares and payment in kind (PIK) securities alongside ordinary shares in the
AISM (alternative interest satisfaction mechanism) and the first to incorporate caps in the usage of the AISM
to meet ratings agency requirements. Last, but not least, it is the first UK insurance transaction to qualify
under the FSA's new GENPRU rule book as innovative Tier 1 capital.
The eventual pricing at plus 133bp was the same level at which the issuer priced its UT2 trade three years
ago, which underscores the fact that credit spreads are at historic tights. The proceeds of the trade will be
used for commercial paper refinancing and for the acquisition of Nationwide Life and Nationwide Unit Trust
Managers (as part of the issuer's distribution agreement with Nationwide).
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L&G's sparkling debut

Legal & General established a number of firsts in the UK hybrid sector with its £600m perpetual non-call 10
Tier 1 trade issued last week (see News story for details). The innovative Tier 1, fixed-to-FRN, 100bp step-up
trade (rated A3/A) rounded off the issuer's capital structure, L&G having issued in UT2 and LT2 formats back
in 2004 and 2005, respectively.
Following a three-day UK roadshow, joint leads HSBC, Merrill Lynch and RBS opened books last Thursday
morning with initial price guidance of 135bp–137bp over Gilts, 2bp–4bp inside the benchmark AXA and
Generali 2016 Tier 1s.
Of a total order book that exceeded £3bn (raised in half a day), £500m dropped away when guidance was
tightened to plus 133bp and the issuer's size ambition capped at £600m. Compared with Aviva's perpetual
non-call 2020 Tier 1, bid at plus 145bp, the deal did not concede any new issue premium. When freed to
trade, the bonds were marked at plus 132bp–130bp, tightening by a further 2bp last Friday.
"We continued to monitor the relative cost of innovative Tier 1 versus UT2 and believed the right spread was
between 15bp and 20bp and therefore we were delighted that we were able to achieve a 17bp differential on
this transaction, that is 133bp over Gilts versus the secondary level of plus 116bp on our existing sterling UT2
[perpetual non-call 15] trade," said John Whorwood, group treasurer at L&G. "Unlike our previous issues, we
have chosen to swap the issue into floating-rate funds, allowing us to raise tax-deductible Tier 1 capital at a
level of 93bp over Libor," he added.
Of the more than 100 accounts in the book, the UK accounted for 97% of the placement. Asset managers
bought half the bonds, followed by insurance and pension funds (42%) and banks and hedge funds (4% each).
Barclays shows human side

(Published in IFR, 11 June 2005)
When Barclays Bank launched its second euro-denominated preference share issue at the beginning of
March – the perp, non-call 2020s – few could have known it had hit the absolute market tights and achieved
pricing levels that one banker described (with only a hint of hyperbole) as unlikely to be revisited for a
generation.
From an issuer perspective, it could be thought that this should be viewed as a utopian outcome – the best
possible in the best of all possible worlds. Not all issuers are quite so simplistic in their approach, however, and
Barclays' claim is that it has always prided itself on its reputation for transactions that perform in the
secondary market. Perform is certainly the one thing that it did do, but not quite in the way envisaged.
From an issue spread of 102bp over Bunds, it tightened marginally when freed to trade (all well and good) but
then fell victim to the extreme volatility that hit the whole market in the middle of the month and spent the
next few weeks lurching between plus 135bp and 175bp, before breaking out and at one stage hitting the
220bp mark. A level of decorum has been regained – albeit at wider levels – and it has spent the last few
weeks around the high 180s/low 190s.
When the market was at its most turbulent, the deal was still primary. It was large (€1.4bn) and therefore
liquid, and relatively long. If anything was likely to become a proxy for the market in general – and bear the
brunt of traders wishing to hedge existing positions or just take a punt – this was it. While this does not make
the circumstances any easier to bear for investors that bought bonds at launch, it does tend to put things in
context.
While all that might seem like ancient history and not strictly relevant to the present, it does have a significant
bearing on Barclays' recent actions. To fund its acquisition of Absa, it announced that it was going to launch
more of the same, or similar in any case. Having already visited the euro market twice, it chose a different
tack, first targeting US institutions two weeks ago with US$1bn of non-call 30s and then concentrating on
the domestic audience for the final leg last week.
When price talk first emerged on the putative sterling issue – 175bp over Gilts – the initial reaction, in some
quarters at least, was that it was more than likely a wide mark designed to entice investors into the book
before the genuine pricing came in tighter. Much of this reasoning was based on the fact that HBOS's pref had
been trading around its launch spread of 162bp over Gilts, and for Barclays to trade back of HBOS would be
against the natural order of things, even allowing for a 12-year rather than 10-year call and the renewed need
for a new issue premium.
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At the Tier 1 level, Barclays is rated Aa3/A+ against HBOS's A1/A.
Barclays' announcement, not surprisingly, had the effect of widening out the bid on the HBOS deal and Anglo
Irish's recent transaction (so recent it is still primary, in fact) by around 10bp. As the news sank in, however,
both began to drift back in. Barclays Capital played a lead management role in both of those trades and was
well placed to know the market's state of mind. The thought began to take hold that maybe Barclays was
willing to price at a concession to where it could if it pushed matters, not only in return for size but also to
make amends for investors' experiences on the euro issue.
Whatever the rationale behind the price talk, it had the desired effect and a book of close on £1.6bn built up. Hedge
funds have been noted creeping back into a few deals – and this looked like one that would suit them perfectly.
Barclays' head of capital issuance, Ross Aucutt, was keen to stress the quality of the order book, however, so it
looked as if real-money accounts were keen to participate as well. With £750m the chosen issue amount, the
size of the book allowed for a degree of manipulation, and Aucutt added that allocation was skewed towards
asset managers, with particular emphasis being placed on the bank's equity investors.
Despite the view that the issue was relatively cheaply priced, it did not tighten in dramatically when freed to
trade. It narrowed a couple of basis points on the break but did not replicate the performance of the previous
week's US dollar deal, which had come in around 15bp. That deal was also rumoured to have been launched
at a level wider than Barclays could possibly have pushed for, and largely for similar reasons to this time round:
namely breaking into a new investor base mindful that they would be aware of what had happened to the
euro deal. By the end of the week, natural order had returned, with Barclays bid at 170bp to HBOS's 171bp.
Although that situation was market-driven rather than having anything to do with the pricing or placement, it
was still something that had to be addressed.
Barclays' decision to do so by trying to guarantee performance in its new transactions to the best of its ability
seems to have been successful, although other prospective issuers will be hoping that investors will not
expect all borrowers to follow suit.
FIG hybrids get a new look

(Published in IFR, 22 September 2007)
This summer's volatility hit the high-beta market for perpetual securities particularly hard, so much so that
borrowers that had recently issued the instruments are now facing significant coupon reductions after the
call periods. It is against that backdrop that investors, borrowers and underwriters are evaluating how to
proceed in a market that has lain dormant for over three months.
Amid the prevalence of coupon step-downs in the market, one investor group lobbed a US$1bn enquiry
towards Barclays Bank, and the firm subsequently obliged by issuing US$1.25bn in perpetual non-call 10
Aa3/A+/AA securities. Those participating in the deal were quickly rewarded with what was said to be an
improvement of 30bp on the break.
Barclays' outstanding 5.926% issue with a call in 2016 was said to be bid 265bp over Treasuries as the credit
re-entered the market. That issue priced in September 2006 at 129bp over, which equated to a coupon step-
up of Libor plus 175bp after the call. With 10-year swap spreads bid in the 60.25bp area, any coupon step-up
on last week's transaction would be likely to arrive in the area of Libor plus 300bp, which is demonstrably
more attractive that the 175bp reset on the outstanding issue.
Although other accounts quickly piled into the trade, the aforementioned investor group was said to have
held out for the pricing concession that it believed was appropriate. Last week's transaction eventually priced
280bp over 10-year Treasuries with a coupon reset of Libor plus 317bp after the call. With the attraction of
that step-up, the securities snapped into the 250bp area on the break.
The Barclays transaction also had the benefit of rapidly improving market conditions following the FOMC
meeting, and it was debatable whether a tighter pricing level could have been achieved prior to the meeting.
The other recent hybrid trade, which was a US$250m A3/BBB+/A– tax deductible trade for FPL, priced with a
concession that was thought to be in the 50bp range.
Several broker/dealers were said to have placed orders for the Barclays Bank securities at the plus 280bp level, and that
demand, in addition to anchor orders, drove the total size of the order book to the US$7bn range.
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Those away from the transaction watched the process closely and indicated that the offering should provide
a foundation for the pricing of subsequent perpetual trades. "The market now knows that there is a level out
there for hybrid securities that can drum up US$7bn in demand," said one observer.
With Barclays reopening the market last week, there should be additional supply forthcoming as investors
rotate away from instruments that carry a coupon step-down after the call. Participants anticipate that
securities issued five or six years ago in the earlier stages of the financial hybrid market will soon catch a bid
due to their step-ups.
The sharp declines in the value of the dollar against the euro and the pound, which are expected to continue,
could also play a role in Yankee issuers' decision to call certain perpetual securities, as the principal
repayment would be reduced.
After pricing a US$1.45bn perpetual non-call five Aa3/A transaction with a dividend of 7.25% last week, RBS
Group is said to be considering a dollar-denominated step-up or non-step institutional trade related to its
acquisition of ABN AMRO.
Bank of America also tapped the retail market last week with a US$500m perpetual non-call five Aa3/A+
offering that printed with a dividend of 6.625%. JPMorgan meanwhile filed a shelf registration for preferred
and junior subordinated securities.
Rexam's hybrid paves way for UK corporates

Rexam opened a new chapter in the European corporate hybrid market last week when it became the first UK
corporate to use the structure. The €750m M&A-driven transaction met with a very positive reception from
investors that ensured it was more than five times subscribed at the reoffer level of mid-swaps plus 190bp.
The key reason why UK corporates had not used the hybrid structure until Rexam's deal is that such
companies have usually been the ones being acquired in bouts of industry consolidation, rather than being
the acquirers, said Debbie Keat, a member of the European new products team at Citi. While she acknowl-
edged that the Rexam transaction is, therefore, unlikely to open the floodgates for more UK corporates, she
believes that the deal's success should entice others to follow suit, a view shared by other market partici-
pants. Peter Jurdjevic, European head of new products at Citi, suggested that there is also an element of
issuers not wanting to be the first to the market.
"Issuers have to go through a lot of work including tax analysis, legal analysis and ratings agency work which
can be quite time consuming. The transaction took around 14 weeks from initial discussions to execution
and this may have prompted potential issuers to hold back until the first deal is out of the way and the
market's reception is seen. Rexam has laid the cornerstone for this to happen."
Jon Drown, director of group treasury at Rexam, acknowledged that the exercise was more time consuming
and more costly than issuing typical senior debt, but he maintained that this is comfortably outweighed by
the product's benefits. "For the amount of work that went into the deal, coupled with the benefits, it offers
remarkably good value," he said, adding that a couple of UK corporates had already been on the phone to
discuss the issue.
This was backed up by Khalid Krim, head of European hybrid capital structuring at Barclays Capital, who also
highlighted additional companies that have expressed an interest in hybrids, although he declined to name
them. "This is a product that is now very available to UK names and there are others that would undoubtedly
benefit their capital structure by limiting dilution to shareholders and avoiding a rights issue," he said.
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Table 6.1: UK termsheets
121
Insurance Tier 1 Bank Tier 1 Bank Tier 1 Corporate Hybrid
Legal and General £600m Barclays Bank PLC £750m Barclays Bank PLC US$1.25bn Rexam €750m 6.75% 60 nc
6.385% Perp nc 10 (issued Apr-07) 6% Perp nc 12 (issued Jun-05) 7.434% Perp nc 10 (issued Sep-07) 10 (issued Jun-07)
Issuer Legal and General Group PLC Barclays Bank PLC Barclays Bank PLC Rexam PLC
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IssuerType Direct Direct Direct Direct

SecurityType Perpetual Preferred Callable Capital Securities Non-Cumulative Callable Preference Shares Step-up Callable Perpetual Reserve Capital Instruments Capital Securities Direct, unsecured and
Status / Subordination Direct, unsecured and subordinated obligations of the The Preference Shares will rank junior to other shares The RCIs constitute direct, unsecured, subordinated subordinated obligations of the Issuer.
Issuer and shall at all times rank pari passu and without ranking in priority to the Preference Shares, equally securities of the Issuer and rank pari passu without The Capital Securities will rank pari passu
any preference among themselves. The rights and claims among themselves and with any other shares in issue any preference among themselves. The rights and claims and without any preference among
of the Holders are subordinated to the claims of Senior ranking pari passu with the Preference Shares,, and of the RCI holders are subordinated to the claims of senior themselves, and subordinated to the
Creditors. senior to the holders of ordinary shares and any other creditors, pari passu with holders of existing TONS and claims of Senior Creditors.
shares ranking junior to the Preference Shares. RCIs and of the most senior class of preference shares of
the Issuer, and senior to all other shareholders of the Issuer.
Maturity Perpetual Perpetual Perpetual 29-Jun-2067
First Call Date 2-May-2017 15-Dec-2017 15-Dec-17 29-Jun-2017
Step-Up at First Call Date +100 bps - +100 bps +100 bps
Early Redemption Yes (Tax Law Change / Capital Disqualification Event). n/a Yes (Tax / Regulatory Event). Redemption subject to prior Yes (Accounting Event / Acquisition Event /
The Capital Securities can be substituted for, or the terms consent of FSA. RCIs redeemed at their principal amount Additional Amounts Event / Capital Event /
varied so that they become alternative Qualifying Tier 1 (Tax / Regulatory Event). Change of Control Event / Minimal
Securities or Qualifying UpperTier 2 Securities, or redeemed, Outstanding Principal Amount Event / Tax
at their prinicipal amount (Tax Law Change), or at their Make Event). Securities redeemed at their
Whole Redemption Price (Capital Disqualification Event). principal amount (Additional Amounts
Redemption subject to prior consent of FSA. Substitution/ Event / Change of Control Event /
Variation of Capital Securities with Qualifying Tier 1 Securities or Minimum Outstanding Principal Amounts
Qualifying UpperTier 2 Securities. (Tax Law Change, Capital Event), or at the Special Make-Whole
Disqualification Event). Redemption Price - higher of principal or

Bunds+100 (Accounting Event / Capital
Event / Tax Event), or at 101% of principal
(Acquisition Event). Issuer option to
redeem securities at any time, at make-
whole redemption price (higher of
principal or Bunds+25).
Table 6.1: UK termsheets (cont)
122
Replacement Clause Replacement Capital Covenant - replacement with n/a n/a Intent-Based Replacement of Redeemed
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qualifying securities. Substitution of Capital Securities Securities. Replacement with ordinary

with preference shares (Capital Breach Event). shares or replacement capital securities
(Minimum Outstanding Principal
Amounts Event / Additional Amounts
Event / Accounting Event / Capital Event /
Tax Event) No intent-based replacement
following a Change of Control Event or
Acquisition Event.
Dividend Pusher/Stopper Dividend Stopper Dividend Stopper Dividend Stopper Dividend Stopper
Regulatory Event Interest payments conditional on Issuer being solvent at Dividends conditional upon no breach of capital Interest payments conditional on Issuer being solvent at the n/a
the time of payment and immediately thereafter. adequacy requirements of the FSA. time of payment and immediately thereafter.
Optional Deferral Interest payments optionally deferrable. Maximum Dividends optionally deferrable and conditional upon Interest payments optionally deferrable. Maximum 10-year Interest payments optionally deferrable.
5-year deferral period (cumulative). Deferred payments to availability of distributable profits. Deferred dividends deferral period (non-cash cumulative). Deferred payments Maximum 5-year deferral period
be settled with via AISM (Alternative Interest Satisfaction non-cumulative. to be settled via ACSM. Mechanism). (cumulative and
compounding). Deferred payments to be
settled with cash or via ACSM.
Rating Agency No rating agency mandatory deferral trigger (see n/a n/a Interest payments mandatorily deferrable.
Mandatory Deferral regulatory payment deferral and RCC). Trigger - Financial Leverage Ratio
(Adjusted Net Debt to Adjusted EBITDA)
greater than 5.5, or greater than 4.5 on
four consecutive determination dates.
Issuer required to pay deferred payments

immediately via ACSM. Maximum 10-
year deferral period (cumulative and
compounding). Deferred payments to be
settled via ACSM.
Deferred Payments Non-Cash Cumulative Non-Cumulative Non-Cash Cumulative Mandatory Deferral (Non-Cash
(Cumulative / Non-Cash Cumulative).
Table 6.1: UK termsheets (cont)
123
ACSM Settlement of deferred interest payments via issuance of n/a Settlement of deferred interest payments via issuance of Settlement of deferred interest payments
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ordinary shares (2% limit in any 12-mth period), ordinary shares (2% limit). Issuer shall use best efforts to immediately, via issuance of ordinary
PIKSecurities (15% limit of principal) or Preferred Parity settle deferred payments. Deferred payments not settled shares, warrants or junior/parity
Securities (25% limit for Preferred Parity and PIK after 10 years will constitute an event of default. securities (25% limit) in six month period
Securities). Issuer shall use reasonable endeavours to prior to deferral date. If Issuer not able to
settle deferred payments. Deferred payments to be settled pay deferred interest on deferral date,
within 5 year period. Issuer shall use best efforts to settle
deferred payments. Deferred payments
not settled after 5 years (optional deferral)
or 10 years (mandatory deferral) will
constitute an event of default.
Additional Features/ Basket D via RCC Not tax-deductible Pre-emption: Issuer/holdco required to keep available for Basket D (MPD)
Comments issue sufficient shares to satisfy two coupon payments via
ACSM.
Source: Compiled by CALYON from respective offerings circulars
CHAPTER06
Ireland
Irish financial institutions have been very active issuers of hybrid capital securities given the
rapid growth of the domestic economy and the successful strategies of the institutions to capture
domestic and international opportunities. Irish financial institutions have tapped both the RPB
and institutional markets. Within the institutional market both step-ups and True Perps have
been seen from Ireland. Irish banks and also building societies have been active in issuing Tier 1
capital and Permanent Interest Bearing Shares (PIBS) in the international debt markets for many
years, and evolved the capital security structures in order to optimise the tax and accounting
aspects while meeting regulatory and legal requirements. So far no corporate hybrid or insurance
sector transactions have been issued by an Irish institution.
The exhibit below details two transactions, one bank – Anglo Irish – and one building society
regulatory capital transaction – EBS Building Society. As in many jurisdiction the structuring
objectives must consider tax efficiency (deductibility, duties, withholding). These two Tier 1
capital structures exhibit some of the variety seen in the market over time. Notable differences
include the ownership and domicile of the SPVs involved.
Irish banks have issued indirectly via an SPV when raising Tier 1 capital in the markets. As seen
with the Anglo Irish Tier 1 transaction in the exhibit, many of these securities are issued through
an English limited partnership (LP) SPV with subordinated guarantee from the bank. The use of an
UK LP SPV was a breakthrough for the Irish financial institutions in meeting the regulatory require-
ments of IFSRA, with UK LP securities providing the sufficient equity characteristics to pass as Tier
1 capital, with classic Tier 1 terms applied (eg. perpetual maturity, non-cumulative deferrable
payments, deeply subordinated, fully paid up equity securities in the hands of investors).
Some of the Irish building societies have traditionally issued PIBS – the Bank Tier 1 equivalent for
building societies and over time the market and structure for these securities has also evolved.
The EBS Tier 1 transaction satisfied IFSRA requirements via issuance of Tier 1 qualifying securities
from a Luxembourg SPV to an independent SPV which then sells its own securities to the
investors. Such an arrangement is in some ways similar to Tier 1 capital structures seen in
Germany and Switzerland, as also discussed in this report.
These independent SPV arrangements can be established by the structuring bank and lawyers
assisting in the transaction to increase the overall fiscal results and aid in the marketability of the
securities to international investors.
As regulatory capital Tier 1 was the objective of these issues there are no additional rating agency
enhancements in the structures such as RCC or ratings driven MPD triggers however regulatory
and issuer discretionary deferral are of course possible.
A forward thinking feature included in some Irish Tier 1 was the structural benefit to the issuers
that could allow minor amendment or substitution of the capital securities if needed. The
investor could for example continue to hold the SPV securities, with the issuer replacing or
modifying the capital securities issued into the SPV to offset potential future changes or alterna-
tively traditional preference shares could be issued to investors to replace the entire hybrid
structure. This type of flexibility can now more frequently be seen in some of the recent transac-
tions across the world as the potential for CEBS driven changes in own funds definitions is
considered as a possibility.
Ireland termsheets
Anglo Irish spreads wings
While it is a credit well known to UK institutional buyers of subordinated debt and has a well-defined sterling
curve, Anglo Irish Bank had not offered European investors the opportunity to gain exposure in their core
currency before last week. It has previously tapped the non-innovative retail market through a CMS-linked Tier 1,
but the fund management fraternity had not had such a chance to buy higher-yielding paper in step-up format.
Although the bank frequently updates investors in its senior paper about its strategy and progress, an
extensive, subordinated-specific pan-European roadshow was arranged by lead managers ABN AMRO, BNP
Paribas and Merrill Lynch, initial talk just being of a perpetual callable step-up issue. As to whether this would
come in the guise of a Tier 1 or UT2 was at first uncertain, Anglo having clearance for a UT2 but requiring
regulatory sign-off for a Tier 1.
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With sterling having offered better execution than euros throughout much of the summer, there were also
whispers – mainly away from those close to the deal – that this would turn out to be the preferred currency.
But it was not, in spite of the fact that the cost would undoubtedly have been less – by up to 10bp, said some
– for such a trade. Anglo's decision was that this was a price well worth paying for the investor diversification a
euro-denominated transaction offered.
Although Anglo had only €300m headroom for innovative capital, the choice made was to opt for a
benchmark (€500m minimum) perpetual non-call 10 Tier 1. The bank has been expanding quickly over the
last few years, and the view was that it would grow into any excess issued. There is only a small differential
between UT2 and Tier 1 funding levels in the euro market, so the incremental cost was relatively minor. And
with a September year-end and results announced on December 6, chances are that this growth will come
sooner rather than later.
Spread talk of 120bp–125bp over mid-swaps was released and the order book grew quickly. The €500m
mentioned was covered within a couple of hours, the final order tally exceeding €2bn. Even when spread talk
was refined to the tight end, there was still around €1.8bn remaining and the final deal size was increased to
€600m, leaving Anglo a little more innovative room into which to grow than first envisaged.
There was probably even scope to push inside 120bp, though Anglo was aware of the need to create a good
impression on its debut visit, especially as it is likely to return. Even so, the level it achieved compared
favourably with its ratings peer group, though there is a strong belief that its ratings are constrained more by
size than market perception.
Anglo's transaction was rated Baa1/NR/A. Erste Bank recently launched A3 rated 10-year callable paper at
plus 127bp, while Sabadell (A3/BBB/A–) was in the market at the beginning of the month with an issue that
was last week bid around plus 121bp. The bonds weakened slightly on the break, though this was against a
backdrop of nervousness prompted by global political developments, the 1bp widening actually being a slight
outperformance.
New issues defy secondary widening

(Published in IFR, 23 July 2005)
Although secondary turnover was slow, the market spent much of the week in mild retreat. In the context of a
number of weeks of spreads ratcheting tighter, it was a minor move, however, and there was no discernible
effect on the primary market. “It was mainly Street jockeying,” said one syndicate official. "Accounts are not
selling, if anything, they are still better buyers for choice.”
This was certainly borne out by the experiences of Banco Pastor and Resona Bank, both of which priced con-
siderably inside initial guidance. And this after Pastor's previous trials at the beginning of May when it had to
shelve plans for a non-step up transaction even before the roadshow stage had been reached (see the feature
at the start of the Bonds section for comment on Resona and Tier 1 preferreds in general).
This time, its €250m perpetual non-call 10 Tier 1 attracted a final book of €1.38bn. Almost half the orders
were pledged after the spread talk had been tightened by 8bp from early indications of a mid-swaps plus
125bp spread. Eventual pricing was at plus 117bp over mid-swaps (126.4bp over Bunds), close to the tights of
all the possible options discussed during the roadshows organised by lead managers Barclays Capital,
Dresdner KW and Morgan Stanley.
During the marketing process, the interested parties largely fell into two groups: one that felt 115bp was
spread enough (mainly Dutch accounts) and those that wanted something nearer 130bp (mainly UK). Both of
these levels was wider than Tier 1 paper from comparable names such as BES (A3/BBB), Kaupthing (A3) and
Eurohypo (Baa1/BBB+), whose bonds ranged from 100bp to 114bp over, although the stringent mandatory
deferral language that earned Baa1/BBB rated Pastor Basket D (75% equity) treatment from Moody's naturally
came with a price attached. The handful of basis points it cost was less than some were predicting, however,
and was largely compensated for by this being the first step-up deal from Spain – and as such had an element
of rarity value attached to it. The differential was further eroded after the bonds were freed to trade,
tightening to 122bp–120bp over Bunds from the 126.4bp launch spread.
The transaction featured two mandatory deferral triggers: one if Tier 1 ratios fall below 5% – more stringent
than the 4% required under Spanish law – the other a standard profits test. It was this slightly unusual
structure plus its relatively small size (at €250m it is too small to qualify for either the iBoxx or Lehman
indices) that caused it to price at a small premium, and this situation was repeated on the week's other new
Tier 1 issue from EBS Building Society.
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The €125m issue size almost guarantees that EBS will not trade in the secondary market, and this lack of
liquidity necessarily limits the number of accounts willing to consider investing in it. The original marketing
was for a €100m issue, the larger size coming in response to an order book built up by joint leads ABN AMRO
and Davy Stockbrokers that could have seen the paper sold twice over.
As a mutual, EBS has limited ways of raising capital as it is unable to access the equity market. The way that
building societies in the UK have historically dealt with this situation has been to launch PIBS (Permanent
Interest Bearing Shares) issues and this was effectively a synthetic PIBS. It was actually launched through an
ABN-sponsored vehicle, Chess Capital Securities, and was a perpetual callable after 10-years with a 100bp
step-up in the case of the call option not being exercised. It priced at 145bp over mid-swaps, and was in
keeping with the theme of the week, which was tighter than initially indicated spreads, although it was not
quite as aggressively repriced as Pastor's deal. Original talk had been in the plus 150bp area.
Pastor also offered a useful comparable when looking at the issue's relative merits. Both transactions were
Baa1 rated by Moody's, although Pastor also carried Triple B from S&P, and both were small and potentially
illiquid. That EBS's issue was half the size of a Pastor transaction already viewed by some as too small to
participate in and the single rating demanded a premium from the Irish issuer, the only question being how
large it should be. At their respective launch spreads it was 28bp, although because Pastor's issue tightened
slightly when freed to trade it made it more like 30bp. For those whose desire for liquidity is secondary to
yield, this made for a healthy pick-up over similarly rated peers.
While Irish investors were the largest single group, they accounted for only 36% of the paper, German buyers
taking almost a quarter and the rest spread around pan-European fund managers. German investors were
also active in the floating-rate market, DZ Bank adding €100m to its perpetual non-call seven Tier 1 FRN,
taking it to €300m. The spread at reoffer on the Baa2/BBB– rated paper was 115bp over Euribor.
Table 6.2: Ireland termsheets

Bank Tier 1 Building Society
Anglo Irish €600m 5.219% Perp nc 10 (Sep-06) EBS Building Society €125m 4.83% Perp nc 10 (Jul-05)
Issuer Anglo Irish Capital UK (2) LP CHESS Capital Securities plc
IssuerType Wholly owned guaranteed SPV Independent SPV
SecurityType Guaranteed Non-voting Non-cumulative Perpetual Step-Up Guaranteed Non-Cumulative
Preferred Securities Perpetual Capital Securities
Status/Subordination The Securities are ranked junior to all liabilities of the The Securities are ranked junior to all Senior
Guarantor including subordinated liabilities (other than Creditors, pari passu with Parity Securities,
Tier 1 Capital or any other liability expressed to rank pari if any, issued by EBS and any guarantee
passu with or junior to the Subordinated Guarantee); pari or support agreement of EBS ranking pari
passu with Parity Se passu with the Subordinated Guarantee, and senior to
Junior Securities.
Maturity Perpetual Perpetual
First Call Date 29-Sep-2016 29-Jul-2015
Step-Up at First +100 bps +100 bps
Call Date
Early Redemption Yes (Tier 1 Event / Tax Event). Securities redeemed at the Yes (Tax Event / Regulatory Event). Securities
higher of principal or Bunds+75 (Tier 1 Event) or principal redeemed at their principal amount
amount (Tax Event). Redemption subject to prior consent (Tax Event / Regulatory Event). Redemption
of the IFSRA. subject to prior consent of the IFSRA.
Replacement n/a n/a
Dividend Pusher/ Dividend Stopper Dividend Stopper
Stopper
Regulatory Event Interest payments conditional upon no breach of capital Interest payments conditional upon no breach of
adequacy regulations, or minimum capital requirements minimum capital requirements, and ability to meet
or solvency ratios not being met. Interest payments not solvency ratios. Interest payments not paid if instructed
paid if instructed by IFSRA. by IFSRA.
Optional Deferral Interest payments optionally deferrable, to be exercised Interest payments optionally deferrable, to be exercised
upon deferred payments on anyTier 1 orTier 2 Securities. upon deferred payments on anyTier-1 orTier-2
Deferred payments non-cumulative. Securities. Deferred payments non-cumulative.
Rating Agency No rating agency mandatory deferral trigger (see No rating agency mandatory deferral trigger (see
Mandatory Deferral Regulatory Event). Regulatory Event).
Deferred Payments Non-Cumulative Non-Cumulative
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Table 6.2: Ireland termsheets (cont)

Bank Tier 1 Building Society
Anglo Irish €600m 5.219% Perp nc 10 (Sep-06) EBS Building Society €125m 4.83% Perp nc 10 (Jul-05)
ACSM n/a n/a
Additional Features/ Substitution with non-cumulative perpetual preference Tax Event - best endeavours to arrange substitution of
Comments shares, or variation of existing security terms so that juristiction or change of residence. Substitution of the
they become alternative Qualifying Tier 1 Securities or Capital Securities with non-cumulative deferred shares,
Qualifying UpperTier 2 Securities. or non-cumulative preference shares if EBS has
converted to a PLC (Capital Deficiency Event).
France
The French ‘TSS’ structure for hybrid securities
The explosive growth of hybrid securities has its roots in the development of tax-efficient hybrid
Tier 1 capital securities for financial institutions, where some of the first transactions were
developed in Europe and later adapted to the US market which in turn started a new wave of
innovation in Europe and globally. Since then, the exchange of ideas has driven the growth of
hybrid issuance across sectors across the Atlantic and around the world. Therefore it is only
possible to understand some of the current opportunities and challenges in structuring corporate
hybrids by reviewing the history of the hybrid Tier 1 capital security market.
Some history
The Titres Super-Subordonnés (TSS) structure in France came into existence in the French legal
system in 2003 in response to years of lobbying by the banking community and advisors for a
more straightforward direct issue form of Tier 1 capital security. Before the TSS creation in 2003,
French banks were only able to structure tax-efficient hybrid Tier 1 capital by using offshore SPVs
which then on-lent the proceeds back to the parent bank. The most common SPV domicile
locations included many that were eventually perceived as tax havens such as the Cayman
Islands, Turks and Caicos, Jersey or US ‘incorporation-friendly’ jurisdictions such as Delaware.
There was no suitable preferred stock security in the legal system when hybrids were first con-
templated for Tier 1, therefore the use of wholly-owned SPVs from jurisdictions where a preferred
type security could be issued from the SPV created an opportunity to develop some of the first
hybrid Tier 1 before the term hybrid existed in relation to capital.
Operating subsidiary Tier 1

In order to satisfy the criteria that capital should be raised via an operating entity (not a shell
company) there was a period of hybrid product development that really demonstrated the capabil-
ities of the banks and the hybrid structuring teams that support them. The structures that
resulted had varying versions of the following:
0 Operating subsidiary – The hybrid capital security issuing entity – this needed to be an entity
with a bona fide business/banking purpose and if the parent bank did not already have a
significant operating subsidiary that was suitable then the ‘bon idée’ was to create an operating
entity that could then issue the capital securities. In order to be deemed an operating subsidiary, a
banking business such as asset management/investment (i.e. mortgage investing and portfolio
management) was used. Since the operating subsidiary was owned by the parent bank, any excess
cash from the asset portfolio could be returned to the parent bank via common dividends from
the sub to the parent bank and the parent bank could provide credit support to the sub in order to
utilise the parent bank ratings for the sale of the hybrid securities. However, the operating sub did
have the value of assets in its capital structure, unlike a shell or pass-through SPV structure.
Importantly, the cash raised from the sale of hybrid securities must flow to provide the parent
bank in order for the transaction taken as a whole to count as capital;
0 Financial assets – Cash-generating assets (such as mortgages) were used to invest the capital
raised by the SPV hybrid transaction and subsequently make payments on the capital securities
issued by the operating subsidiary to third party investors. Since most banks had such assets on
balance sheet it was a logical choice for these transactions. By acquiring the assets from the bank,
the cash raised by selling the hybrid securities was routed back to the parent bank fulfilling that
element of the Tier 1 criteria;
0 Hybrid capital security – The nature of the terms of the SPV security issued need to meet the re-
quirements of Tier 1 and so the issuing entity and jurisdiction needed to be selected with these
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objectives in mind so that perpetual, non-cumulative securities could be issued. On consolidation

these securities would have counted as minority interest or a form of mezzanine equity which
would support the Tier 1 analysis at that time.
Evolution
Two change catalysts led finally to the development of TSS and its adoption into the French legal
system:
0 The SPV-based Tier 1 structures were only accounted for as Tier 1 on a consolidated basis when
the SPV securities were included at the parent bank level financial statements. SPV hybrid Tier 1
was not counted as ‘solo’ Tier 1 on a non-consolidated basis. While some issuers were content to
have consolidated low-cost Tier 1, others continued to lobby for direct issue hybrid securities that
would count as solo Tier 1 capital at the parent bank;
0 There was an EU community desire to reduce the use of jurisdictions perceived to be tax
havens, even for legitimate transactions such as bank Tier 1.
Outside France, other jurisdictions had forms of preferred stock or preference share types of
securities defined in the legal system and this made it easier to create a tax-efficient synthetic
preferred equivalent security that would also eventually satisfy the emerging Basel requirements
for hybrid Tier 1. Several jurisdictions, such as the UK, were relatively early (1999–2000) to adapt
new hybrid Tier 1 securities for banks that were:
0 Tax efficient;
0 Direct bank issues;
0 Tier 1 qualifying.
Finally, in 2003 the French TSS became a reality and this is the basic structure used for all
corporate and financial hybrid capital securities from French issuers. Although it was slow in
arriving, the TSS security is very flexible and it is able to be a very equity-oriented security and
therefore useful in satisfying the accounting and rating agency requirements for equity treatment
in addition to regulatory guidelines.
As the hybrid capital security market develops and investors are becoming more discriminating
about hybrid structures, an increased demand for investor protection is being seen and more con-
sideration given to TSS hybrid variations that could improve the pricing and demand for an
issuer’s potential TSS transaction. Therefore more debt-like TSS hybrid structures from corporate
issuers can be expected in future.
By observing the highlighted transactions in the summary examples section you will see an illustrative
cross-section of the various TSS issues from different sectors in the market that demonstrated the
flexibility of the TSS structure. Bank Tier 1 transactions thus far do not exhibit the rating agency en-
hancements (RCC, MPD) seen in other sectors like insurance and do not provide additional investor
comforts like ACSM. Pioneering corporate transactions such as the Vinci deal were fully non-
cumulative with no ACSM again taking advantage of the highly equity-oriented TSS bank type
structure. The insurance sector shows more diversity among issuers and compared to the other
sectors. As always attention to detail is suggested in looking at the complete transaction offering
circulars for the transactions in the market. In the summary examples below a full featured Basket D
issue by AXA is highlighted that provides significant rating agency equity credit and regulatory capital.
French hybrid issues have been successfully completed across all major sectors in both the RPB
and institutional markets.
More recent French bank capital developments
Commission Bancaire sets a maximum limit of 25% on hybrid capital
New framework for eligibility of Tier 1 regulatory capital:
0 Tier 1 must be constituted at least up to 50% by share capital + reserves + carry-forward profits,
the remaining 50% with the other type of products;
0 Within the remaining 50% threshold, hybrids will be able to amount up to a maximum 25%
(innovative or non-innovative, including minority interests resulting from the consolidation of ad-
hoc vehicles used for indirect issues of hybrid instruments) but not up to 30% or 33%, as expected;
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0 Within the 25% maximum limit for hybrid securities, the maximum limit for innovative
hybrids remains at 15%;
0 Minority interests (other than minority interests resulting from consolidation of ad-hoc vehicles
used for indirect issues of hybrid instruments) and preference shares are excluded from the
above-mentioned 25% threshold (but included in the 50% threshold).
More information on the Commission Bancaire is available on www.banque-france.fr
There has been a similar move in Italy, where Italian regulators have recently increased the limit
for Hybrid Tier 1 capital from 15% to 20%, allowing for more True Perps but keeping step-up
structures capped at 15%.
More information on the Bank of Italy is available on www.bancaditalia.it
Additional points:
0 The preference shares (actions de préférence) are non-deductible and would be admitted within the
non-core and non-hybrid 25% to the extent they meet ‘the relevant criteria of eligibility, notably the
loss absorption and the permanence features, with a particular attention to any early buy-back
option’. Since a number of market players raised some concern about the meaning and application of
such criteria to preference shares in the French context, the Commission Bancaire indicates that they
will be discussed with the French banking organisations and the Autorité des Marchés Financiers;
0 The French Banking Commission would probably consider non-cumulative prefs, with a step-up
and a buy-back option as an innovative hybrid (i.e. within the 15% threshold) and would be still
reluctant to agree to such structure.
Table 6.3: France – total Tier 1 capital breakdown

Hybrid secuities
Max. 25% of total tier 1 capital:
- Hybrid securities (Innovative, Non-innovative and minority interests resulting from
consolidation of ad-hoc vehicles used for indirect issues of hybrid instruments).
- Innovative, step-up and deductible hybrids up to 15%
- Non-innovative, non step-up and deductible hybrids 0-25%
} 25%
Non-core and non-hybrid

Max. 25% of total tier 1 capital:
- Preference shares or "actions de préférence"
(Non-deductible, no step-up)
- Minority interests (Not resulting from consolidation of as-hoc vehicles used for
indirect issues of hybrid instruments). } 25%
Core tier 1
Min. 50% of total tier 1 capital:

- Share Capital

- Reserves
- Carry-Forward profits
} 50%
France termsheets
AXA calms Tier 1 nerves
AXA's heavily oversubscribed Tier 1 euro and sterling trades brought some semblance of stability back to the
volatility-plagued perpetual hybrid sector. But the issuer's promise of no-return to the same space this year as
an added assurance to investors is not an effective insulation against the vagaries of a market recovering
from an overhang.
Boxed in by its acquisitions calendar following the Winterthur buy, AXA had to raise capital quickly. But with
swings of 5bp–10bp per day in the Tier 1 banks and insurance sector it found itself navigating in choppy
waters. Citigroup was roped in as the global co-ordinator across both tranches, with Merrill Lynch and SG
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joining it on the €1bn perpetual non-callable 10-year euro trade and Barclays Capital on the sterling dual
tranche – a £500m perpetual non-callable 10-year trade and £350m of perpetual non-callable 20-year paper.
The leads had their work cut out; the main challenge was in holding out until a stable window could be found
to unleash the credit. Overall, the leads raised just shy of €2.5bn-equivalent from a market that was hitherto
not playing ball. The structure mimicked Generali's Tier 1 issuance of June 16.
For AXA, which was on the verge of launching its own deal, Generali's plans to raise a further €1.2bn in the
hybrid market to partly fund its €3.85bn Assicurazioni Toro acquisition later this year or in early 2007 proved
to be the unkindest cut of all. Having just taken €2.8bn-equivalent out of the market in June, Generali's
proposed return to the market – see separate story – unnerved investors and spreads widened.
Against these mounting odds, the leads went out with an indicative range of the high 150bps to 160bp over
mid-swaps for the euro trade, and Gilts plus 190bp area for the short sterling trade, with a 20bp premium to
that for the long sterling portion. An improvement in sentiment a day later, and a consequent tightening of
spreads, eventually saw the euro trade priced at a tightened 150bp over mid-swaps, the sterling NC 10-year
trade at Gilts plus 183bp, and the 20-year trade at Gilts plus 203bp, also the tight end.
At the time of AXA's (Baa1/BBB/A) final guidance, Generali (A3/A) was bid at 131bp over mid-swaps, which
indicated a 19bp new issue premium for the AXA euro trade. This compensated for a slight differential in
rating, plus the fact that in choppy markets the new issue premium can be put at around 15bp–20bp, argued
one of the leads.
The euro trade garnered €4.7bn of total orders from 195 accounts, mainly anchored in the UK at just under
50%. France, the Netherlands and Germany were the other main buyers. More than 70% participation came
from investment managers, 15% from banks, and hedge funds claimed the remainder.
The £500m of paper raked in £2.2bn of orders from 120 accounts and the perpetual non-callable 20-year
£350m trade garnered £1.25bn from around 70 accounts. The UK claimed 92% of the short sterling paper and
87% of the long paper. Insurance companies bought 46% of the short paper, followed by asset managers (30%)
and hedge funds (10%), among others. The distribution pattern was largely replicated by the long paper.
AXA said it would not access these same markets with perpetual hybrids for the remainder of the year, a bid to
address investors' concerns about potential flooding of markets on the back of accelerating consolidation in
the industry. But that does not help much if there is a volley of other hybrid issuances, pointed out one asset
manager who bought the sterling trades. "We think it is well priced. It came at an opportune time from an
investor's point of view. It helps us to diversify our portfolios," he added.
Overall, the lead managers managed to hit the cusp of the swing in sentiment. In the secondary market, the
euro paper traded around 15bp tighter versus both asset swaps and Bunds; the sterling short traded 19bp
tighter than pricing while the sterling long was bid 18bp tighter
French first
(Published in IFR,18 February 2006)
When ABN AMRO's £750m UT2 issue drew an order book of £1.8bn and priced inside guidance a couple of
weeks ago, few were left in doubt about the level of appetite for sterling subordinated paper from European
financials. For Crédit Agricole (CASA) waiting in the wings with its inaugural sterling-denominated Tier 1
(indeed, the first such issue from a French bank at all), the prospects looked encouraging.
Nothing changed during the days that separated the deals and CASA drew a large audience, although at
£850m, the order book did not quite match ABN's behemoth. It was still more than sufficient to warrant an
increase from the initial talk by the lead management triumvirate of ABN AMRO, Calyon and Merrill Lynch of a
transaction of £300m plus to an eventual £500m. It also meant that the spread talk could be pared from
90bp–93bp over Gilts to plus 90bp (57.5bp over mid-swaps).
This put the perpetual non-call 10 some 14bp back of its 2018 callable UT2, a differential in keeping with
banks with established curves in both asset classes (such as HBOS) whose Tier 1/UT2 premium is nearer
11bp–12bp. Chances are that CASA's differential will narrow as the new bonds bed down. Indeed, this process
began as soon as the issue was freed to trade, the paper tightening in by 1bp.
Plus 90bp put it at a slight premium over domestic UK names such as Lloyds TSB and HSBC, which trade in
the high 80s, although in terms of spread at launch, it did make it the third tightest print after Rabobank's
non-call 15 (Aa2/AA), which priced at plus 78bp in October 2004 and Danske Bank's non-call 12, which came
at plus 71bp in March 2004. Neither could match it for size (and liquidity prospects), however. Rabo printed
£350m, Danske just £150m. Although the bulk of the paper was placed with domestic buyers, almost 25%
went to overseas investors, most notably in Asia, which accounted for 11% of the bonds.
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The diverse range of financial credits available in sterling capital is set to continue with ING Groep having
mandated ING Bank, Lehman Brothers and UBS for a benchmark Tier 1 transaction. UK roadshows start this
week. There is also the possibility of supply coming from Commerzbank, which is considering including a
sterling element in its upcoming multi-tranche Tier 1 funding exercise. The appointed lead managers are
Commerzbank itself, Deutsche Bank, DresdnerKW and Morgan Stanley.
Vinci against the odds

(Published in IFR, 11 February 2006)
Although many bankers had written the transaction off early last week, the hybrid bond from French con-
struction company Vinci eventually found a good reception from real money accounts through lead
managers Merrill Lynch and SG.
Rival bankers had been predicting the demise of the transaction after a recent profit warning from French
electronics company Thomson helped push the outstanding hybrids 20bp–30bp wider during the marketing
period. But investors bought into the credit story against the volatile market backdrop. Although the con-
struction sector can be notoriously cyclical, Vinci was able to convince investors of its utility-like characteris-
tics through its recent purchase of a majority stake in Autoroutes du Sud de la France (ASF).
"The deal finally went to those accounts that had done their credit work and liked the credit story. Vinci is an
ideal candidate for hybrid bonds having a strong credit profile with utility-like cashflows and a 40% dividend
pay-out ratio, which will increase following the integration of ASF," said Jeff Tannenbaum, director, syndicate
desk at Merrill Lynch.
Although the transaction was sold alongside a wider €9.1bn acquisition refinancing package for the purchase
of ASF, it was intended to provide some flexibility in the issuer's financial structure and offers an attractive
cost of funding compared with equity with a 6.25% tax deductible coupon against an estimated 8%–8.5%
cost of equity.
Following a week of roadshows, the leads announced guidance at Tuesday lunchtime at 275bp over mid-
swaps area, and priced at exactly that level with books about twice subscribed in less than three hours. Real-
money accounts provided the bulk of the orders, with asset managers taking 69% of the deal while 16% went
to insurers and 6% to banks. Geographically, distribution was broad, with just under a third placed in France
while the rest found good interest from UK, Scandinavia, Benelux and Germany.
"Our idea was to go out focusing on real-money demand from investors that had done their credit work, and not
to grow the book irrespective of its quality. In this market, a stable and solid investor base is much more
important than absolute oversubscription levels," said Jean-Francois Mazaud, head of corporate debt origination
at SG. "This view was fully shared with Vinci, which was very keen in getting a solid aftermarket. And such type of
execution strategy should have a very positive impact for the future of the corporate hybrid market."
While the transaction was able to offer investors some strong credit fundamentals and a chunky coupon, one
of the major criticisms was the non-cumulative coupon deferral structure, which many investors are shying
away from, particularly following the poor performance of the Thomson hybrid that included the same
structure. But according to bankers involved in the transaction, the issuer's decision was technical.
Cumulative coupon structures are associated with mandatory deferral mechanisms and Vinci was forced to
opt for optional deferral in order to maintain an investment-grade rating for the issue.
"Ultimately investors are buying into the credit story and if investors are concerned about an issuer being
unable to pay a coupon then it shouldn't make too much difference whether those coupons are cumulative
or not," said Merrill Lynch's Tannenbaum.
In the aftermarket the bonds immediately pushed 6bp tighter on the break and were seen as much as 12bp
tighter in the week, as trading accounts that had been aggressively shorting the in the grey market were
forced to chase tightly held bonds to cover their positions.
Hybrid volatility
With hybrids providing the only real liquidity in the secondary market, the sector has become a proxy for
market risk, particularly since GM's notoriously volatile 2033 bond plunged deep into the junk market. But
bankers believe that there is no reason for the entire sector to continue widening at its current rate.
"The volatility of the hybrid sector has been tremendous and highlights the importance of stable placement.
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So far the corporate hybrids have tended to trade as a sector. Understanding how to trade these instruments
by differentiating the credits within that sector is critical to further growth in this product," said Tannenbaum.
The transaction might have come some 20bp wider than the issuer could have expected when the deal was
first announced, but the end result provides another boost to the corporate hybrid sector, particularly given
last week's backdrop of extreme volatility and, in particular, the poor Thomson performance. While there are
certainly more transactions on the cards for 2006, bankers believe that the trigger for issuance has become
more event-driven, with M&A leading the next wave.
"We are now seeing the emergence of a true asset class. When you look at the hybrids issued last year, none
were directly linked to acquisitions, but this year all form part of a financing package that is linked to acquisi-
tions. The instrument has now become truly complimentary to all other sources of funding for acquisition
financing," said SG's Mazaud.
However, many issuers will be looking at the wider market performance of the entire sector, and with the
spread between senior and subordinated bonds steepening dramatically since the beginning of January (see
graph), some wonder whether one of the real drivers for issuance is fast running its course.
But many bankers dismiss the recent widening trend, given that the lack of regulatory incentive effectively
makes corporate hybrids an equity proxy, so issuers will increasingly use the cost of equity for comparison rather
than the cost of debt, as would be considered by financial issuers selling bonds in the capital securities market.
Table 6.4: France termsheets

Insurance Tier 1 Bank Tier 1 Capital Corporate Hybrid
AXA €1bn 5.777% Credit Agricole £500m Vinci €500m
Perp nc 10 (issued Jun-06) 5.136% Perp nc 10 (issued Feb-06) 6.25% Perp nc 10 (issued Feb-06)
Issuer AXA SA Credit Agricole SA Vinci SA
IssuerType Direct Direct Direct
SecurityType Undated Deeply Subordinated Notes Undated Deeply Subordinated Fixed to Undated Deeply Subordinated Fixed
Floating rate Notes to Floating Rate Bonds
Status/ Direct, unconditional, unsecured and Direct, unconditional, unsecured, Direct, unconditional, unsecured,
Subordination undated Deeply Subordinated undated and deeply subordinated and lowest ranking subordinated
Obligations of the Issuer. The Notes obligations of the Issuer. The Notes obligations (titres subordonnes de
rank pari passu among themselves and rank pari passu among themselves and dernier rang) of the Issuer. The
all other present and future Deeply with all other Deeply Subordinated Bonds rank pari passu among
Subordinated Obligations of the Issuer, Obligations, and subordinated to all themselves and with all other Deeply
subordinated to all titres participatifs prêts participatifs and titres participatifs, Subordinated Obligations, and
and prêts participatifs, Ordinary Ordinarily Subordinated Obligations subordinated to all prêts participatifs
Subordinated Obligations and and Unsubordinated Obligations and titres participatifs, Ordinarily
Unsubordinated Obligations of the of the Issuer. Subordinated Obligations and
Issuer. The Notes shall rank in priority Unsubordinated Obligations of the
to any class of share capital - ordinary Issuer.
shares or preference shares (actions de
préférence) issued by the Issuer.
Maturity Perpetual Perpetual Perpetual
First Call Date 6-Jul-2016 24-Feb-2016 13-Nov-2015
Step-Up at First +100bps +100bps +100bps
Call Date
Early Redemption Yes (Tax / Regulatory / Accounting Yes (Tax / Regulatory Event). Notes Yes (Tax / Accounting Event). Bonds
Event). Notes redeemed at their redeemed at the higher of principal redeemed at their principal amount
principal amount (Tax Event). Notes or Bunds+50 (Tax / Regulatory Event). (Tax Event - additional amounts).
redeemed at the Early Redemption Redemption subject to prior consent Bonds redeemed at higher of
Amount - higher of principal or Bunds of SGCB. principal or Bunds+75 (Tax Event -
+87.5 , exchanged for, or terms varied so change to tax deductibility /
securities constitute Tier 1 capital or core Accounting Event).
capital (Regulatory /Accounting Event).
Redemption subject to prior consent of ACAM.
Replacement Intent-Based Replacement of n/a Intent-Based Replacement of
Clause Redeemed Securities. Replacement Redeemed Securities. Replacement
with share capital securities, securities with common equity, pari passu/
with same terms and conditions, or junior securities with same terms
mandatorily convertible bonds/notes and equal/greater equity content.
with a maturity of 3 years or less.
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Table 6.4: France termsheets (cont)

AXA €1bn 5.777% Credit Agricole £500m Vinci €500m
Perp nc 10 (issued Jun-06) 5.136% Perp nc 10 (issued Feb-06) 6.25% Perp nc 10 (issued Feb-06)
Dividend Pusher/ Dividend Pusher Dividend Pusher Dividend Pusher
Stopper
Regulatory Event Interest payments conditional on Issuer Interest payments conditional upon no n/a
being solvent at the time of payment and breach of minimum capital requirements.
immediately thereafter. Interest payments not paid if instructed
by the SGCB.
Optional Deferral Interest payments optionally deferrable Interest payments optionally deferrable, Interest payments optionally
and non-cumulative. with a view to restoring regulatorycapital deferrable and non-cumulative.
to ensure Issuer's continuity of activities.
Deferred payments non-cumulative.
Rating Agency Interest payments mandatorily No rating agency mandatory deferral n/a
Mandatory deferrable. Trigger - i) the Accumulated trigger (see Regulatory Event).
Deferral Net Earnings of the Issuer for the two
6-mth periods ending on the Lagged
Reporting Date is less than or equal to
zero, AND ii) the Adjusted Shareholders
Equity Amount as at the Lagged Reporting
Date has declined by 10% or more as
compared to the Adjusted Shareholders
Equity Amount as at the end of the
Benchmark Half-Year Period; AND iii)
the Adjusted Capital as at the Current
Reporting Date has declined by 10% or
more as compared to the Adjusted
Shareholders Equity Amount as at the
end of the Benchmark Half-Year Period.
Deferred Payments Non-Cumulative (Regulatory Event / Non-Cumulative Non-Cumulative
Optional Deferral) / Non-Cash
Cumulative (Mandatory Deferral)
ACSM Settlement of deferred interest n/a n/a
payments via issuance of ordinary
shares (2% limit in any 12-mth
period), PIKSecurities or Parity
Securities (25% limit for PIK and
Parity Securities). Issuer shall use
best efforts to settle deferred payments.
Deferred payments cancelled if not
settled within 5 year period.
Additional Loss absorbtion upon the occurance Loss absorption upon the occurrence of –
Features/ of a solvency event. Reinstatement if a Supervisory Event. Reinstatement if
Comments a positive consolidated net income is a positive consolidated net income is
recorded for at least two consecutive recorded for at least two consecutive
financial years reported following financial years reported following the
the end of a solvency event. end of a Supervisory Event. Reinstatement
will also occur in certain circumstances
(payment of dividends on share capital,
redemption of the Notes or liquidation of
the Issuer).
Germany
Bank Tier 1 issued via an SPV
As discussed, bank SPV issues are still the most common form of outstanding Bank Tier 1 capital
since Basel 1998 because the SPV reconciles structuring challenges within many jurisdictions.
In Germany there are two main alternatives for bank capital SPV issues:
1) Independent SPV holding bank silent participation (Stille Einlage);

2) Bank-owned SPV with inter-company deposit/loan to bank.
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Both structures are widely accepted by investors and are well established within the German
banking system. Despite the complicated structural diagrams the SPV structures are relatively
easy to administer once the structure is set up given the large amount of precedent transactions
and experienced, competitive intermediaries to service these transactions (i.e. Trustees, etc).
Taking the second alternative first, the bank-owned SPV is very similar to the other popular SPV
Tier 1 formats already discussed in several jurisdictions. As a summary example of one such
German bank structure the Commerzbank Capital Funding Trust issue is a good example of how
this SPV Tier 1 structure has been issued in the market. This non-cumulative Tier 1 issue achieves
consolidated Tier 1 since the Trust Preferred Securities exhibit the requisite Tier I capital equity
features and the inter-company security running from the SPV to the parent bank does not. Tax
deductibility, however, is based on inter-company debt/deposit. The bank-owned SPV can be a
European rather than US-based SPV entity – particularly if a Euro-denominated issue is intended.
Use of the bank owned SPV results in consolidated rather than Solo Tier 1 and this is a key
distinction that results in some issuers selecting the Stille Einlage alternative.
Generally rating agency equity credit is typically ‘low to intermediate’ but can potentially be
increased by raising the mandatory non-payment threshold above regulatory minimums or by incor-
porating binding replacement language. Like strong banks in many other countries, the German
banks have not placed a high priority on the enhancement of bank regualtory capital for ratings
purposes at this time. Therefore the Commerzbank issue does not exhibit rating agency mandatory
deferral or RCC features. Also this bank Tier 1 issue does not have the ACSM non-cash cumulative
features we see in other sectors like insurance and corporates and in some bank Tier 1 such as the UK.
Let us now look at the two main variations of the Stille Einlage SPV Tier 1 structures in the
market. These clever structures address potential cross-border withholding tax issues that would
make it difficult to sell the Stille Einlage Tier 1 to international investors on terms acceptable to
issuers or investors. These early innovations served as precedent for some transactions in other ju-
risdictions (such as Switzerland and Ireland).
Figure 6.1: German SPV Tier 1 structure
Bank/branch
Waiver and improved
(100% owned)
LLC Common
LLC Common
Securities
proceeds
Subordinated
Securities
agreement
Subordinated note proceeds

note
LLC Partnership for

US Tax purposes
Partnership
Partnership
interests proceeds
interests
SPV
Certificates Certificates
proceeds
Investors
Source: : COMPILED BY CALYON
Tier 1 issued via a Stille Einlage and German GmbH

Highlights:
0 Regulatory Tier 1 capital (solo basis for the bank issuer);

0 An independent SPV such as a German GmbH acquires a Tier 1 qualifying Stille Einlage from
the bank and funds this by selling its own securities to investors;
0 Cross-border withholding tax concern is addressed by the independent SPV so international
investors are not impacted.
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Figure 6.2: German Stille Einlage structure
Bank
Stille Einlage Stille Einlage

proceeds
German GmbH
Bond issue Bond proceeds
Investors
Source: COMPILED BY CALYON
Tier 1 via a Stille Einlage and Jersey Limited Partnership

Highlights:
0 Regulatory Tier 1 capital (solo basis for the bank issuer);

0 An independent offshore SPV such as a Jersey LP acquires a Tier 1 qualifying Stille Einlage from
the bank and funds this by selling its own securities to investors;
0 A bank subsidiary provides liquidity loans to the Jersey SPV to address Kapitalertragssteuer on
the Stille Einlage payments;
0 Cross-border withholding tax concern is thereby addressed so international investors are not
impacted.
Figure 6.3: German Stille Einlage structure with Jersey LP
Bank
Stille Einlage Stille Einlage

proceeds
Limited partner
Loan
Bank subsidary SPV (Jersey LP) GmbH
Bond issue Bond proceeds
Investors
Source: COMPILED BY CALYON
Broad tax system changes have been proposed in Germany and the choice of structures will likely
be impacted by the final enactment of any new rules, but both Jersey and Gmbh structures are
currently in the market. Since the banks were exclusively able to use Stille Eillage structures,
other sectors such as corporates needed to devise alternative methods for hybrids.
In the summary examples provided it can be seen that German hybrids can be issued in either
direct or SPV format in other sectors.
Several direct issue hybrids have now been issued internationally and have been enhanced to
provide the issuers with both rating agency equity benefits as well as regulatory capital.
As the examples show Basket D type issues have been accomplished by including MDP features
and investor comfort has been increased by the inclusion of ACSM type features. Issuers ensure a
degree of enhanced comfort via several early redemption options to address future uncertainty.
Pioneering German hybrids for non-bank issuers exhibited the unique interplay between
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discretionary optional payment deferral (with cumulative resolution) and trigger based
mandatory payment deferral (with non-cash cumulative resolution) which helped to navigate tax
requirements as further explained below. When a direct issue hybrid is used by a German issuer a
German tax ruling should be obtained from the appropriate German tax authority to ensure best
results in line with issuing objectives. In the following section we highlight an interpretation of
some of the fiscal drivers that led to these useful hybrid structures.
Germany termsheets
Munich Re debuts
Even though technicals remained strong, sentiment weakened in the credit markets last week. The iTraxx
Crossover index widened, closing almost 20bp wider than its levels of around 190bp seen two weeks ago. The
weakening of sentiment can be attributed to a cocktail of ingredients ranging from the shaken global equity
markets to a frothing up of interest rates as central banks turn increasingly hawkish.
The debut euro-denominated hybrid transaction (A3/A/NR) from Munich Re was a direct issue (with a tax
ruling), with the terms being largely similar to the most recent sterling and Australian dollar offering from
Swiss Re through ELM. Joint leads Deutsche Bank, JPMorgan and UBS priced the multiple-times covered
€1.5bn perpetual non-call 10-year fixed to floating-rate note step-up deal at 104bp over mid-swaps (Bunds
plus 130.5bp), 1bp tighter than its initial guidance. On the regulatory side, the transaction provides the issuer
with undated subordinated debt under the current capital regulations, caters for future Tier 1 requirements
(in line with the UK FSA's rules) and contemplates the publication and introduction of Solvency 2.
The securities qualify for Basket D treatment from Moody's. As on previous occasions, achieving Basket D did
not simply involve a clean replication of former deals. With Moody's new notching approach to meaningful
mandatory deferral triggers, the deal was rated A3, which was three notches below Munich Re's financial
strength rating of Aa3.
Munich Re did consider the enforceable replacement capital option at an early stage (which would have
resulted in an instrument rating of A2) but for various reasons (including timely documentation and
corporate governance), it did not proceed with this approach.
On the S&P side, the instrument received “Intermediate-strong” equity credit and is two notches below the
issuer's S&P financial strength rating of A (identical to its pre-existing LT2-style dated subordinated issues).
This is the second occasion on which S&P has accepted the following 30-day best endeavours language
within an ACSM clause.
S&P said in a statement: “It is the intention of the issuer that in the unlikely case of a mandatory deferral in
respect of the bonds (other than in circumstances where the issuer is deferring on distributions on all
outstanding hybrid issues) to use its best endeavours to arrange for the issue or sale of payment shares or
placement securities so as to raise cash to enable the issuer to settle interest no later than 30 days after its
original due date for payment.” The security also achieved 75% equity credit from Fitch Ratings.
A European roadshow held by the issuer encountered robust investor demand, which translated into around
€5.8bn in total orders at the initial plus 105bp guidance. Of these, just €300m dropped away when the
guidance was tightened by 1bp, where the deal was eventually placed and compared well with the around
plus 100bp level at which Swiss Re was bid. Shorter-dated outstanding callable trades from AXA and Generali
were bid in the high 80s and 90s over mid-swaps.
Of the 200 investors in the book, the UK accounted for a quarter of the placement, closely followed by Italy
and Germany, with each claiming 21%. The remainder enjoyed pan-European distribution. Asset managers
bought 38% of the deal, followed by insurance companies (29%), with the remainder split among banks,
private banks and hedge funds. In line with the softening seen in the hybrid market, the issue was bid around
7bp wider in the secondary market last Friday.
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Commerz advances on two fronts

(Published in IFR,18 March 2006)
Whichever way one looks at Commerzbank's dual-tranche Tier 1, it was a sizeable transaction. Whether the
€1bn perpetual non-call 10/£800m perpetual non-call 12 combination represented the largest German Tier
1 capital raising or the largest such European deal in sterling was largely irrelevant. What was of note was that
there was substantial oversubscription in both cases on a deal against which there would have been long
odds until relatively recently.
This was essentially acquisition finance for Commerz's Eurohypo venture (it is eyeing up banking assets in
Berlin as well). The headroom for raising additional Tier 1 was made possible by the sale of its stake in KEB.
While the combination of Commerz and acquisition finance is no great surprise, recent history would have
pointed to the German bank being the acquisition target rather than the acquirer.
With such a large amount to raise (€2bn equivalent was the number most often mentioned), there was never
much doubt that a single-tranche approach would not suffice. The anointed lead managers, Commerzbank,
Deutsche Bank, Dresdner KW and Morgan Stanley, made it plain early on that euro and sterling were the
chosen targets, although there was no pre-ordained decision on what exactly the split would be.
The two markets have endured different experiences of late. While the euro sector has shown signs of
nervousness, with spreads widening out some 10bp, sterling has remained more resolute. This fact played a
major role in determining the relative sizes. Had the two moved in tandem, talk is that a €1.25bn/£500m split
would have been more likely, and with respective books of €3.5bn and £2bn, most combinations could have
been accommodated.
It was the speed with which the sterling book came together that convinced the leads on the eventual split,
however. Historically, UK investors are slower than their European counterparts at committing themselves to
a deal. This time round, however, they were the driving force. There is still cash to put to work in both markets,
although in the words of one syndicate official: in the euro sector, it is "cash without conviction". Sterling
buyers, on the other hand, are currently more active in their search for yield.
The bonds were priced at 115bp over mid-swaps (Bunds plus 133.9bp) and 150bp over Gilts, both at the tight
end of their initial 5bp spread ranges. Because this was an inaugural visit, it was seen as a one-off as far as
pricing was concerned; the roadshow was the single most important discussion forum.
Eurohypo has an outstanding 2013 callable that was also taken into account. It was bid at 107bp over mid-
swaps. The original guidance came from adding 4bp–5bp per year to take into account the longer call date.
This euro range was then used as a staring point for the sterling tranche. The mid-swaps equivalent was
pitched at similar levels.
Pricing such issues can be a less than scientific exercise, the accuracy of the final answer often only
assessable when the bonds are freed to trade. With both tranches tightening by 2bp in early trading, the
numbers arrived at on this occasion look to have been fairly precise.
Siemens sees record demand

For many investors who had yet to dip their toes in the corporate hybrid market, German engineering
company Siemens offered the perfect opportunity to buy subordinated corporate credit with a strong
investment-grade rating and investor-friendly structure. Deutsche Bank and UBS were joint bookrunners,
with Morgan Stanley and RBS acting as joint lead managers.
Investors flocked into the A2/A– rated transaction, generating one of the largest ever order books seen for a
corporate issue: €9bn of demand seen on the €900m euro tranche and £4bn of orders placed on the £750m
sterling part. Given the strong ratings, the transaction saw a larger participation from insurers and pension
funds than on any of the previous corporate hybrids.
With basket D treatment from the ratings agencies, the transaction is closer to equity than the Linde
structure due to the mandatory deferral feature. But a number of investor-friendly characteristics made the
transaction particularly attractive to many accounts that have so far been nervous of corporate hybrids.
The mandatory deferral trigger of a cashflow fraction (operating cashflow plus gross interest divided by gross
interest) below three was a particular selling point given that the figure has come in at between 10 and 16.5
for the past seven years. In addition, the 100bp step-up feature is significantly more valuable in a transaction
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that prices in the low 100s over mid-swaps rather than a spread of 300bp or more, which has been a typical
feature on recent corporate hybrid transactions. Final pricing was fixed at 125bp over mid-swaps on both
tranches, equating to Bunds plus 148.1bp on the euro part and Gilts plus 160.2bp on the sterling portion.
The final spread level was through initial guidance of 130bp–135bp and significantly through some early
indications, which suggested spreads as wide as 140bp–150bp.
While some investors continue to talk in terms of CDS multiples, the recent growth of the hybrid market
makes relative value analysis an easier task. Even so, with such high ratings, investors were being pushed to
the bank capital market for comparables and the deal came through AXA, which has a Tier 1 deal trading at
mid-swaps plus 135bp and just outside Generali, which trades at 120bp over.
In the aftermarket, both tranches were seen significantly tighter, the euros jumping by as much as 9bp to 139bp
over Bunds, while the sterling paper saw slightly more modest performance, tightening by 4bp to Gilts plus 156bp.
With GECC entering the subordinated space with its own 60 non-call 10 hybrid issue, also in euros and
sterling, some thought that Siemens could be overshadowed by the higher quality credit. But with the
majority of investors viewing GECC as a financial rather than a true corporate, Siemens was able to stay in the
spotlight with corporate investors, and according to bankers involved in the deal, the success of the GECC
transaction helped to further boost confidence in the hybrid market with its high subscription levels and tight
pricing (see feature story for GECC comment).
One of the criticisms that some of the more sceptical investors have levelled at corporate hybrids is their
tendency to trade as a market rather than displaying any significant credit differentiation. But given that
Siemens was able to price its hybrid bonds so much tighter than where the rest of the corporate subordinated
market currently trades, bankers hope that the new issue will lead to further differentiation between credits.
The iBoxx non-financial corporate subordinated index was trading around Bunds plus 236bp for most of last
week, but closed aggressively tighter at 232.9bp as the new Siemens bond led a marked improvement across
the sector. Sadly for investors, who welcome the opportunity to buy Double A names with a spread pick-up by
going deeper into the capital structure, similarly rated issuers are few and far between in the corporate world.
And as the rationale for hybrid issuance increases further down the ratings spectrum, top-rated corporate
credits are unlikely to become a regular feature of the market. For Siemens, the transaction is intended to
provide a ratings cushion following its recent €4.2bn acquisition of Bayer's diagnostics division.
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Table 6.5: Germany termsheets

Munich Re €1.5bn 5.767% Commerzbank €1bn 5.012% Siemens €900m 5.250%
Perp nc 10 (issued Jun-07) Perp nc 10 (issued Mar-06) 60 nc 10 (issued Sep-06)
Issuer Münchener Rückversicherungs- Commerzbank Capital Funding Trust I Siemens Financieringsmaatschappij
Gesellschaft Aktiengesellschaft in NV
München
IssuerType Direct SPV SPV
SecurityType Undated Subordinated Fixed to Noncumulative Trust Preferred Subordinated Fixed to Floating Rate
Floating Rate Bonds Securities Bonds
Status/ The obligations of the Issuer under the The Class B Securities will rank junior to The Bonds rank pari passu among
Subordination Bonds constitute direct, unsecured and the Company Class A Preferred Security, themselves, and junior to all other
subordinated obligations of the Issuer and the Company Class B Preferred present and future obligations of the
ranking junior to Senior Securities, Securities will rank senior to the Issuer, whether subordinated or
pari passu among themselves and with Company Common Security. unsubordinated.
Parity Securities, and senior to Junior
Securities, except for any subordinated
obligations required to be preferred by
mandatory provisions of law.
Maturity Perpetual Perpetual 14-Sep-2066
First Call Date 12-Jun-2017 12-Apr-2016 14-Sep-2016
Step-Up at First +100 bps +100 bps +100 bps
Call Date
Early Redemption Yes (Gross-up Event/ Tax Event/ Yes (Regulatory Event / Tax Event / Yes (Gross-up Event / Tax Event /
Accounting Event/ Capital Event / Investment Company Act Event). Capital Event / Conversion Event).
Regulatory Event). Bonds redeemed at Securities redeemed at the redemption Bonds redeemed at their principal
their principal amount (Tax Event / price (Tax Event), or at the higher of amount (Gross-Up Event), or higher
Gross-Up Event), or higher of principal principal or Bunds+50 (Regulatory of principal or Bunds+75 (Tax Event /
orBunds+67 (Accounting Event/ Capital Event / Investment Company Act Event). Capital Event), or higher of principal
Event / Regulatory Event). Redemption Trust Special Redemption Event to result or m/s+50 (Conversion Event).
subject to regulatory approval. in liquidation of the Trust. Redemption
subject to regulatory approval.
Replacement Bonds to be replaced by other at least Replacement of redeemed securities Intent-Based Replacement of
Clause equivalent regulatory capital. with subordinated debt securities, Redeemed Securities. Replacement
with terms identical to the redeemed with common equity, and/or treasury
securities. shares, and/or pari-passu/junior
securities. Replacement clause
excludes redemption following a
Conversion Event.
Dividend Pusher/ Dividend Pusher Dividend Pusher Dividend Pusher
Stopper
Regulatory Event Interest payments not paid if instructed Capital Payments will not made if so n/a
by the BaFin, or upon occurance of ordered by BaFin or other relevant
solvency event. regulatory authority, or upon occurrence
of any other regulatory provision
prohibiting payment.
Optional Deferral Interest payments optionally Interest payments optionally deferrable Interest payments optionally
deferrable. Maximum 5-year deferral and non-cumulative. deferrable. Maximum 5-year deferral
period (non-cash cumulative). period (cumulative). Deferred
Deferred payments to be settled via payments to be settled with cash.
ACSM.
Rating Agency Interest payments mandatorily No rating agency mandatory deferral Interest payments mandatorily
Mandatory deferrable. Trigger- (i) the Accumulated trigger (see Regulatory Event). deferrable. Trigger - Cashflow
Deferral Consolidated Result on the Lagged fraction (net income plus minority
Reporting Date is less than or equal to interest plus amortization,
zero; and (ii) the Adjusted Shareholders’ depreciation and impairments, plus
EquityAmount as at the Lagged interest expenses, divided by interest
Reporting Date has declined by 10% expenses. Maximum 5-year deferral
or more as compared to the Adjusted period. Deferred payments to be
Shareholders’ Equity Amount on the settled via ACSM.
BenchmarkReporting Date; and (iii) the
Adjusted Capital Amount as at the
Current Reporting Date has declined by
10% or more as compared to the Adjusted
Shareholders’ Equity Amount on the
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Table 6.5: Germany termsheets (cont)

Munich Re €1.5bn 5.767% Commerzbank €1bn 5.012% Siemens €900m 5.250%
Perp nc 10 (issued Jun-07) Perp nc 10 (issued Mar-06) 60 nc 10 (issued Sep-06)
Benchmark Reporting Date. Maximum
5-year deferral period. Deferred payments
to be settled via ACSM.
Deferred Payments Non-Cash Cumulative Non-Cumulative Cumulative (Optional Deferral).
Non-Cash Cumulative (Mandatory
Deferral).
ACSM Settlement of deferred interest payments n/a Settlement of deferred interest
via issuance of Payment Shares (ordinary payments via issuance of new shares
shares or qualifying mandatory and or treasury shares and/or
convertibles, subject to a total limit of parity/junior securities or PIK (20%
2% in any12-mth period), orPlacement PIK limit and 25% PIK/parity/junior
Securities (paritysecurities, subject to a securities limit). If Issuer not able to
25% limit). Issuer shall use best efforts pay deferred interest on deferral
to settle deferred payments. Deferred date, Issuer shall use best efforts to
payments cancelled if not settled within settle deferred payments. Deferred
5 year period. payments not settled after 5 years
will constitute an event of default.
Additional — Conversion Event - early redemption
Features/ upon conversion of Siemens Finance
Comments - BV €2.5bn 1.375% 2003/2010
convertible bond.
Some German tax influences on hybrid structures

Overview
The legal and tax treatment of the modern corporate hybrid capital security transactions that have become
very popular in Germany for blue chip German corporate hybrid issuers are based on long-standing rules
within the German legal and tax system. This summary provides an indication of the complexity of the tax
rules and the subtlety of applying the rules in the context of hybrid structuring. One should always engage one
of the leading German law firms with an international practice when examining German hybrid capital security
transactions and as noted seek a ruling from the authorities for German direct issues.
While German banks and financial institutions have been issuing tax-efficient Tier 1 capital securities and
other tax-efficient subordinated capital securities for many years, the progressive adaptation of the corporate
hybrid issuers has brought the need to apply the traditional rules to new hybrid capital securities which are
designed to satisfy rating agency requirements and/or accounting guidelines rather than regulatory capital
requirements.
To determine the debt/equity classification of a German financial instrument and therefore create an
informed judgment as to the suitable treatment of the payments on the financial instrument for tax de-
ductibility, legal professionals reference Section 8(3) of the German Corporate Income Tax Code which states
that a ‘mezzanine instrument’ (Genussrecht) – typically subordinate to senior but senior to equity – will be
evaluated and classified based upon the nature of two features. The features are:
1. Participation in profits;
2. Participation in liquidation proceeds.
If the mezzanine instrument is structured to simultaneously include both features of equity then the
payments will not be tax-deductible expenses and the security is classified as equity. Under a tax decree, a
long maturity might be viewed as a participation in liquidation proceeds and, thus, might endanger tax de-
ductibility. Although, not mentioned in the decree, we understand that a payment discretion might be viewed
as participation in profits since there is much similarity to a dividend. If one of the two criteria is fulfilled,
German withholding tax of approximately 27% will apply, which might be reduced under a double taxation
agreement to 15% by way of a refund upon application.
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Some important German hybrid capital characteristics

Maturity
Evaluating and classifying instruments as debt or equity in the German Tax Code requires the consideration of
the final maturity of the instrument under review. If there is a final maturity term (a dated security) and the
date is within the range which is typical in the capital markets, then the argument is strong for debt classifica-
tion and the deductibility of payments is reasonably straightforward (unless there is a cumulative participation
in profits and liquidation proceeds).
However, for this reason the German tax authorities consider a very long dated security where the final
repayment is due more than 30 years from the date of issue as an effectively ‘participating’ security with
regard to the liquidation of the company. That is to say, a final maturity of over 30 years makes the security
more like equity in that the holder could be getting paid out principal only at a potential future liquidation
rather than at some more easily imaginable credit scenario at a near-term date (three, five, seven or 10 years
maturity) and that the security is therefore more risky than a shorter-term debt issue where principal
repayment can be predicted with greater certainty.
Obtaining medium to high equity content from the rating agencies requires the instrument to exhibit
‘permanence’ as one of the three main criteria for equity credit, which generally means perpetual securities
such as common stock or some preferred stock or a minimum 60-year final maturity. In Germany some 100-
year hybrids have been seen, for example, in addition to perpetual hybrids. Therefore, for the modern German
hybrid designed to satisfy the rating agencies’ equity definitions, this makes it difficult but not impossible to
satisfy the criterion of no participation in liquidation proceeds. A number of positive binding rulings are
believed to be issued in this respect.
Payment discretion/obligation
Payment discretion is a key feature under both the German tax code and for the rating agencies. The second of
three major rating agency equity criteria is ‘no ongoing payment obligations which could trigger a default’ When
evaluating and classifying instruments as debt or equity in the German Tax Code this also requires the careful
consideration of the obligation or discretion of the payments under the terms of the instrument being evaluated.
If the payments are deemed to be overly discretionary then the instrument is deemed to be equity (like
common stock or some preferred stock) and the payments should not be treated as tax-deductible expenses
for income tax purposes. This is appears to be in direct conflict with the rating agency criteria, but a
reconciling solution to the puzzle has been found by using ‘triggers’ based on criteria which must not be
deemed overly discretionary by the German tax authorities but are deemed to provide significant financial
flexibility to the German hybrid capital security issuer by the rating agencies.
Participation in profits
Given the negative impact of the long-term nature of the hybrid capital security on the participation in liquidation
evaluation, it is critical that the instrument have the correct structure for the payment terms. To avoid the tax
classification as equity, which would then eliminate the possible tax deductibility of the hybrid capital security
payments, the discretionary nature must be limited by the triggers so that, first, the right to defer (cumulative)
and/or, second, the obligation to eliminate payments (non-cumulative) are dependent upon a breach or a
predefined ‘profit trigger’ for optional deferral and ‘cash flow trigger’ for mandatory deferral respectively.
In practical terms, this has resulted in a class of German hybrid capital securities where the hybrid capital
security can optionally defer payments on a cumulative basis at any time (provided that the payments on
common equity have also been halted) but payments are mandatorily deferred and lost (non-cumulative) if a
predefined cash flow financial trigger is breached (i.e. cash flow/sales < x %). The predefined trigger counter-
balances the concern that payments are too discretionary provided that they are not deemed to be profit-par-
ticipating payments. Where the ultimate payment determination is based on a cash flow trigger and the
mandatorily deferred payment is lost due to the non-cumulative nature, the optional cumulative deferral can
be fully discretionary (no profit trigger required).
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Participation in liquidation
As discussed above, to satisfy the first rating agency equity criteria of ‘permanence’, hybrids are either
perpetual or have a very long maturity (over 60 years) and this causes an automatic classification as
liquidation participating, which means payments may not be deductible if the other features are deemed too
equity-like. The third of the three major equity features is ‘loss absorption’ and this is generally satisfied by
structuring the hybrid to be subordinated to all securities except common equity.
To rating agencies, this level of subordination ‘absorbs loss’ because the hybrid cash proceeds fund the
operations, driving new cash generation during the business growth, then in times of financial stress the
payments can/must be deferred/eliminated and finally in liquidation the senior creditors benefit from a
cushion created by the hybrid, since hybrid capital security holders are nearly last in line to collect any
remaining proceeds and they do not have the ability to accelerate the debt default proceedings. Therefore,
the hybrid can help the corporate hybrid issuer maintain its solvency during a period where accumulated
losses erode the capital base and retained earnings.
Obtaining a tax ruling

In the event of a direct issue, German corporate hybrid capital security issuers should obtain a German tax
ruling on the intended tax deductibility and absence of withholding tax for non-German investors for any con-
templated hybrid capital security issued from Germany.
Where a non-German SPV is used for the issuance of the hybrid capital security, the SPV jurisdiction could be
the more relevant for determining tax deductibility of payments from the hybrid capital security SPV to hybrid
capital security investors – but this will depend on a case-by-case basis. A simple (rather than hybrid) inter-
company loan between the SPV and the parent company would not likely need a tax ruling.
Popular locations for SPVs are the Netherlands and Luxembourg, where double tax treaties are in place with
Germany, in addition to Delaware and Jersey. UK and Irish SPVs also became more attractive recently due to
increased competition and the Prospectus Directive. In some cases an SPV may be used as a hub to allow
proceeds to be directed to where they are needed in the operating entities of the business group In such
cases a hybrid inter-company loan to Germany under German tax law should require a ruling to be prudent.
Market precedent transactions from Germany have been supported by German tax rulings and so significant
precedent exists for the German tax authority; however, where an issuer is located in a region where no hybrids
have obtained rulings the process may take longer.
Withholding tax considerations

Provided the security is deemed to be tax debt-based on the key criteria above, there should not be a
withholding tax imposed on capital security payments cross-border from Germany to international investors
unless one of the two criteria above is fulfilled.
Switzerland
Switzerland has been the source of significant issuance from the financial sector but so far no
corporate issues. In some of the other jurisdictions (i.e. Germany) it has been seen that cross-
border capital raising via the sale of hybrid securities to international investors has required
packaging in some cases to enhance marketability and improve the economics.
By observing the summary examples provided it can be seen that a variation of the SPV Tier 1
structure has been used by Swiss Re whereby an independent SPV is used to raise investor
proceeds to fund the Swiss Re Tier 1 capital security. The transaction is full featured for regulatory
and rating agency purposes (Basket D type) and is investor friendly given the ACSM.
By comparison the bank capital Tier 1 issue from Credit Suisse is more straightforward and in the
form of a classic bank Tier 1 issue (perpetual, fully non-cumulative with no ACSM, no rating
agency equity enhancements). Notably the Credit Suisse Tier 1 issue is out of its Guernsey branch
and so no SPV was required.
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Switzerland termsheets
Overwhelming demand for Swiss Re
(Published in IFR, 6 May 2006)
Although the euro tranche of Swiss Re's Tier 1 funding exercise for the acquisition of GE Insurance Solutions
was the senior in terms of size, it was the US dollar piece that many were looking to for answers. With the
continuing NAIC saga effectively placing insurance buyers hors de combat for the time being, the question
was: would the insurer manage to satisfy its diversified needs at an acceptable level without them. (See US
Debt & Globals for comment on the US dollar tranche).
The fact that so many minds were concentrated on the US dollar tranche seemed to have not disadvantaged
the euro piece, but that is not to say it was not without challenges. It was launched through ELM BV, a pre-
existing UBS repackaging vehicle, and was secured over perpetual subordinated loan notes issued directly by
Swiss Re. The structure also provides solo capital for regulatory purposes at the parent level. With a total of
US$2bn required across the two tranches and a 9bp premium needed to ensure placement of the US dollar
side of the equation, there was a marginal preference for euros to provide the greater size.
With lead managers Dresdner KW, HSBC and UBS building an order book of €6bn, the potential was there to
choose virtually any size desired. The respective volumes were eventually fixed at €1bn and US$750m, both
coming in perpetual non-call 10 format as expected. Initial talk was at the mid-swaps plus 115bp area,
although the book remained intact at the revised level of 109bp (129.8bp over Bunds). With the bonds
tightening 3bp on the break, there was speculation that the margin could have been squeezed tighter,
although gargantuan books can disappear without trace and seemingly without reason when lead managers
and issuers conspire to take the last basis point available. Demand was widespread with orders from 256
accounts received, 237 of which were allocated bonds. UK-based buyers led the way, taking 43% of the paper,
fund managers dominating with half the allocated bonds.
While the post-launch performance prompted some scrutiny of the pricing, arriving at the appropriate level
was far from a precise science. There was no shortage of opinion as to where the spread should have been
pitched in relation to outstanding paper from the likes of Allianz and Munich Re, each as self-serving as the
next. The acid test, however, was to pick a level that would appeal to investors without appearing to be too
generous. Despite the 3bp post-launch performance (or perhaps because this marked the extent of the
tightening), Swiss Re appears to have been successful in achieving both.

Some desks commented earlier in the year about the conspicuous absence of Credit Suisse's self-led deals,
but the issuer returned to the market last week with what was described as the third-largest dollar-
denominated Tier 1 deal.
Acting through its Guernsey Branch unit, the firm issued US$1.25bn in fixed-to-floating perpetual non-call 10
Aa3/A securities at 123bp over Treasuries. A US$750m perpetual non-call 10 floating issue priced with a
coupon of three-month Libor plus 69bp. Breaching the Libor plus 70bp mark was said to be one significant
aspect of the transaction. SocGen's outstanding A1/A+ issue appeared to be the most appropriate
comparable and it was 128bp bid.
The Credit Suisse trade was said to receive about US$4.5bn in demand, and the fixed issue improved to a
market of 122bp/121bp while the floater narrowed to Libor plus 68bp/66bp.
Table 6.6: Switzerland termsheets

Insurance Tier 1 Bank Tier 1
Swiss Re €1bn 5.252% Perp nc 10 (issued May-06) CreditSuisse US$1.25bn 5.86% Perp nc10 (issued May-2007)
Issuer Swiss Reinsurance Company Credit Suisse (Guernsey branch)
IssuerType SPV (Independent) Direct
SecurityType Perpetual Subordinated Step-Up Loan Notes Fixed to Floating Rate Tier 1 Capital Notes
Status / SubordinationThe Loan Notes constitute unsecured and subordinated The Notes are direct, subordinated and unsecured
obligations ranking junior to Senior Securities, pari passu obligations of the Bank, ranking junior to senior
among themselves and with Parity Securities, and senior creditors, pari passu with parity obligations and senior
to Junior Securities. to share capital.
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Table 6.6: Switzerland termsheets (cont)

Insurance Tier 1 Bank Tier 1
Swiss Re €1bn 5.252% Perp nc 10 (issued May-06) CreditSuisse US$1.25bn 5.86% Perp nc10 (issued May-2007)
First Call Date 25-May-16 15-May-17
Step-Up at First +100 bps +100 bps
Call Date
Early Redemption Yes - Par Redemption Event (Recalculation of Interest Yes - Special Event Redemption - (Tax Event /
Event / Special Tax Event) / Make Whole Redemption Event Regulatory Event). Notes redeemed at greater of
(Accounting Event / RegularTax Event / Regulatory Event). principal orT+50. Redemption subject to prior consent
Loan Notes redeemed at their principal amount (Par of the Swiss Federal Banking Commission.
Redemption Event), or the higher of principal or Bunds+65
(Make Whole Redemption Event). Redemption subject to
prior consent of FOPI.
Replacement Clause Intent-Based Replacement of Redeemed Loan Notes. n/a
Replacement with ordinary shares or securities with
equal or greater equity characteristics to the Loan Notes.
Dividend Pusher/ Dividend Pusher Dividend Pusher
Stopper
Regulatory Event Interest payments conditional on Issuer being solvent at Interest payments conditional on Issuer being solvent at
the time of payment. the time of payment.
Optional Deferral Interest payments optionally deferrable. Maximum Interest payments optionally deferrable and non-
2-year deferral period (non-cash cumulative). Deferred cumulative.
payments to be settled via ACSM.
Rating Agency Interest payments mandatorily deferrable. Trigger -
Mandatory Deferral (i) consolidated net income forthe two consecutive Reporting No rating agency mandatory deferral trigger (see
Periods ending on the Lagged Reporting Date is less than zero, Regulatory Event).
and (ii) Adjusted EquityAmount as at the Lagged Reporting
Date has declined by more than 10% as compared to the
Adjusted Equity Amount as at the Reporting Date that is 24
months prior to such Lagged Reporting Date, and (iii)
Adjusted Capital Amount as at the Current Reporting Date
has declined by more than 10% as compared to the Benchmark
Adjusted Equity Amount. Maximum 2-year deferral period
(non-cash cumulative). Deferred payments to be settled via
ACSM.
Deferred Payments Non-Cash Cumulative Non-Cumulative
ACSM Settlement of deferred interest payments via Ordinary n/a
Share Settlement (ordinaryshares orqualifying mandatory
convertibles), ParityShare Settlement, orPayment-in-Kind.
Ordinary Share Settlement subject to a total limit of 2% of
outstanding share capital in any 12-mth period, and Parity
Security/PIK amount subject to 25% of initial aggregate
principal of the Notes. Issuer shall use best efforts to settle
deferred payments. Deferred payments cancelled if not
settled within 2 year period.
Additional Features/ Substitution/ Modification of the Loan Notes following an Modification or Amendment of the Notes.
Comments Early Redemption Event. Ordinary Share Settlement
Covenant - best efforts to keep available for issue Payment
Securities required to satisfy all interest payments on the
Loan Notes for a 12-month period.
Spain
The Preferentes structure
There are similarities between the history and evolution of the current day Tier 1 Preferentes
structure in Spain and that of the French TSS-based hybrid Tier 1 described above. The Preferentes
hybrid Tier 1 structure for Spanish banks today is the product of years of lobbying by the Spanish
banking community to eliminate the need to issue hybrid Tier 1 capital securities from offshore
SPVs.
A key difference in Spain is that the essential terms and conditions of the Cayman Island SPV
preferred stock type of hybrid Tier 1 were carried over into the Spanish law 19/2003 which
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determines the current parameters for Preferentes issuance. An SPV is still typically involved but
now it should be Spanish rather than offshore to minimise the investor reporting requirements of
the issuer. The goal of direct issuance was not accomplished by copying the Cayman precedent
but the alleged offshore SPV ‘tax haven’ taint was removed and the onshore preferentes provided
banks with a domestic tax-efficient Tier 1 capital security and that was the main priority for the
banks.
Therefore, there are elements of the Law 19/2003 Preferentes which are fine for banks, but may
be considered overly restrictive or awkward for corporate issuers. In particular, the Preferentes
payment (or deferral) is ‘hard wired’ to the existence of distributable profits. If the Preferentes
issuer has distributable profits they must pay the hybrid coupon, and if the issuer does not have
distributable profits they must defer or cancel the payment. This is a focus on ongoing structuring
evolution. Recently S&P softened its view on this feature and no longer inflicts a third notch down
for Bank Preferentes.
The equity accounting treatment of a hybrid capital security under IFRS is driven by the securities
terms and the degree to which the issuer is free to defer or eliminate payments fully at the
issuer’s discretion without causing a default. Under most GAAP regimes the SPV minority interest
was equity on consolidation, so IFRS has been a consideration for corporate hybrid issuers seeking
equity treatment.
However, banks were not primarily driven by accounting equity treatment when they were
lobbying for onshore Tier 1 and this was not considered. If fact, banks typically swap the issue
proceeds from a Tier 1 transaction and therefore they may prefer debt treatment for the hybrid
Tier 1 because they can apply hedge accounting to eliminate P&L volatility. For a Spanish
corporate that desires equity accounting treatment for their hybrid the classic bank style
Preferentes may be too restrictive, but with modifications could be used effectively.
The summary examples exhibit two transactions – one bank and one corporate – in order to allow
a high level comparison of the modern bank Tier 1 preferentes structure recently used by BBVA
and the enhanced format issued by Union Fenosa. So far there have been no insurance Tier 1
hybrids from Spain. A key distinction in the Union Fenosa hybrid is the issuer’s option to resolve
payments via a non-cash distribution accomplished by increasing the nominal value of the
Preferentes by the amount of the payment deferred. This flexibility helped to support equity
accounting and to obtain significant rating agency equity credit.
The BBVA deal included a pricing novelty that was very clever in the way future investor cash
flows would be calculated. The issue was a standard True Perp with no step-up – fixed rate
payments for the first 10 years up to the call date and thereafter there is no step-up but the rate
switches to a floating format. The novelty was that BBVA included a floor equal to the original
fixed rate. This payment mechanism was valued by investors and therefore provided lower
funding cost for BBVA.
Spain termsheets
Tweak for BBVA
(Published in IFR, 24 March 2007)
Spanish bank BBVA issued US$600m in perpetual non-call 10 fixed-to-floating notes with an uncommonly
high coupon floor after the call that was said to save the credit 10bp–12bp. The securities featured a yield of
5.919% as they priced at 134bp over Treasuries, or 83bp over Libor. After the call, the securities will float at the
equivalent issue spread over three-month Libor, but the coupon floor will also be the initial yield of 5.919%,
providing investors with some added assurance that the issuer will call the securities.
In a lower interest rate environment, the credit would be facing a higher coupon than it could otherwise
achieve in the market. In a higher interest rate environment, BBVA would face a coupon step-up once the
coupon starts to float.
The perpetual fixed-to-floating callable structure has been used previously and, without the floor, thoughts
were that a new BBVA step-up would print in the mid-140bp area.
One account based its decision to participate in the trade on the floor, noting that it could hedge against what
it knows would be the lowest yield it would receive if BBVA chose to extend past the discrete call. There was
said to be a good mix of money management, insurance and money fund participation in the deal.
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The transaction came under the 144a rule and is QDI eligible based on the classification of the payments to
investors. The combination of an unregistered trade and the QDI eligibility, which is often seen in retail deals,
has surfaced on several Yankee transactions, such as Standard Chartered's perpetual trade late last year.
Lehman Brothers led the BBVA offering
Fenosa prefers retail

Spanish utility Union Fenosa turned its back on the revived corporate subordinated market and instead opted
for a retail targeted perpetual preference share, which priced last week through lead managers SCH and Caja
Madrid. The issuer raised €750m in floating securities that pay 65bp over Euribor, stepping up to 165bp over
Euribor if the securities are not called after 10 years.
The transaction is accounting driven and intended to replace the €609m of preference shares issued in 2003,
which counts as debt under the new IFRS accounting rules, whereas the new notes are considered as 100%
equity under IFRS.
Table 6.7: Spain termsheets

Bank Tier 1 Corporate Hybrid
BBVA US$600m 5.919% Perp nc 10 (issued Mar-07) Union Fenosa €750m 4.814% Perp nc10 (issued Jun-05)
Issuer BBVA International Preferred, S.A. Unipersonal Union Fenosa Preferentes S.A. (Sociedad Unipersonal)
IssuerType SPV SPV
SecurityType Non-Cumulative Guaranteed Preferred Securities Non-Cumulative Perpetual Guaranteed Floating Rate
Preferred Securities
Status and The Preferred Securities rank junior to all liabilities of the The Preferred Securities rank junior to all liabilities of
Subordination Issuer including subordinated liabilities, pari passu with the Issuer including subordinated liabilities, pari passu
each other and with any Parity Securities of the Issuer and with each other and with any Parity Securities of the
senior to the Issuer’s ordinary shares. Issuer and senior to the Issuer’s ordinary shares.
First Call Date 18-Apr-2017 (then every 10-years) 30-Jun-2015
Step-Up at First Coupon Floor: 5.919% +100 bps
Call Date
Early Redemption Yes (Regulatory Event / Tax Event). Securities redeemed at n/a
the special redemption price (Regulatory Event), or at the
higher of principal or UST+75 (Tax Event). Redemption
subject to prior consent of the Bank of Spain.
Replacement Clause n/a n/a
Dividend Pusher/ Dividend Stopper Dividend Stopper
Stopper
Distributable Profits? Distributions conditional on availability of distributable Interest payments conditional on availability of
profits. distributable profits.
Regulatory Event Distributions conditional upon no breach of minimum n/a
capital requirements, applicable under Spanish banking
regulations.
Optional Deferral Distributions optionally deferrable and non-cumulative. n/a
Mandatory Deferral No rating agency mandatory deferral trigger n/a
(see Regulatory Event).
Deferred Payments Non-Cumulative Non-Cumulative
ACSM n/a n/a
Additional Features/ n/a Issuer option to pay a non-cash-distribution by
Comments increasing the nominal value of the preferred securities
instead of paying the cash distribution. Conditional
upon existence of distributable profits and no dividend
payment made to ordinary shareholders.
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Italy
Italian banks were early issuers of hybrid Tier 1 securities but the history of the hybrids in Italy
has been constrained by difficulty in obtaining BoI transparency for hybrid structuring
innovations and lack of advance notice of expected changes in regulatory requirements. As a
result, Italian banks were absent from the hybrid Tier 1 new issue market for several years.
Italian banks were active in the first wave of European bank hybrid Tier 1 issuance in the 1990s
and some creative financial engineering produced a noteworthy hybrid Tier 1 structure which
was successful until BoI cut back on what they would permit as capital. For several years, the
Italian banks suffered a disadvantage relative to international peers in that their hybrid Tier 1
issuance was limited in the calculation of Tier 1 requirements. So far, the possibility to issue core,
non-innovative Tier 1 that is tax efficient is not a possibility for Italian banks.
Given the rapidly changing environment in the Italian banking industry, BoI has allowed banks to
issue new tranches of innovative hybrid Tier 1 to support the M&A activity that is ongoing in Italy
(for example, the innovative Tier 1 issues by Unicredit and Lodi). Innovative structures can
therefore be computed as part of the target Tier 1 ratio requested by BoI. Previously, ‘innovative’
was not eligible to reach the minimum targets.
Current innovative Tier 1 structuring opportunities

For some time we advocated the theoretical opportunity to update the ‘classic’ style of Italian Tier
1 which has historically been issued indirectly through an ‘offshore’ SPV based in the US.
However, the majority of M&A-driven innovative Tier 1 issues followed the classic model
involving US SPVs (Limited liability company, or LLC, and Trust) since it was a proven structure
that could be quickly executed with limited hassle. The focus was more on the M&A deal and
strategic issues rather than the specific innovative Tier 1 structure – especially since BoI has been
conservative in adopting new innovative Tier 1 ideas in the past.
A logical streamlining of the classic structure would be to use a European SPV to replace the US SPVs
(LLC and Trust) or even a direct issue with no SPV. The legacy US structure via Delaware is awkward for
a European bank selling Euro-denominated Tier 1 to European investors. So a ‘neo-classical’ European
SPV structure could be an alternative to consider (see Figure 6.3), if not a direct issue with no SPV at all.
Most EU countries have moved away from offshore SPV structures altogether and favour direct
issuance (UK, France, the Netherlands) even if this required a change in tax or securities law. This
is because there was a concern among Basel ll members that an SPV in the Tier 1 structure
somehow reduced the quality of the Tier 1 capital and restricted its equivalence to the own funds
definition. Other jurisdictions that still use SPVs for innovative hybrid Tier 1 (such as Germany,
Ireland and Spain) have moved to EU SPVs since it is easier and often cheaper in Europe than it
was only a few years ago. Based on our discussion with the BoI, they are open to the use of an EU
SPV and they see the rationale for doing so, but do not require it as some other regulators do.
Direct issues have also finally been seen, as shown in the summary examples where a Tier capital
issue for BPVN is highlighted
Hybrid structuring in Italy

The ‘classic’ hybrid Tier 1 structure for banks using a Delaware Trust structure is shown in Figure
6.4 and highlighted in the summary examples.
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Figure 6.4: Italian hybrid Tier 1 structure via a US trust
Bank
common securities
100% of LLC
Subordinated Subordinated
Subordinated guarantees
Deposit Cash deposit and
Proceeds Derivatives contracts
LLC
common Securities
100% ofTrust
LLC Preferred LLC Preferred

Security Cash Securities
Proceeds
Trust
Trust Preferred
Trust Preferred
Security Cash
Securities
Proceeds
Investors
Source: Compliled by CALYON
The bank security issued to the LLC can be structured as either an Upper Tier 2-style bond to
obtain Tier 1 capital on a consolidated basis, or a subordinated deposit with a derivative contract
that creates bank level loss absorption in the event of a capital deficiency event. This achieves Tier
1 capital on a solo basis.
The Italian bank sets up an SPV in the form of a Delaware LLC in the US and routes the proceeds
from the issue back to the parent bank in Italy through the US LLC. The use of the US LLC is a
legacy left over from BoI approvals of early Tier 1 structures in the past, which were using SPVs in
many European jurisdictions.
Figure 6.5: Italian hybrid Tier 1 structure – EU SPV
Bank
Subordinated
Interest
guarantee
Intercompany
payments
securities
(tax deductible)
SPV
Proceeds Tier 1
from Tier 1 securities
Investors
Although Tier 1 could be issued by the bank itself, normally the issuer is an SPV which raises the
funds from investors and passes them through a subordinated loan to the bank. The bank will
issue a subordinated guarantee in favour of the holders of the securities issued by the SPV and will
have to pay interest on the subordinated loan to the SPV.
Since the SPV will be consolidated, on the group level proceeds from the issue of the securities by
the SPV are recognised as Tier 1 capital at the bank’s level. The SPV is located in a domicile that is
fiscally neutral for the issuers and to the investors (such as UK/Ireland/Netherlands), providing the
following advantages:
0 Gross payment of interest on the securities issued by the SPV and bank;
0 Derivative contract between bank and SPV provides loss absorption;
0 Deductibility of payments of interest under the subordinated loan – no withholding tax cross
border.
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A variation of the European SPV structure has been used by Generali, which issued €1.275bn
through an EU SPV based in the Netherlands and listed in Luxemburg. This structure is more s-
traightforward and lower cost than the Delaware structure (especially for a first-time issuer). In
particular, a European SPV is easier to implement, following the implementation of the EU
prospectus directive.
More information on the Bank of Italy is available on www.bancaditalia.it
Recent developments
Italy hybrid capital limit increases to 20% of total capital
In December 2006, BoI made beneficial changes to banking regulations for Tier 1 regulatory
capital. This provided an opportunity for Italian banks to issue more low-cost hybrid Tier 1 in the
form of no-step Tier 1, targeting either the institutional True Perp market or RPB market.
The key change was the increase to the limit on hybrid issuance from 15%, which allows for more
True Perp issuance – under the new regulations the hybrid limit was increased to a maximum of
20% of total Tier 1 capital. Step-up ‘innovative’ hybrid Tier 1 was still limited to a maximum 15%
but the overall hybrid limit was increased to 20% to allow additional issuance of hybrid Tier 1 with
no step-up coupon.
This is similar to a recent change to the guidelines in France, where limits on total hybrid
issuance were recently increased – also allowing for more True Perps but keeping step-ups capped
at 15%. Therefore, in France hybrid Tier 1 can now amount to 25% of total Tier 1.
Ultimately, the future of Italian Bank Tier 1 issuance should lead to direct issues. During strong
market conditions both step-up and True Perp formats are possible, with the True Perp having the
advantage of falling outside the 15% limit and into the larger 20% limit.
Two key issues

Following the publication of BoI's new guidelines at the end of December 2006 there were two
key issues that were ironed out in the latest direct issuance structures:
1. How the hybrid Tier 1 ‘loss absorption’ required by BoI for all hybrid Tier 1 could eventually be
structured – In the ‘classic’ US SPV structure there was an inter-company mechanism whereby the
subordinated deposit amount could be diminished via the parallel derivative agreement between
the hybrid Tier 1 US SPV and the Italian parent bank. In the end, BoI has accepted an Upper Tier 2
style loss absorption on the direct issue hybrid Tier 1. In prior engineering attempts to modify the
classic structure this was not accepted on the inter-company subordinated loan. The resulting
evolved structure simply allows for suspension of the hybrid Tier 1 principal amount in order to
avoid an insolvent condition. This amount will be restored if the bank returns to surplus. Most
importantly, the investor maintains the full claim for the unadjusted principal amount in
liquidation;
2. The ‘permanence’ of the security given that most Italian companies have a limited duration –
The solution is to link the maturity of the security to the life of the company as seen in recent non-
bank hybrid innovation in Italy. Additionally, this resolves the potential tax issue for international
investors as it allows gross payments (no withholding tax) to non-Italian international investors.
Direct issuance was first accomplished by a corporate (Lottomatica), as highlighted in the

summary examples. Since the motivation was rating agency-driven rather than regulatory, the
transaction could be in dated format (rather than perpetual) and still achieve significant equity
credit. By avoiding a perpetual issue format the transaction did not raise concerns with potential
withholding tax faced by investors on ‘atypical’ perpetual securities. A curious feature of the
Italian system is that an issuer cannot issue a financial liability with a term longer than the legal
life of the company itself. So for very long dated hybrids the term of the security needed to be
harmonised with the company life and extended along with the company itself.
Generali also issued a Tier 1 hybrid in the direct format (and also SPV format) taking advantage of
the new opportunity. Subsequently, Banca Navarro issued the first direct issue bank Tier 1 in Italy
which should open the way for others to follow. One of the interesting themes which can be
observed is that banks are now being led by the innovations of corporates and insurance
companies who are leap-frogging the advances pioneered by the banks. All parties are benefiting
from the evolution of hybrids. Direct issuance is likely to dominate over time. However, where a
bank already has substantial SPV issuance outstanding they may wish to continue SPV issuance
rather than switch immediately. Over time it can be expected that the same pattern seen in other
jurisdictions and direct issuance will become most common.
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A change in Italian law (Legge Viette) has provided a flexible new preferred stock type of security
called Strumenti Finanziari Partecipativi (SFP), which should be considered in the structuring of
Italian capital securities and could potentially provide additional structuring flexibility in future.
The SFP could be a useful replacement for the use of common shares in the ‘FRESH’ type structure
issued by Banca Monte dei Paschi di Siena SpA without the potential problems caused by the need
to issue common stock (i.e. approvals and dilution).
Italy termsheets
Smooth operator Generali
(Published in IFR, 3 February 2007)
In stark contrast to its €2.8bn cross-currency, three-tranche Tier 1 trade launched last June, Assicurazioni Generali
(A3/A/A+) raised €2bn-equivalent in a dual-tranche trade last week. While the borrower launched last year's deal
in a nervous market stricken by stock volatility that caused spreads to widen out, its latest well thought out and
well executed offering was set against a backdrop of a rock-solid, benign market flush with funds.
The trade amassed one of the largest order books ever seen for a subordinated transaction, scooping €7.8bn
of orders for the euro tranche and £4.4bn for the sterling, within around 45 minutes of opening the books.
The phenomenal demand and lack of price sensitivity in the books helped the borrower to print both the
trades much tighter than the initial guidance.
The €1.25bn perpetual non-call 10 trade priced at 114bp over mid-swaps and the £495m (to achieve the
€2bn target in hybrid Tier 1 exactly) piece priced at 146bp over Gilts. The final pricing was within 3bp of the
secondary trading level of the 2016s on announcement of the transaction and through the interpolated
trading level of the 2016s and 2026s in sterling, which was commendable for a transaction of this size. The
feat stands out even more coming just seven months after the issuer’s €2.8bn Tier 1 funding exercise.
Close on the heels of its Tier 1 trade last June (IFR 1637), the issuer had announced its intention of raising a
further €1.2bn in the hybrid market (IFR 1640) in the first quarter of this year to part-fund its €3.85bn
acquisition of Italian motor insurer Assicurazioni Toro. Although the acquisition made compelling strategic
sense for Generali, it required the firm to cancel its share buy-back programme, which was a key element in its
capital optimisation strategy (part of its three-year strategic corporate plan announced in March 2006).
A quick flashback into 2006 would reveal that the strategic plan included a buy-out of minority stakeholders
in several countries and a share buy-back (totalling €4.1bn) that the borrower planned to finance through a
combination of hybrid and other debt. In keeping with the plan, soon after the firm completed its minority
acquisitions, the borrower priced its €2.8bn hybrid Tier 1 transactions, leaving approximately €1.2bn to be
raised in dated subordinated capital. However, the Toro acquisition not only forced the firm to deviate from its
buyback plan but also raised its capital funding needs to around €2bn.
A combination of the borrower’s natural currency and duration objectives with investor preferences dictated
the tranching of the transaction, jointly led by HSBC, JPMorgan, Mediobanca (all involved in the June 2006
three-part trade) and UBS. As the 2006 exercise relied more on the sterling market (£1.05bn versus
€1.275bn), a bias towards euro was the natural choice this time around.
A clear investor bias towards the perpetual non-call 15 as opposed to a perpetual non-call 17 structure for the
sterling tranche explained the choice of format. Besides, the former sat comfortably between the two existing
sterling benchmarks and optimised the overall funding cost of the trade as the Libor curve in sterling was
marginally flatter than that available in euros, thus permitting a modest Libor arbitrage for the borrower.
To tailor the trade to fit the specifications put out by ratings agencies, the issuer made some structural
tweaks primarily related to the ACSM (alternative coupon settlement mechanism) clause. Settlement under
the ACSM is only permissible to the extent of funds raised by either issuing new shares (up to 2% of the share
capital) or by issuing securities ranking junior or pari passu, with the latter threshold lowered from 25% to
15%. Besides, when the coupon is deferred, it triggers a best-efforts period of five years if not settled in the
five years (previously 10 years) following the deferral. Neither change had any impact on pricing or distribu-
tion, according to the lead managers.
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“As we were essentially removing a large overhang of supply from the Generali curve, investors acknowledged
that the premium for a new transaction versus their existing curve would be modest and that proved to be
the case,” said Richard Howard, executive director on JPMorgan's financial institutions syndicate desk.
Although the issuer planned to print a larger euro piece compared with the sterling tranche at the outset, it
refrained from defining the size of either. The leads also left enough room for manoeuvre when announcing
the guidance of mid-swaps plus the mid-to-high teens over 100bp for the euro piece (with the issuer's 2016s
bid at 109bp over mid-swaps) and 150bp area over Gilts for the sterling tranche (representing a modest
concession to the interpolation of the 2016s (bid at Gilts plus 138bp) and 2026s (bid at Gilts plus 150bp).
Both the trades performed well in the secondary market, with the euro tranche bid at Bunds plus 143.5bp
(3bp tighter than reoffer) and the sterling print also bid 3bp tighter through reoffer.
Of the almost 400 orders received across the two tranches, asset managers dominated the euro trade,
claiming 58% of the bonds, followed by pension funds and insurance companies, which together bought
22% of the issue. Italy accounted for less than 10% of the placement, with the UK and Ireland, France, the
Benelux countries and Germany representing the main buying regions. As expected, the UK accounted for
92% of the placement on the sterling tranche, which was bought primarily by asset managers, though there
was also participation from insurance firms and pension funds.
Twin-sets in fashion
(Published in IFR, 8 October 2005)
UniCredito Italiano spread the net wide for its acquisition-related Tier 1 financing, adopting a two-tranche
strategy. It targeted buyers in Continental Europe with a euro-denominated deal and the UK with one in
sterling. Both were perpetuals with a call after 10 years. JPMorgan and Merrill Lynch were joint lead managers
on both tranches, being joined by HVB and UBM on the euro and HSBC on the sterling.
The transaction was extensively roadshowed, giving investors the opportunity to hear UniCredito's version of
events regarding its merger with HVB. Despite the fact that all three rating agencies are reviewing the credit
with a view to a possible downgrade as a result, the response was enthusiastic – close on €5bn of orders
being pledged at the initial spread talk of the mid-swaps plus 80bp area and Gilts plus 110bp–115bp.
The stated intention was to launch benchmark-sized issues in each currency, although the entire €1.2bn
equivalent final amount (€750m and £300m) could easily have been raised by concentrating solely on the
euro market and even in sterling, had UniCredito been so minded. It was keen to diversify its investor base,
however, and the sterling option opened up a new avenue, this being its inaugural transaction in the currency.
It was also its first visit to the euro Tier 1 market for five years, so credit lines were freely available.
Given the level of demand, a downward revision of the prospective spreads was not surprising. The new
figures were mid-swaps plus 75bp–77bp and Gilts plus 107bp–109bp. Even at these tighter levels, both
tranches were still significantly oversubscribed, with final books standing at around €2.5bn on the euro when
it priced at plus 76bp and just short of £1bn on the sterling at its launch spread of 107bp.
At plus 76bp, it was only slightly wider than SG's 2015 callable (plus 72bp) with which it shares current ratings
of A1/A, and inside ING Groep's (plus 84bp), which at A2/A sports the ratings towards which UniCredito is
expected to gravitate. This one-notch downgrade was also factored in when pricing the sterling tranche, the
two bonds most closely looked at being KBC's 2019 callable (A2/A–), which was bid at 106bp over Gilts, and
NAB's 2018 (A2/A) at plus 114bp.
The novelty value of a new issuer meant that the spread could be squeezed further in on the sterling portion
as investors clamoured for a fresh name for their portfolios. There were 70 accounts in the final book,
comprising most of the largest UK funds, although this was dwarfed by the 200 that participated in the euro
transaction. The UK, France, Germany and the Benelux region took the bulk of the bonds (70%), a further 20%
remaining in domestic hands.
The initial indications on the euro tranche had been of a coupon in the 5% area. When €2.3bn worth of orders
flooded in with a rapidity not normally associated with retail transactions, it became clear that demand for such
a product was rife and a journey into the previously uncharted 4% handle territory could be contemplated.
The coupon was eventually pitched at 4.875%, the bulk of the bonds being bought by retail intermediaries from
whom they would eventually be filtered into their networks. As is normal with this kind of paper, placement was
at a price of 99.00. Those that bought bonds were soon in profit, early trading seeing them bid just above par.
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Those that invested in the US dollar tranche were sitting on an even greater profit. It moved up to 100.375
bid, with buyers attracted by the 6.25% annual coupon. Pricing two days before the euro, its US$400m size
was smaller than some were expecting, although BNP had only limited requirements and those working on
the exercise will have been aware of the overwhelming demand for the euro, meaning that raising a huge
amount in US dollars was not a pressing necessity.
The order book fell just short of the US$500m that would have afforded a rounder number, although the
eventual US$400m was comfortably covered.
BPVN braves rough weather

Published in IFR, 16 June 2007
Banco Popolare di Verona e Novara (BPVN) last week became the first Italian borrower to issue a direct Tier 1
deal and a non-step Tier 1 offering when it launched its dual tranche perpetual non-call 10-year trades.
It is also the first time globally that a step and non-step transaction have been executed simultaneously,
claimed joint leads Goldman Sachs, HSBC and JPMorgan. The non-step issuance is the fourth such
transaction following the two Barclays deals (callable 2014 and 2020) and the Dresdner trade issued last year.
The deal was aimed to raise capital to fund BPVN's merger with Banca Popolare Italiana, which will become
effective on July 1. The capital-raising along with the announced share buyback programme form the key
elements of the issuer's acquisition financing plan. After the merger, BPVN will become the third largest bank
in Italy, with assets of €120bn and more than 2,200 branches. It is rated A2/A/A+ at the senior level.
To showcase the merged entity, roadshows were held for six days across all the major investor constituencies
in the UK, Germany, France, the Netherlands, and Italy. The issuer met with almost 100 investors.
Though the roadshow concluded in Milan on June 6, investor calls were held by the leads well into last
Monday to give buyers time to monitor and digest the Banca Italease situation, given that BPVN owns 30%
of Italease.
BPVN shares had suffered a 15% loss since May 1 due to concern that the Italease crisis might generate
financial losses and put at risk its planned merger with Banca Popolare Italiana. An improvement in sentiment
was seen last Monday as share prices in Milan rebounded from losses two weeks ago.
Given the volatility in the markets and the widening seen on Tier 1 deals in the secondary market, the leads
waited for a stable window to launch the deal. With the market exhibiting some semblance of stability late last
Monday combined with a strong opening last Tuesday, the leads issued initial guidance of mid-swaps plus
130bp–133bp for the step-up deal and mid-swaps plus 190bp–195bp for the non-step tranche.
For the step-up offering, the leads referred to the outstanding euro perpetual non-call 2015 Tier 1 notes,
which were bid at plus 112bp, and adjusted for the two-year curve extension and threw in a modest new issue
premium.
Price discovery was tricky in the case of the true perp offering. Absent a like-for-like comparison, the non-step
premium was worked out from a number of different measures, including AIB's outstanding euro Tier 1 step
and non-step benchmarks that trade at a roughly plus 55bp differential in the secondary market.
Targeting an intra-day execution to minimise market risk, the leads closed the books when the trades were
effectively oversubscribed. At just under €5bn, orders were skewed towards the step-up tranche and reflected
an appropriate step and non-step differential.
Of the 150 investors that placed orders, about 20% dropped off when the guidance was refined to the tight
end across both tranches, with the €350m step-up tranche placed at plus 128bp (Bunds plus 156.7bp) and
the €300m non-step piece at plus 188bp (Bunds plus 216.7bp).
Across the two tranches, asset managers bought about 60%, and insurance and pension funds about 25%,
with the remainder split among banks, private banks and hedge funds. The UK and the Netherlands were well
represented, followed by Germany and France. Notably, domestic participation was less than 10% of the
combined trade.
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A relatively small deal issued by not the strongest of Italian banking credits in not the strongest of market
environments definitely commands a premium, which the issuer paid, said market participants.
The deals performed well in the secondary market, with estimates ranging from 7bp to 11bp tighter on the
step-up tranche and from 14bp to 23bp on the non-step piece – with talk being that some market partici-
pants have used these transactions as a market proxy short only to find themselves having to cover their
positions at higher prices.
Lottomatica picks right number

Italian lottery concessionary Lottomatica’s eagerly awaited €750m 60-year non-call 10 hybrid securities
(144a/Reg S) did not disappoint on Wednesday by pricing at the tight end of talk to yield 8.25% at par. Credit
Suisse is sole bookrunner and Goldman Sachs joint lead manager.
The price equates to a spread of 405bp versus 10-year mid-swaps, or 425bp versus the DBR 3.5% due January
2016. The securities feature a margin step-up after 10 years, flipping to a floating rate of 505bp over six-
month Euribor, from which point they are callable at the make whole or margin step-up rates. Interest
payments are deferrable in some circumstances. The Ba3/BB– rated deal had been expected in a
8.25%–8.5% range. Settlement is T+5 (May 17).
This issue is a good result for the leads as the lack of benchmarks and the broad mix of potential investors
means this was a difficult deal to price. The hybrid allows Lottomatica to retain its Baa3/BBB– corporate
rating despite the extra leverage required to finance its circa €4bn acquisition of US gaming group GTech. As
such, the deal attracted interest from both investment-grade and high-yield accounts.
One of the high-yield investors described the deal as “more generous than expected” and speculated that the
leads had probably been careful not to push pricing too tight as doing so could have left the deal vulnerable
to a sell-off. Judging by the secondary performance, which saw the deal wrapped around the 102 mark on
Friday, the corresponding risk of pricing the deal too richly has also been successfully negotiated. The
remainder of the financing was secured through a €1.9bn senior loan and a €1.4bn rights issue. The
acquisition creates the world's largest lottery company.
153
Table 6.8: Italy termsheets
154
Generali €1.25bn 5.479% UniCredito Italiano €750m 4.028% BPVN €350m 6.156% Perp nc 10 (issued Jun-07) Lottomatica €750m 8.250%
Perp nc 10 (issued Jan-07) Perp nc 10 (issued Oct-05) 60 nc 10 (issued May-06)
Issuer Generali Finance BV UniCredito Italiano Capital Trust III Banco Popolare de Verona E Novara S.C.A R.L. Lottomatica SpA
CHAPTER06
IssuerType SPV SPV Direct Direct

SecurityType Perpetual Fixed/Floating Rate Notes Non-cumulative Guaranteed Fixed/Floating Rate Perpetual Step-Up Subordinated Fixed-Floating Subordinated Interest-Deferrable Capital
Perpetual Trust Preferred Securities Rate Notes Securities
Status / Subordination The Notes rank pari passu among themselves, junior to The Bank’s obligations rank subordinate and junior to The Notes constitute direct, unsecured and subordinated the Issuer, financial instruments
unsubordinated and less deeply subordinated all indebtedness of the Bank (other than any instrument obligations of the Issuer and rank pari passu among (strumenti finanziari), any savings shares
obligations of the Issuer, and senior to payments of all or contractual right expressed to rank pari passu with the themselves and with any parity securities, The securities and preference shares, and any other
classes of share capital of the Issuer and any other Subordinated Guarantees), pari passu with the most will rank pari passu among themselves and with parity equity interest or junior obligations of the
obligation junior to the Notes. seniorpreference shares of the Bank, if any, and seniorto securities, junior to all other unsubordinated and Issuer.
the share capital of the Bank, including its Azioni subordinated creditors, and senior to ordinary shares of
Privilegiate, ordinary shares and Azioni di Risparmio. junior to all unsubordinated and less deeply subordinated
obligations, and senior to any junior securities.
Maturity Perpetual Perpetual Perpetual 31-Mar-2066
First Call Date 8-Feb-2017 27-Oct-15 21-Jun-2017 31-Mar-2016
Step-Up at First Call Date +100 bps +100 bps +100 bps +100 bps
Early Redemption Yes (Regulatory Event / Tax Event). Notes redeemed at the Yes (Capital Event / Investment Company Event / Tax Yes (Step-Up Regulatory Event / Tax Event). Notes redeemed Yes (Withholding Tax Event / Tax Event /
higher of principal or make-whole amount (Regulatory Event / Change in Law Tax Event / Interpretation at the higher of principal or Bunds+108.35. Redemption Change of Control Event). Securities
Event) or their principal amount (Tax Event). Redemption TaxEvent). Securities redeemed at the higherof principal subject to prior consent of Bank of Italy. redeemed at their principal amount
subject to prior consent of ISVAP. orBunds+50 (Capital Event / Investment CompanyEvent / (Withholding Tax Event), or at the higher
TaxEvent), orthe principal amount (Change in Law TaxEvent / of principal or Bunds+75 (Tax Event /
Interpretation Tax Event). Redemption subject to prior Change of Control Event). Mandatory
consent of Bank of Italy. Redemption Event - mandatory
redemption at 101% of principal at the

earlier of the termination of the merger
agreement (Lottomatica/GTECH), and
October 10th 2006 (if acquisition not
completed).
Replacement Clause Intent-Based Replacement of Redeemed Securities. n/a n/a Intent-Based Replacement of Redeemed
Replacement with ordinary shares or securities with Securities. Replacement with ordinary
equal or greater equity characteristics than the Notes. shares or securities with similar terms and
conditions.
Table 6.8: Italy termsheets (cont)
155
Generali €1.25bn 5.479% UniCredito Italiano €750m 4.028% BPVN €350m 6.156% Perp nc 10 (issued Jun-07) Lottomatica €750m 8.250%
Dividend Pusher/Stopper Dividend Pusher Dividend Pusher Dividend Pusher Dividend Pusher / Stopper
CHAPTER06
Regulatory Event Interest payments conditional upon no request from ISVAP Interest payments conditional upon no breach of Interest payments conditional upon no breach of minimum n/a
(oranyothersupervisoryauthority) to restore the required minimum capital requirements. Interest payments capital requirements. Interest payments not paid if prohibited
solvency margin at this time. not paid if instructed by the Bank of Italy. under Italian legislation.
Optional Deferral Interest payments optionally deferrable. Maximum Interest payments optionally deferrable and Interest payments optionallydeferrable and non-cumulative. Interest payments optionally deferrable.
5-yeardeferral period (cumulative). Deferred payments to non-cumulative. Maximum 10-year deferral period
be settled via ACSM. (cumulative). Deferred payments to be
settled with cash (first 5-year period) or via
ACSM (next 5-year period).
Rating Agency Interest payments mandatorily deferrable. Trigger - No rating agency mandatory deferral trigger (see No rating agency mandatory deferral trigger Interest payments mandatorily deferrable.
Mandatory Deferral (i) the aggregate Net Income of the Guarantor for two Regulatory Event). (see Regulatory Event). Trigger - Coverage Ratio is less than 1.35.
consecutive Reporting Periods ending on the Lagged No deferral if issuer has available cash
Reporting Date is less than zero, and (ii) the Adjusted Equity proceeds raised via equity issuance in
Amount of the Guarantor as at the Lagged Reporting Date has prior 6-month period. Issuer to pay
declined by more than 10% as compared to the Adjusted Equity deferred payments promptly via ACSM.
Amount as at the Reporting Date that is 24 months prior to such Maximum 10-year deferral period
Lagged Reporting Date, and (iii) the Adjusted Capital Amount of (cumulative).
the Guarantor as at the Current Reporting Date has declined by
more than 10 per cent. as compared to the Adjusted Equity
Amount as at the Reporting Date that is 30 months prior to such
Current Reporting Date. Maximum 5-year deferral period
(cumulative). Deferred payments to be settled via ACSM.
Deferred Payments Non-Cash Cumulative Non-Cumulative Non-Cumulative Mandatory Deferral (Non-Cash

(Cumulative - first 5 years / Non-Cash
Cumulative - next 5 years)
ACSM Settlement of deferred interest payments n/a n/a Settlement of deferred interest payments
("best efforts") via issuance of new shares (2% limit in immediately, via issuance of Issuer Equity
any 12-mth period), junior or pari passu securities (15% (ordinary shares),.Issuer undertakes to
junior/pari passu securities limit). Deferred payments not keep available authorised shares to
settled after 5 years will be cancelled. enable payment of deferred interest via
ACSM. Deferred payments not settled after
10 years will constitute an event of default.
Table 6.8: Italy termsheets (cont)
156
Generali E€1.25bn 5.479% UniCredito Italiano €750m 4.028% BPVN €350m 6.156% Perp nc 10 (issued Jun-07) Lottomatica €750m 8.250%
Additional Features/ n/a n/a Loss absorption upon the occurrence of a Capital Deficiency Fast Pay ACSM avoided typical third notch
CHAPTER06
Comments Event. Reinstatement if a capital deficiency event is no from S&P. Mandatory Redemption Event -
longer occuring. Reinstatement will also occur in certain mandatory redemption at 101% of
circumstances (redemption of the Notes or liquidation of the principal at earlier of termination of
Issuer). Merger Agreement, and October 10th
2006 (if acquisition not completed).
CHAPTER06
USA
In the early 1990s the US already had a healthy preferred stock market which as mentioned
previously included variations such as auction rate preferred, fixed rate perpetual preferred,
adjustable rate preferred, etc. While these variations of classic preferred stock were not tax
deductible some institutional investors were able to benefit from something called the Dividend
Received Deduction (DRD). This improved the tax adjusted return to these investors and could
thereby reduce the issuers cost of preferred capital. The DRD in the US is similar to the UK ACT in
terms of the end result of improving the issuer’s tax adjusted cost. It is an interesting point to note
in the history of preferred securities, since the current tax deductibility of hybrids is threatened
from time to time as if it is an inappropriate result of financial engineering. Historically, there is
precedent for preferred debt/equity ‘hybrids’ to have tax benefits that result in lower cost to the
issuer. As discussed in great clarity by Tom Humphreys, tax lawyer at MoFo, in the tax article he
contributed to this publication, tax remains the key binding constraint to further equity
enhancement of US hybrids (see Appendix).
The early US market activity included preferred stock issuance from many domestic and some in-
ternational sectors including banks, utilities, energy companies and other industrials. European
issuers tapped the US market with so called ‘Yankee’ issues.
Texaco issued a first ever SPV oriented hybrid security in the US back in 1993. The structure,
which resembled some European SPV concepts, kicked off a wave of new corporate hybrid
issuance that evolved through various types of SPV issuing entity (LLC, LP, Trust) and spread
eventually to bank issuers as a tax-efficient form of capital. These SPV securities provided the
equity benefits of preferred shares but were also tax deductible. Many prior issuers of preferred
stock started to issue these SPV capital securities instead and some engaged in preferred stock
tender and/or exchange programmes to replace outstanding preferred stock with the more cost
effective SPV capital securities. US bank issuance exploded into the multi-billions and sparked an
international drive to develop, promote and evolve variations of the hybrid capital security
theme. US hybrids have many debt oriented characteristics that comfort investors and secure the
tax deductibility. Compared to other jurisdictions there are no perpetual structures that are tax
deductible and the deferral provisions are investor friendly. The US hybrid market has also
exhibited great diversity in call structures (American, European, nc10, nc30) and leads in the
development of hybrid hedging tools such as Preferred CDS (PCDS). The US retail investor market
remains a unique and very important niche in the global hybrid market. For issuers that can meet
the SEC registration requirements the US retail market offers at times the most attractive market
to issue hybrids both in terms of low cost and flexible structure. Over time the size and diversity
of transactions executed in this market has grown dramatically and very large deals (over US$1bn)
have been successfully completed. It was noteworthy that this segment continued to function
during some periods of market turmoil that reduced access to the institutional investor market.
RPB markets have developed rapidly in Europe and elsewhere (with no SEC registration hurdles)
but still lag behind the development of the US retail market.
The summary examples provide an indication of just some of the varieties in the US market today
(some others were also mentioned in the article by Tom Humphreys). The recent drive to
maximise rating agency equity has been a catalyst for new structuring creativity – particularly
regarding maturity extension. For this reason you will see in the summary examples some
references to a ‘Scheduled Maturity’ at 30 years with a later ‘Final Maturity’ such as 60 years from
issue date. The use of legally binding RCCs has also taken off far faster in the US than elsewhere in
the world as shown in two of the transactions summarised here. The historical use of SPVs is more
frequently complemented by direct issues as also seen in the summary examples.
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US termsheets
AIG tests market
(Published in IFR, 10 March 2007)
American International Group's euro and sterling trades gave slight positive momentum to a market looking
for direction. The borrower's SEC-registered global junior subordinated issuance programme (Its inaugural
such deal) was done in three parts, with AIG raising around US$3.75bn-equivalent in total. As well as raising
€1bn and £750m through 60-year final maturity/30-year scheduled maturity non-call 10 step-up trades, it
also sold US$1bn of paper structured with a 2087 final and a 2037 scheduled maturity (see US Debt and
Globals report for details).
The proceeds will be used to fund the bulk of the borrower's approximately US$5bn stock repurchase
programme, with the remainder coming out of its free cashflow. Citigroup, Deutsche Bank and JPMorgan acted as
global co-ordinators and structuring advisers on the trades, while ABN AMRO and Credit Suisse joined them as
bookrunners on the euro deal and Barclays Capital and HSBC were similarly employed on the sterling tranche.
Since US companies issue more dated debt for tax reasons, the final maturity of 60 years was chosen,
replicating the structure used by GE Capital when it issued debt last September. The offering has sufficient
investor-friendly language thrown in. It has a cumulative, compounding structure (unlike many in Europe), a
provision for an alternative payment mechanism (similar to the ACSM), which means that after five years of
deferral the company has to issue securities of a junior nature in order to pay the coupons.
The Aa3/A+/AA– deal has no mandatory deferral feature (unlike the AXA and Generali transactions of last
year) and is more similar to earlier offerings from Allianz and Clerical Medical. It qualifies for Basket D
treatment (75% equity) from Moody's.
In view of the spike in volatility experienced in the last two weeks, the issuer was keen not to have overnight
market exposure, hence intra-day execution was targeted. The US dollar trade, which performed well in the
secondary market, set the stage for smooth execution for the European offerings and they raked in multi-
billion euro order books within two hours of book-building. At the guidance of 73bp–75bp over mid-swaps, the
euro portion was four times covered and at Gilts plus 110bp–112bp, the sterling tranche was five times
covered. Although the issuer lost a number of accounts in the euro transaction at the final pricing of plus
73bp, the sterling book had limited price sensitivity at the plus 110bp pricing level, despite the fact that, on a
Libor basis, that was 3bp tighter.
Although there are no direct comparables for the trades, compared with the perpetual non-call 2015 UT2
issue from HBOS (bid at mid-swaps plus 55bp) and insurance Tier 2 from Allianz (perpetual non-call 2017, bid
at 82bp over mid-swaps), AIG conceded only a modest new issue premium.
While the sterling print was unsurprisingly bought mainly by UK asset managers, the euro paper also saw
substantial take-up from the UK, with Germany, France and the Netherlands also prominent. Again, though
participation from asset managers was strong, pension funds, agencies and banks also claimed their share.
While over 200 accounts participated in the euro trade, around 175 investors bought the sterling issue.
The transactions held well in the secondary market, with the sterling deal bid 3bp–4bp tighter and the euro
wrapped around its reoffer level of 97.3bp over Bunds, closing on Friday at 97.5bp–96.5bp.
CVS rings up year's largest

While participants recognised last week's US$5.5bn trade for CVS Caremark as the largest investment-grade
deal this year, the M&A-related offering was also notable for the rare combination of a non-finance hybrid and
multiple senior tranches as the company looks to improve its ratings after a string of major acquisitions.
To gain some equity credit and move towards an eventual ratings goal of Single A, which it possessed before
its acquisition of the Eckerd chain, CVS Caremark issued US$1bn in hybrid securities that carried a 55-year
final tenor, 30-year scheduled maturity, a call option in year five, and a 100bp step-up after the call. "We are
very committed to our credit ratings. This combination of debt and equity improves upon our existing capital
structure and demonstrates our strong desire to maintain and improve upon our investment-grade rating,"
said company spokesman Mike McGuire.
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Although any acquisition totalling US$26.5bn is sure to give potential investors pause for thought, CVS
Caremark's substantial free cashflow, as well as a change of control covenant on the senior tranches,
mitigated some of the risk for investors.
In terms of the pricing, the company and sole active lead Lehman Brothers found the appropriate level on the
10-year senior, and backed into the hybrid level from there. The company has an outstanding 6.125% issue of
2016 that does not have change of control language and was trading in the low 100bp area as the credit re-
entered the market. Five-year protection on CVS Caremark was quoted at a Treasuries equivalent of about
65.75bp, while 10-year protection was quoted with an equivalent bid of 97bp.
Thoughts were that a new five-year senior issue without a change of control would price in the range of
80bp–85bp, and a senior-to-hybrid premium for an industrial credit was estimated to be in the 75bp area. That
placed the US$1bn hybrid offering, which receives 50% equity credit from Moody's, at 155bp over Treasuries.
Although it seems that investor requests for change of control covenants on hybrid deals are set to increase,
CVS Caremark said from the outset that the language would not be included on the hybrid portion .
Considering the 6.125% issue is in the low 100bp area, a new 10-year without a put option was estimated at
115bp over. The US$1.75bn 10-year senior with the change of control then priced at 107bp, for a slight
negative basis to CDS of about 10bp. Although some accounts were said to have employed a negative basis
trade, the amount was not said to be meaningful amid a total order book of more than US$12bn and an
allocation to 220 accounts.
Banks and money market funds were prevalent in the US$1.75bn three-year non-call 18-month floater, which
was priced at three-month Libor plus 30bp and was said to draw multiple orders for US$100m or more. A
variety of investors received allocations in the 10-year issue, while insurance accounts and pension funds had
a strong presence in the US$1bn 20-year issue that was priced at plus 135bp.
The hybrid received interest from insurance accounts, hedge funds and dedicated preferred funds. There was
said to be a decent number of investors that received both senior and hybrid allocations, and some accounts
that were in every tranche offered.
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Table 6.9: US termsheets

Insurance Hybrid Bank Tier 1 Corporate Hybrid
AIG €1bn 4.875% 60 nc 10 Citigroup £500M 6.829% CVS Caremark US$1bn 6.302% 55 nc 5
(issued Mar-07) 60 nc 10 (issued Jun-07) (issued May-07)
Issuer American International Group, Inc. Citigroup Capital XVIII CVS Caremark Corporation
IssuerType Direct SPV Direct
SecurityType Series A-3 Junior Subordinated Fixed Rate/Floating Rate Enhanced Enhanced Capital Advantaged
Debentures Trust Preferred Securities Preferred Securities
Status / The Junior Subordinated The Issuers obligations are subordinated The Issuers payment obligation under
Subordination Debentures will be unsecured and and junior to all senior indebtedness of the ECAPS will be unsecured and
will rank junior in payment to all Citigroup. Senior indebtedness will not subordinated and will rank junior to all
existing and future senior debt, include any indebtedness that is senior indebtedness and will rank
pari passu with the US$ and GBP subordinated to or ranks equally with equally with any pari passu securities.
Debentures, and will be effectively the junior subordinated debt securities.
subordinated to all subsidiary
level liabilities.
Maturity 15-Mar-2067 28-Jun-2067 1-Jun-2062
(scheduled 15-Mar-2037) (scheduled 28-Jun-2037) (scheduled 1-Jun-2037)
First call date 15-Mar-17 28-Jun-17 1-Jun-12
Step-Up at first 100bps (March-2017) 100bps (June-2037) 100bps (June-2012)
call date
Early Redemption Yes (Tax Event/Rating Agency Yes (Tax Event/Investment Company Yes (Tax Event/Rating Agency Event).
Event/Additional Amounts Event). Event/Rating Agency Event/Regulatory ECAPS redeemed at the higher of
Debentures redeemed at the CapitalEvent/Additional Amounts Event). principal orT+50 (within 90 days after a
higher of principal or Bunds+50 Securities redeemed at principal amount Tax Event/Rating Agency Event), or at
(Tax Event/Rating Agency Event), (Investment Company Event/Regulatory the higher of principal orT+25 (not
or at their principal amount Capital Event/Additional Amounts Event), within 90 days after a Tax Event/Rating
(Additional Amounts Event). or at the higher of principal or G+50 (Tax Agency Event).
Issuer option to redeem securities Event/Rating Agency Event). Issuer
at any time, at the higher of option to redeem securities at any time,
principal or Bunds+25. at the higher of principal or G+20.
Redemption subject to prior consent of
the Federal Reserve.
Replacement Replacement Capital Covenant - Replacement Capital Covenant - Replacement Capital Covenant -
Clause replacement with common stock, replacement with common stock, replacement with common stock, rights
rights to acquire common stock, debt exchangable for common stock, to acquire common stock, mandatorily
mandatorily convertible preferred rights to acquire common stock, and/ convertible preferred stock, debt
stock, debt exchangeable for or mandatorily convertible preferred exchangeable for equity and certain
equity, or certain qualifying stock before June-2047. qualifying capital securities before
capital securities before June-2047.
March-2047.
Dividend Pusher/ Dividend Stopper Dividend Stopper Dividend Stopper
Stopper
Regulatory Event n/a Supervisory Event. Payment/APM may n/a
be restricted by the Fed.
Optional Deferral Interest payments optionally Interest payments optionally deferrable. Interest payments optionally
deferrable. Maximum 10-year Maximum 10-year deferral period. deferrable. Maximum 10-year deferral
deferral period. Deferred Deferred payments to be settled via period (cumulative). Deferred
payments to be settled via cash cash/ACSM (first 5-years) or ACSM payments to be settled via cash.
(first 5-years) or ACSM (next 5 years). Deferred payments not settled after 10
(next 5 years). years will constitute an event of default.
Rating agency n/a n/a n/a
mandatory deferral
Deferred payments Cumulative - first 5 years/ Non-Cash Cumulative Cash Cumulative
Non-Cash Cumulative -
next 5 years.
ACSM Settlement of deferred interest Settlement of deferred interest payments n/a
payments via APM - common via APM - common stock (180m share
stock (100m initial limit), limit)or qualified warrants. Issuer shall
qualifying warrents (100m initial use commercially reasonable efforts to
limit) and qualifying non- settle deferred payments. Deferred
cumulativepreferred stock (25% payments not settled after 10 years will
limit). Issuer shall use constitute an event of default. Issuer
commercially reasonable efforts option to utilise APM in first 5 years via
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to settle deferred payments. issaunce of common stock.

Deferred payments not settled
after 10 years will constitute an
event of default. Issuer subject to
APM in first 5 years if current
interest paid (2% limit on
issuance of common stock/
qualifying warrents).
Additional Bankruptcy/insolvency claim for
features/ deferred/unpaid interest
comments payments limited.
161
CHAPTER THE FUTURE OF THE HYBRID MARKET
07 Introduction
Looking at the past as precedent one can only realistically expect continued evolution –
‘perpetual change’ – for the hybrid market. There will be even more widespread applications
among issuers and new developing investor markets.
From the early niche applications for a variety of preferred stock securities to the highly specific
tax-efficient hybrid capital security structures of today, the asset class has morphed and evolved to
meet the needs of an ever wider universe of issuers and investors alike.
Market conditions, global economics and the business credit cycle will play a role in the demand
for hybrid capital securities. As has been discussed, new issue volumes surged when equity
features became cheap for issuers in a low rate, tight credit spread environment. These conditions
also facilitate M&A activity which has been a catalyst for hybrid issuance as an equity-rich
enhancement to the consolidating companies’ capital structures post-merger.
For the same reasons investors were driven in their quest for yield to buy ‘riskier’ structures –
initially only from strong rated, regulated entities and later stretching to lower rated, unrated,
and unregulated issuers.
However, the product development road map is not a smooth linear progression and rather tends
to proceed in a ‘stair step’ fashion with bursts of innovation followed by an integration period
when innovation becomes more marginally incremental and hybrid products begin to
commoditise.
Growing the investor base

For investors this commoditisation can be an advantage, as less energy is required to track and
evaluate product structural nuances within the hybrid security asset class and investors’ focus can
be concentrated on the investor’s core competence of credit analysis.
Another benefit of more standardised structures is the ability to develop hedging products such
as PCDS. The ability to hedge the risks in a hybrid portfolio on an efficient basis is vital to the
expansion of the institutional market. PCDS is still new in the US where it originated and has a
promising future globally. Ideally, investors in the future would be able to buy/sell payment risk,
extension risk, and subordination individually or in a bundle to fine-tune their risks.
Because the US has a comparatively large and homogenous pool of hybrid securities, innovations
such as the hybrid CDO have flourished first in the US before export to global markets where
local jurisdictional differences defy standardisation. Through these structures a pool of smaller
hybrid issues (i.e. US$10–50m each) are aggregated into a pool with critical mass to provide a size
attractive to institutional investors (US$300–500m or more). These smaller issues might not be
able to generate investor demand at reasonable issuer pricing on their own but can be placed in
the CDO on an attractive basis.
A further benefit of the hybrid CDO is that the pooled cash flows can be structured to provide
tranches of securities with a range of ratings from triple A senior (higher than the individual
securities input) down to the CDO ‘equity’ tranche – thereby creating more investor choice.
This technology has spread and can be expected to continue to provide benefits to issuers and
investors alike, but it works best when the securities input to the CDO have enough structural
similarity in features so that the CDO cash flow modelling can be reasonably completed to
estimate the expected risk of the tranches in accordance with rating agency guidelines for
CDO structuring.
So commoditisation can actually help the product proliferate and become more liquid and readily
tradable in the major global markets.
Additionally, however, there can be unique local markets that provide extremely attractive
capital raising opportunities for well known issuers in their home national markets. It can be
expected that these choices will increase as global markets develop.
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For many years the US retail investor market has provided attractive funding to issuers that can
meet the SEC registration disclosure requirements. In the past several years the Asian and
European RPB markets have developed in a similar fashion and at times provide extremely
attractive opportunities. In all these markets strong name recognition is key, therefore local
players tend to get the best execution. As the capital markets of Asia, Eastern Europe and the
Middle East continue their rapid development, the wealthier investors will look to hybrids for a
portion of their investment portfolios.
The institutional market generally provides larger size and at times more sure execution but the
RPB markets are continuing to expand and should always be considered as an alternative.
Occasionally the turmoil suffered in the institutional markets is not spilled over into the RPB
market and it can provide the only alternative for funding, as was seen during the market turmoil
in August 2007 when the only hybrid deals being completed were in the US retail market.
New and emerging investor jurisdictions around the world look set to continue to deepen and
support new hybrid supply. This will be particularly relevant going forward for domestic issuance
in those jurisdictions where smaller issuers will be able to benefit from local name recognition
(jurisdictions such as the Middle East have already provided for a significant amount of subordi-
nated private domestic issuance). The expansion of investor jurisdictions will also allow for new
cross-border transactions, providing for some issuers attractive diversification away from the
more traditional US and European markets (the Canadian and Australian markets have recently
opened for this reason).
Expansion of the issuer pool

Issuers across the world will increasingly take advantage of new structural innovations, with new
techniques continuing to develop and providing issuers with more reasons to issue. This will
enable issuers from more sectors to better optimise their balance sheets and gain maximum
benefits from the rating agencies, investors, regulators or other key constituents.
Issuers particularly focused on liability management are also likely to increase interest in the
product, with the flexible and innovative nature of hybrid securities ideally suited to the process.
It looks certain, therefore, that hybrids will increasingly become a standard product in the
market, both for corporates and for regulated banks and insurers.
More frequent cross-border issuance has been seen by issuers of hybrids, as they seek to diversify
their international investor bases and create new pools of demand that can be tapped at will or as
opportunities present themselves, thereby minimising reliance on any one market. Ability to
issue in a variety of currencies also allows for funding global expansion on a currency-hedged
basis – including hybrids.
There has been a marked increase in lower rated and unrated issuers as the market expands to
seek new issuer names for investor portfolio diversification. This trend will continue and more
issuers from more sectors and more geographies will enter the international markets and seek to
develop local markets in their home jurisdictions. As shown in Table 7.1, there are an increasing
number of jurisdictions that are tapping the hybrid market more frequently.
Tax, accounting, rating agency and regulatory

The stair steps of progress can of course go up or down. Continued developments at the rating
agencies and regulators will also drive structuring innovation forward, even if a less accommodat-
ing stance from any of these constituents were to develop. Any change from one of the currently
supportive constituents (tax, accounting. rating agencies, regulators, others) could reduce
issuance even while structural modifications flourish to patch up the holes.
The deductibility of US Trust Preferred Securities was questioned by the last Clinton administra-
tion – hopefully for the last time. However, the ability to work around the very restrictive US tax
rules on maximum debt maturity was a key factor in the development of recent high equity
content hybrids in the US. Any future attack on hybrids could limit the availability of these
structures and set off a new wave of hybrid structuring. In the past the hybrid market has been
able to adapt to overcome these threats.
Issuers and investors alike were stunned when the NAIC unpredictably turned negative on the
perceived investor risk of some hybrid structures that had been in the market for years. These
shocks have a major impact on the hybrid market but still it moves forward.
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The implementation of IFRS accounting rules caused a series of structural revisions in hybrid
issuance and the impact of hedge accounting required new thinking about the implications of
swapping hybrid proceeds at issue. Again the hybrid market was resilient and moved ahead.
While rating agencies have been one of the most significant drivers of recent growth in issuance
and structural refinements they have also created some shocks by changing or ‘considering’
changes to their still young hybrid methodologies.
Some potential corporate issuers are hesitant to pursue hybrid issuance for fear the currently
touted benefits could be easily eliminated if the rating agencies were to make a policy or
methodology change for the worse over the next 10 years (before the typical first scheduled call
date of a hybrid). This concern is reflected in the documents of recently completed hybrid transac-
tions which provide for optional early redemption if issuer benefits are lost due to tax,
accounting, regulatory and rating agency rules. The current batch of next generation corporate
hybrids rely on the guidelines of today – what about the next generation of rating agency
executives? It can be hoped they will recognise the need for affirming the longevity of their
methodologies, but it is likely that issuers will continue to seek flexibility by including early
redemption options in their hybrids.
The development of Basel ll and Solvency ll should be positive for regulated financial institutions
who will potentially benefit from lower capital requirements (as diversified asset risk is better
understood) and the global regulators try once again to level the playing-field regarding available
capital instruments.
Conclusion
In conclusion, the rate of change may vary for structural innovation and the new issue volumes
will wax and wane over time but the continued use of hybrid capital securities in the capital
structures of sophisticated issuers seems assured for the foreseeable future.
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Table 7.1: Select new entrants to the hybrid capital market

Nationality of risk Issuer Issue date (yr) Currency Tranche value Coupon
Brazil BANESPA 2005 US$ 500 8.7000
Hong Kong Swire Pacific Capital Ltd 1997 USD 300 8.8400
India State Bank of India 2007 US$ 400 6.4390
India ICICI Bank Ltd 2006 US$ 340 7.2500
India State Bank of India (Nassau) 2007 US$ 225 7.1400
India State Bank of India 2007 US$ 225 7.1400
India UCO Bank Ltd 2006 RUP 2,300 9.3500
Kazakhstan BTA Finance Luxembourg SA 2006 US$ 400 8.2500
Kazakhstan ALB Finance BV 2006 US$ 150 9.3750
Kazakhstan Kazkommertsbank OAO 2005 US$ 100 9.2000
Malaysia Syarikat Prasarana Negara Bhd 2002 M$ 1,000 3.7000
Malaysia Public Bank Bhd 2006 M$ 1,200 5.1000
Malaysia SBB Capital Corp (Labuan) 2005 US$ 200 6.6200
Malaysia AMBB Capital (L) Ltd 2006 US$ 200 6.7700
Malaysia Public Bank Bhd 2006 US$ 200 6.8400
Mexico C10-EUR Capital Ltd 2007 EUR 730 6.2770
Mexico C10 Capital Ltd 2006 US$ 900 6.7220
Mexico BBVA Bancomer SA (Grand Cayman) 2007 US$ 500 6.0080
Mexico Cemex International Capital LLC 1998 US$ 250 9.6600
Mexico Banorte (Cayman Islands) - Banco Mercantil 2006 US$ 200 6.8620
Mexico Banco Macro SA 2006 US$ 150 9.7500
Mexico Metrofinanciera SA de CV 2006 US$ 75 11.2500
Mexico Metrofinanciera SA de CV 2006 US$ 25 11.2500
Philippines Metropolitan Bank & Trust Co - Metrobank 2006 US$ 125 9.0000
Philippines Development Bank of the Philippines 2006 US$ 130 8.3750
Philippines Rizal Commercial Banking Corp - RCBC 2006 US$ 100 9.8750
Singapore DBS Capital Funding Corp 2001 US$ 725 7.6570
Singapore Development Bank of Singapore Ltd 2001 S$ 1,100 6.0000
Singapore UOB Cayman I Ltd 2005 US$ 500 5.7960
Singapore Oversea-Chinese Banking Corp Ltd 2003 S$ 500 4.5000
Singapore OCBC Capital Corp 2005 S$ 400 3.9300
Singapore OCBC Bank (Malaysia) Bhd 2005 M$ 400 6.2700
Singapore DBS Capital Funding Corp 2001 S$ 100 5.3500
South Africa Investec plc 2005 EUR 150 7.0750
South Korea Woori Bank 2007 US$ 6.2080
South Korea Shinhan Bank 2006 US$ 350 6.8190
South Korea Korea First Bank 2004 US$ 300 7.2670
South Korea Shinhan Bank 2005 US$ 300 5.6630
South Korea Hana Bank Funding Ltd 2002 US$ 200 8.7480
Taiwan Chinatrust Commercial Bank Ltd 2005 NTD 9,000 3.3500
Taiwan Chinatrust Commercial Bank Ltd 2005 NTD 3,000 3.3500
Thailand Krung Thai Bank Ltd (Singapore) 2006 US$ 220 7.7380
Thailand TMB Bank pcl 2006 US$ 200 7.7500
166
APPENDIX TAX DEDUCTIBLE EQUITY AND OTHER
HYBRIDS IN THE US – A BRIEF HISTORY
01 AND CURRENT DEVELOPMENTS
By Thomas A. Humphreys1, Morrison & Foerster LLP
Anyone looking at the tax treatment of US hybrid securities transactions for the first time would
be understandably confused. There is no one simple, completely reliable way to create a tax
deductible US hybrid. Instead, US issuers are installing billions of dollars of hybrids in their capital
structures that are diverse, complicated and in a few cases, tax risky. No one structure is
universally accepted. Each structure has a full menu of tax issues.
To understand why the US hybrid market operates this way the reader must understand the brief
history of US hybrid transactions – the first part of this article. Only then will the US system, in all
its grand complexity, begin to make sense. The second part of this article then explores current
developments in the US hybrid market from a US tax perspective.
Early attempts to create deductible equity

US taxpayers have for many years tried to create tax deductible equity. The most relevant history,
however, begins in the 1980s, a time of great turmoil for US financial institutions. The story
begins with a published Internal Revenue Service (IRS) ruling sought by desperate bankers to help
shore up US bank capital during these turbulent times.
Revenue Ruling 85-119

In the early 1980s US banking regulators adopted their first capital requirements for banks and
bank holding companies. Among the instruments that qualified for primary capital treatment
were ‘mandatory exchangeable securities’. Revenue Ruling 85-119 dealt with one such security
issued by a bank holding company (BHC). The instrument was denominated as debt. It had a 10-
year term. If interest was not paid, the debt was not accelerated, the holder could only sue for the
defaulted interest. At maturity, the issuer paid the holder with primary capital securities
(common or preferred stock) with a value equal to the debt instrument’s face amount. The holder
could either take the stock or have the issuer sell it on the holder’s behalf. In the latter case, the
sales proceeds would be paid to the holder. A shortfall gave the holder a right to sue for the
difference.
The IRS held that the instrument was debt for federal income tax purposes. The holder’s weak
remedies did not pose much of an issue according to the ruling. While the ‘payable in equity’
feature gave the government more pause, the ruling reasons that the holder always had an
ultimate debt claim and therefore was entitled to principal payment in all events.
The mid-1980s were as bad for the banking business as the late sixties and early seventies were
for the securities business. Penn Square Bank went bankrupt in 1982 and, soon after rumours of
its impending bankruptcy, Continental Illinois was bailed out by federal regulators in 1984. One
suspects it is not a coincidence that the government decided that lowering the cost of capital by
granting a tax deduction is a cheap price to pay for shoring up the nation’s bank holding
companies2. Unfortunately, the markets did not accept mandatorily convertible securities and
only a handful of transactions were actually done. Nevertheless, it is apparent today that the debt-
equity line moves farther towards debt when a regulated industry is in financial distress.
1 © 2007, Thomas A. Humphreys

2 Rev. Rul. 83-98, 1983-2 C.B. 40, involving adjustable rate convertible notes (ARCNs), shows the IRS’s relatively less
favourable treatment of non-regulated taxpayers in the same time frame as Revenue Ruling 85 119, 1985-2 C.B. 60. An
ARCN was a 20-year debt issued by a corporation. The debt was subordinated to general creditors. It was issued for
US$1,000 or 50 shares of issuer’s publicly traded common stock (which had a US$20 per share price). At maturity, the
holder could elect to receive US$600 or 50 shares of stock. It paid interest equal to dividends on the underlying common;
the issuer’s comparable yield for non-convertible, non-contingent debt was 12%. Revenue Ruling 83-98 holds that the
ARCNs are equity for federal income tax purposes. The ruling is based on the notion that there was no sum certain payable
because of the “very high probability” that the ARCN would be converted into stock. This, in turn, was based on the deep-
in-the money nature of the conversion feature. The IRS discounted the fixed principal and fixed interest on the ARCNs on
the basis that buyers did not given them any value – the ARCNs were sold for a price equal to that of the underlying
common stock. According to the IRS, Revenue Ruling 68-54, 1968-1 C.B. 69 was “fundamentally different” because there
was an obligation to pay a sum certain on a given date and although interest was dependent to some degree on the issuer’s
earnings, it was not tied to dividends and the notes were not convertible.
167
APPENDIX 01
MIPS, etc.
The first MIPS transaction was done by Texaco Corporation in 1993. Texaco had gone bankrupt in
1987. In the MIPS transaction Texaco set up Texaco Capital LLC, a Turks and Caicos limited life
company (The Company). The Company issued US$25 par value ‘Cumulative Adjustable Rate
Monthly Income Preferred Shares, Series A’ to investors. It issued common securities to Texaco.
The Company then made a 50 year subordinated loan to Texaco. In a new feature, not previously
seen in the debt markets, Texaco had the right to defer interest payments on the subordinated
loan for 18 months without a default occurring. If Texaco deferred interest for more than 18
months then a default was declared and the subordinated loan was accelerated. The subordinated
loan was extendable by Texaco for another 50 years but only if certain conditions were met. These
financial conditions, while objective, were not very stringent.
The net effect of the transaction was that Texaco was able to deduct interest on the subordinated
loan. The Company was treated as a partnership for federal income tax purposes. Accordingly, the
partnership itself did not pay tax. Instead its income was allocable to the preferred security
holders and to Texaco. For GAAP accounting purposes, Texaco consolidated the results of the
Company with its own because it controlled the Company through its common securities. The
accountants treated the preferred securities as a ‘minority interest’ on Texaco’s balance sheet.
Accordingly, they were not shown as debt. The rating agencies apparently gave the MIPS
substantial equity credit.
The Texaco transaction was followed in short order by a transaction by Enron Corporation, then a
newly emerging oil and gas powerhouse.3 By the spring of 1994, the MIPS security was gaining
acceptance in the market place. It is not coincidental that at this point the IRS issued Notice 94-
47.4 This Notice discusses various debt equity factors and then sets out some markers for
taxpayers. It remains the most recent published guidance by the IRS on the factors used to weigh
debt versus equity. It has been cited by the courts, although not frequently.5
The next development was the issuance of preferred securities by a grantor trust. This solved
what had been a nagging problem – the fact that a MIPS-type partnership was required to give
investors Schedule K-1s. Investors in the preferred securities associated K-1s with partnership tax
shelter investments. In addition the K-1 rules require reporting to the ultimate beneficial owner
in a manner that can be quite expensive.6
In the prototypical ‘trust preferred’ transaction, the end-user creates a Delaware statutory trust.
The trust issues two classes of beneficial ownership: preferred securities and common securities.
The preferred securities are perpetual on their face; however, they must be retired if the
underlying subordinated loan is retired. The preferred securities are senior to the common upon
the trust’s liquidation. The trust invests the proceeds of the trust preferred offering in a subordi-
nated, long-dated (e.g. 49 year) debt issued by the end-user. Interest on the debt instrument can be
deferred, usually for up to five years, without default. As in a MIPS, from a federal income tax
standpoint, interest on the subordinated loan is deductible. The trust is a grantor trust for federal
income tax purposes and its income does not attract a separate tax.7
The next milestone in the development of deductible equity was a Federal Reserve Board an-
nouncement in October 1996.8 The Federal Reserve Board held that trust preferred securities
could be counted as Tier 1 capital9 for a BHC so long as certain requirements were met.10 Since
1996 the BHC market has seen billions of trust preferred issuances. One of the more recent
innovations is to pool trust preferreds issued by smaller banks or bank holding companies. These
transactions, which are arranged by investment banks, allow smaller issuers to obtain the same
benefits of trust preferreds as larger issuers. Importantly, none of the other US bank regulators
have been comfortable that trust preferreds should be counted as Tier 1 capital. For example, the
Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC)
and Office of Thrift Supervision (OTC) all treat trust preferreds as Tier 2 capital. Therefore, at the
bank level, as opposed to the BHC level, trust preferreds have been of little use.
3 LEE A. SHEPPARD, IRS ATTACKS ENRON MIPS, TAX NOTES TODAY, 98 T.N.T. 104-4 (June 1, 1998).
4 I.R.S. Notice 94-47, 1994-1 C.B. 357.
5 The most recent citation was in Castle Harbour, TIFD III-E Inc. v. United States, 342 F. Supp. 2d. 94 (2004), where the court
used the factors in Notice 94–47 to conclude that an interest held by Dutch banks was in reality equity, rather than debt, a
taxpayer-friendly finding on the facts of the case.
6 See I.R.C. § 6031; see also DEPARTMENT OF THE TREASURY AND INTERNAL REVENUE SERVICE, INSTRUCTIONS FOR
FORM 1065 available at http://www.irs.gov/pub/irs-pdf/i1065.pdf.
7 Treas. Reg. § 301.7701-4(c), Example 2.
8 Press Release, Federal Reserve Board, Use of Cumulative Preferred Stock in Tier 1 Capital of Bank Holding Companies
(October 21, 1996) [hereinafter FRB 1996 Press Release] available at
http://www.federalreserve.gov/boarddocs/press/bcreg/1996/19961021/default.htm.
9 See the discussion at III. C.
10 FRB 1996 Press Release
168
APPENDIX 01
Prior to the Federal Reserve Board’s press release at least one other approach was taken to develop
deductible equity. In the best known transaction, Chase Manhattan Bank formed Chase Preferred
Capital Corporation (CPCC) as a subsidiary. CPCC qualified as a real estate investment trust (REIT)
for federal income tax purposes. CPCC sold US$550m of preferred stock to the public. It used the
proceeds to buy real estate mortgages from Chase. The preferred stock was perpetual and
cumulative. This structure achieved the same results as deductible equity because the income
stream on the mortgages was paid out by the REIT without a corporate level tax. Chase treated the
CPCC preferred stock as a minority interest and as Tier 1 capital of the bank. A handful of similar
transactions have been done since the Chase transaction.
Treasury department and legislative responses

The Treasury Department’s administrative response to the proliferation of deductible equity has
been a measured one.11 In Notice 94-4712 the IRS set out familiar factors to distinguish debt from
equity and added a few new ones to the mix including treatment by rating agencies and
treatment for accounting purposes.13 It posted an ‘off-limits’ sign around certain transactions and
warned that taxpayer attempts to expand Revenue Ruling 85-119 beyond its current scope was
not advisable.
On the legislative front, while there has been plenty of talk about curbing deductible equity,
relatively little legislation has actually been enacted. In 1992, Congress did add a consistency rule
in subsection 385(c) of the Internal Revenue Code of 1986, as amended (‘the Code’).14 This bound
the issuer and holders (but not the IRS) to an issuer’s characterization of a corporate interest as
stock or debt. Holders may take an inconsistent position so long as the inconsistency is disclosed
on their tax returns. Congress recognised that there was (and is) no definition in the Code that can
be used to determine whether an interest in a corporation is debt or equity for federal tax
purposes.15 However, instead of taking the opportunity to create one, Congress instead opted for
this administrative rule.
Next, several Clinton Administration budget proposals included proposed changes that would
have limited the tax benefit of hybrid securities. The first budget proposal was the Clinton
Administration’s proposed plan for a balanced budget which was initially released on 7 December
1995. All of the tax proposals in this budget proposal were reintroduced later in January 1996,
March 1996, and February 1997.16 Since 1997, the Treasury has also re-proposed deferring
interest deductions for ‘original issue discount’ on certain convertible debt instruments.17
11 This may reflect the government’s wariness over divining debt-equity questions since withdrawal of the I.R.C. § 385
regulations.
12 I.R.S. Notice 94-47, 1994-1 C.B. 357.
13 The Notice 94-47 factors are:
(i) Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed
maturity date that is in the reasonably foreseeable future
(ii) Whether holders of the instruments possess the right to enforce the payment of principal and interest;
(iii) Whether the rights of the holders of the instruments are subordinate to the rights of general creditors;
(iv) Whether the instruments give the holders the right to participate in the management of the issuer;
(v) Whether the issuer is thinly capitalised;
(vi) Whether there is identity between the holders of the instruments and stockholders of the issuer;
(vii) The label placed on the instruments by the parties;
(viii) Whether the instruments are intended to be treated as debt or equity for non-tax purposes.
14 Energy Policy Act of 1992, Pub. L. No. 102-486, § 1936, 106 Stat. 2776 (1992).
15 H.R. REP. NO. 102-1018 (1992).
16 See, e.g., STAFF OF THE JOINT COMMITTEE ON TAXATION, 104th CONG., DESCRIPTION OF THE TAX AND HEALTH
INSURANCE REFORM PROVISIONS IN THE PRESIDENT’S SEVEN-YEAR BALANCED BUDGET PROPOSAL RELEASED ON
DECEMBER 7, 1995 (JCX-58-95) at 64-65 (1995); H.R. 2903, 104th Cong. (1996); STAFF OF THE JOINT COMMITTEE ON
TAXATION, 104th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1997
BUDGET PROPOSAL (RELEASED ON MARCH 19, 1996) (JCS-2-96) at 64-65 (1996); STAFF OF THE JOINT COMMITTEE ON
TAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1998
BUDGET PROPOSAL (JCX-6-97R) at 53-54 (1997).
17 See, e.g., Office of Management and Budget, Analytical Perspectives, Budget of the United States Government, Fiscal
Year 1999, at 69, available at http://www.gpoaccess.gov/usbudget/fy99/pdf/spec.pdf; see also, STAFF OF THE JOINT
COMMITTEE ON TAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S
FISCAL YEAR 1999 BUDGET PROPOSAL (JCS-4-98) at 143-144 (1998).
169
APPENDIX 01
The first of these proposed tax changes would have disallowed interest and original issue discount
deductions for issuers of a debt instrument (i) with a weighted average maturity of more than 40
years, or (ii) which is payable in the stock of an issuer or a related party (within the meaning of
sections 267(b) and 707(b) of the Code).18 A debt instrument that is payable in equity of the issuer
or a related party included an instrument that would be (a) mandatorily convertible, (b)
convertible at the issuer’s option, or (c) convertible at the holder’s option if there was a
substantial certainty that it would be converted into the issuer’s (or a related party’s) equity.19
While this proposal originally only excluded demand loans, the 1997 version of this proposal also
excluded redeemable ground rents and certain other specified debt instruments.20
The second proposed change would have deferred interest deductions in the case of certain
convertible debt instruments until the interest was actually paid.21 This, in essence, would have
been an expansion of the ‘applicable high yield discount obligation’ limitations of Code sections
163(e)(5) and 163(i).
Third, for purposes of section 385 of the Code, equity treatment would have been given to
corporate interests that (i) had a term of more than 20 years and (ii) were not shown as debt on
the issuer’s balance sheet.22 This proposal was reintroduced several times and the term was
lowered from 20 to 15 years in the Clinton Administration’s budget proposal for fiscal year
1998.23
Of these legislative tax proposals, only one, the non-deductibility of interest on debt payable in
stock, was adopted by the Taxpayer Relief Act of 1997 and became effective as Code section 163(l)
on 9 June 1997.24 That section provides that interest on debt payable in equity is not deductible
for federal income tax purposes. The section is so broad that it arguably encompasses the fact
pattern in Revenue Ruling 85-119 where, although the debt was payable in the issuer’s equity, the
holder had a claim if the amount of issuer’s stock was insufficient to repay the debt instrument.
The IRS also weighed in on MIPS during an audit of a taxpayer (apparently Enron) in 1998. This
resulted in the issuance of Technical Advice Memorandum 199910046 (15 March 1999). The TAM
held that the issuer can deduct interest on a MIPS-like security. This TAM joins the ranks of other
heavily negotiated technical advice memoranda and bears the earmarks of a TAM where
substantial advice was solicited from or provided by market participants.
Congress briefly reawoke after the Enron scandal and again began looking at deductible equity
simply because Enron had been one of the early MIPS issuers.25 However, this effort went
nowhere. The only tax remnant of the anti-Enron sentiment were amendments to Section 163(l)
to expand its scope to debt payable in stock of unaffiliated parties held by the issuer or a related
party.26
18 See STAFF OF THE JOINT COMMITTEE ON TAXATION, 104th CONG., DESCRIPTION OF THE TAX AND HEALTH
INSURANCE REFORM PROVISIONS IN THE PRESIDENT’S SEVEN-YEAR BALANCED BUDGET PROPOSAL RELEASED ON
DECEMBER 7, 1995 (JCX-58-95) at 64 (1995).
19 Ibid. at 64.
20 STAFF OF THE JOINT COMMITTEE ON TAXATION, 105th CONG., DESCRIPTION OF REVENUE PROVISIONS CONTAINED
IN THE PRESIDENT’S FISCAL YEAR 1998 BUDGET PROPOSAL (JCX-6-97R) at 54 (1997).
21 See Staff of the Joint Committee on Taxation, 104th Cong., supra note 18 at 65.
22 Ibid. at 64.
23 See, e.g., STAFF OF THE JOINT COMMITTEE ON TAXATION, 105th CONG., DESCRIPTION AND ANALYSIS OF CERTAIN
REVENUE-RAISING PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 1998 BUDGET PROPOSAL (JCS-10-97) at
54 (1997). In addition, the Taxpayer Relief Act of 1997 added a rule that certain ‘debt-like’ preferred stock would be treated
as ‘boot’ for purposes of sections 351 and 356 of the Code, which would result in taxable gain but no loss to the recipient
of such stock in transfers to controlled corporations and tax-free reorganisations. This rule applies if (a) the holder of such
stock has the right to put the stock to the issuer or a related party, (b) such stock is mandatorily redeemable by the issuer
or a related party, (c) the issuer or a related party has the right to call the stock and such right is more likely than not to be
exercised, or (d) such stock has a floating dividend rate.
24 Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1005, 111 Stat. 788 (1997).
25 John D. McKinnon and Greg Hitt, How Treasury Lost In Battle to Quash A Dubious Security --- Instrument Issued by
Enron and Others Can be Used as Both Debt and Equity --- Win for Flotilla of Lobbyists, WALL STREET JOURNAL, February
4, 2002, at A1.
26 Taxpayer Relief Act of 1997, supra note 24.
170
APPENDIX 01
Regulatory developments
As noted previously, the FRB decided in 1996 to treat ‘trust preferred’ securities as Tier 1 capital,
subject to a limit equal to 25% of a BHC’s Tier 1 capital.27 The FRB guidance treated such
instruments as Tier 1 capital so long as they (i) were subordinated to all subordinated debt, (ii) had
the longest feasible maturity, and (iii) provided for a minimum five year deferral period. As “with
other preferred stock includable in capital” according to the FRB, FRB approval was required
before the instrument could be redeemed. It appears that the most important feature to the FRB
was the five year interest deferral, the thought being that a financial institution would either be
bankrupt or recovered in five years.
In 1998, the Basel Committee issued its own press release dealing with ‘innovative capital
instruments’. The press release was apparently a response to developments in the market for
bank capital both in the US (such as trust preferreds) and outside the US28 For example, various
European issuers had issued preferred stock out of tax haven subsidiaries in order to avoid
withholding taxes in their home country.29 Apparently concerned that a bank would convert a
substantial amount of its capital structure into these ‘efficient’ instruments, the press release
stated that common stock and disclosed reserves or retained earnings should be the predominant
form of Tier 1 capital.30 The press release also reminded banks that transparency in terms of the
components of Tier 1 capital was required. Most importantly, the press release focused on
instruments such as trust preferreds and stated that such instruments should be included in Tier
1 capital only to the extent they met certain criteria including permanence, deferability of distri-
butions on a non-cumulative basis and ability to absorb losses within the bank on a going concern
basis. The press release also dealt with one other feature: rate step-ups. It stated that a Tier 1
instrument could include a rate step-up after 10 years but that instruments with such a feature (or
any other that might lead to early call) would be limited to 15% of Tier 1 capital. Outstanding
instruments that violated the tenants of the press release were grandfathered.31
The Federal Reserve Board then responded the same day by issuing its own press release that
affirmed its treatment of trust preferred in light of the Basel Committee’s press release.32
In 1998, the Basel Committee adopted amendments to Basel I in the so-called Sidney
Agreement.33 The Sydney Agreement stated that internationally active bank holding companies
generally would be expected to limit restricted core capital elements to 15% of the sum of core
capital elements, net of goodwill. Prior to the Sydney Agreement, the FRB was informally
encouraged bank holding companies to comply with this standard even though no formal rule
was in place.34
In March, 2005 the Federal Reserve Board amended its risk-based capital requirements to reflect
the Sidney Agreement. At that time, the FRB explained its approach to tax-deductible Tier 1
instruments. It commented that the original 1996 decision on trust preferred had been based on
two key factors: the long life of the underlying debt instrument ‘approaching perpetuity’ and the
‘dividend’ deferral rights (allowing deferral for 20 consecutive quarters) approaching economical-
ly indefinite deferral.35 It noted that those features provide substantial capital support. The FRB
also noted the change in GAAP accounting treatment for trust preferreds,36 but said that “A
change in the GAAP accounting for a capital instrument does not necessarily change the
regulatory capital treatment of that instrument.”37 It went on to state: “Regulatory capital re-
quirements are regulatory constructs designed to ensure the safety and soundness of banking or-
ganisations, not accounting designations established to ensure the transparency of financial
statements.”38
27 FRB 1996 Press Release, supra note 8.

28 See Joyce M. Hansen, Ivan J. Hurwitz and Diane L. Virzera, Capital Regulation and Supervision of International Banking
Organizations, in Regulation of Foreign Banks (Michael Gruson and Ralph Reisner eds., 2003) [hereinafter ‘Capital
Regulation’] at 175.
29 Ibid. at 174.
30 Ibid. at 175.
31 Ibid.
32 Ibid.
33 Federal Reserve System, Risk-Based Capital Standards: Trust Preferred Securities and the Definition of Capital, 69 Fed.
Reg. 28851 at 28853 (May 19, 2004).
34 Ibid.
35 Preamble to Final Regulation (March 1, 2005) [hereinafter FRB Final Rule] available at
http://www.federalreserve.gov/boarddocs/press/bcreg/2005/20050301/attachment.pdf.
36 Ibid.
37 FRB Final Rule, supra note 35 at 4.
38 Ibid.
171
APPENDIX 01
The FRB’s final rule allowed the continued limited inclusion of trust preferred in a BHC’s Tier 1
capital. The FRB considered “its generally positive supervisory experience with trust preferred
securities, domestic and international competitive equity issues, and supervisory concerns with
alternative tax-efficient instruments.”39 The FRB made clear that it is aware of competitive
pressures noting that:
“Approximately 800 BHCs have outstanding over US$85bn of trust preferred securities, the
popularity of which stems in large part from their tax-efficiency. Eliminating the ability to
include trust preferred in Tier 1 capital would eliminate BHCs’ ability to benefit from this tax-
advantaged source of funds, which would put them at a competitive disadvantage to both US and
non-US competitors. With respect to the latter, the Board is aware that foreign competitors have
issued as much as US$125bn of similar tax-efficient Tier 1 capital instruments.”40
The final rule permitted trust preferred to be included in Tier 1 capital but limited to 25% of the
sum of core capital elements. Internationally active BHCs are subject to a limit that trust
preferreds not exceed 15% of the sum of core capital elements. An internationally active BHC is
basically defined as one that has significant activity in non-US markets. The final rule permitted
qualifying mandatory convertible preferred securities to be included in Tier 1 up to a 25% limit.
Finally, the FRB continued to prohibit interest rate step-up provisions in Tier 1 capital
instruments and Tier 2 subordinated debt but dropped a requirement that trust preferred
securities include call provisions.41 The changes were effective, with various grandfathers and
phase-ins beginning 11 April 2005.
Current tax developments
Tax treatment of new (and old) equity-like features

In early 2005, Moody’s Investors Service rolled out refinements to its ‘tool kit’ which sets forth the
various criteria for classification of instruments as equity or debt for ratings purposes.42 In
general, those refinements made it easier for hybrid instruments to be classified as equity for
rating agency purposes. Since that development, issuers have been developing new hybrid
features in order to get the highest possible rating agency equity credit while still maintaining a
tax deduction. These new features include mandatory deferral, replacement covenants, longer
maturities, scheduled maturities, and interest caps.
Mandatory deferral
One of the features of some current hybrids is mandatory deferral of interest payments. As seen
previously, a typical trust preferred provides for five year optional deferral of interest. If the
obligor continues to defer interest beyond the five year period then, in most cases, a default
occurs. The problem with optional deferral is that the rating agencies believe there may be
outside factors that influence whether optional deferral is exercised.43 Therefore, in effect, there
is still an obligation to make ongoing payments on the instrument.
A mandatory deferral feature, on the other hand, must be exercised. A typical mandatory deferral
feature provides that if the obligor fails certain financial tests, then distributions on the
instrument must be suspended.44 There are various types of financial covenants, for example,
whether the issuer has suffered net losses for a sustained period or if the issuer’s leverage ratio
increases above a certain threshold. The mandatory triggers are designed to give the issuer some
latitude, if they are too tight then they may cause the very problem they are designed to cure.45
On the other hand, they cannot be so loose that the issuer is on the brink of bankruptcy when the
trigger occurs.46
39 Ibid. at 6.
40 Ibid. at 7.
41 Ibid. at 14.
42 NEW INSTRUMENTS STANDING COMMITTEE, MOODY’S INVESTORS SERVICE, RATING METHODOLOGY – MOODY’S
TOOL KIT: A FRAMEWORK FOR ASSESSING HYBRID SECURITIES [hereinafter MOODY’S TOOL KIT] (1999).
43 See MOODY’S TOOL KIT, supra, note 42 at 5-6.
44 For example, a recent Burlington Northern Santa Fe Corporation (BNSF) (NYSE:BNI) trust preferred offering, the BNSF
Funding Trust I (the Trust) uses the proceeds from the sale of its trust preferred securities to purchase junior subordinated
notes (the Notes) issued by BNSF. In addition to a discretionary interest deferral feature, the Notes provide that BNSF will be
prohibited from paying interest, except from the net proceeds of certain sales of its common stock and/or qualifying
preferred stock, in certain circumstances such as when for the preceding three calendar quarters, the total leverage of BSNF
is more than 5:1 or if BSNF’s interest coverage is less than 2:1. See BNSF Funding Trust I US$500,000,000 6.613 percent Fixed
Rate/Floating Rate Trust Preferred Securities Prospectus Supplement, Registration No. 333-130214, filed pursuant to Rule
424(b)(5) as of Dec. 12, 2005, available at http://www.sec.gov/Archives/edgar/data/934612/000119312505242274/d424b5.htm.
45 See MOODY’S TOOL KIT, supra, note 42 at 4-5.
46 See STANDARD & POOR’S COMMENTARY REPORT, EQUITY CREDIT FOR BANK AND INSURANCE HYBRID CAPITAL, A
GLOBAL PERSPECTIVE (2006) at 7.
172
APPENDIX 01
Deferral on debt instruments has been one of those unique features that gives the non-tax
audience comfort but does not cause the tax advisor too much pain. There seem to be several
reasons. First, at the end of the deferral period the instrument’s holders still have creditor’s
rights.47 This assists in showing that the ‘intent of the parties’ is that the holders are creditors
rather than equity owners. Second, the deferral feature is analogised to a zero coupon instrument.
The tax advisor reasons that if the issuer could have issued a long-term zero coupon debt then
deferral of five years interest (or 10 years for that matter) is really no worse.48 Of course under
this analysis, the advisor must be comfortable that the issuer’s credit quality is so strong that a 60-
year zero coupon bond would still fall on the right side of the debt-equity line.
Mandatory deferral seems in some ways both better and worse than optional deferral. Depending
on the triggers, it may be better because it takes discretion on the payment of interest out of the
obligor’s hands. Unless the trigger is hit, interest must be paid. Of course if the mandatory
deferral is coupled with optional deferral, which it may be, this argument cannot be made.
Mandatory deferral is worse than optional deferral because its links the instrument more closely
to the issuer’s business fortunes. In this sense it is much like provisions that provide for interest
contingent on earnings of the obligor. While these are not by any means fatal to debt classifica-
tion they are nevertheless negative factors.49
The other feature that may be coupled with mandatory deferral is an obligation on the part of the
issuer to sell additional equity in order to pay interest if mandatory deferral occurs. Thus, in a
typical provision, interest is mandatorily deferred if the trigger is hit but an issuer must continue
to pay interest out of the proceeds of stock sales, if it can sell stock. While this is a little better
than flat out mandatory deferral it would seem that selling stock when the issuer’s financial
fortunes are declining may not be that easy. Again, much depends on the mandatory deferral
trigger. If the issuer will still be rated investment grade even though the trigger is hit, it may well
be possible to sell stock to pay interest. If the trigger is hit on the brink of bankruptcy, the
possibility of selling stock is speculative at best and should be disregarded.
Replacement covenants
Another current rating agency favourite is a replacement covenant. In the base case, ‘replacement
language’ simply says that the issuer will not redeem the instrument unless it does so out of the
proceeds of equal or better equity content securities. If the issuer ignores the replacement
language, the instrument’s holders are not harmed – they are repaid. Instead, the harm is to the
issuer’s senior creditors; however, they are not in privity of contract with the issuer, at least as far
as the replacement language is concerned.
47 These rights may be to sue for the unpaid interest or may be a default that gives the debt holders the right to accelerate
the instrument.
48 See, e.g., Fed. Exp. Corp. v. United States, 645 F. Supp. 1281 (W.D. Tenn. 1986) (Holding that the interest deferral
received “no weight” in determining whether the debentures were debt or equity, because the deferral of interest until
after payment of superior indebtedness does not affect the accrual of that interest or the obligation to repay). See also
William T. Plumb, Jr., The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L.
Rev. 369 (1971), at 603 (“[b]ut if cumulative interest is unconditionally payable at maturity regardless of the sufficiency of
earnings, the interim deferability of the payments, whether or not discretionary, should be given no adverse weight at all”.
Plumb, supra, at 603. A footnote explains: “Since all or part of the obligation to pay interest may be properly deferred until
maturity in the case of bonds issued at a discount, it should make no difference that a part of the ultimately fixed amount
of interest may be paid sooner, on whatever conditions.” Plumb, supra, at n. 1386. Plumb notes that debt equity proposals
of the American Law Institute, the American Bar Association and the Advisory Group would have made it sufficient for a
debt safe harbor provision if interest were payable no later than maturity. Plumb, supra at n. 1386.
49 See, e.g., John Kelley Co. v. Comm’r, 326 U.S. 521 (1946); Crawford Drug Stores, Inc. v. United States, 220 F.2d 292, 296
(10th Cir. 1955) (a debt holder is usually entitled to interest even though there are no net earnings and the fact that
interest is payable absolutely is a factor tending to establish a true debt); Tribune Publ’g Co. v. Comm’r, 17 T.C. 1228, 1234
(1952). See Note, Bonds—Income Bonds—Rights of Bondholders and Deductibility for Federal Income Tax Purposes, 56
Mich. L. Rev. 1334 (1958), cited in Plumb, supra note 46, at n. 348.
173
APPENDIX 01
Recently, issuers have attempted to strengthen replacement language to address this

shortcoming.50 The issuer enters into a ‘Declaration of Covenant’. Under the Declaration of
Covenant, the issuer is contractually obligated to redeem the subject instrument only out of a
specified security, with equal or better equity content. The Declaration of Covenant identifies
specific senior debt that is the beneficiary of the promise made. It is thought, although it has not
been proven, that the senior debt holders could sue for damages if the issuer acts in contraven-
tion of the Declaration of Covenant. This type of feature gives Moody’s comfort and pushes the
ranking on an undated hybrid from moderate to strong in terms of the ‘no maturity’ factor.51
From a federal income tax standpoint, neither type of replacement feature should be a negative
debt factor. The replacement language only affects the issuer’s right to call the security before the
maturity date. It does not affect the issuer’s unconditional obligation to repay its obligation at
maturity. Accordingly, it does not diminish the issuer’s unconditional obligation to pay. On the
other hand, an instrument that is payable upon maturity only out of the proceeds of the sale of
stock has a high risk of being treated as equity for federal income tax purposes. 52
Longer maturities
The US tax law on maturity dates is fairly well known. A debt instrument must have a maturity
date that is not unreasonably far in the future. Courts have tested long-dated debt instruments by
inquiring whether the obligor will be around at the time the debt matures.53 On one level, this
test does not make much sense because no-one knows whether any of the obligors in today’s
world will be around in 10 years, much less 60 years or 100 years. In that sense, the relevant court
opinions should be seen as a test of credit quality: what is the assessment that the instrument will
be paid?
After Notice 94-47,54 issuers limited the subordinated debt underlying trust preferreds to 49 years
or less. More recently, issuers have been extending maturities to 60 years, mainly because the
rating agencies view that as ‘perpetual’. However, 60-year or 100-year debt is not unknown and
with the right issuer should not tip the scale on debt classification.55
50 See, e.g., USB Capital VIII $375,000,000, 6.35 percent Trust Preferred Securities Prospectus Supplement, Registration
No. 333-124535, filed pursuant to Rule 424B2 as of Dec. 21, 2005, available at
http://www.sec.gov/Archives/edgar/data/1325524/000095013405023855/c00888be424b2.htm.
51 See NEW INSTRUMENTS STANDING COMMITTEE, GLOBAL BANKING TEAM AND INSURANCE TEAM, MOODY’S
INVESTORS SERVICE, REFINEMENTS TO MOODY’S TOOL KIT: AN ADDENDUM FOR BANKS AND INSURERS [hereinafter
REFINEMENTS II] (2006) at 4.
52 Dillin v. United States, 433 F.2d 1097, 1101 (5th Cir. , 1970). In Dillin, the demand notes in question were payable only
when the issuer issued stock in an initial public offering.
53 Monon Railroad v. Commissioner of Internal Revenue, 55 T.C. 345 (1970).
54 Notice 94-47 states: “The [IRS] also is aware of recent offerings of instruments that combine long maturities with
substantial equity characteristics. Some taxpayers are treating these instruments as debt for federal income tax purposes,
apparently based on [Monon Railroad] which involved an instrument with a 50-year term. The [IRS] cautions taxpayers
that, even in the case of an instrument having a term of less than 50 years, Monon Railroad generally does not provide
support for treating an instrument as debt for federal income tax purposes if the instrument contains significant equity
characteristics not present in that case. The reasonableness of an instrument's term (including that of any relending
obligation or similar arrangement) is determined based on all the facts and circumstances, including the issuer's ability to
satisfy the instrument. A maturity that is reasonable in one set of circumstances may be unreasonable in another if
sufficient equity characteristics are present.” I.R.S. Notice 94-47, 1994-1 C.B. 357.
55 Arguments have been made that 100-year debt should be treated as debt for federal tax purposes because it more
resembles debt than equity particularly where the yield difference between an issuer’s 100-year debt and its (or a similar
issuer’s) 30-year debt is relatively small. See, e.g., KAM C. CHAN & P.V. VISWANATH, CENTURY BONDS: ISSUANCE
MOTIVATIONS AND DEBT VERSUS EQUITY CHARACTERISTICS, September 2002, available at
http://webpage.pace.edu/pviswanath/research/papers/kamchan_final_version_102303.pdf.
174
APPENDIX 01
Scheduled maturities
Several recent issuers of trust preferred securities have bifurcated their security’s maturity into a
‘scheduled’ maturity and a ‘final’ maturity. In general, these securities have 30 year scheduled
maturities and 60 year final maturities. However, the issuer’s obligation to fully repay the
instrument after 30 years is generally limited to the extent of proceeds raised from the sale of
qualified ‘replacement securities’ such as, in the case of trust preferred securities, securities (other
common stock, rights to acquire common stock, and securities that convert into common stock)
that qualify as the issuer’s core capital and generally rank either pari passu or junior to the trust
preferred securities. This bifurcation changes the debt/equity analysis for US federal tax attorneys
who are asked to opine on a hybrid security’s debt/equity character in connection with the
offering. The relevant question now is whether the issuer will be able to sell enough replacement
securities to pay off the hybrid in 30 years. If the answer is yes, the 30 year maturity favourably
impacts the debt classification of the instrument from a US federal income tax perspective. US tax
advisers generally view this reduction in a hybrid security’s maturity date as a trade-off for other
more equity-like features.
Interest caps
Another feature seen recently is interest caps in bankruptcy. In a typical formulation, the
instrument provides that interest on the instrument can be deferred for up to 10 years. The
instrument also provides that if interest has been deferred and the issuer goes bankrupt, then the
holder will have a bankruptcy claim for interest limited to 25% of the face amount of the debt
instrument. Accordingly, the excess interest is not treated as a bankruptcy claim and is forfeited.
All principal is still payable.56
There is little tax authority on the treatment of such interest limitations. In the first instance, the
question is whether interest on the instrument is unconditionally payable. It would seem that the
correct analysis is to say that only an amount equal to 25% of the face amount is unconditionally
payable. Another way to view the interest cap is a form of subordination. In either event, interest
caps of this sort are a negative feature. On the other hand, the issuer may conclude that the cir-
cumstances under which interest will be forfeited are remote and that, therefore, the feature is
not too damaging to debt treatment.
56 For example in a 2005 offering by BNSF Funding Trust I, the issuer was obligated to sell stock to pay interest during a
mandatory deferral period. There was no obligation to sell stock, however, during a ‘market disruption event’. A market
disruption event included (i) a trading halt on US exchanges generally or with respect to the issuer’s stock, (ii) failure to
obtain a regulatory body’s consent to issue stock despite reasonable attempts to obtain consent, or (iii) an event occurs that
causes an offering document for the issuer’s securities to be defective. If the issuer did not pay all accrued and unpaid
interest for two consecutive years during a mandatory trigger period, all claims with respect to such interest after the two-
year period and to the last day of the mandatory trigger period would be extinguished if the issuer went bankrupt during
the period. Conceivably, according to the prospectus, this could result in extinguishment of claims for five years worth of
interest. See BNSF Funding Trust I $500,000,000 6.613 percent Fixed Rate/Floating Rate Trust Preferred Securities
Prospectus Supplement, supra note 44 at s-15.
175
APPENDIX 01
Current structures
The new wave of hybrid securities57 addresses the fundamental contradiction inherent between
tax and non-tax precepts. From a non-tax standpoint substantial equity credit is only given for
instruments that are perpetual and non-cumulative. From a federal income tax standpoint a
perpetual non-cumulative debt instrument would be treated as equity for federal income tax
purposes. In 2005 and 2006 a number of different structures emerged to address these competing
goals. By mid-2007 two structures appeared to have gained broad market acceptance. The first is
the enhanced trust preferred. It works in the classic hybrid fashion – creating an instrument that
has characteristics of both debt and equity. The second involves two instruments that are held
together with a ‘velcro’ strip. That is, a perpetual non-cumulative security is issued along with a
term cumulative security. The intent is to have the instruments treated as one instrument for
non-tax purposes and as two separate instruments for US federal income tax purposes.
Enhanced trust preferred - CENTs, etc.

One winner in the competition for the next generation hybrid is the ‘enhanced trust preferred’. An
example of this is the Capital Efficient Notes (CENTs) created by JP Morgan.58 In the typical
enhanced trust preferred the underlying debt instrument has a 30-year scheduled maturity with a
60 year legal final maturity. It provides for interest deferral for five years coupled with an
additional five year interest deferral for another five years. During that five years, the issuer is
under an obligation to sell its securities, including common stock or warrants to buy common
stock to repay the deferred interest. The obligation to sell such securities is limited, usually to 2% of
market capitalisation at the time the securities are sold. Also, in some transactions part, but not all,
of the deferred interest may be permanently cancelled, even if the issuer is not bankrupt or
insolvent, if (i) interest is deferred for a period of 10 years, (ii) no event of default and acceleration
is continuing, and (iii) the issuer is unable to raise sufficient proceeds to pay the deferred interest
(whether because of caps on the amount of securities that must be sold, or otherwise). The addition
of this interest cancellation feature helps certain issuers of hybrid securities gain the enhanced
rating agency equity credit they seek. From a federal income tax standpoint, the tax advisor may
accept them if the possibility that an actual interest cancellation will occur seems remote.
WITS and HITS

The second winner is the WITS/HITS instrument.59 In these structures, the issuer issues a non-
cumulative security (actually a forward contract to buy a non-cumulative security) along with a
long-dated subordinated debt instrument. The forward contract requires the investor to purchase
non-cumulative perpetual preferred stock of the issuer in five years. The subordinated note has a
much longer term, say 40 years. Sometime before the five year forward settlement date, the
interest rate on the subordinated note is reset and the subordinated note is remarketed to
unrelated third parties. The investor uses the cash from the sale to deliver the purchase price
under the forward. If the subordinated note cannot be remarketed (presumably because the
issuer is in bad financial shape) then the subordinated note is transferred to the issuer as the
purchase price for the preferred stock.
57 This new wave includes the following transactions: Lehman Brothers Holdings E-Capital Trust I $300,000,000 [the
public document is an Offer to Exchange its Floating Rate Enhanced Capital Advantaged Preferred Securities (ECAPSSM)
which have been registered under the Securities Act of 1933 for any all of its outstanding Floating Rate Enhanced Capital
Advantaged Preferred Securities, Form S-4, SEC File No. 333-129195, dated Oct. 21, 2005 (subject to completion) available
at http://www.sec.gov/Archives/edgar/data/806085/000104746905025084/a2163393zs-4.htm]; BNSF Funding Trust I
$500,000,000 6.613 percent Fixed Rate/Floating Rate Trust Preferred Securities, supra note 44; Stanley Works Capital Trust
I $450,000,000 5.902% Fixed Rate/Floating Rate Enhanced Trust Preferred (November 22, 2005), see
http://www.sec.gov/Archives/edgar/data/93556/000134100405000414/nyc521812.txt;
Wachovia Capital Trust III $2,500,000,000 5.80 percent Fixed-to-Floating Rate Normal Wachovia Income Trust Securities
Prospectus, SEC File No. 333-131237 and 333-131237-01, filed pursuant to Rule 424(b)(2), dated January 25, 2006 available
at http://www.sec.gov/Archives/edgar/data/36995/000095014406000558/g99243bae424b2.htm; Washington Mutual, Inc.
$1,150,000,000 5.38 percent Trust Preferred Income Equity Redeemable Securities Prospectus Supplement, Registration
No. 333-63976, filed pursuant to Rule 424(b)(3) as of January 21, 2003, available at
http://www.sec.gov/Archives/edgar/data/1143930/000090730303000015/prosupp12103b.htm, see also Washington Mutual,
Inc. Annual Report for Fiscal Year Ended Dec. 31, 2005 Filed Pursuant to Section 13 and 15(d) (Form 10-K) as of March 15,
2006 available at http://www.sec.gov/Archives/edgar/data/933136/000110465906016786/a06-2446_110k.htm; USB Capital
VIII $375,000,000 6.35% Trust Preferred Securities Prospectus Supplement, File No. 333-124535, Filed Pursuant to Rule
424B2 as of August 3, 2005, available at
http://www.sec.gov/Archives/edgar/data/36104/000095013405023741/c00888b2e424b2.htm; USB Capital IX $1,250,000,000
6.189% Fixed-to-Floating Rate Normal Income Trust Securities Prospectus Supplement, File No. 333-132297, filed pursuant
to Rule 424(b)(2) as of March 10, 2006, available at
http://www.sec.gov/Archives/edgar/data/36104/000095013406005305/c02886b2e424b2.htm.
58 See, for example, JP Morgan’s own CENTs; JP Morgan Chase Capital XXII $1,000,000,000 6.450% Fixed Rate Capital
Securities Prospectus Supplement, File No. 333-126750, filed pursuant to Rule 424(b)(5) as of January 26, 2007, available at
http://www.sec.gov/Archives/edgar/data/19617/000119312507016403/d424b5.htm.
59 See, for example, Bank of America’s BAC Capital Trust XIII $700,000,000 Floating Rate Preferred Hybrid Income Term
Securities Prospectus Supplement Registration Nos. 333-133852 and 333-133852-08, filed pursuant to Rule 424(b)(5) as of
February 12, 2007, available at http://www.sec.gov/Archives/edgar/data/70858/000119312507029674/d424b5.htm
176
APPENDIX 01
The subordinated note and the forward contract can be separated through some rather
complicated mechanics which essentially involve substituting Treasury securities for the subordi-
nated note. The investor can also extract the note and accept the remarketing-set interest rate so
long as it deposits cash necessary to exercise the forward contract.
The WITS/HITS structure basically relies on Revenue Ruling 2003-97.60 That ruling dealt with an
investment unit composed of (i) a debt instrument, and (ii) a forward contract to buy stock.
Revenue Ruling 2003-97 concludes that the two components of the investment unit are separate
for federal income tax purposes so long as (i) they are not legally linked, and (ii) there is no
economical compulsion to hold them together.61 Assuming the note and forward are separate,
the other tax conclusions follow. Interest on the debt instrument is deductible and the instrument
is not payable in equity and therefore does not run afoul of Code section 163(l).
The WITS/HITS creates Tier 1 capital outside of the 15% basket and instead subject to the 25% limit
applicable to ‘mandatory convertible’ securities.
The FRB on 23 January 2006 issued a letter62 that considered this structure. The letter concluded
that the security would count outside of the 15% basket as Tier 1 capital. The Federal Reserve took
this position despite the fact that the market viewed the structure as having a step-up in rate after
five years. Thus, the FRB has historically not permitted Tier 1 instruments to contain stepped-up
interest rates coupled with a call option. The thinking apparently is that the step-up will induce
the issuer to exercise the call, creating a de facto maturity date for what the FRB requires be a
perpetual instrument. In the transaction the letter was written for when the perpetual preferred
stock is issued, the issuer will be paying a non-deductible coupon as compared to a deductible
coupon on the subordinated note. The regulatory issue is whether the issuer will be induced to
call the perpetual preferred because its after-tax cost of keeping the security outstanding has
increased dramatically. So far, there is no indication the FRB believes that this constitutes a de
facto step-up. Moreover, in 2007 the FRB dropped its objection to step-ups in Tier 1 capital
instruments.
Hybrids issued by foreign issuers in the US

Another aspect of the current hybrid market involves hybrid securities issued by foreign issuers to
US holders. In 2003, Congress reduced the US tax rate on dividends received by individuals to
15%.63 To qualify, the dividend must be ‘qualified dividend income’ (QDI). Congress decided that
dividends on equity issued by foreign corporations should also qualify for the preferential rate. In
general, the foreign corporations are ones that reside in a jurisdiction that shares tax information
with the US or foreign corporations whose shares are traded on a public exchange. Also, the
foreign corporation cannot be a ‘passive foreign investment company’ under US tax rules64 which
basically means that the foreign corporation must be in an active business.
What makes this provision attractive is that the US treats perpetual debt as equity for federal
income tax purposes. Therefore, a foreign corporation can issue perpetual debt which may qualify
for a tax deduction in the home jurisdiction. In the US, however, it is treated as equity and
individual US holders are treated as receiving qualified dividend income. A number of foreign
issuers have taken advantage of this opportunity.
In March 2007 Representative Richard E. Neal (D.-Mass.) introduced legislation (HR 1671) that
would exclude foreign equity from QDI treatment. The bill would deny the special 15% individual
US tax rate on dividends to the extent stock is issued by foreign issuer and foreign issuer receives
a deduction in home country for the dividend or the instrument is treated as other than stock
under the foreign country’s tax law. A companion bill (S. 1006) was introduced by Sen. John Kerry
(D.-Mass.). The proposed effective date is for dividends received after enactment. The proposed
legislation has not yet been enacted and its prospects are uncertain.
60 Rev. Rul. 2003-97, 2003-2 C.B. 80.

61 The genesis of Revenue Ruling 2003-97 was an instrument known as “Feline PRIDES”. This instrument was originally
adopted by corporate issuers.
62 Letter from the Federal Reserve Board to Wachovia Corporation dated January 23, 2006 available at http://www.federal-
reserve.gov/boarddocs/legalint/bhc_changeincontrol/2006/20060123/attachment.pdf.
63 Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L.108-27 (108th Cong. , 1st Sess).
64 Section 1293 et. seq.
177
APPENDIX SELECTED STANDARD & POOR’S
GUIDELINES
02
179
CRITERIA
Criteria: Assigning Ratings To Hybrid

Capital Issues
Primary Credit Analystss: Note: This article supercedes the one that was published on March 28, 2006. We have
Scott Sprinzen
New York subsequently decided not to implement the possible, alternative approach discussed at that
(1) 212-438-7812 point. (See separate release.) This write-up also provides additional guidance on our
scott_sprinzen@
standardandpoors.com methodology for assessing the risk posed by mandatory deferral triggers, among other matters.
Scott Bugie In the Corporate and Financial Services sectors, Standard & Poor’s Ratings Services assigns
Paris two types of credit ratings—one to issuers and the other to individual issues. The first type is
(33) 1-4420-6680
scott_bugie@ called an issuer credit rating (ICR), counterparty credit rating, or corporate credit rating. It is
standardandpoors.com our current opinion of an issuer’s ability and willingness to meet its financial commitments on
Emmanuel Dubois-Pelerin
Paris a timely basis. In contrast, while issue ratings address timeliness, they also address the
(33) 1-4420-6673 potential for recovery of principal in the event of a bankruptcy or liquidation of the issuer—
emmanuel_dubois-pelerin@
standardandpoors.com 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.)
Publication Date
May 8, 2006
Criteria: Assigning Ratings To Hybrid Capital Issues
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
Standard & Poor’s | CRITERIA 2

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.
www.standardandpoors.com 3
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
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FINANCIAL SERVICES
CRITERIA
Financial Services Criteria: Equity

Credit For Bank And Insurance Hybrid
Capital, A Global Perspective
Primary Credit Analysts: (Editor’s Note: This article (published alongside "Credit FAQ: Recent Hybrid Capital
Michelle Brennan
London Issuances By U.S. Bank Holding Companies May Be Models For Future Transactions")
(44) 20-7176-7205 presents the first comments regarding Standard & Poor's criteria prepared under the aegis of
michelle_brennan@
standardandpoors.com our recently established New Instruments Committee (see related press release entitled "New
Secondary Credit Analysts: Instruments Committee To Hold Teleconference On Rating Hybrid Bank And Insurance
Scott Bugie Capital," also published on Feb. 16, 2006). In the coming months, we also plan to publish: an
Paris
(33) 1-4420-6680 updated version of our corporate equity hybrid criteria; a discussion of how we assign issue
scott_bugie@ ratings to equity hybrids; and an article comparing and contrasting the corporate and financial
standardandpoors.com
Additional Contacts: David Anthony services frameworks for the attribution of equity credit. We also plan to comment regularly on
London our views regarding new instruments in the market.
(44) 20-7176-7010
david_anthony@
standardandpoors.com Standard & Poor's Ratings Services is requesting comments from investors, issuers, and other
Grace Osborne market participants regarding any aspects of our methodology for assessing equity credit for
New York
(1) 212-438-7227 bank and insurance hybrid capital. Kindly submit your comments on any aspect of this
grace_osborne@ proposal by March 17, 2006, to criteriacomments@standardandpoors.com or by contacting
any of the individuals listed as contacts in this article.)
Mark Puccia
New York
(1) 212-438-7233 Executive Summary
mark_puccia@
standardandpoors.com Investors, issuers, and market intermediaries increasingly seek clarification of the value of
Scott Sprinzen specific hybrid securities in Standard & Poor’s Ratings Services’ analysis of a bank or
New York
(1) 212-438-7812 insurance group’s capital. Our approach closely resembles that of financial regulators, since
scott_sprinzen@ they have the power to intervene in the operations of a financial services company, and
determine whether to do so based on their own perceptions of capital adequacy, as reflected in
Terry Chan
CFA
Melbourne
(61) 3-9631-2174
@
Financial Services Criteria: Equity Credit For Bank And Insurance Hybrid Capital, A Global
Perspective
their definitions of capital. Even so, Standard & Poor’s has developed generalized guidelines that vary
somewhat from regulators’ to facilitate cross-border comparisons. We differentiate the capital value of
hybrid securities by their equity-like characteristics, and classify them as follows:
Category 1: High Equity Content
Category 2: Intermediate Equity Content (divided into two levels: Category 2: Strong and Category
2: Adequate)
Category 3: Minimal Equity Content
This streamlined approach is coordinated across Standard & Poor’s Financial Services and Corporates
Ratings groups. The approach allows for the different regulatory environments facing many issuers of
hybrid securities.
Standard & Poor’s includes qualifying hybrid securities in its published total capital measures for
banks and insurers up to limits that are the highest for Category 1 (High Equity Content) hybrids, but
that exclude Category 3 (Minimal Equity Content) hybrids. Standard & Poor’s applies limits for the
inclusion of hybrids in its capital measures. These limits vary by category and broadly reflect the
regulatory policy of capping the inclusion of hybrids in regulatory capital.
Standard & Poor’s capital measures and classification of hybrid securities by category complement
measures based strictly on regulatory capital. At the very least, qualification as Tier 1 or Tier 2
regulatory capital by national bank regulators is necessary for Standard & Poor’s to include a hybrid
security in its published total capital measures. For regulated insurance companies, qualification as
regulatory capital by the national insurance regulator is necessary. When insurance regulators express
no views on specific hybrid securities, Standard & Poor’s establishes its own stance on likely regulatory
policy with respect to the instrument.
The regulatory treatment of hybrids issued by regulated financial services companies matters because
regulators typically have the legal authority to intervene in operations to stop or suspend coupon
payments on hybrid securities of troubled entities. Standard & Poor’s considers that regulators will
intervene to suspend hybrid coupon payments at an earlier point than an unregulated corporate would
decide to suspend coupons on its hybrids. This has been demonstrated most clearly in the U.S. banking
sector.
Standard & Poor’s treatment of hybrid securities issued by nonregulated financial services companies
is likely to increasingly mirror the treatment for other unregulated corporate issuers. Standard & Poor’s
will publish additional articles on this topic.
Standard & Poor’s includes hybrid securities in capital analysis when it concludes that the hybrids
can act like equity when the issuer is under stress: for example, they preserve cash and to some degree
bear the downside risk of poor performance. We limit hybrids in capital because:
The quasi-fixed cost of most hybrids increases coverage requirements (the servicing cost is usually
not linked to the performance of the company),
The complexity of many hybrids introduces uncertainty of performance under stress, and
Regulators limit hybrids in regulatory capital.
The growing inclusion of call options with step-up clauses weakens the permanency of hybrid
securities. This trend heightens the importance of analyzing the regulatory approval of the call and the
replacement covenants that commit the issuer to replace the retired security with hybrid capital of
equivalent strength. Mandatory, enforceable replacement covenants restore permanency and equity
value to hybrid capital securities that have call options and step-up clauses, but clear regulatory policy
Standard & Poor’s | FINANCIAL SERVICES CRITERIA 2

Perspective
can also achieve this for regulated financial services companies. In many cases, regulators can prevent a
call if unhappy with the company’s financial standing, or can insist on the instrument being replaced
with one of equivalent strength.
The existence of a clause that obligates the issuer to defer or suspend the coupon payment under
defined circumstances makes a hybrid capital security more equity-like, all else being equal.
Nevertheless, for regulated financial services companies a mandatory coupon deferral clause is not a
material factor in the classification as a Category 1, Category 2: Strong, Category 2: Adequate, or
Category 3 hybrid security. This is because regulators retain authority over the deferral of coupon. The
mandatory deferral clause may be a factor that increases the potential for payment deferral, but the
regulatory intent and authority is more important analytically. Furthermore, in the event of a stress at a
company, the ability to write down the instrument’s principal on a going-concern basis may be a more
important signifier of equity content than the coupon deferral clause.
Overview
The recent rapid growth in hybrid capital issuance by banks and insurance companies highlights the
important role played by hybrid instruments in capital and balance-sheet management. U.S. banking
regulators effectively launched the hybrid capital market in the early 1980s, when they were seeking a
way to encourage the then-overleveraged U.S. financial sector, and particularly the so-called money
center banks, to build capital. Since then, the issuance of hybrid capital by financial institutions has
spread globally and has followed an uninterrupted upward path of development. Hybrid capital’s
usually tax-deductible coupon payments, lack of dilution of common shareholders, wide access to
fixed-income investors, regulatory capital credit, and benefits for reported ROE, have made it an
unbeatable capital markets product for banks and insurers, particularly in the past decade of low
interest rates and recent very low credit spreads.
The global markets have also experienced a proliferation of innovative hybrid capital structures in
recent years. Several trends are behind this. The dynamic growth of risk assets and the high amount of
mergers and acquisitions in the financial services sector have fueled a need for capital, often in a short
timeframe. In addition, the global acceptance of hybrids as regulatory capital, and the convergence of
banking and insurance regulation, has led national authorities to allow more variations in hybrid
structures over time. Moreover, many financial institutions have reached regulatory limits for
“traditional” types of hybrids. Lastly, market participants and financial regulators have worked with
unlisted cooperative and mutual banking and insurance groups unable to issue common equity to
develop innovative hybrid instruments that allow them to raise regulatory capital like their listed
counterparts.
Standard & Poor’s Approach Parallels Regulators’

Standard & Poor’s employs a simple methodology for analyzing hybrid securities that parallels the
regulatory approach, classifying hybrids into three categories, reflecting their relative degree of equity
strength. We include hybrid capital in our published total capital measures up to limits established in
relation to the following categories:
Category 2: Intermediate Equity Content (divided into two levels: Category 2: Strong and Category
2: Adequate)
Perspective

Table 1 summarizes the criteria for inclusion of hybrid capital securities in Standard & Poor’s
published total capital measures for financial services companies. The limits for inclusion by category
broadly parallel the regulatory policy of capping the inclusion of hybrids in regulatory capital, and
allow for global comparisons of capital measures.
Table 1.
Classification Of Hybrid Securities For Financial Services Companies (cont.'d)

Inclusion in Standard & Poor’s total
Category capital measures Examples
Up to 35% of ATE or up to 25% of TAC Short-dated mandatory convertible securities (<3 years)
High quality hybrids with participating coupons
Category 2: Strong
Up to 25% of ATE or up to 15% of TAC Perpetual preferred shares

Most bank and insurer undated deferrable Tier 1 instruments
Insurance long-dated hybrid instruments (residual maturity of 20 years or more)
with coupon deferability
Category 2: Adequate
Up to 10% of ATE or up to 15% of TAC Most, but not all, bank Upper Tier 2 instruments
Limited life preferred shares (e.g. U.S. trust preferred)
Insurance hybrid instruments with a residual maturity of less than 20 years,
with coupon deferability*
Eligible funded contingent capital for insurers
Not included in ATE or TAC Dated hybrid instruments with a residual maturity of five years or less
Auction-preferred securities
Nondeferrable subordinated debt
Instruments with put options
ATE—Adjusted total equity (for banks). TAC—Total adjusted capital (for insurers). *Within 10 years of the repayment date, Standard & Poor’s will gradually
treat the instrument as more debt-like, using a five-year amortization schedule whereby for each year under 10 years, an incremental 20% of the instrument is
treated as debt until, at five years of remaining life, the issue is viewed as completely debt-like.
Why Regulators Matter

Standard & Poor’s approach parallels the regulatory approach for an important reason: financial
regulators have the authority and the power to intervene in the operations of a bank or regulated
insurance company, and they make this determination based on regulatory capital. The capital policy
of financial regulators is inscribed in the terms of most bank hybrid capital issues, and increasingly so
for regulated insurance company issues. Not only will the chosen structure of a hybrid instrument be
influenced by the regulatory treatment, but also the redemption of hybrid capital instruments typically
is subject to regulatory review. Regulators can intervene to enforce the suspension or nonpayment of

Perspective
hybrid coupons, can restrict the amount of hybrids that an entity can issue, and can also require any
redeemed hybrid to be replaced with an instrument of equivalent strength.
Regulators define and accept hybrid capital instruments to allow financial groups to build and
manage regulatory capital. They seek instruments that rank below debt in liquidation and that absorb
losses while permitting the financial institution to continue to operate.
Bank regulators in mature and emerging markets around the world have adopted the Tier 1 and Tier
2 categories of hybrid instruments to rank the instruments by relative capital strength and to regulate
capital and leverage in the industry. They distinguish between “plain vanilla” subordinated debt, which
provides protection to depositors and senior creditors in liquidation, and stronger types of regulatory
capital, which defer or eliminate coupon payment under defined circumstances. In many countries, and
notably in the European Union, regulators further define Tier 2, setting specific standards for eligibility
as Upper and Lower Tier 2 capital.
Differences among definitions and interpretations of regulatory capital have multiplied with the
expansion of the hybrid capital market; consequently, no single definition of Tier 1 or Tier 2 capital
exists. That said, hybrids that qualify as Tier 1 regulatory capital are generally either deeply
subordinated, permanent (although callable under certain circumstances), and the coupon deferral is
noncumulative. Upper Tier 2 instruments generally are permanent (although not in all countries),
subordinated to debt, but the coupon deferral is cumulative. Lower Tier 2 is usually subordinated debt
with nondeferrable coupons.
Consequently, when Standard & Poor’s reviews the hybrid capital instrument of a financial
institution, the regulatory intent with respect to the instrument is a dominant factor in the analysis of
equity content and of payment deferral risk. If insurance regulators express no view on a specific hybrid
security issued by an insurer, Standard & Poor’s establishes its own stance on likely regulatory policy
with respect to the security.
Standard & Poor’s criteria, and capital ratios, are not the same as regulators’. This would be
impracticable, since our goal is to produce capital measures that are globally comparable, while
regulators’ concerns are first and foremost at the national level.
Hybrids Act Like Equity

Hybrid capital securities of banks and insurers are designed to act like equity:
They preserve cash when the issuer is under pressure,
Nonpayment does not provoke default,
Their value fluctuates with the performance of the issuer, and
In certain circumstances for some instruments, the principal may be available to be written down
without provoking a legal default or liquidation.
Standard & Poor’s considers that all hybrid capital securities issued by regulated financial services
companies—banks and insurers—carry a high risk of nonpayment if the issuer falls below the
minimum capital requirements set by the national regulator.
While the incidence of payment deferral generally has been low over the past decade, many cases of
payment deferrals and even write-down of principal have occurred. The incidents of deferral and
principal write-down are in the U.S., Japan, and Germany, the latter two countries having financial
sectors that came under stress during the last decade.
Perspective
U.S. bank regulatory policy is to order a deferral of interest in cases where the issuing financial
institution is considered a troubled institution and needs to preserve cash because it is taking losses or is
under threat of losses in the future. The institution may be close to regulatory capital minimum, but
this is not a necessary criterion for regulatory action. The regulators, and notably the Federal Reserve
Bank, have broad powers to intervene with respect to hybrids. U.S. bank regulators have directed
banks to defer hybrid coupons even in cases where the banks have been in compliance with regulatory
capital standards. Prominent cases in the U.S. include: Riggs National Corp., a bank holding company
whose trust preferred securities deferred payment in December 2004 and resumed in June 2005; Bay
View Capital Corp., a bank holding company that deferred payments on its preferred shares in
September 2000 and resumed in 2002; and City Holding Co., a bank holding company that deferred
payments on its preferred shares in July 2001 and resumed in July 2002. Many other cases of interest
deferral of smaller institutions occurred during the past five years.
In Japan, two recent prominent examples of interest deferral are: Resona Bank, whose perpetual
preferred shares suspended payment in 2003; and UFJ, whose preference certificates suspended
payments in mid-2005, prior to its merger with The Bank of Tokyo-Mitsubishi.
In Germany, a prominent recent example is WestLB AG (A-/Stable/A-2), whose hybrid capital
securities specific to the German market, silent partnership certificates called “stille Einlagen” (included
in regulatory Tier 1), absorbed losses in 2003 and 2004, even though its other Tier 1 hybrids continued
to pay coupons. Lastly, a current case to cite is that of Allgemeine Hypothekenbank Rheinboden AG
(AHBR; BB+/Negative/B). AHBR, a troubled German mortgage bank, has Tier 1 stille Einlagen and
dated upper Tier 2 cumulative profit participation certificates called “Genussrechte” in its regulatory
capital base. Standard & Poor’s expects these unrated instruments will forego coupons and be written
down in 2006, following the recent U.S.-based Lone Star Fund’s takeover of AHBR.
The U.S., Bermudan, and Japanese insurance sectors have several cases of hybrid security coupon
nonpayments over the past five years. U.S. insurance examples include Conseco Inc. (BB-/Stable/N.R.),
whose Feline Prides hybrids stopped paying coupons in October 2002; and Southwest Life Holdings,
whose preferred shares stopped paying coupons in February 2000. In Bermuda, La Salle Re Holdings
stopped paying preferred share coupons in December 2002. Many Japanese insurers maintained
payments on their hybrids through periods of stress, but some nonpayments did occur, such as Asahi
Mutual Life’s nonpayment of coupons on its “kikin” hybrids in 2003. Many prominent examples of
nonpayment of insurers are due to default of the issuer rather than simply coupon deferrals of hybrids.
In the insurance cases, the hybrids of the holding companies defaulted, while the operating
companies did not. This shows that the hybrids provided a degree of protection to the operating
companies.
Standard & Poor’s expects to see a higher incidence of coupon deferrals and suspensions on hybrid
securities of financial services companies in the future, as the amount of issuance grows and when the
financial services industry experiences a cycle of weaker performance.
Why Limit Hybrids In Capital?

Excessive reliance on hybrid securities increases financial leverage due to the fixed cost of servicing the
hybrids and potential concentrations in the redemption dates of dated or callable instruments. The
servicing cost of hybrids is less flexible than that of common equity, and many hybrids are less
permanent than common equity. Investors expect hybrid securities to pay a fixed coupon. Hybrids

Perspective
often contain features that create incentives for management to retire the instrument, or to repurchase
common shares that might be issued as a result of a conversion clause. Moreover, many hybrid
securities include highly complex combinations of different features and are still relatively novel and
untested, making it difficult to foresee how the securities would perform for issuers in different
scenarios—and may cast doubt over how they would absorb losses on a going-concern basis. Thus, a
prudent financial policy dictates a degree of caution about reliance on capital in this form.
Hybrid issuance that exceeds Standard & Poor’s limits for published total capital measures is
reflected in financial flexibility, regulatory capital strength, and the overall quality of the capital base.
Excess issuance could improve the quality of capital if the new issuance has higher equity content than
the existing stock of hybrids.
With respect to insurance holding companies, Standard & Poor’s generally views incremental hybrid
capital issuance over the limits as more debt-like than equity-like, and reflects this in its analysis of
leverage as is appropriate. Nevertheless, we review an issuer’s potential to defer coupons on hybrids
excluded from Total Adjusted Capital (TAC), and the role the hybrid plays in overall balance-sheet
management.
Companies may decide to issue hybrids above regulatory limits and rating agency guidelines to
opportunistically exploit low financing rates, or to achieve a sufficiently liquid issue size.
Assessing The Quality Of Hybrid Instruments

Standard & Poor’s defines capital as funds that are permanent in nature, lacking repayment
requirements or fixed financing costs, are able to defer payments without provoking a default or
liquidation, and are sufficiently fungible within a group to be able to absorb losses on a going concern
basis. Capital is a cushion of protection subordinated to all claims of creditors.
To assess where a hybrid security sits in the spectrum between capital and debt, Standard & Poor’s
reviews the economic merit of its capital characteristics as defined above, as well as aspects that could
make it more debt-like, such as features that could render coupon deferral difficult and trigger early
redemption, including in times of stress.
Management intent is important. Standard & Poor’s discussion of financial policy with senior
management provides insights into potential future retirement and replacement of hybrids. Just as a
financial institution can buy back or issue new share equity or issue additional shares, it can structure
and manage hybrid capital securities in a way that makes them less permanent. Preferred shares
increasingly contain provisions for redemption or exchange, if not an outright stated maturity. A
preferred share issue that will likely be refinanced with debt down the road is more debt-like than
equity-like from the time of issue. Other aspects to consider when assessing management intent include
voting rights of the instrument, the potential for dilution of existing common shares, and conversion
features.

Category 1 High Equity Content hybrids have very strong equity-like characteristics and materially
improve the overall quality of the issuer’s capitalization. They convert to common equity in the short to
medium term, or have a coupon that varies with the earnings of the issuer, much like the common
dividend. Investors in Category 1 hybrid instruments typically bear equity-like risk; the value of a
Category 1 hybrid security will have a high correlation with the value of equity. High Equity Content
Perspective
hybrids will usually have acceleration triggers that lead to a conversion into common equity if the
issuer is under financial stress.
Hybrids are more equity-like when the coupon is linked to the issuer’s performance. A hybrid with a
coupon linked to the common dividend, even if a portion of the coupon is fixed, is more like common
equity than a security with a coupon that is wholly fixed to an external indicator such as a market
interest rate.
Category 1 hybrids include mandatory convertible securities (MCS) that convert to equity in the
short to medium term, usually defined as three years or less. Short to medium dated MCS are High
Equity Content provided that the conditions surrounding the conversion do not encourage the issuer to
redeem existing shares so that the issuer can prevent shareholder dilution upon conversion. (The
securities should have a robust mechanism that ensures that conversion will not excessively dilute the
issuer’s share price. This mechanism should reduce to a minimum the potential buy-back of newly
issued shares resulting from conversion.) Longer dated MCS that are not classified in Category 1 at
issuance due to the long time period to conversion become considered as Category 1 when the residual
period to mandatory conversion falls to three years or less. Recent examples of Category 1 High Equity
Content MCS include a $650 million MCS issued in December 2005 by XL Capital Ltd. and a Swiss
franc 1.25 billion MCS issued in December 2002 by Credit Suisse Group.
Rabobank Nederland’s membership certificates are another example of a Category 1 instrument.
The membership certificates are permanent, deeply subordinated, and the fixed coupon is suspended if
the bank does not report a profit. As Rabobank has a cooperative ownership structure that precludes
common shares, the certificates represent the most equity-like instruments that the cooperative bank
can issue.

Category 2 Intermediate Equity Content hybrids have equity-like features that protect senior
bondholders and insurance policyholders and enhance regulatory capital flexibility in the event of
stress. Nevertheless, a Category 2 Intermediate Equity Content hybrid is debt-like in some respects,
typically due to the fixed nature of the coupon. Investors expect the coupon to be paid. This category
is divided into two levels: Category 2: Strong, and Category 2: Adequate.
Standard & Poor’s removes securities from Category 2 as they approach maturity. A dated
instrument is excluded from total capital measures when it has five years or less left to maturity.
Category 2: Strong
Standard & Poor’s classifies the majority of regulatory Tier 1 bank securities as Category 2: Strong.
Bank Tier 1 instruments have a clearly defined role in acting like risk capital in the event of stress—this
has been reinforced by regulatory action in the U.S., Japan, and Germany in recent years, as noted
earlier. Most perpetual preferred shares are in the Category 2: Strong classification. Bank perpetual
preferred shares typically have an optional coupon, although in practice the set coupon payment is
much more reliable than the common dividend. Issuers increasingly include an option to call perpetual
(and long-dated) hybrid securities after 10 years. The result is that perpetual and long-dated preferred
shares trade like fixed-income instruments with assumed maturity at the first call, but with a risk
premium that reflects the potential payment default risk, and extension risk.

Perspective
A recent example of a Category 2: Strong instrument is the January 2006 issue of WITS (Wachovia
Income Trust Securities) by Wachovia Corp. The Federal Reserve Bank accepts WITS in Tier 1
regulatory capital.
With respect to insurers, the market for perpetual deferrable subordinated debt/trust preferred
traditionally was not strongly developed. Insurance hybrid securities are almost always dated, although
Standard & Poor’s considers that perpetual instruments are stronger and more like common equity.
Influenced by the Tier 1 eligibility requirements of the U.K. insurance regulator, a number of leading
British insurance groups have succeeded in issuing undated Category 2: Strong hybrids, including
Prudential PLC (AA-/Negative/A-1+), Aviva PLC (A+/Stable/—), and Friends Provident PLC
(A-/Stable/—). Longer dated (at least 20 years) insurance deferrable subordinated debt and trust
preferred are considered Category 2: Strong hybrids. The difference between bank and insurance
treatment reflects the different regulatory and market environment for the insurance sector, where
regulators generally do not tier hybrid capital.
Category 2: Adequate
Category 2: Adequate instruments are sufficiently able to defer payments and act like capital in a stress
situation, but relatively less than Category 2: Strong hybrids due to their limited life and/or limits on
payment deferral (usually five years or less).
Regulatory classification is an important factor for hybrids issued by regulated financial institutions.
An eligible hybrid issue included in Tier 2 by the national regulator is likely to be classified as Category
2: Adequate. For example, European bank Upper Tier 2 instruments are classified in Category 2:
Adequate. Standard & Poor’s considers that Tier 1 hybrids are more likely to defer payments and
absorb losses through write-down of principal than Upper Tier 2 instruments, due to the more
stringent regulatory requirements for Tier 1. While insurance regulators generally do not make this
distinction, insurance issuers have adopted the same hybrid structures as banks, with the result that
they vary in relative equity strength as well. In some countries, notably the U.K., regulatory policy
concerning hybrid capital securities is the same for banks and insurers. Standard & Poor’s classifies
traditional U.S. trust-preferred securities, which have limited life and limited coupon deferral
characteristics, as Category 2: Adequate rather than Category 2: Strong, even though the U.S.
regulators include them in Tier 1. In the case of U.S. banks, enhanced trust preferred is classified as
Category 2: Strong, but is still limited to up to 15% of ATE because of regulatory considerations. (See
“Credit FAQ: Recent Hybrid Capital Issuances By U.S. Bank Holding Companies May Be Models For
Future Transactions,” published on Feb. 16, 2006.)
Category 2: Adequate instruments includes shorter dated instruments issued by insurers, namely
those with an initial maturity of 10-20 years. For insurers, it also includes instruments that are callable
under 10 years (typically, five years). In order for shorter dated instruments to receive equity credit,
Standard & Poor’s must be comfortable with management’s intent to maintain a capital structure
consistent with the expectations embedded in the insurers’ ratings. Category 2: Adequate instruments
for insurers also include pre-funded contingent capital arrangements, although only up to 5% of TAC,
only for investment-grade issuers, and only assuming acceptable security features.
Perspective
Instruments excluded from Standard & Poor’s financial services published measures of capital
Certain instruments have insufficient equity-like features for inclusion in ATE or TAC. Nondeferrable
(plain vanilla) subordinated debt, whether perpetual or limited life, is excluded because it only absorbs
losses in liquidation. Instruments with put features (where the investor can redeem at a sign of
deteriorating performance) and auction preferred securities are also excluded. Auction preferred are
perpetual in name, but often represent merely a temporary debt alternative for companies that are not
current taxpayers until they can once again benefit from the tax deductibility of interest expense.
Moreover, the holders of auction preferred would pressure for redemption in the event of a failed
auction or a ratings downgrade.
Standard & Poor’s also excludes from its capital measures hybrid instruments that are felt to be ring-
fenced within a group structure, or where the proceeds are otherwise insufficiently fungible within the
group for the instrument to be expected to defer coupon payments or to be written down in the event
of group stress. For example, Standard & Poor’s has excluded from ATE several Tier 1 trust-preferred
securities issued by German banks via trust structures. This is because the instruments are considered
sufficiently ring-fenced that the resources would not be available to absorb losses on a going-concern
basis. (This was shown in the case of WestLB, where coupons were skipped on directly issued Tier 1
instruments (and the principal was written down), but nondirectly issued Tier 1 securities continued to
pay their coupons in full on a timely basis.)
Table 2.
Definitions Of Standard & Poor’s Capital Measures

Adjusted common ACE includes common equity, share reserves, retained earnings, most equity minority interests, and asset revaluation
equity (ACE) reserves on insurance investments where appropriate. ACE excludes intangible assets, unseasoned asset revaluation
reserves that may not be accessible in times of stress, and equity held in unconsolidated subsidiaries.
Adjusted total ACE plus hybrid capital issues up to prescribed limits: (1) Category 1 High Equity Content: up to 35%; (2) Category 2:
equity (ATE) Strong: up to 25%; (3) Category 2: Adequate: up to 10%; (4) Category 3 Minimal Equity Content: excluded at 0%. Total
(measure used for hybrids (Categories 1, 2, and 3) limited to 35% of ATE. Total of Category 2: Strong and Category 2: Adequate limited to
bank analysis) 25% of ATE. ATE excludes intangible assets, asset revaluation reserves, and equity held in unconsolidated
subsidiaries.
Total adjusted ACE plus equity-like reserves, a percentage of realizable intangibles, and hybrid capital issues up to prescribed limits:
capital (TAC*) (1) Category 1 High Equity Content: up to 25%; (2) Total of Category 2: Strong, and Category 2: Adequate: up to 15%; (3)
(measure used for Category 3 Minimal Equity Content excluded at 0%. Total hybrids (Categories 1, 2, and 3) are limited to 25% of TAC.
insurance Total of Category 2: Strong and Category 2: Adequate limited to 15% of ATE. Pre-funded contingent capital facilities
analysis). limited to 5% of TAC. For the purpose of calculating hybrid equity tolerances for U.S. and BermudA-based insurance
companies, TAC is defined as total common equity, preferred shares and other hybrid securities, minority interest, and
debt less unrealized appreciation (depreciation) on fixed-income securities.
*TAC represents the total economic capital of the company or group calculated at market values.
Call Options And Step-up Clauses Reduce The Permanency Of Hybrids

Call options are common features in perpetual hybrid capital instruments. Over the past decade, issuers
have retired hybrids at the first call date with such regularity that investors assume that the call is
automatic. The main reason for this is the widespread inclusion of step-up clauses, whereby the coupon
rate steps up (increases) starting from the call date. The step-up creates a strong incentive to retire the
instrument at the first call. Hybrid capital issues with call and step-up features provide the issuing
entities with the best of both worlds—an instrument that trades as a dated fixed-income security, has
(usually) deductible interest payments, and counts as capital.

Perspective
Banking regulators impose restrictions on call and step-up features to limit the incentives to retire
regulatory capital that is intended to be permanent. In 1998, the Basle Committee on Banking
Supervision issued a notification for regulators to limit acceptance of “innovative capital instruments”
with calls and step-ups to a maximum of 15% of Tier 1 capital and to subject innovative hybrids to
stringent conditions:
The call option with step-up should be a minimum of 10 years after the issue date,
The step-up should be less than or equal to 100 basis points, less the swap spread between the initial
index basis and the stepped-up index basis,
The step-up should be less than 50% of the initial credit spread, less the swap spread between the
initial index basis and the stepped-up index basis,
There should be no more than one rate step-up over the life of the instrument, and
The swap spread should be fixed as of the pricing date and reflect the differential in pricing on that
date between the initial reference security or rate and the stepped-up reference security or rate.
Regulators in mature banking markets around the world generally have implemented a 15% Tier 1
limit on innovative hybrids broadly in line with the conditions suggested by the Basel Committee
(although there are some exceptions based on the “grandfathering” of previous regulatory agreements).
Bank regulators usually forbid issuers from committing to call at a particular date, and require financial
institutions to obtain regulatory approval to exercise a call. This makes bank hybrids with a call more
equity-like than similar hybrids issued by an unregulated corporate.
Regulatory policy in the insurance sector is less developed, thus many insurance regulators look to
banking regulators for guidance in establishing policy on inclusion of hybrid instruments, including
securities with calls and step-ups, in regulatory capital. In some countries, from the U.K. to The
Netherlands and Financial Center regulators in the Gulf, the combination of bank and insurance
regulation under one roof (the Financial Services Authority in the U.K.) has facilitated a convergence of
bank and insurance regulatory policy with respect to hybrid capital. Standard & Poor’s typically
expects 10 years to the first call for an insurance issue with a step-up feature, although the different
regulatory environments mean that hybrids with shorter call dates may still be included in TAC.
Standard & Poor’s considers a hybrid with a longer period to the call date to be stronger (more
equity-like) than one with shorter period to the call, all else being equal. This reflects the longer period
that the former will remain in the capital structure on an obligatory basis. Moreover, an instrument
with a step-up at an optional call date is less permanent than one without a step-up. Everything else
being equal, Standard & Poor’s assessment of an issuer’s capital base will be weaker if there is heavy
use of hybrids with step-up features and with call dates that are close together.
Standard & Poor’s excludes from ATE or TAC hybrids with step-ups that exceed the regulatory
limits. For insurance issuers operating without regulatory policy in the area, Standard & Poor’s
excludes from TAC hybrids with step-ups greater than 100 basis points, consistent with market
practice. If a step-up is linked to deterioration in the issuer’s credit standing or rating, the instrument
will become excessively expensive when the issuer is under stress, and the issue is therefore excluded
from ATE or TAC.
The Value Of Replacement Covenants

Issuers increasingly commit to replace hybrid capital securities retired at the first or subsequent call
dates with securities that are at least as strong from the point of view of capital. Even if there is a step-
Perspective
up provision, the replacement language in the issue can restore a degree of permanency to the security,
by providing a formal statement of management’s intent—even though it is questionable whether such
a stipulation is legally enforceable, particularly outside of the U.S. In the U.S. in July 2005, First
Tennessee Bank N.A. demonstrated the feasibility—at least in certain jurisdictions—of providing a
legally binding replacement clause when it made a “declaration of covenant” in connection with its
preferred stock issuance. The covenant runs in favor of holders of the bank’s covered debt.
Nevertheless, among regulated financial institutions, the existence of a replacement clause or
covenants is a secondary factor in the classification as a Category 1, Category 2: Strong, Category 2:
Adequate, or Category 3 hybrid security. This is because regulators retain authority over the retirement
of a hybrid capital security irrespective of the existence of any replacement provision—the regulator
can prevent redemption or enforce the replacement with another instrument of equivalent strength. The
spirit of financial institution regulation is to maintain a sound level of capital. Standard & Poor’s
expects bank and insurance regulators to step in and prohibit the retirement of a hybrid capital security
if that retirement would materially weaken the capital adequacy of the institution in question, although
regulators may in some cases focus only on whether minimum solvency requirements are met. The
replacement provision is a comforting factor, but the regulatory intent and authority is more important
analytically.
For unregulated financial institutions, the form of the replacement provision and the capital policy of
management assume greater analytical significance. A hybrid security with a call option and an
acceptable replacement provision is more equity-like than one without a replacement cause, “ceteris
paribus”. For unregulated firms, instruments with nonlegally binding replacement provisions do not
qualify for Category 1 treatment, but can be included in Category 2.
Standard & Poor’s monitors the profile of potential redemption dates for hybrid securities as well as
long-term debt when assessing the quality of capital and balance-sheet management.
Mandatory Coupon Deferral

The existence of a clause that obligates the issuer to defer or suspend the coupon payment under
defined circumstances makes a hybrid capital security more equity-like, all else being equal.
Nevertheless, for regulated financial institutions a mandatory coupon deferral clause is not a material
factor in the classification as a Category 1, Category 2: Strong, Category 2: Adequate, or Category 3
hybrid security. This is because regulators retain authority over the deferral of coupon. For banks, the
national regulator has the explicit or implicit authority to intervene and stop a coupon payment of a
hybrid qualifying as regulatory Tier 1 and Upper Tier 2 capital, usually when the entity in question is at
or below the then-applicable regulatory capital limits. Standard & Poor’s expects national financial
authorities to stop payments in these situations, irrespective of whether the status of the coupon
deferral is optional or mandatory. The mandatory deferral clause may be a factor that increases the
potential for payment deferral, but the regulatory intent and authority is more important analytically.
Furthermore, in the event of a stress at a company, the ability to write down the instrument’s principal
on a going-concern basis may be a more important signifier of equity content than the coupon deferral
clause.
For unregulated financial institutions, a mandatory coupon deferral clause makes the instrument
more equity-like, but may restrict the options of an entity to manage situations of temporary financial
stress. The nature of the mandatory deferral trigger and the capital policy of management take on

Perspective
greater analytical importance for unregulated financial institutions. Standard & Poor’s expects coupons
to be deferred in a material stress situation, but recognizes that the suitable management behavior in
some temporary stresses could be to keep paying coupons on the hybrid until the problem is corrected,
thus maintaining debt market confidence and access.
Classification Reflects Many Factors

Hybrid capital securities are increasingly complex, combining several features; for example, coupon
deferral, payment in common shares, conversion to common under certain circumstances, varying
triggers for coupon deferral, contingent call features, among others. The classification of a specific
hybrid as a Category 1, Category 2: Strong, Category 2: Adequate, or Category 3 hybrid, and the
reflection of the hybrid in the overall capital analysis of the issuer, reflects the analysis of these specific
features, and also takes account of regulatory restrictions, relative servicing costs, investor profile and
expectation, and importantly, the overall capital and credit profile of the issuer. The classification is
often a judgment call that is not clear cut.
While qualitative assessment of a specific hybrid capital security is obligatory to classify the security
by its relative equity value, it is rare that the detailed features of a hybrid instrument have a material
impact on an issuer’s overall creditworthiness (see “Capital Is More Than A Ratio” below).
Banks Versus Insurers

Standard & Poor’s applies compatible methodology when assessing the capital strength of banks and
insurers, while recognizing the different nature of business risk and regulation in the two industries.
The capital analysis of banking groups, which are highly leveraged, principally focuses on common
equity and retained earnings, along with loan reserves and hybrid securities that can absorb losses in
times of difficulties.
Meanwhile, the capital analysis of insurance companies focuses more on broad capitalization
inclusive of eligible hybrid capital. For insurers, the ability to pay cash claims derives from several
sources: routine cashflows, reinsurance proceeds, the liquidation of investment assets at prevailing
market values, bank and capital market borrowings, and the potential realization of the present value
of future profits on the current “in-force” book of life business or the securitization of other insurance
flows.
Regulated financial institutions issue hybrid capital securities first and foremost to build regulatory
capital. Qualification as regulatory capital (Tier 1 or Tier 2) by national bank regulators is a
mandatory requirement for Standard & Poor’s to include a hybrid security in its total capital measures
for banks. If the bank regulator excludes an instrument from regulatory capital, the instrument
provides no cushion between minimum capital and regulatory action, which could include closure.
In contrast to many banks, insurers traditionally have maintained capital well in excess of regulatory
requirements. Insurance groups issue hybrid capital securities to manage economic capital and satisfy
constituents (including rating agencies like Standard & Poor’s) in addition to boosting regulatory
capital. Regulatory intent historically has been less of a factor in the analysis of hybrid instruments
issued by insurance concerns, given that many insurance regulators have been less prescriptive
regarding hybrid instruments than have bank regulators, but the situation is changing. The increasing
use of risk-based capital adequacy methodologies by insurance regulators places greater emphasis on
hybrids as a way of complying with more onerous regulatory capital requirements. Some insurance
Perspective
regulators, such as those in the U.K., are adopting certain bank-type hybrid structures as suitable for
insurance issuance. As in the banking sector, if the insurance regulator excludes an instrument from
regulatory capital, the instrument provides no cushion between minimum capital and regulatory action.
Note that in jurisdictions where the insurance regulators have expressed no view on a specific hybrid
capital instrument issued by an insurance group, Standard & Poor’s establishes its own stance on likely
regulatory policy with respect to the instrument.
Capital Is More Than A Ratio

The analysis of hybrid capital must be placed in the context of the broader analysis of capital, and of
the creditworthiness of a bank or insurer. Formulaic ratio-driven analysis represents only a part of the
overall quantitative and qualitative assessment of capital, which in turn can only be analyzed within the
broader commercial and financial profile of the rated company. Capital ratios are visible shorthand
signals of balance-sheet strength, but are not correlated with credit rating levels. Qualitative analysis of
capital policy is fundamental to the global assessment of the creditworthiness of banks and insurers.
No single measure fully captures the breadth of information needed to evaluate an entity’s capital
adequacy. Industry participants—investors, securities analysts, the company management itself—at
times focus excessively on the management of bank and insurance capital with respect to a specific
ratio, to the detriment of analysis of broader issues such as risk profile and management. Capital ratios
based on historical data are also less meaningful than expectations of future capitalization under
various scenarios.
Components in the qualitative analysis of capital include: unrealized capital gains or losses, and
hidden reserves or losses, access to capital and liquidity from third parties, the nature and extent of
minority interests, dividend policy, potential for earnings generation and retention, and management
strategy with respect to acquisitions, disposals, and investments.
For insurers particularly, analytical factors also include overall financial leverage, the manner in
which structural subordination and double leverage are treated by local regulators, interest and fixed-
charge cover, the use of reinsurance to mitigate peak exposures, and reserving policy for long-tail and
other technical liabilities.
While the classification of hybrid instruments affects Standard & Poor’s capital ratios for financial
services companies, the overall assessment of capital adequacy is based on many quantitative and
qualitative factors rather than ratios alone.

Perspective
CRITERIA
Criteria: Equity Credit For Corporate

Hybrid Securities
Primary Credit Analystss: Equity hybrids—as the name suggests—combine features of debt and of equity. The many
Solomon B Samson
New York combinations and permutations of such features are growing, as new instruments are devised
(1) 212-438-7653 almost daily. Standard & Poor’s Ratings Services’ analytical treatment reflects this varying
sol_samson@
standardandpoors.com equity content—basically attributing ‘partial credit’ to various hybrid instruments.
Scott Sprinzen
New York Hybrid Hierarchy Has Been Streamlined
(1) 212-438-7812
scott_sprinzen@ We introduced the equity hybrid hierarchy in 1999, pioneering a quantitative approach to the
standardandpoors.com equity credit associated with hybrids securities issued by corporates. Last year, we streamlined
Emmanuel Dubois-Pelerin
that hierarchy in order to communicate our position more effectively. The different levels of
Paris
(33) 1-4420-6673 equity content consist of three categories:
emmanuel_dubois-pelerin@ ‘Minimal equity content,’ which includes instruments with little or questionable
permanence; terms or nomenclature that restrict or discourage discretion over payments;
after-tax costs or conversion terms that may become unattractive to the issuer.
‘Intermediate equity content,’ which encompasses most the of preferred stock genre, from
30-year trust preferred with five-year cumulative deferral rights to perpetual, tax-deductible
preferred (as in the U.K.), with unlimited and/or non-cumulative deferral rights.
‘High equity content,’ which include features that support the current rating. These typically
involve a mandatory component, either regarding deferral of ongoing payments at
appropriately high trigger levels, or near-term conversion into a fixed number of common
equity shares (on a basis that would not be deemed unpalatable to the issuer at the time of
conversion).
Publication Date The treatment of hybrids for ratio calculation purposes is discussed below (‘Rating
May 8, 2006 Methodology’). We recently decided to change how we calculate ratios for the intermediate
Criteria: Equity Credit For Corporate Hybrid Securities
equity content category. Going forward, we will emphasize the ratios that split hybrid-related amounts
50%-50% between debt and equity.
We use a common framework across our Corporate and Financial Services practices and across
regions. However, there are significant differences, reflecting the different nature of the companies and
the rating methodologies. The analysis of regulated financial institutions emphasizes capital
adequacy—and, in particular, regulatory capital. In turn, the hybrid methodology for financial
institutions does not follow the partial approach described above; rather, it grants full equity credit
with certain threshold limits, which are set depending on the degree of equity content.
Moreover, potential regulatory intervention is a critical aspect of the financial institution dynamic.
Given the high funding needs of banks and the importance of maintaining confidence in the specific
bank and the entire financial sector, regulators may order deferral when the credit quality of a bank is
still stronger than the point where most corporates would consider such an action.
Standard & Poor’s ratings on the hybrid securities themselves highlight the risk of nonpayment—
even while the company has not legally defaulted. Since we deem payment deferral or partial payment
deferral a (nonlegal) default, upon such deferral, the issue rating would be ‘D’. Working backwards,
the impending issue default risk rises as the triggers for nonpayment approach, and the initial rating on
such securities can be several notches below the corporate rating. (See “Corporate Default Risk With A
Twist,” published July 5, 2005, on RatingsDirect, Standard & Poor’s web-based publishing system.)
Equity Has Several Attributes

What constitutes equity in the first place? Traditional common stock—the paradigm equity—sets the
standard. But equity is not a monolithic concept; rather, it has several positive characteristics:
Equity requires no ongoing payments that could lead to default;
It has no maturity or repayment requirement;
It provides a cushion for creditors in the case of a bankruptcy; and
It is expected to remain as a permanent feature of the enterprise’s capital structure.
Equity hybrids normally possess some—or all—of these characteristics to some degree. Yet, because
equity has these several defining attributes, it should be apparent that a specific security can have a
mixed impact. Hybrid securities, by their very nature, can be equity-like in some respects and debt-like
in others. Moreover, the specific features may provide the positive characteristic only to a limited
extent.
In any event, the security’s economic impact is most relevant: its nomenclature is a secondary
consideration. A transaction labeled debt for accounting, tax, or regulatory purposes may still be
viewed as equity for rating purposes, and vice versa.
Soft capital—a commitment from a nonaffiliated provider of capital to inject equity capital at a later
date—can be valuable. Still the company does not have the funds now, when it might be invested to
support the health of its business. And, by making the funds available at the company’s discretion,
there is the risk that a delay in exercising that option may lead to a situation of too little, too late.
Ongoing payments.
Equity pays dividends, but has no fixed requirements that could lead to default and bankruptcy if
these dividends are not paid. Moreover, there are no fixed charges that might, over time, drain the
company of funds that may be needed to bolster operations. While a company is under pressure to pay

both preferred and common dividends, it ultimately retains the discretion to eliminate or defer payment
when it faces a shortage of funds. The degree of discretion, however, can vary.
We assume a company will have greater reluctance to pass on a preferred dividend than to reduce or
eliminate its common dividend. Accordingly, there is a difference in ‘equity credit’ afforded to common
equity relative to preferred equity. Similarly, common equity issued in conjunction with so-called
income depository securities (IDSs), master limited partnerships, and real estate investment trusts
(REITs) is viewed as possessing less discretion over dividends: investors are promised a payout of
virtually all cash flow, and they are marketed with an expected yield.
The longer a company can defer dividends, the better. An open-ended ability to defer until financial
health is restored is best. As a practical matter, the ability to defer dividend payments for five or six
years is most critical in helping to prevent default. If the company cannot restore financial health in five
years, it probably never will. The ability to defer payments for shorter periods also is valuable, but
equity content diminishes quickly as constraints on the company’s discretion increase.
We also discount the right of deferral if it entails some potential disincentive. For example, some new
instruments require the company to issue stock—common or preferred—once they have deferred for
one or two years. Because companies presumably would want to avoid such a requirement, they would
be even more reluctant than usual to defer in the first place.
Debt instruments can be devised to provide equity-like flexibility with regard to debt service.
Deferrable payment debt issued directly to investors—i.e., without a trust structure—legally affords the
company flexibility regarding the timing of payments that is analogous to that of preferreds. Yet, the
identification of a security as debt constrains the company’s practical discretion to defer payments,
thereby diminishing the equity credit attributed to such hybrids compared with deferrable payment
preferred stock.
By removing the discretionary element, mandatory trigger mechanisms can increase comfort that
deferral actually will occur when the circumstances of the issuer make this desirable from the creditors’
perspective. (Historically, income bonds—i.e., where the payment of interest is contingent on achieving
a certain level of earnings—were designed with this in mind. However, to the extent that cash flow
diverges from earnings measures, income bonds tend to be imperfect instruments.) The equity content
of such instruments is a function of the trigger levels used to determine when payments are diminished.
For example, if the level of cash flow that triggers payment curtailment is relatively low, that
instrument is not supportive of high ratings. A more straightforward concept entails linking interest
payments to the company’s common dividend, creating an equity-mimicking bond. (A number of
international financial institutions issued such bonds in the late 1980s.) Of course, if a company had an
inordinate amount of dividend-linked issues outstanding, this ultimately could increase its reluctance to
curtail its common dividend.
Maturity or repayment requirement.
Obviously, the ability to retain the funds in perpetuity offers the company the greatest flexibility.
Extremely long maturities are next best. Accordingly, 100-year bonds possess an equity feature in this
respect (and only in this respect) until they get much nearer their maturity. (To illustrate the point,
consider how much, or how little, the company would have to set aside today to defease or handle the
eventual maturity.) However, interest payments are not deferrable and cross-default provisions would
lead to these bonds being accelerated.
Preferred equity often comes with a maturity—as a limited-life or sinking-fund preferred—which

would constitute a clear shortcoming in terms of this aspect of equity. Limited credit would be given
for this type of preferred; even if it could be assumed the issue successfully is refinanced at maturity, the
potential for using debt in the refinancing would be a concern (see the following discussion on the
permanence of equity). Our normal standard for intermediate equity credit is 25 years remaining life.
Cushion for creditors in the event of default.
What happens in bankruptcy also pertains to the avoidance of bankruptcy and default, albeit
indirectly. Companies’ access to debt capital depends on providers feeling secure about the ultimate
recovery of their loans in the event of a default. Debt-holders’ claims have priority in bankruptcy, while
equity holders are relegated to a residual claim on the assets. The protective cushion created by such
equity subordination allows the company access to capital, enabling it to stave off a default in the first
place.
Subordination typically is a secondary consideration compared with other beneficial aspects of
equity. Thus, if an instrument is senior, but ongoing payments are deferrable and it has a long-dated
maturity, we could well view it as having substantial equity content. On the other hand, if an
instrument is subordinated, but lacks the other equity-like traits, it would be viewed as predominantly
debt-like.
The distinction between subordination and deep subordination generally is not significant in our
analysis, although deep subordination incrementally is somewhat more supportive. Also, many U.S.
securities—to meet IRS guidelines for tax-deductibility—may be termed subordinated while providing
pari passu status to trade creditors. This can be a meaningful shortcoming—although, in the total
scheme of things, it rarely would determine the overall equity category.
Permanence.
At any time, a company can choose either to repurchase equity or to issue additional shares.
However, some securities are more prone to being temporary than others. Our analysis tries to be
pragmatic, looking for insights as to what may ultimately occur. For example, auction or remarketed
preferred stock is designed for easy redemption. Even though the terms of this type of preferred provide
for its being perpetual, failed auctions or lowered ratings typically prompt the issuer to repurchase the
shares. (They are sold as commercial paper equivalents, which leads to failed auctions if credit quality
ever falls to ‘A-3’—or even ‘A-2’—levels. While the company has no legal obligation to repurchase the
paper—i.e., the last holder could be left with this ‘perpetual’ security—the issuer invariably bows to
market pressures, and chooses to repurchase the preferred. Accordingly, such frequently remarketed
preferreds are treated as debt.)
The ability to call always gives reason for pause; however, we have not placed much emphasis on
this feature if the instrument is truly low-cost—such as tax-deductible preferred—and, therefore, should
not pressure the company to refinance. Calls exercisable after five years are very common to long-dated
hybrids. (We would question the rationale for a call date only two to three years after issuance.)
However, coupon step-ups are designed to motivate calling the issue. To address the risk of refinancing
with a less equity-like security, issues should have at least 10 years of no call and incorporate
replacement language that specifies the type of replacement security to be used. To achieve intermediate
equity treatment, it ordinarily suffices to establish management intent regarding replacement—even
though companies’ financial policies can vary over time, future capital market conditions could limit
the ability to issue specific types of securities, and legal enforcement is dubious.

Another important consideration is the issuer’s tax-paying posture. It is difficult for a nontaxpaying
issuer to make the case that the company will continue to finance with non-tax-deductible preferred
stock once it becomes a taxpayer, and can lower its cost of capital by replacing the preferred with debt.
Other clues can come from the nature of investors in the issue (e.g., money market, as opposed to
long-term fixed-income investors) and the mode of financing that is typical of the company’s peer
group. For example, utilities traditionally finance with preferred stock, and industry regulators are
comfortable with it; therefore, the usual concern that limited-life preferred stock will be refinanced with
debt is less of an issue in the case of utilities.
In the case of so-called tax-deductible equity, risk exists that their favorable tax status is overturned,
and—especially with new hybrids—that risk may be substantial. This concern can be mitigated by
provisions in the transaction to convert into another equity-like security in the event of loss of tax-
deductibility.
Rating Methodology
Different attributes of equity hybrids are relevant to different elements of Standard & Poor’s analytical
methodology. The aspect of ongoing payments is considered in fixed-charge coverage and cash-flow
adequacy; equity cushion in leverage and asset protection; need to refinance upon maturity in liquidity;
and potential for conversion in financial policy. The before- and after-tax cost of paying for the funds
also is a component of both earnings and cash flow analysis.
How to reflect hybrids in credit ratios, though, is not a simple question. One possibility is to divide
the amounts involved in proportion to the equity content of the specific security. However, the
resulting numbers can be misleading. To illustrate: the company will either pay the stipulated amount
or defer it; in no scenario would it defer a fraction of the payment. So calculating a fixed charge
coverage ratio with a fractional amount has no intuitive meaning.
Accordingly, hybrids with minimal equity content are treated entirely as debt for ratio purposes;
hybrids with high equity content are treated entirely as equity for calculating ratios.
For hybrids with intermediate equity content, we have computed financial ratios both ways—viewed
alternatively as debt and as equity, i.e., two sets of coverage ratios are calculated—to display deferrable
ongoing payments (whether technically dividends or interest) entirely as ordinary interest and
alternatively as an equity dividend. Similarly, two sets of balance-sheet ratios are calculated for the
principal amount of the hybrid instruments, displaying those amounts entirely as debt and entirely as
equity.
For these hybrids in the middle category, analytical truth lies somewhere between the two. Analysts
can interpolate between the two sets of ratios to arrive at the most meaningful depiction of an issuer’s
financial profile. They can note and give effect to each more-equity-like/less-equity-like feature of
various hybrids in the same category—although such nuances play, at most, a very subtle role in the
overall rating analysis. (The numerical gradations we used to indicate equity content never implied
fractional treatment for the purpose of ratio calculations—as we clearly stated.)
However, this methodology also has drawbacks, including the challenges for issuers in appreciating
the potential impact on our view of their financial profile. Therefore—notwithstanding the issues
mentioned above—we decided to calculate ratios with the amounts relating to intermediate category
hybrids split 50%-50%. This set of ratios will be emphasized as the basic adjusted measures, and these
are the ratios we intend to publish. We expect the advantages of this approach—greater transparency
and ease of comparability (including with measures used by other rating firms)—will outweigh the
negatives. Analysts are encouraged to continue viewing hybrids from all perspectives—i.e., continuing
to compute additional ratios with the security as debt and, alternatively, as equity.
Tax-Deductible Preferreds: A Major Innovation In Hybrid Securities

Texaco Capital LLC issued the first of the so-called ‘tax-deductible’ preferred stocks in 1993. This
hybrid equity security was a major innovation in corporate finance, creating a modern-day version of
the long-existing preferred stock. A version of this instrument was introduced the following year that
used a trust as the issuer—leading to the term ‘trust preferred’. The typical terms of this very popular
instrument set the minimum standard for intermediate equity content. These include:
Optional deferral of payments for up to 60 months, as long as no common dividends are being paid.
(Conventional preferreds have unlimited potential for nondeclaration of dividends, subject only to
board representation by preferred holders after six quarters of nonpayment.)
Deep subordination.
Thirty-year life. (Conventional preferreds are perpetual, although many have call provisions. The
new-genre preferreds also are nominally perpetual, but terminate when the intercompany loan
matures, normally in 30 years. As the remaining life of the specific issue dwindles over time, the
equity attribution is reduced. Conventional preferreds, by way of comparison, typically possess
equity content that does not diminish over time, given their perpetual tenor.)
To broaden investor appeal, preferreds with variable rates were introduced. This does not, in our view,
alter the equity content, although the exposure to floating rates, if material, can pose a risk that is
considered in other aspects of the analysis.
A further ‘innovation’ called for resetting rates after an initial five- or 10-year period. The idea was
to create an incentive for the company to call the issue at that point, to avoid a penalty rate. We regard
issues with step-up rates (of 50 basis points or more) as having an effective maturity at that point,
thereby largely undermining their equity content.
A reset that merely captures any change in the issuer’s credit spreads is less troublesome, because the
company presumably would have little incentive to refinance the issue. That still could be problematic,
if, for example, the issuer dropped to noninvestment grade: its cost for long-term funds might be
expected to widen to the point that only shorter-term alternatives would be palatable.
To mitigate the impact of stepped-up rates on the equity credit afforded to that financing, some
issues proffer replacement language, promising that any refinancing of the instrument will come from
proceeds of an equity issuance or a new instrument of equivalent equity content. The legal
enforceability of such terms is highly dubious. Nonetheless, we put some stock in such provisions as
expressions of intent—as long as the company involved has a decent record of credibility, and the
language is highly specific regarding the definition of instruments that would qualify as replacements.
Some European deals introduced greater restrictions on the ability to defer dividends. The issuer can
defer only after curtailing its common dividend for some period of time. This translated into seriously
lower equity credit afforded to those issues. In the case of companies that do not pay a quarterly
common dividend—not unusual in Europe—the problem is compounded, because there might be an
even longer period between when the company experiences financial distress and when it can defer
preferred dividend payments. Similarly, the value of deferability is diminished if the deferral can only

occur following a period when the company has reported a net loss, but where the company reports
results on a semiannual, rather than quarterly, basis.
On the other hand, the quest for enhancing equity content continues. Recent preferred instruments
make payment deferral automatic upon reaching certain triggers or occurrence of certain events.
Indeed, replacing issuer discretion with a formulaic approach to deferral adds significantly to the equity
content—if the threshold for stopping payments is set high. Each issuer’s situation requires a unique
analysis, making standardization impossible. Triggers can be based on financial data or ratios or rating
levels. (Alternatively, payments could be linked to the company’s common dividend.)
Additionally, some issues offer longer deferral periods and/or longer tenor. Others are non-
cumulative, and do not require the company to make up for payments skipped because of financial
distress. (Beyond that, forgiveness of part of the principal in cases of company stress could theoretically
be offered.)
The rub is that investors would be leery about accepting the risks associated with nonpayment
associated with high thresholds. (Such incremental risk of nonpayment is reflected in our rating policies
for notching of issue ratings.) The key is to find the right balance that would be meaningful for the
issuer and still acceptable to investors at a reasonable rate. In any case, the stigma in the capital markets
that might be associated with involuntary deferral needs to considered, apart from the cash savings that
result.
Our High Standards For The High Equity Content Category

Much of the recent innovative efforts in designing mandatory instruments are intended to achieve
rating-agency treatment as ‘high equity content’; however, we believe most of the proposed and actual
recent mandatory securities only merit the intermediate equity category. Securities that would warrant
high equity content recognition would entail the following features:
High thresholds. The mere existence of a mandatory deferral provision is meaningless: Everything
depends on the thresholds that define the deferral trigger. To illustrate: If the trigger for nonpayment
is 10 years of losing money, that provision is virtually worthless. The company would probably have
defaulted prior to the deferral provision going into effect. To be included in the high equity category,
an instrument’s trigger must go into effect at a level relatively close to the current rating level. The
scenario that triggers deferral must be within two or three rating notches from the company’s current
credit quality. A threshold that approximates crossing over to noninvestment grade does not suffice
(unless, of course, the corporate rating happens to be within two or three notches of that level.) A
variety of financial benchmarks can serve as a proxy for that threshold level—and need to be crafted
to fit the specific corporate context. In any event, we need to be mindful that a single ratio cannot
entirely be relied upon to capture all of the business and financial changes the credit may have
undergone by the time the trigger activates. This fact itself lends support to the tight standard we
apply.
No loopholes. For example, some deals stipulate that the mandatory deferral must be simultaneous
with or following cessation of common dividends (a look-back period). As long as the company
chooses to pay even a paltry dividend, the security continues to pay. Obviously, such an instrument is
‘mandatory’ in name only. (With respect to the intermediate equity category, these limitations may
also be problematic, for other reasons. While the middle equity category only calls for the company’s
discretion over payments, an extended look-back period undermines the flexibility of discretionary
deferral.)
No back-door payment mechanisms. Many proposed high-equity structures provide for requiring
payment or allowing payment in common stock while mandatory deferral is in effect. While
appealing on the surface, we believe such provisions could defeat the purpose of mandatory deferral.
The likelihood is that the company will feel pressured—if not actually obliged—to make the
payment, and then turn around and repurchase the stock it issued (unless it were otherwise inclined
to issue common stock for whatever reason). Ironically, the higher the threshold of the instrument,
the greater the likelihood the company would pay and repurchase.
No step-up without a legally binding replacement provision. A key equity attribute is longevity.
Securities with five- or 10-year step-up/call provisions are designed to terminate at the step-up date—
and our policy has been to treat that date as an effective maturity. To restore the equity credit for
step-up deals, companies have proffered so-called replacement language in the issue that promises to
replace the called instrument with one that is equivalent in terms of equity content. These clauses in
the hybrid security itself are not legally enforceable: The investors who are called out of the security
definitely will not sue regarding how they are replaced. Essentially, then, the clauses represent a
statement of intent on the part of current corporate management. For the high-equity category, that
does not suffice. In July 2005, First Tennessee Bank N. A. demonstrated the feasibility of providing a
legally binding replacement clause when it made a declaration of covenant in connection with its
preferred stock. The covenants run in favor of holders of the bank’s covered debt. For us, this created
a litmus test for companies to now back their declarations of intent with a legally enforceable
provision.
Similarly high standards apply with respect to mandatory convertibility. (See “Hybrids’ ‘High Equity
Content’ Category Held To High Standards”, published Sept. 7, 2005, on RatingsDirect, Standard &
Poor’s web-based publishing system.)
Frequently Asked Questions
Does it make a difference whether a security is identified as preferred stock or junior subordinated
debentures?
We consider the legal form and nomenclature of a security to be relevant to the amount of equity
credit. The rationale is that there would be a distinction in the investor perception of the instrument—
and, consequently, to the issuer’s discretion over deferring payments. We all along have made a
distinction between trust-preferred and the debt version of that security—despite the two having
identical economic substance. That distinction was explicit in the hierarchy of hybrids that we
published for many years—and translates into an ‘intermediate equity category’ for the preferred stock
version and ‘minimal equity category’ for the debt version in our current terminology.
However, we look at equity features of a given hybrid security in a holistic fashion. Recent proposed
securities incorporate enhancements to the original trust preferred genre—such as doubling the
maturity and providing longer deferral periods—and these would serve as offsetting positives to the
weakness associated with debt form. Taking such enhancements into account, even a debt-form hybrid
would qualify as ‘intermediate’.

Is a mandatory share issuance feature positive, neutral, or negative?

Some new-variety securities require the issuer to pay the dividend with proceeds of a common-stock
issuance, if certain financial triggers have been breached, or if optional deferral continues beyond a year
or two. We view this apparent plus as a potentially serious step backward in terms of equity content.
The advantage associated with deferral of payments can be undermined when the company still needs
to pay—albeit with the proceeds of a share issuance. The company presumably will want to repurchase
shares that it is not inclined to issue, especially given the likelihood that its share price would be
depressed (because of the stress situation the company would face at the time of a trigger breach). If the
forced share issuance follows a period of optional deferral, this requirement could be a disincentive for
the company to exercise its right to defer in the first place. For an instrument with optional deferral to
achieve intermediate equity content, we consider five years of unfettered deferral to be a minimum
requirement.
Generally speaking, companies cannot be ‘forced’ to issue stock: They can always repurchase it (that
is, if they cannot manage to find a legal loophole to avoid enforcement of the provision in the first
place). And, if a particular company were in fact inclined to issue stock, it could always have done so
without being coerced. The same is true with respect to being forced to issue ‘equity-like’ preferred
stock. When a company faces distress, the pricing for very long-dated preferred stock could be
prohibitive, indeed.
Our concern with mandatory share issuance precludes securities with such features from meriting
even intermediate equity treatment. However, there a two possible ways to neutralize this problematic
feature:
The security could preserve the right of optional deferral in the face of breaching the mandatory
triggers. That would allow them to get to the intermediate category—just like other optional deferral
instruments. (In reality, though, most proposed term sheets we see provide for the mandatory
remedies trumping the optional deferral provisions.)
If the optional deferral provision included a requirement to issue common or other hybrids within
five years, this could deter the deferral, as explained above, and we would relegate such a hybrid to
the ‘minimal’ equity content category. To avoid this outcome, the security could mitigate the risk by
allowing flexibility as far as timing of the issuance; allowing choice of common or various hybrids;
and/or limiting potential dilution (for example, by restricting the maximum share issuance
requirement to 2% of number of shares outstanding).
Some companies seem prepared to foreswear their ability to repurchase shares—and to covenant to
that effect in a legally enforceable fashion. As long as the no-repurchase period extends for as long as
the company is in breach of the triggers—and perhaps some period thereafter—the security could
still qualify for the intermediate category. (Restricting repurchases helps with regard to stock issued
subject to mandatory triggers; with respect to stock issued subsequent to optional deferral, any
restriction in repurchases would just exacerbate the problem—by further discouraging the choice to
defer.)
Shouldn’t such forced share issuance help—at least as far as the issue rating is concerned?
It certainly could help avoid the incremental subtraction of notches that otherwise would apply to the
issue ratings of securities with mandatory deferral—since the payment would, after all, be made with
proceeds from the share issuance. However, timeliness of payment is also critical. Timeliness can be
accomplished either by immediate issuance of shares that equal in value the stipulated dividend directly
to the holders or by allowing sufficient time between the determination of a breach and the dividend
payment date to market new shares.
Is there a limit to the amount of hybrids a company can issue and still get ‘equity credit’?
Without drawing any red lines, we would, indeed, be sensitive at a certain point. That is not because
the character of the security changes when a lot of it is issued. Rather, beyond a certain point, a
company’s nonstandard, complex, or over-engineered balance sheet begins to puts its financial policies
in a negative light. In turn, this could lead to market pressures to restructure or normalize company
finances. This concern would be compounded to the extent that a company also uses various off-
balance-sheet financing vehicles, derivatives, and long-term contracts, and/or other techniques that
contribute to an overall opaque financing structure. The perception of financial aggressiveness—by us
or the investment community—would certainly overshadow any theoretical benefit from the equity
content that might be afforded to hybrid securities.
It helps to focus on measures that would indicate little or no concern. In simple terms, there should
be no problem with issuing conventional hybrids in an aggregate amount up to 15% of capitalization.
(Capitalization is defined as debt + hybrids + book equity, adjusted for substantial goodwill.)
Some European deals incorporate look-backs: In these instruments, the right to defer applies only
after a period with no share repurchases or payment of common dividends. When do these features
cause concern?
The main point of payment-deferral securities is to accommodate a company that has a crisis and
would like to save cash. Look-backs constrain this flexibility, as a practical matter, if the company had
recently paid a dividend or repurchased any stock. (By way of contrast, we are not concerned about
‘dividend stoppers’ that merely restrict common dividends from being paid in the future—until the
preferred arrearages are paid up. This makes sense, as a company that is deferring its preferred
dividend payments should not be paying common stock holders.)
The details of the look-back provision dictate the extent of the potential problem. For example: Does
even the repurchase of a trivial amount of stock in conjunction with an employee option plan violate
the look-back? Is the look-back period a quarter? Six months? One year? How do the frequency and
juxtaposition of common and preferred dividend payment dates affect the possible delay?
The existence of a look-back that could potentially impose a maximum delay of one year would
disqualify a security for our intermediate equity category. (In the case of hybrid issuers that are already
rated speculative grade, even a potential delay of six months would rule out equity treatment.)
Importantly, even where a look-back period is shorter and does not in itself disqualify the security, the
potential for delay is still problematic—and, in combination with other features of the security, can
affect its equity credit categorization.
With respect to mandatory-deferral instruments, look-backs undermine the nondiscretionary aspect
of the deferral. The company can choose to short-circuit the deferral by paying a paltry common
dividend, for example. Such issues would, therefore, never qualify for our high equity content category.

How has Standard & Poor’s thinking evolved about call provisions?
We continue to limit our concern to those securities that build in incentives to exercise the call—i.e., by
stepping up the yield at the call date. Where such a step-up applies, we assume the issue will be called.
The higher the differential, the greater the likelihood of a call—but even a 50 basis point penalty,
compared with the market rate, could be sufficient incentive to refinance such a long-dated instrument.
And, ordinarily, we could not presume the instrument will be replaced with a security of equivalent
equity content.
To merit being in our high equity category—if the current security otherwise qualified—only legally
enforceable replacement language suffices to give us confidence regarding the outcome. Provisions in
the instrument itself are not enforceable as a practical matter: Investors called out of the issue have no
interest in what replaces that issue. Covenants on behalf of other creditors are, therefore, key. When
such legally enforceable provisions exist, it is acceptable if the non-call period were as short as five
years.
To qualify for the intermediate category, we use a lower standard. If the instrument includes highly
specific wording regarding the replacement with an equity equivalent, we take such statement of
management intent seriously. Obviously, situations can change—and management itself will change;
nonetheless, companies tend to honor this type of public commitment. However, in those cases where
we rely on statement of intent to qualify for intermediate equity treatment, we expect the non-call
period be at least 10 years.
Also, we expect to revisit the question of whether to accept mere intent once there is some track
record with the legally enforceable approach, which only recently has been introduced. If there are no
drawbacks that become apparent with the legally enforceable approach, it will be hard for a sincere
management to explain why they are not prepared to offer this provision. This determination will take
more than just a few quarters.
In any event, legally enforceable provisions remain stronger than statement of intent. Since we
approach the combination of hybrid features in a holistic fashion, the length of the non-call period and
the strength of replacement provisions can still play a role in determining the overall characterization of
a specific instrument.

APPENDIX SELECTED MOODY’S GUIDELINES
02
217
Rating Methodology
February 2005
Contact Phone
New York
Barbara Havlicek 1.212.553.1653
Glenn Eckert
Mark Gray
Harshan Jeyakumar
Jim Mannoia
Karen Nickerson
Atsi Sheth
Kevin Stoklosa
Nicolas Weill
London
Lynn Exton 44.20.772.5454
Niel Bisset
Timour Boudkeev
Hong Kong
Sombat Jiwariyavej 852.2509.0200
Sydney
Charles Macgregor 61.2.9270.8120
Refinements to Moody’s Tool Kit:

Evolutionary, not Revolutionary!
A Product Of The New Instruments Standing Committee

Summary Of Refinements To Moody’s Tool Kit
Moody’s Tool Kit, which is a framework for calibrating the relative debt and equity characteristics of hybrid securities,
was introduced to the market in 1999. Since that time, the New Instruments Committee (NIC) has assessed hundreds
of instruments, positioning them along the debt – equity continuum in baskets from A to E1. Against this backdrop,
the NIC decided to step back and review its approach to assessing hybrids with the benefit of five years’ experience and
feedback from market participants.
The conclusion of the NIC review process was that Moody’s Tool Kit, which compares the characteristics of
hybrids to the features of common equity, remains a relevant and useful framework. At the same time, there are a
number of areas where refinements to our thought process are warranted. For example, in addition to considering
how a hybrid behaves relative to common equity, it is also important to recognize the support that a hybrid may pro-
vide for senior creditors as well as its ability to impact the issuer’s probability of default2. The NIC also revisited how
a number of hybrid characteristics compare to the features of common equity to ensure that the same criteria are being
applied consistently.
In summary, the evolution in our thought process has led to changes in the way that certain hybrid characteristics
are ranked along the three dimensions of equity:
No Maturity
The NIC’s thinking has changed on undated hybrids with cash calls3, which confer a right rather than an obligation to
repay the hybrid. In general, capital structures have become more fluid as issuers determine the most cost-effective
cushion to cover their risks. Driven by economic considerations, an issuer may repurchase common shares at any time
or refinance existing hybrids by exercising a call option. This general lack of permanence is not driven by the features
of common equity or the hybrid’s characteristics themselves, but is driven by the issuer’s view of the optimal capital
structure. Consequently, a cash call is viewed less negatively than previously.
No Ongoing Payments
In shifting focus to consider how a hybrid may impact an issuer’s probability of default, the NIC recognizes that non-
payment of deferrable distributions generally does not result in an event of default. This is the same outcome as for
the non-payment of common dividends. A hybrid may have one of a number of deferral mechanisms, which may
result in the cessation of distributions at a time of financial distress. While continuing to calibrate the relative equity-
like benefit of each, deferral mechanisms overall will now receive greater equity benefit than in the past due to the rec-
ognition of their generally favorable impact on an issuer’s probability of default.
Loss Absorption
In many cases, hybrids provide a loss absorbing cushion for senior creditors with recovery far closer to common equity
than to either senior or subordinated debt in a default. The NIC now more fully recognizes this benefit by giving pre-
ferred securities, and certain types of subordinated debt, a ranking that is closer to that of common equity.
In subsequent sections, this rating methodology describes in detail the refinements that are being made to Moody’s
Tool Kit, the rationale for the changes, and how they impact commonly issued hybrids.
Refresher on Moody’s Approach to Hybrid Analysis

Before discussing the refinements to Moody’s Tool Kit, it is important to start with a refresher on the thought process
used to assess hybrids. In 1999, Moody’s introduced a comparative framework, which ranks, on a relative basis, various
hybrids and places them in a basket from Basket A (more debt-like) to Basket E (more equity-like) on the debt – equity
continuum. Through this analysis, the hybrid is broken down into its basic characteristics including maturity, call
options, conversion options, deferral mechanisms, and priority of claim in liquidation. These basic attributes are then
compared to the following features of equity:
• No maturity.
• No ongoing payments, the absence of which would result in an event of default.
• Loss absorption for all creditors.
1. Please refer to the section below entitled Refresher on Moody’s Approach to Hybrid Analysis. In addition, see also Moody’s Tool Kit: A Framework for Assessing
Hybrid Securities, dated December 1999.
2. This approach is consistent with Moody’s expected loss ratings, which incorporate the probability of default and severity of loss.
3. Specifically, the issuer can exercise a call for cash without having to replace the hybrid with a security that has the same or more equity-like characteristics.
2 Moody’s Rating Methodology

The hybrid’s characteristics are then scored in terms of their strength relative to common equity. The four grada-
tions of modifiers used are none, weak, moderate, and strong relative to common equity with none corresponding to
most debt-like and strong corresponding to most equity-like. Once these scores have been assigned, the hybrid is
compared to hybrids already on the debt – equity continuum and placed in a basket. There is a specific percentage of
debt and equity associated with each basket, which is used to adjust full sets of financial statements4. The hybrid is then
considered within the context of each issuer’s overall credit fundamentals and its impact on the rating is left to the rel-
evant rating committee.
Changes in Scoring for Certain Hybrid Characteristics

The following chart summarizes the changes that have been made to the scoring for certain hybrid characteristics. It
is applicable to investment grade issuers including corporates, insurers, and banks. The changes are classified accord-
ing to the dimension of equity that is impacted, with explanations provided below.
Feature Old New

No Maturity
Cash call for an undated hybrid (corporates) None Weak
Cash call for an undated hybrid (banks and insurers) None Moderate
Cash call for an undated hybrid with replacement language (all issuer types) Moderate Moderate
No Ongoing Payments
Mandatory deferrala, non-cumulative (all issuer types) Moderate Strong
Mandatory deferrala, stock settled (all issuer types) Moderate Strong
Optional deferral, non-cumulative (all issuer types) Weak Moderate
Loss Absorption
Preferred securities Moderate Strong
Subordinated debt (no rights; only common equity is more junior) Moderate Strong
Subordinated debt (no rights) None Moderate
a
Mandatory deferral of distributions tied to the breach of pre-specified triggers.
Changes to Scoring: Hybrid Characteristics that Impact No Maturity

The scoring changes impacting the No Maturity dimension of equity relate solely to an issuer’s ability to call an
undated hybrid. When the Tool Kit was first introduced, a cash call5 was viewed negatively because the hybrid could
be called in the future with no guarantee that the replacement security would be neutral in its effect on other senior
creditors. While a call is only likely to occur when the issuer’s financial condition is sound and there is economic justi-
fication for doing so, it could potentially hurt creditors if the replacement security is debt. A call was viewed as detract-
ing from the instrument’s permanency, which made the instrument less equity-like.
The concept of capital permanency has increasingly become a fluid notion as issuers have become more active in
adjusting their capital structures in response to changing operating environments. Driven by economic consider-
ations, an issuer may repurchase common shares at any time or refinance existing debt or hybrids. This general lack of
permanence is not driven by the features of common equity or the hybrid’s characteristics themselves, but results from
decisions made by the issuer regarding its view of the optimal capital structure.
In addition, the existence of a cash call does not necessarily result in a de-facto maturity. When a hybrid with a
cash call is issued, the call does not result in an obligation to repay the hybrid, but only provides the issuer with the right
to repay the hybrid. As a result, a call, when exercised, acts in a manner similar to a common share repurchase6.
For these reasons, we have shifted scoring of a cash call on undated hybrids to weak from none for corporates.
While the argument could be made to shift the scoring further to moderate, the new designation reflects the uncer-
tainty in terms of the replacement security. The scoring for a cash call where the hybrid can only be called if it is
4. On the balance sheet, the hybrid is classified in accordance with the weights assigned to its equity and debt features. The income statement is also adjusted to reflect
interest expense or dividends, depending on the balance sheet classification. Similar thinking is applied to the cash flow statement, again reflecting cash outflows as
interest or dividends depending on the balance sheet classification. Ratios are then computed based on the adjusted financial statements in the same manner for
both investment grade and non-investment grade issuers. This is a change to the approach described in Hybrid Securities Analysis: New Criteria for Adjustment of
Financial Ratios to Reflect the Issuance of Hybrid Securities, dated November 2003, which established that fixed charge coverage ratios would generally not be
adjusted for investment grade issuers while coverage ratios for non-investment grade issuers would be calculated both with and without hybrid coupons that are defer-
rable, payable-in-kind, or payable in common stock.
5. See footnote 3
6. Note that the ability to repurchase common stock or call a hybrid may be viewed similarly in terms of equity replication. However, both actions may have negative rat-
ing implications.
Moody’s Rating Methodology 3

replaced by a similar or more equity-like security remains moderate. While such replacement language signals an
issuer’s intent regarding the form of replacement security for the hybrid if called, it only signals intent. As a result, it is
not viewed as legally enforceable, although an issuer may have some moral obligation to act in accordance with its pub-
lic statement of intent.
A further distinction has been made for banks and insurers on this dimension of equity. The ability of regulators
to prohibit a cash call for a hybrid7, if regulatory capital has deteriorated, is viewed to be at least as effective as a corpo-
rate with the intent to replace a hybrid with the same or more equity-like security. Consequently, for undated regula-
tory capital hybrids issued by banks and insurers, a cash call will receive moderate on No Maturity, which is the same
scoring for a corporate that issues a hybrid with a cash call subject to replacement language. The moderate score is
more equity-like than the weak that corporates receive with a cash call and no replacement language.
Changes to Scoring: Hybrid Characteristics that Impact No Ongoing Payments

The change in scoring for hybrid characteristics that impact the No Ongoing Payments dimension of equity relates to
deferral mechanisms and whether a dividend is skipped entirely or settled with common shares. Many hybrids posi-
tively impact an issuer’s probability of default because non-payment of deferrable distributions does not result in an
event of default. Since non-payment of common dividends also does not result in an event of default, many hybrid
scorings where deferral features are present have been shifted to stronger equity-like designations.
Moody’s continues to believe that investment grade corporates, insurers, and banks are not likely to defer on
hybrid distributions in order to retain capital market access. Consequently, mandatory deferral of distributions tied to
the breach of triggers is viewed as a way to level the playing field between common dividends (which an investment
grade issuer may opt to defer) and hybrid distributions (which an investment grade issuer is unlikely to defer). By
introducing triggers, the decision to defer hybrid distributions is taken out of the hands of the issuer and based on
objective criteria. The investor knows upfront that deferral is a possible outcome. While leveling the playing field,
mandatory deferral may also result in a hybrid that provides more equity-like benefit than common equity itself.
Due to these considerations, we still view mandatory deferral based on the breach of pre-specified triggers to be
beneficial, but it is now scored as strong rather than moderate. Moreover, we will score hybrids with optional defer-
ral as moderate rather than weak. The moderate scoring for optional deferral captures the same optionality that
exists for the payment of common dividends, but considers that an issuer will always be less likely to defer hybrid
distributions than common dividends.
The revised designations assume that the deferral of hybrid distributions, whether optional or mandatory, are
non-cumulative and will effectively be skipped if unpaid. An alternative to skipping dividends, which also scores strong
on this dimension of equity, is stock settlement of the distribution if pre-specified triggers are breached. While share
settlement results in the “payment” of distributions, it is a non-cash payment that provides the issuer with flexibility at
a time of financial distress and is covered by the issuance of the most junior form of capital.
Changes to Scoring: Hybrid Characteristics that Impact Loss Absorption

The primary change impacting the Loss Absorption relates to the scoring for preferred securities and subordinated
debt that effectively behaves like preferred securities. To date, preferred securities have received moderate on Loss
Absorption because while preferred securities have always provided a loss absorbing cushion, it is clearly secondary to
the cushion provided by common equity. However, Moody’s defaulted bond recovery studies have shown that in
default, the average recovery rate on preferred securities is closer to the recovery rate on common equity than it is to
the recovery rate for either senior or subordinated debt holders8. Consequently, preferred securities are now scored as
strong versus moderate on this dimension of equity.
There are certain jurisdictions, primarily in Europe, where preferred securities do not exist or issuers themselves
may not have board resolution to issue preferred securities. Consistent with our past views9, we have become comfort-
able with subordinated debt as equivalent to preferred securities if:
• It cannot default or cross default and has no rights in bankruptcy.
• Only common equity is more junior during the life of the subordinated debt. If more junior capital is issued
between the subordinated debt and common equity, the original terms of the subordinated debt require
that it will be exchanged into or refinanced by the more junior capital.
7. That is, a hybrid qualifying for regulatory capital treatment.

8. Please refer to Default & Recovery Rates of Corporate Bond Issuers: A Statistical Review of Moody’s Performance, 1920 – 2003, dated January 2004.
9. Please refer to An Application of Moody’s Tool Kit: Characteristics of a Basket C Perpetual Preferred for Financial Institutions and Corporates, dated May 2004.

For this type of subordinated debt, consistent with the scoring for preferred securities, the designation has also
shifted to strong from moderate on this dimension of equity. For subordinated debt, which has no rights, but which
may have more junior capital issued under it10, the scoring shifts to moderate from none.
Refinements in Practice: Some Examples

The charts below illustrate the impact of the Tool Kit’s refinements on commonly issued hybrids for investment grade
issuers. There is no change to basket designations for trust preferred securities. The biggest impact of the refine-
ments is on perpetual preferred securities and, depending on their characteristics, they will generally be placed in more
equity-like baskets.
Perpetual Preferreds with Replacement Language and Mandatory Dividend Deferral

• Perpetual preferred securities.
• Callable only if it is replaced with a security that has the same or more equity-like characteristics.
• Mandatory deferral of dividends tied to the breach of meaningful triggers; non-cumulative if deferred (i.e.,
dividend is skipped). If triggers are breached, dividends may also be settled with common shares.
Equity Replication Summary Old New

No Maturity Moderate Moderate
No Ongoing Payments Moderate Strong
Loss Absorption Moderate Strong
Basket C D
Perpetual Preferreds without Replacement Language, but with Mandatory Dividend Deferral
• Perpetual preferred securities
• Callable, but without replacement language.
• Mandatory deferral of dividends tied to the breach of meaningful triggers; non-cumulative if deferred (i.e.,
dividend is skipped). If triggers are breached, dividends may also be settled with common shares.

No Maturity None Weaka
No Ongoing Payments Moderate Strong
Basket A C
a
Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket D.
Perpetual Preferreds with Replacement Language and Optional Dividend Deferral, non-cumulative
• Optional deferral of dividends; if deferred, dividends are non-cumulative (i.e., dividend is skipped).

No Ongoing Payments Weak Moderate
Basket B C
10. For example, subordinated debt issued by Australian companies.

Perpetual Preferreds without Replacement Language, with Optional Dividend Deferral, non-cumulative
• Optional deferral of dividends, non-cumulative if unpaid (i.e., dividend is skipped).

Basket A B
a
Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.
Perpetual Preferreds with Replacement Language and Optional Dividend Deferral, cumulative
• Optional deferral of dividends; if deferred, dividends are cumulative.

No Ongoing Payments None Weak
Basket B B
Subordinated Debt with No Rights and Inability to Issue More Junior Capital
• Perpetual subordinated debt which: 1) cannot default or cross default and has no rights and 2) nothing else
is more junior to the subordinated debt except common equity . If more junior capital is issued, it will be
exchanged for or refinance the subordinated debt.

Basket A B
a Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.
Subordinated Debt with No Rights, but the Ability to Issue More Junior Capital
• Perpetual subordinated debt, which cannot default or cross default and has no rights.

Loss Absorption Moderate Moderate
Basket A Bb
a Banks and insurers receive a Moderate on No Maturity and the security is placed in Basket C.
b
Note that in this example and the previous one (subordinated debt with no rights and the inability to issue more
junior capital), the designation for loss absorption is different. However, the basket outcome is the same
because less weight is given to the Loss Absorption dimension of equity for investment grade issuers.

Trust Preferred Securities
• Trust issues preferred securities and proceeds are on-lent to the parent company through a deeply subordi-
nated loan. The terms of the subordinated loan mirror the terms of the preferred securities.
• The maturity is typically 30 years.
• Optional deferral of dividends for 5 years; if deferred, dividends are cumulative

No Maturity None None
No Ongoing Payments None None
Loss Absorption Weak Weak
Basket A A
Mandatorily Convertible Preferred

• Preferred securities, which mandatorily convert into equity within 3 years.
• Non-callable for life.
• Optional deferral of dividends; if deferred, dividends are cumulative.

No Maturity Strong Strong
No Ongoing Payments Moderate Moderate
Loss Absorption Strong Strong
Basket E E
Summary and Conclusion

This research methodology describes the refinements that we have made to Moody’s Tool Kit. While not affecting the
basket designations for certain hybrids such as trust preferred securities, they generally result in more equity-like treat-
ment for perpetual preferred securities. The changes are evolutionary, not revolutionary. They better reflect the sup-
port that hybrids provide for more senior creditors and give more weight to characteristics that are similar to the
features of common equity. The changes also consider the fluidity of an issuer’s capital structure, which increasingly
needs to provide more flexible support than in the past to cover a range of risks that issuers continue to face.
List of Publications by the New Instruments Committee

Rating Methologies:
Hybrid Securities Analysis: New Criteria for Adjustment of Financial Ratios to Reflect the Issuance of Hybrid
Securities Products, November 2003, #79991
Moody’s Tool Kit: A Framework for Assessing Hybrid Securities, December 1999, #49802
Special Comments:
An Application of Moody’s Tool Kit: Characteristics of a Basket E Mandatorily Convertible Security, November 2004,
#89899
An Application of Moody’s Tool Kit: Characteristics of a Basket C Perpetual Preferred for Financial Institutions and
Corporates, May 2004, #86981
Aussie Hybrids: The Search for Equity-Like Instruments, March 2001, #64504
An Application of Moody’s Tool Kit: The Analysis of Foundation Funds or Kikin for Japanese Mutual Life Insurers,
September 2004, #88441
A Time to Unwind: Moody’s Views about the Use of Exchangeable Bonds by Insurers, March 2000, #54632

The Role of The New Instruments Committee
Through the use of Moody's Tool Kit, the New Instruments Committee (NIC) primarily assesses the relative debt and equity characteristics of
hybrid securities. In addition, the NIC assesses monetization structures that seek to unlock the value of specific balance sheet assets or
investment holdings as well as liquidity products provided by the capital markets. Given the proliferation of hybrids, monetization structures, and
liquidity products worldwide, the NIC is focused on achieving global consistency.
To order reprints of this report (100 copies minimum), please call 1.212.553.1658.
Report Number: 91696
Author Associate Analyst Production Associate

The New Instruments Committee Jim Mannoia Alba Ruiz
© Copyright 2005, Moody’s Investors Service, Inc. and/or its licensors including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALL INFORMATION
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Rating Methodology
January 2006
Contact Phone
New Instruments Committee:
New York
Barbara Havlicek 1.212.553.1653
Peter Abdill
Glenn Eckert
Jim Mannoia
Michael McDermitt
Peter Neckles
Karen Nickerson
Atsi Sheth
Allen Tischler
London
Niel Bisset 44.20.7772.5454
Timour Boudkeev
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Sydney
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Global Banking Team:

Maria Cabanyes, Madrid
Lynn Exton, London
David Fanger, NY
Mutsuo Suzuki, Tokyo
Deborah Schuler, Singapore
Global Insurance Team:

Timour Boudkeev, London
Ann Perry, NY
Refinements to Moody’s Tool Kit:

An Addendum for Banks and Insurers
A Product of the New Instruments Committee and the
Global Banking and Insurance Teams
Why Publish an Addendum Specifically for Banks and Insurers?
In February 2005, the New Instruments Committee (NIC) released its report entitled, Refinements to Moody’s Tool Kit:
Evolutionary, not Revolutionary! In it, a number of refinements were made to Moody’s thought process regarding hybrid
securities. In addition to considering how a hybrid mirrors the features of common equity, greater recognition was
given to the support that a hybrid may provide for more senior creditors as well as the positive impact of a hybrid on an
issuer’s probability of a default1.
The refinements impacted all issuer types including banks, insurers, and corporate entities. At the same time,
additional benefit was given to hybrids issued by regulated financial institutions due to their oversight by regulators.
The purpose of this report is to provide greater clarity around the benefit of regulatory oversight in hybrid analysis and
other issues covered in our February piece related specifically to banks and insurers. Moody’s views on the use of man-
datory deferral triggers and how they are evaluated for regulated financial institutions is also discussed. Finally, greater
detail on how the baskets are used to adjust financial statements is provided.
Background on the Refinements to Moody’s Tool Kit

The refinements have generally resulted in more equity-like treatment for certain hybrids on Moody’s Debt – Equity
Continuum, which classifies hybrids in a basket from A to E according to their relative debt and equity characteristics
(Basket A is closest to debt while Basket E is closest to equity). The hybrid’s characteristics are ranked relative to the
features of common equity including No Maturity2, No Ongoing Payments3, and Loss Absorption4. The rankings can
be either none, weak, moderate, or strong relative to equity with none being the closest to debt and strong being the
closest to equity. For more detail on how baskets are assigned, refer to Appendix A.
The refinements made to the rankings of certain hybrid characteristics are summarized in the chart and explained
below:
Feature Old New

No Maturity
Undated hybrid with a cash call (corporates) None Weak
Undated hybrid with a cash call (banks and insurers[a]) None Moderate
Undated hybrid with a cash call and replacement language (all issuer types) Moderate Moderate
Undated hybrid with a cash call and binding replacement language (all issuer types) — Strong
Undated convertible hybrid with provisional call[b] (all issuer types) — Strong
Undated hybrid, non-callable (all issuer types) Strong Strong
No Ongoing Payments (for all issuer types)
Mandatory deferral[c], non-cumulative or non-cash cumulative[d] Moderate Strong
Optional deferral, non-cumulative or non-cash cumulative[e] Weak Moderate
Optional deferral, cumulative None Weak
Restricted optional deferral[f], non-cumulative or non-cash cumulative[g] — Weak
Restricted optional deferral, cumulative — None
Loss Absorption (for all issuer types)
Preferred securities Moderate Strong
Subordinated debt (no rights; only common equity is more junior to it) Moderate Strong
Subordinated debt (no rights) None Moderate
[a] If an undated hybrid with a cash call is issued by a bank or an insurer, the ranking may be favorably impacted by the benefit of regulatory oversight in certain
circumstances.
[b] Callable only if equity trades at a substantial premium to the equity conversion strike price.
[c] Mandatory deferral tied to the breach of pre-specified, meaningful triggers.
[d] Moody's standard for non-cash cumulative settlement of hybrid distributions will be described in greater detail in a future publication. One way that non-
cash cumulative settlement can be achieved is by settling distributions with the issuance of common shares within one year of the skipped distribution payment .
Additionally, if distributions are not settled due to a market disruption event (defined as a remote event where the issuer's common shares have been suspended
from trading), certain accumulated distributions would be forgiven in liquidation. If the issuer adds settlement with preferred securities, they must have a
perpetual maturity, replacement language if there is a call, mandatory deferral of distributions tied to the breach of meaningful triggers, and be non-cumulative.
Such “benign” preferred securities are subject to a cap of 25% of the principal amount of the issued hybrid.
[e] Same as footnote [d].
[f] With restricted optional deferral, an issuer does not have the option defer on hybrid distributions unless certain well out-of-the-money triggers are breached.
For example, an issuer may not have the option to defer unless minimum regulatory solvency ratios are breached or if the issuer has deferred on its common
dividends for a minimum of 12 months. These restrictions may prevent an issuer from deferring a hybrid distribution until it is in severe financial distress,
potentially limiting the benefit of the deferral mechanism and reducing its equity-like characteristics.
[g] Same as Footnote [d].
1. This is consistent with Moody’s approach to ratings, which captures expected loss defined as the product of the probability of default and the expected severity of loss.
2. There is no requirement to repay common equity.
3. Non-payment of a common dividend does not result in an event of default and there is no accumulation of unpaid dividends.
4. Common equity provides a loss absorbing cushion for more senior creditors in bankruptcy.

The modifications made to the rankings for the No Maturity dimension of equity reflect more equity-like treat-
ment than previously for undated hybrids5 with cash calls, which confer a right, rather than an obligation to repay the
hybrid. Driven by economic considerations, an issuer may repurchase common shares at any time or refinance exist-
ing hybrids by exercising a call option. This general lack of permanence is not driven by the features of common equity
or the hybrid’s characteristics themselves, but by the issuer’s view of the optimal capital structure. Consequently, a cash
call is viewed less negatively than in the past.
In terms of No Ongoing Payments, the modifications recognize that non-payment of deferrable hybrid distribu-
tions does not result in an event of default. This is the same outcome as for the non-payment of common dividends. A
hybrid may have one of a number of deferral and settlement mechanisms, which result in the cessation of distributions
at a time of financial distress. While continuing to calibrate the relative equity-like benefit of each, deferral mecha-
nisms overall receive greater equity benefit than in the past due to their generally favorable impact on an issuer’s prob-
ability of default.
For Loss Absorption, the modifications reflect the loss absorbing cushion that hybrids provide for senior creditors
with recovery far closer to common equity than either senior or subordinated debt in liquidation. This benefit is more
fully recognized by giving preferred securities, and certain types of subordinated debt that act like preferred securities
in practice, a ranking that is closer to that of common equity.
The Impact of Regulatory Oversight for Banks and Insurers in Hybrid Analysis
Unlike corporate entities, banks and most insurers6 are subject to the oversight of regulators, which ascertain the
soundness of a given country’s banking and insurance systems and provide strict guidance in terms of capitalization
standards. In the case of banks, regulators are interested in protecting depositors while insurance regulators are focused
on protecting policyholders. Banks and insurers may be subject to both state and federal or national regulation. In addi-
tion, for banks, Basle I established a global capital adequacy framework, which will be enhanced by the forthcoming
introduction of Basle II with risk-based capital adequacy requirements and a global supervisory framework.
With our February 2005 special comment, Moody’s recognized the benefit of regulatory oversight in its hybrid
assessment framework for the first time. The benefit is now given on the No Maturity dimension of equity, which cap-
tures the degree of permanence that a hybrid has in an issuer’s capital structure. Specifically, for an undated hybrid with
a cash call, the benefit of regulatory oversight is recognized if we believe that regulators will:
• not allow a hybrid to be called if the bank or insurer is in financial distress;

and
• generally require that a hybrid be replaced with a similar or more equity-like security due to regulatory
tiering of the capital structure.
In many countries, regulators facilitate the tiering of capital structures by designating issued securities as Upper
Tier 1, Upper Tier 2, or Lower Tier 2 Capital where Upper Tier 1 Capital provides the greatest loss absorption char-
acteristics. While there is no guaranty that the replacement hybrid will have similar features to the security that it
replaces, regulatory tiering of capital, which roughly corresponds to Moody’s basket designations, provides some com-
fort that this will happen.
The Benefit of Regulatory Oversight for Banks and Insurers Varies with the Regulatory Regime
The benefit of regulatory oversight will be given to banks or insurers that issue hybrids from the holding company or
operating company to the extent that regulatory oversight, including strict capital requirements, extends to the issuing
entity and Moody’s is satisfied with its quality. Bank operating companies are usually subject to this criteria on a global
basis. As a result, in most countries, hybrids issued by bank operating companies receive the benefit of regulatory over-
sight and do not need replacement language7 to receive a more equity-like ranking.
For bank holding companies, regulation can vary widely from country to country. For example, in the US, both
bank holding and operating companies are tightly regulated with strict capital requirements at both the holding com-
pany and operating company level. Therefore, hybrids issued by either one of them do not need replacement language.
5. Very long-dated hybrids may also receive more equity-like treatment.

6. European reinsurers are generally not subject to regulatory oversight.
7. Replacement language typically states that it is the issuer's intent to only call the security if it is repaid with proceeds from the issuance of the same or more equity-like
security. The replacement security must be issued within 6 months prior to the call date. Additionally, statements such as "it is the issuer's current intention" or "there
is no obligation to abide by this statement of intent" weaken the issuer's intention and, as such, do not meet Moody's criteria for acceptable replacement language.

In contrast, thrift holding companies in the US are not subject to capital requirements and, as a result, a hybrid issued
by a thrift holding company still requires replacement language to receive a more equity-like ranking.
In Europe, there are far fewer bank holding companies than in the US. In most of these cases, a single regulator
provides strict oversight of a bank group in its entirety and there is tiering of the capital structure. In Asia, not many
banks have holding company structures and regulatory treatment of them is inconsistent. While organizational struc-
tures may vary, regulators in Japan, Singapore, and Australia provide sufficient regulatory oversight generally and, con-
sequently, replacement language may also be unnecessary. As bank organizational structures and regulatory capital
requirements continue to evolve in Asia, Eastern Europe, and Latin America, Moody’s will adjust its views on the ben-
efit of regulatory oversight accordingly.
For US insurers, hybrids are generally issued by the holding company while it is the operating company that is
regulated. Consequently, hybrids issued by a US insurance holding company do not receive the benefit of regulatory
oversight and need to put replacement language in place.
Outside the US, insurance groups have holding and operating company structures, but their nature is different than
in the US.8 Except in the UK, where insurance regulators have put in place well-defined capital standards applying to
both holding and operating companies, European regulators have not yet defined their capital requirements in a way
that encourages replacement of a hybrid with a similar-type security. Therefore, in Europe, hybrids issued by all insurers
outside the UK, regardless of whether the issuing entity is a holding or operating company, do not receive the benefit of
regulatory oversight and need to put replacement language in place. In some countries in Europe, banks and insurers are
converging into one group and are subject to bank regulatory oversight (the Solvency 2 Initiative). While this regulatory
framework may provide benefit for some insurers from Moody’s perspective, the process will take time to implement.
The Benefit of Regulatory Oversight is as Good as Intent-based Replacement Language for Corporates
In reaching its decision to incorporate the benefit of regulatory oversight in its hybrid assessment, Moody’s considered
the use of intent-based replacement language by corporates that issue hybrids. Since replacement language is only
intent-based, it is not viewed as legally binding or enforceable.9 For banks and insurers, the regulators play the role of
replacement language in the corporate setting by having some say about the timing of the call and the terms of the
replacement security. Consequently, an undated hybrid with a call subject to replacement language, which is issued by
a corporate, and an undated hybrid with a call subject to regulatory oversight (as previously described), which is issued
by a bank or insurer, will both be ranked moderate on the No Maturity dimension of equity.10
A Recent Innovation: Strengthening Replacement Language

A recent innovation in the US market has been the introduction of a more binding form of replacement language. In
its issuance of a hybrid, US Bancorp11 achieved a Basket C by entering into a legally enforceable Declaration of Cove-
nant (Declaration). Under the terms of the Declaration, the bank is contractually obligated to redeem its preferred
stock only with the proceeds from the issuance of a specifically defined security, which has equal or greater equity con-
tent. The Declaration identifies specific classes of debt as Covered Debt that could potentially be harmed by the bank’s
inaction.12
Through a Declaration, a more direct link is established between the potentially harmed party (more senior cred-
itors) and the issuer, if it fails to issue the identical security or equity. If the issuer fails to act in accordance with the
terms of the Declaration, Covered Debt holders have the right to sue. With this strengthening of replacement lan-
guage, the ranking for an undated hybrid on the No Maturity dimension of equity shifts to strong from moderate.13
Consequently, assuming all other characteristics of a Basket D hybrid are the same,14 an issuer can achieve a Basket D
8. In the US, there is typically a holding company, which is a shell, and an operating insurance subsidiary. In contrast, European holding companies may have many
operating subsidiaries and the holding company may, at the same time, act as a non-life operating company.
9. Intent-based replacement language is not a binding obligation and the holders of the security will not be harmed if a similar replacement security is not issued. The
potentially harmed parties are more senior creditors, which always have the right to sue, although the link to the damaged party is not direct.
10. Note that Moody's views a strong regulatory environment as effectively a substitute for replacement language. As such, combining the two does not serve to provide
additional benefit in terms of the No Maturity dimension of equity.
11. Refer to the press release dated December 19, 2005 entitled, "Moody’s Assigns Aa3 To Trust Preferred Securities of US Bancorp's Subsidiary USB Capital VIII.”
12. It is preferable to designate subordinated debt rather than senior debt as Covered Debt because subordinated debt holders will more likely be harmed than senior
debt holders. If a company fails to replace a hybrid that ranks below subordinated debt with an equity-like replacement security, the subordinated debt holders will
have less loss-absorbing cushion beneath them and thus may be exposed to more losses than previously. For senior debt holders, as long as the replacement secu-
rity is not senior debt, they will be less harmed than subordinated debt holders because there will still be the same amount of junior debt behind them.
13. For an undated hybrid with a call covered by a Declaration to be eligible for a strong ranking on the No Maturity dimension, the Declaration must: 1) cover a desig-
nated class of subordinated debt that meets certain criteria regarding size and maturity, or, in the absence of existing subordinated debt, a class of senior debt that
meets the same criteria with language stating that any newly issued class of subordinated debt meeting the criteria will be included as covered debt; 2) clearly define
a replacement security having the same or more equity-like characteristics; and 3) be supported by an enforceability opinion from outside counsel that the Declaration
is legally enforceable.
14. A Basket D security is typically an undated preferred security or very long-dated subordinated debt with limited rights. If callable, it is subject to replacement language.

classification for its hybrid by either strengthening replacement language or using mandatory deferral triggers with
appropriate deferred distribution and settlement mechanisms.
Defining Mandatory Deferral Triggers

Hybrid securities typically allow an issuer, at its option, to defer distribution payments without creating an event of
default. Hybrids can also be structured with mandatory deferral where the breach of certain pre-specified meaningful
financial triggers result in automatic deferral of distribution payments. There has been heightened interest in manda-
tory deferral triggers because, if structured with them, a hybrid may potentially receive significant equity benefit
depending on its other characteristics.
Moody’s Views on the Benefit of Mandatory Deferral Triggers

Moody’s continues to believe that investment grade insurers and banks are not likely to defer hybrid distributions due
to concerns about potential loss of capital market access. Consequently, mandatory deferral of distributions tied to the
breach of meaningful triggers is viewed as a way to level the playing field between common dividends (which an invest-
ment grade issuer may opt to defer) and hybrid distributions (which an investment grade issuer is unlikely to defer). By
introducing triggers, the decision to defer hybrid distributions is taken out of the hands of the issuer and based on
objective criteria. The investor knows upfront that deferral is a possible outcome and receives a higher coupon for tak-
ing this risk.
While Moody’s considered extending the benefit of regulatory oversight to the payment of hybrid distributions,
our conclusion was that regulators may react differently to a period of stress at a financial institution. Specifically, a
regulator in one jurisdiction may prohibit hybrid distribution payments far earlier than a regulator in another jurisdic-
tion. Moreover, even within the same jurisdiction, regulators may behave differently for a different financial institu-
tion. Given this lack of consistency and predictability, mandatory deferral triggers based on objective criteria may
provide more consistency in terms of conservation of cash flow at a time of financial stress.
Moody’s general concept behind meaningful mandatory deferral triggers is, if breached, they result in the deferral
of hybrid distributions and provide cash flow relief in a deteriorating financial situation. The triggers should be based
on publicly available financial and/or operating parameters that best capture an issuer’s deteriorating financial condi-
tion and not be set at a level that is too tight, thereby creating the very market access disruption that they were meant
to protect against. Moreover, they should not be set at such a low level that they are breached only when the financial
institution is in such a severe state of financial distress that it is taken over by regulators. Our view is that the appropri-
ate level for a trigger breach is close to the time that a financial institution would consider suspending or cutting its
common dividend payments.
Assuming that a meaningful trigger is determined and any deferred hybrid distributions are non-cumulative, the
ranking for the deferral and settlement mechanism would be strong on the No Ongoing Payments dimension of
equity.15 In the absence of a meaningful trigger, the ranking would drop to moderate. Finally, if optional deferral is
restricted to a trigger breach, which is well out-of-the money, the ranking may be lowered further because the restric-
tion could limit the issuer’s ability to opt for deferral when needed.
Triggers for Banks in Concept and Practice

Mandatory deferral triggers for banks are designed to capture a deteriorating financial situation prior to regulatory
intervention. One indicator of a bank’s financial health is regulatory capital ratios that measure available capital relative
to the risks that a bank retains. Consequently, a number of European banks have issued hybrids with this type of trig-
ger either by itself or combined with a distributable profits or net loss test (see chart on next page), which Moody’s has
viewed as meaningful. No such precedent has yet been established for US banks.
15. This also applies to corporate issuers.

Bank Mandatory Deferral Trigger
[a]
Banco Comercial Portugues Dividends > Distributable Funds (Net Loss) or Tier 1 Capital < 5%.
Banco Pastor[b] Distribution Requirements > Distributable Profits (Net Loss) or Shortfall in Group’s Own Resources
> 20% of Minimum Own Resources (capital adequacy requirement) or Group Basic Own
Resources < 5/8 of Minimum Own Resources required for compliance with Tier 1 Capital > 5%.
DZ Bank[c] Tier 1 Capital < 5% or Consolidated Net Loss.
Fortis Bank, SA/NV[d] Tier 1 Capital < 5%.
[a] €500,000,000 Series D Perpetual Non-Cumulative Guaranteed Non-voting Step-Up Preference Shares, issued on October 12, 2005.
[b] €250,000,000 Fixed/Floating Rate Non-Cumulative Perpetual Guaranteed Preferred Securities issued on July 27, 2005.
[c] €400,000,000 Non-Cumulative Trust Preferred Securities issued on November 23, 2004.
[d] €1,000,000,000 4.625% Directly Issued Perpetual Securities issued on October 27, 2004.
While the definition of distributable profits may vary from country to country, Moody’s does not view the lack of
distributable profits (when defined as accumulated or retained profits) by itself to be a meaningful trigger because a
bank may experience several years of losses and substantial depletion of its capital position before it lacks distributable
profits. We believe that for financial institutions, including banks, most meaningful triggers should incorporate both an
earnings or profitability test and a capital adequacy or leverage test. Such triggers have already been used for hybrids
issued by a number of non-bank financial institutions including Lehman Brothers, CIT Group, and Met Life.
The combination of both tests better captures financial deterioration at a bank than either one on its own.16 For
example, a 4-quarter cumulative loss would be strong evidence of a weakening in a bank's financial condition. To the
extent that such losses caused a significant erosion in capital, it would indicate a strong need to conserve capital
resources even if the bank’s capital was still above trigger levels. On the other hand, a decline in a bank's regulatory
capital ratios below some “well capitalized” threshold would also indicate a strong need to conserve capital, even if
earnings remained positive.
In assessing triggers for banks in the context of hybrid analysis, Moody’s will consider the type and/or combination
of triggers used as well as the proposed level for a breach. The strength of the regulatory environment is also a consid-
eration and may result in the trigger level being set under the level required for a bank in a weak regulatory jurisdic-
tion. Particular scrutiny will be given to any jurisdictions where a regulator has overridden a mandatory deferral
trigger and forced payment of a hybrid distribution. In these cases, Moody’s believes that the determination of a mean-
ingful trigger is not possible.
Triggers for Insurers in Concept and Practice

The concept behind mandatory deferral triggers for insurers is the same as for banks: they are designed to capture a
deteriorating financial situation in advance of regulatory intervention. Triggers for insurers have been used both in
Europe and the US and have evolved over time:
Insurer Mandatory Deferral Trigger

[a]
Allianz Net Loss.
AGF, a subsidiary of Allianz[b] Net Loss with 4-quarter look-back at capital formation.
MetLife, Inc.[c] (i) 4-quarter Net Loss and shareholders’ equity has fallen by more than 10%
compared to prior 8 quarters; 2-quarter cure period, or (ii) the covered insurance
subsidiaries’ risk-based capital ratio is less than 175%.
[a] €1,500,000,000 Perpetual Subordinated Notes issued on February 27, 2004.

[b] €400,000,000 Undated Deeply Subordinated Notes issued on January 27, 2005.
[c] $600,000,000 Floating Rate Non-Cumulative Preferred Stock, Series A, issued on June 13, 2005, and $1,500,000,000 6.50%
Non-Cumulative Preferred Stock, Series B, issued on June 16, 2005.
The current trigger standard for all insurers is the one used in the Metropolitan Life transaction. The combina-
tion of financial tests is consistent with the insurance business model and the way that Moody’s analyzes the creditwor-
thiness of insurers. That is, if an insurer has a significant increase in claims payout, it may have the ability to raise
premiums and access the equity capital markets, potentially repairing any damage to its capital base.17
Consequently, this “or” trigger looks at a cumulative net loss, the change in the capital base over a period of time,
and allows for a cure period where financial strength may be restored through the issuance of equity. The second piece
of the trigger is a minimum solvency ratio, which is another important facet in the credit analysis of insurers. Taken
16. The combined trigger would likely be an “or” test.

17. This is particularly true for property/casualty insurers.

together, these financial tests are designed to isolate a one-off credit event and capture an ongoing decline in credit-
worthiness.18
Some Examples of Hybrid Securities Issued by Banks and Insurers

To illustrate the application of Moody’s Tool Kit to investment grade banks and insurers, examples of two generic
hybrids issued by each are provided.
Perpetual Preferred Issued by a Bank or Bank Holding Company

The characteristics of the hybrid are:
• The security has a perpetual maturity and can be called after 10 years. There is no replacement language,
but the bank or bank holding company is regulated and subject to regulatory capital requirements.
• Dividends can be deferred at the option of the bank or bank holding company and, if deferred, are non-
cumulative.
• The security has a preferred claim in bankruptcy.
This security is then compared to the features of common equity and ranked none, weak, moderate, or strong rel-
ative to common equity with none closest to debt and strong closest to equity:
Features of Common Equity Ranking Relative to Equity

No Maturity (1) Moderate
No Ongoing Payments (2) Moderate
Loss Absorption (3) Strong
Basket C
The rationale for each ranking and the basket is described below:
(1) The security has a perpetual maturity with a call after 10 years. Since the bank or bank holding company is a
regulated entity and subject to capital requirements, our view is that the regulator will not allow the security to
be called if the bank is in financial distress. In addition, if the security is called, the regulator may require that
it be replaced with a similar or more equity-like security. As a result, the security has some permanence relative
to common equity and is ranked moderate on the No Maturity dimension of equity.
(2) Dividends can be deferred at the issuer’s option and are non-cumulative, if deferred. Although a bank or bank
holding company is less likely to defer a preferred dividend than a common dividend, it has a degree of flexibil-
ity at a time of financial distress. Moreover, similar to common dividends, any preferred dividends that are
deferred are non-cumulative. This deferral and settlement mechanism is ranked moderate on the No Ongoing
Payments dimension of equity19.
(3) A preferred security has a claim in liquidation that is only senior to equity and provides a cushion to absorb
losses. As a result, it is ranked strong relative to equity on the Loss Absorption dimension.
Perpetual Preferred Issued by an Insurance Holding Company

The characteristics of the security are:
• Perpetual maturity that can be called in 10 years. Regulatory oversight does not extend to the insurance
holding company, but there is explicit, intent-based replacement language. It says that the insurer intends to
call the security only if it is repaid from proceeds of the issuance of the same or more equity-like security.
• Dividends must be deferred if certain pre-specified, meaningful triggers are breached. If deferred, dividends
are non-cumulative or may be stock-settled under certain circumstances (as previously described).
• The security has a preferred claim in bankruptcy.
This security is also compared to the features of common equity and ranked none, weak, moderate, or strong rel-
ative to common equity with none closest to debt and strong closest to equity:
18. For insurers outside the US, regulatory group solvency ratios are generally not well developed. As a result, a solvency test would not be included in a trigger.
19. In this example, the bank or bank holding company has the ability to defer dividends without restriction. However, in certain hybrids, the issuer’s ability to defer may be
limited. For example, if a bank or bank holding company has the right to defer dividends only if a minimum regulatory capital ratio is breached, we view this as
restricted optional deferral and would assign a weak ranking on the No Ongoing Payments dimension of equity. Since the bank or bank holding company only has
the right to defer when a minimum regulatory capital ratio is breached and it is in severe financial distress, the issuer has less flexibility than it has with truly unre-
stricted optional deferral (effectively, optional deferral is available too late). When combined with the other characteristics in this example, the Basket would shift from
C to B.

Features of Common Equity Ranking Relative to Equity
No Maturity (1) Moderate
No Ongoing Payments (2) Strong
Loss Absorption (3) Strong
Basket D
The rationale for each ranking and the basket is described below:
(1) The hybrid has a perpetual maturity with a call after 10 years. While we do not believe that regulators will
impose standards for the replacement security if this security is called, there is intent-based replacement lan-
guage, which does provide some discipline. Similar to the ranking for the security issued by the bank, this
characteristic is ranked moderate on No Maturity.
(2) There is mandatory dividend deferral tied to the breach of certain pre-specified meaningful financial triggers.
The lead analyst and rating committee at Moody’s reviewed the type of trigger and believes that it is effective
at capturing a deteriorating financial condition. In addition, with verification through back testing and peer
comparison, it has been set at a level where there would likely be a breach at the time the common dividend is
suspended or cut. At the insurer’s option, dividend payments are non-cumulative or stock-settled under certain
circumstances (as previously described), which means they preserve internally generated cash. This deferral
and settlement mechanism closely replicates common dividend deferral and is ranked strong on the No Ongo-
ing Payments dimension of equity.
(3) A preferred security has a claim in liquidation that is only senior to equity and provides a cushion to absorb
losses. As a result, it is ranked strong relative to equity on the Loss Absorption dimension.
Clarification on the Use of Baskets to Adjust Financial Statements

In our Refinements to Moody’s Tool Kit: Evolutionary, not Revolutionary!, a number of questions were raised about footnote
4 on page 3. In that footnote, we describe how the baskets are used to adjust corporate financial statements. Specifically,
the hybrid is classified on the balance sheet according to the debt and equity components assigned to the basket. The
income statement is also adjusted with a certain percentage of the hybrid distribution classified as interest expense and
the remainder classified as preferred dividends20. Ratios are then computed based on the adjusted financial statements.
For financial institutions, the basket is used to classify the hybrid for balance sheet purposes only. The hybrid dis-
tributions remain classified according to the GAAP or IFRS presentation. The rationale for this difference in classifi-
cation treatment relates to what is emphasized in credit analysis for either corporates or financial institutions. In the
credit analysis of banks, the differentiation between interest and fixed charge coverage ratios is not particularly rele-
vant21. As a result, the breakdown of hybrid distributions into an interest expense component and a preferred dividend
component does not provide additional useful information.
For insurers, fixed charge coverage is an important ratio to consider and since it incorporates both interest expense
and preferred dividends, it is less relevant to separate the interest expense component from the preferred dividend
component. However, for corporates, since both interest and fixed charge coverage ratios are important to consider,
the use of baskets to allocate hybrid distributions is more relevant.
Summary and Conclusion

In this addendum, we have not presented any new thinking related to hybrid analysis, but instead clarified some of our
refinements to hybrid analysis, specifically in the context of banks and insurers. More in-depth discussion is provided
on our rationale for recognizing the benefit of regulatory oversight in hybrid analysis. We also covered how mandatory
deferral triggers, if set at a meaningful level, may result in cash flow relief at a time of financial distress, similar to the
way that common equity acts. Finally, greater clarity is provided on the use of baskets to adjust financial statements,
particularly in the context of hybrid distributions.
20. For example, if a Basket C security is issued, 50% of the hybrid distribution is classified as interest expense with the remaining 50% classified as preferred dividends.
If a company refinances a Basket B security with a Basket C security, there will be a positive impact on interest coverage as the interest expense component drops
while the preferred dividend component rises. However, there will be no impact on fixed charge coverage because both interest expense and preferred dividends are
used in the calculation.
21. However, these ratios have more relevance for the liquidity analysis of bank holding companies.

Related Research
Special Comments:
An Application of Moody's Tool Kit: The Analysis of Preferred Securities Issued by US Real Estate Investment Trusts
(REITs), May 2005 (# 92580)
Characteristics of a Basket E Mandatorily Convertible Security for Financial Institutions and Corporates, November
2004 (# 89899)
Aussie Hybrids: The Search for Equity-Like Instruments, March 2001 (# 64504)
A Time to Unwind: Moody’s Views about the Use of Exchangeable Bonds by Insurers, March 2000 (# 54632)
Rating Methodologies:
Hybrid Securities Analysis: New Criteria for Adjustment of Financial Ratios to Reflect the Issuance of Hybrid
Securities, November 2003 (# 79991)
Refinements to Moody’s Tool Kit: Evolutionary, not Revolutionary!, February 2005 (# 91696)
Moody’s Tool Kit: A Framework for Assessing Hybrid Securities, December 1999 (# 49802)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this
report and that more recent reports may be available. All research may not be available to all clients.

Appendix
Refresher on Moody’s Approach to Hybrid Analysis
Moody’s published its Tool Kit for assessing hybrid securities, including preferred securities, in 1999. A comparative
framework was introduced, which ranks various hybrids on a relative basis and places them in different baskets on the
Debt-Equity Continuum. The baskets range from Basket A (more debt-like) to Basket E (more equity-like). Through
this analysis, the hybrid is broken down into its basic characteristics including maturity, call options, conversion
options, deferral mechanics, and priority of claim in liquidation. To see how closely equity is replicated, these basic
characteristics are compared to the features of equity including:
• No maturity.
• No ongoing payments, the absence of which would result in a default.
• Loss absorption for all creditors.
The hybrid’s characteristics are scored in terms of their strength relative to common equity. The four gradations
of modifiers used are none, weak, moderate, and strong relative to common equity with none corresponding to most
debt-like and strong corresponding to most equity-like. Once these scores have been assigned, the hybrid is compared
to hybrids already on the Debt-Equity Continuum for consistency purposes and is placed in a basket. The hybrid is
then considered within the context of each issuer’s overall credit fundamentals and its impact on the rating is left to the
relevant rating committee.
Adjustment of Financial Statements to Reflect the Issuance of Hybrids

In November 2003, Moody’s assigned a specific debt and equity percentage to each basket to improve consistency in
the interpretation of the baskets. The specific percentages assigned to each basket are:
Basket A Basket B Basket C Basket D Basket E

100% debt 75% debt 50% debt 25% debt 100% equity
25% equity 50% equity 75% equity
To illustrate, a $100 million hybrid placed in Basket C will result in a $50 million increase in debt and a $50 mil-
lion increase in equity on the balance sheet. For the income statement of corporate issuers, the hybrid distribution is
also broken down based on the basket with 50% of the distribution allocated to interest expense and 50% allocated to
preferred dividends. Ratios are then computed based on the adjusted financial statements in the same manner for both
investment grade and non-investment grade issuers.
For financial institutions including banks, insurers, and REITs, the balance sheet is adjusted for the baskets, but
hybrid distributions are captured according to GAAP or IFRS accounting. This means that distributions for a pre-
ferred security in Basket C will be reflected fully in preferred dividends in the financial statements rather than adjusted
for the basket. Ratios are then computed based on the adjusted balance sheet and the hybrid distributions presented
on a GAAP or IFRS basis for both investment grade and non-investment grade issuers.

Author Associate Analyst Production Specialist

Barbara Havlicek Jim Mannoia Ida Chan
© Copyright 2006, Moody’s Investors Service, Inc. and/or its licensors and affiliates including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALL
INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED,
FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN
ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by
MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to $2,400,000. Moody’s Corporation
(MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS’s ratings and rating
processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly
reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder Relations — Corporate
Governance — Director and Shareholder Affiliation Policy.”
Moody’s Investors Service Pty Limited does not hold an Australian financial services licence under the Corporations Act. This credit rating opinion has been prepared without taking into
account any of your objectives, financial situation or needs. You should, before acting on the opinion, consider the appropriateness of the opinion having regard to your own objectives,
financial situation and needs.

Rating Methodology
February 2007
Contact Phone
New York
Jerome Fons 1.212.553.1653
Barbara Havlicek
David Fanger
Daniel Gates
London
Eric de Bodard 44.20.7772.5454
Lynn Exton
Updated Summary Guidance for Notching Bonds,

Preferred Stocks and Hybrid Securities of
Corporate Issuers
Notching refers to the general practice of making rating distinctions among the different liabilities of a single entity or
of closely related entities. The conceptual framework underlying Moody's approach to notching was first laid out in a
November 2000 rating methodology report, "Notching for Differences in Priority of Claims and Integration of the
Preferred Stock Rating Scale." In September 2001, Moody's released a special comment "Summary Guidance for
Notching Secured Bonds, Subordinated Bonds, and Preferred Stocks of Corporate Issuers" which outlined its notch-
ing practices. This methodology updates the 2001 summary guidance to include hybrid securities and concludes the
November 2006 request for comment "Rating Preferred Stock and Hybrid Securities."
Notching for Subordination

The guidance provided in this section for subordination-based notching applies to all corporate issuers, except those
speculative-grade non-financial corporate issuers subject to Moody's Loss Given Default methodology.1 The guid-
ance integrates a stylized definition of Moody's ratings, expressed in terms of expected-loss rates, with information
about expected relative loss severity in the event of default for the various security classes of a single issuer.
Moody's notching guidelines are intended to ensure that two securities with the same rating have the same
expected loss rate. An obligation's expected loss rate is defined as the product of the probability of default and the
expected severity of loss given default. Generally, it is assumed that the probability of default is linked to the issuer of
the obligation and is consequently the same across all obligations of that issuer. Notching practices based on this
assumption are referred to as subordination-based notching.
Whenever possible, Moody's estimates issuer-specific expectations of relative expected loss severity upon default.
However, relative loss severity estimates alone are insufficient to answer the following key questions:
• Are any differences sufficient to merit a rating distinction?
• If so, should the differences be one notch, two notches, or more?
• And do notching recommendations vary, depending where an issuer's benchmark rating is located on the
rating scale?
As discussed in the September 2001 summary guidance document, in order to answer these questions, one needs
to know the percentage change in expected-loss rates as one traverses the long-term rating scale.
Moody's benchmark expected loss rates define the meaning of Moody's ratings, both for structured finance trans-
actions and for fundamental corporate issuers. In particular, Moody's idealized expected loss (and default) rates exhibit
the following characteristics:
1. This includes US and Canadian issuers, as well as EMEA issuers from end of March 2007 on. Please see Moody's Rating Methodology "Probability of Default Rat-
ings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate Obligors in the United States and Canada," August 2006 and the Novem-
ber 2006 request for comment "Probability of Default Ratings and Loss Given Default Assessments for Corporate Obligors in Europe, Middle East and Africa:
Recommended Framework."
• For rating categories Ba2 and higher, the percentage difference in risk, relative to one category higher, is
45% or greater.
• For rating categories Ba3 and below, the percentage difference in risk, relative to one category higher, is less
than 45%.
In order to translate these differences into notching guidance, we need estimates of differences in loss across debt
classes. The table below summarizes the percentage difference in average severity of loss, relative to an issuer's senior
unsecured rating, for a number of debt classes.
Average Loss Severity Rates for Various Debt Classes

(relative to the historical loss severity on the same issuer's senior unsecured bonds)
Secured bonds -30%
Senior unsecured bonds n/a
Senior subordinated bonds 40%
Subordinated bonds 52%
Junior subordinated bonds 62%
Preferred stock 85%
For those adjacent rating categories where the percentage difference in risk is greater than 45%, the percentage
difference in loss severity, relative to senior unsecured bonds, must be at least 45% to justify a rating notch. Two
notches would require a difference in loss severity of at least 110%. For rating categories where the percentage differ-
ence in risk is less than 45%, a difference in loss severity in excess of 45% would justify possibly multiple rating
notches.
For example, as shown in the table above, subordinated bonds recover on average 52% less than senior unsecured
bonds. Accordingly, they would be notched once if the senior unsecured rating is Ba2 or higher and perhaps twice or
even three times at lower rating levels.
Using this logic, we developed the following, simplified guidelines for subordination-based notching. As men-
tioned previously, speculate-grade corporate issuers subject to Moody's LGD methodology are not covered by these
guidelines. Also note that no distinction is made between cumulative and non-cumulative preferred stock.
Guidance on Notching for Subordination

Number of Notches
("+" greater than;
Security Class "-" less than) Reference Rating
Secured Bonds +1 Sr. Unsecured
Sr. Unsecured 0 Sr. Unsecured
If Sr. Unsecured or Sr. Subordinated -1 Sr. Unsecured
Corporate Family Rating
is Ba2 or higher Subordinated -1 Sr. Unsecured
Jr. Subordinated -1 Sr. Unsecured
Preferred stock -2 Sr. Unsecured
Number of Notches
("+" greater than;
Security Class "-" less than) Reference Rating
Secured Bonds +1 CFR or Sr. Unsecured
Sr. Unsecured 0 CFR or Sr. Unsecured
If Sr. Unsecured or Sr. Subordinated -2 CFR or Sr. Unsecured
Corporate Family Rating
is Ba3 or lower Subordinated -2 CFR or Sr. Unsecured
Jr. Subordinated -2 or -3* CFR or Sr. Unsecured
Preferred stock -3 or -4# CFR or Sr. Unsecured
*Junior subordinated debt is rated 2 notches below senior unsecured (or the corporate family rating), unless a
company has a substantial amount of senior subordinated or ordinary subordinated debt outstanding; then it is rated
3 notches below the senior implied rating.
#Preferred is rated one notch below the lowest rating assigned to any type of subordinated debt.

Notching Hybrid Securities
Modern hybrid securities — combining features of debt and equity and usually ranked as either subordinated debt or
preferred stock in terms of priority of claim — pose a unique set of risks that may not be adequately captured in the
guidelines above. In particular, issuers may be allowed — or, in some cases, required — to omit dividends (or other
payments) without triggering a broader default. In order to justify incremental notching beyond subordination-based
outcomes, we must address the following questions:
• Is the risk of payment deferral material?
• If so, are the expected losses due to deferral large enough to warrant a rating notch?
To compare the relative potential loss rates on hybrids and ordinary debt securities, one needs to consider not only
any differences in loss on principal, but also the possibility that the hybrid security will go into "default" under circum-
stances in which the non-hybrid security does not default, or if it does, it enters default at a later date.2 Given, how-
ever, the lack of empirical data on hybrid losses, we are not suggesting incremental notching for deferral risk where
deferral is optional, since anecdotal evidence to date suggests that the option to defer is very rarely exercised. Where
"meaningful" mandatory deferral features are present, however, the following guidance holds:
Hybrid Notching Guidelines

A hybrid security with a meaningful mandatory trigger and a priority of claim
above preferred stock will be rated one notch below the subordination-based (or
LGD derived) rating.
A hybrid security with a preferred stock (or equivalent) priority of claim will have
no additional notching.
As a general rule, notching should not exceed guidance for preferred stock. For example if a hybrid security were
already notched twice because it is deeply subordinated, no further notching would be warranted.
Meaningful mandatory deferral triggers are defined in footnote 8 of Moody's December 2006 Rating Methodol-
ogy "Supplemental Comments on Rating Preferred Stock and Hybrid Securities":
Meaningful triggers are those set at a level such that they would be breached when: 1) the issuer is
just beginning to experience financial distress (before it is in severe financial distress); and 2) at a time
when the issuer may cut or eliminate its common dividend.
Typically for non-financial corporate issuers, Moody's rating committees have set triggers to be activated when
financial measures correspond to a mid-Ba rating. For financial issuers, the January 2006 Rating Methodology
"Refinements to Moody's Tool Kit: An Addendum for Banks and Insurers," provides further guidance:
Moody's general concept behind meaningful mandatory deferral triggers is, if breached, they result
in the deferral of hybrid distributions and provide cash flow relief in a deteriorating financial situa-
tion. The triggers should be based on publicly available financial and/or operating parameters that
best capture an issuer's deteriorating financial condition and not be set at a level that is too tight,
thereby creating the very market access disruption that they were meant to protect against. More-
over, they should not be set at such a low level that they are breached only when the financial institu-
tion is in such a severe state of financial distress that it is taken over by regulators. Our view is that
the appropriate level for a trigger breach is close to the time that a financial institution would con-
sider suspending or cutting its common dividend payments.
Moody's ranks instruments with meaningful mandatory deferral triggers and an acceptable settlement mechanism
as "strong" on the "No Ongoing Payments" dimension of its equity credit methodology.3 Such triggers are typically
set at a level that would be crossed before the issuer experiences severe financial stress. The probability of tripping is
considered to be material enough to warrant a rating notch.
2. Payment deferral on hybrid securities usually cannot trigger either a default on the hybrid itself or a cross-default on the issuer’s other obligations. In rating hybrid secu-
rities, Moody’s assumes hybrid investors expect to receive payments as scheduled.
3. An acceptable settlement mechanism is one that is viewed as effectively non-cumulative, according to Moody's hybrid basket methodology.

The financial metrics used in setting meaningful mandatory deferral triggers usually vary from industry to indus-
try. Furthermore, hybrid securities with mandatory deferral provisions may use a combination of more than one
financial ratio test for Moody's to consider the triggers meaningful. Some common financial ratio tests used in hybrids
with meaningful mandatory deferral triggers include:
• Negative GAAP income for four consecutive quarters combined with a decline in book capital and a cure
period which allows the capital base to be restored
• Gross cash flow less than X% of consolidated sales
• Interest coverage ratio less than or equal to X times
• Retained cash flow-to-debt ratio of less than X%
• Tangible equity below X% of assets under management (for an asset manager)
Global Application of Notching Guidelines

The guidance presented here is global and applies to all industries. It is expected that the vast majority of corporate
ratings will conform to these guidelines. Certain exceptions, however, will be made where Moody's believes the terms
of a security materially increase an investor's expected loss beyond established norms. Consequently, some securities
may be subject to an additional notch. In particular, examples will be found in the case of certain European non-finan-
cial corporate issuers, banks, and reinsurers in certain countries (e.g. Germany and Switzerland).
European Non-Financial Corporate Issuers
While many European countries allow the issuance of preferred stock, the practice is rare due to a lack of investor
appetite. In addition, some issuers either lack a board resolution authorizing issuance of preferred stock, or have cove-
nanted not to do so. For such firms, hybrid securities can act as a substitute for preferred stock. Hybrids issued by
European firms are typically classified as "deeply subordinated" notes, senior only to common stock. Moody's consid-
ers the junior position of such European corporate hybrid obligations as increasing an investor's expected loss to levels
typically associated with preferred stock, and therefore ratings on such hybrid instruments typically follow guidance
given for preferred stock. For example, a deeply subordinated hybrid instrument issued by a European corporate with
a senior unsecured rating at Ba2 or above would be rated two notches below the issuer's senior rating.
Banks
Moody's notching guidance uses an issuer's senior unsecured rating as a benchmark, or reference point, for determin-
ing the ratings on subordinated obligations. The rating methodology for banks first determines deposit ratings, then
in most cases sets senior unsecured debt ratings equal to the deposit ratings. Moody's does not believe, however, that
bank deposit ratings are always an appropriate notching benchmark.
Notching between a bank's deposit rating and more junior bond ratings may be wide in cases where Moody's
expects the sovereign government to support the depositors and senior debt holders of a failing bank, but may not pro-
vide the same support to junior bond holders. That is, Moody's believes that certain governments will try to push
down the losses of a failing bank on junior debt holders, while protecting depositors and other senior debt holders. For
a bank in such jurisdictions, these relatively higher levels of investors' expected loss may lead to wider notching for
hybrid ratings than indicated by the above guidelines.
Reinsurers
For reinsurers in certain countries (e.g. Germany and Switzerland), unlike primary insurers, senior debt holders are not
subordinate to policyholders, reflecting the regulatory protection that exists for primary insurance policyholders, but not
for reinsurance policyholders. As a result, while senior debt ratings for primary insurance operating companies are
notched below the Insurance Financial Strength Rating (IFSR), a reinsurer's senior unsecured debt will typically be rated
at the same level as the IFSR. However, this preferential parity status does not extend to subordinated or more junior
obligations, and such instruments are expected to bear a substantially greater loss in default than senior creditors (policy-
holders and senior debt).

Hence, Moody's rates subordinated debt in such cases two notches below senior - in line with the IFSR/subordi-
nated debt notching differential for primary insurers. Consequently, the existence of a meaningful mandatory trigger
for the subordinated debt of a reinsurer with a senior rating of Ba2 or above, under the revised guidelines, would be
rated one notch lower than other subordinated debt and at the relevant preferred security rating level (three notches
below senior).
This was the rationale underlying Moody's February 2007 rating action which placed the hybrid ratings of two
reinsurers - Allianz SE (the holding company and reinsurer for the Allianz Group) and Swiss Re - on review for possi-
ble downgrade.4
4. Please see "Moody's Set to Issue Revised Guidelines for Hybrid Securities," February 2006, available on moodys.com.

Related Research
Special Comments
Notching for Differences in Priority of Claims and Integration of the Preferred Stock Rating Scale,
November 2000 (61680)
Summary Guidance for Notching Secured Bonds, Subordinated Bonds, and Preferred Stock of Corporate Issuers,
September 2001 (70456)
Rating Methodologies
Rating Preferred Stock and Hybrid Securities, November 2006 (100692)
Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate
Obligors in Europe, Middle East and Africa: Recommended Framework, November 2006 (100673)
Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate
Obligors in the United States and Canada, August 2006 (98771)
Refinements to Moody's Tool Kit: Evolutionary, not Revolutionary!, February 2005 (91696)
Moody's Tool Kit: A Framework for Assessing Hybrid Securities, December 1999 (49802)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report
and that more recent reports may be available. All research may not be available to all clients.

Author Senior Production Associate

Jerome Fons Charles Ornegri
© Copyright 2007, Moody’s Investors Service, Inc. and/or its licensors and affiliates including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALL
INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED,
FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN
ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by
MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000.
Moody’s Corporation (MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of
MIS’s ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and
have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder
Relations — Corporate Governance — Director and Shareholder Affiliation Policy.”

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market intelligence

HYBRID CAPITAL SECURITIES:

© Thomson Financial 2007

Typeset by: Claire Taylor and Nicola O’Hara

ACSM Alternative coupon satisfaction mechanism

01 What are hybrid capital securities?

The preferred stock paradigm

Table 1.1: The preferred stock paradigm

Preferred stock Paradigm

Deeply subordinated and senior

Source: Compiled by CALYON

Some bank regulatory history

The Basel Capital Accord

0 Common stock and perpetual non-cumulative preferred stock, preference shares;

0 Reserves (through appropriations of retained earnings or other surplus);

0 Issued and fully paid up (to the bank);

0 Non-cumulative payments at the bank/regulator discretion;

0 Support going-concern status (loss absorption);

Rating agency impact

Accounting, legal and tax considerations

2 Refinement to Moody’s Tool kit: Evolutionary, not revolutionary!’ (February 2005)

Who are the issuers?

Figure 1.1: Sectoral differences in the rationale for hybrid issuance

Banks Insurance Corporates

Usually Depends - some Mostly

Source: Compiled by CALYON

Source: Compiled by CALYON

Diversity and globalisation prevalent in geographical issuance trends

Who are the investors?

Figure 1.3: Institutional hybrid investors – illustrative global breakdown (%)

Source: Compiled by CALYON

Evolution – historical milestones and outlook

Hybrid market size, growth and structure

Source: Compiled by CALYON

Source: Compiled by CALYON

Source: Compiled by CALYON

The European investor market

Figure 2.4: European investor market hybrid supply, by issuer region,

15% 1% Other Benelux

Source: Compiled by CALYON

Source: Compiled by CALYON

Source: Compiled by CALYON

Bank Tier 1 sector

Source: Compiled by CALYON

Figure 2.8: European investor market bank Tier 1 supply, by currency,

Source: Compiled by CALYON

Insurance hybrid sector

Figure 2.10: European investor market insurance hybrid supply, by currency,

Source: Compiled by CALYON

Corporate hybrid sector

Figure 2.12: European investor market corporate hybrid supply, by currency,

Source: Compiled by CALYON

The US investor market

Other European countries Other countries

Source: Compiled by CALYON

15% Bank tier 1