Hybrid Securities....

courtesy : FT.com
Friday December 8, 2:05 pm ET

Not for the first time this year, the hybrid securities market is in a bit of a spin. Some investors are irritated by last month's proposals by Moodys to tighten its approach to hybrids, which mix the attributes of debt and equity instruments. On Thursday, the rating agency put out a clarification of its plans in an attempt to address concerns about the proposal.

The change would mean a one-notch rating reduction for "non-cumulative" securities - those that allow issuers to cancel interest payments without the possibility of making them up later. Moody's thinks this could affect about 300 securities and some analysts worry that the proposed change could lead to an excessive ratings gap between senior debt and some lower ranking hybrid securities.

It is worth remembering that the whole purpose of these instruments is to have it both ways: investors receive higher interest rates than on senior debt in exchange for greater risk; issuers benefit from the equity-like characteristics of the instruments. Banks get to count hybrids as Tier One capital for regulatory purposes. Companies can raise extra financing without affecting the rating of their senior debt or diluting equity.

It is impossible for a ratings system to reflect every nuance of the risks involved in these securities. The subordination of hybrid securities - they rank below senior debt in the event of a default - is not their only risky aspect. Both Standard & Poors and Moody's have been grappling with how to approach the risk of non-payment of coupons. S&P backed down on its own proposed adjustment earlier this year.

The risk for the agencies is that ratings become too complex to be meaningful or even useful to investors. Irritated critics also argue that market prices already reflect the different features of these securities. This is true but that could be an argument for better reflecting these in ratings. While the banks want clear, simple ratings, they also keep structuring ever more complex - and risky - instruments. Wanting to have it both ways can get to be a habit.