The revised approach would change debt to total capitalization calculations for many firms that issued these securities, but is unlikely to affect their overall credit ratings.
Moody's is also looking to simplify the way in which it characterizes hybrid securities as the basis for its equity credit analysis and to better align its hybrid rating and equity credit assignment practices.
The changes are based on the observed behavior of hybrid issuers and the performance of these securities during the financial crisis.
Hybrid securities are designed to absorb losses before an issuer heads into a general default, as does equity with dividends that may be skipped. Moody's awarded equity credit largely based on this ability.
In assigning equity credit, Moody's assumption was that banks and non-banks would not exercise the option to skip coupon payments, largely out of concern for reputational damage. However, during the financial crisis, regulators intervened and made it clear that banks should impose losses on hybrids in order to preserve capital.
"We have learned that it generally took outside factors to prompt issuers to use the loss-absorbing features of hybrids and skip payments on them.
In certain cases, the breach of triggers resulted in the same outcome. We have also learned that some features effectively become loss absorbing only when the issuer faced a general default, and hence the instruments are in fact only a step away from debt in the capital structure," says Moody's Senior Vice President Barbara Havlicek.
Moody's recently lowered a significant number of ratings on hybrids issued by banks after it became apparent that systemic support for them should not be assumed in the ratings. Additionally, the ratings were adjusted further downward based on the riskiness of a hybrid's features.
Moody's has also taken a single rating action on an insurance hybrid where systemic support generally does not apply.
Moody's is considering changes to the ratings of certain hybrids issued by non-financial companies, which would result in downgrades for a small number of instruments. Any resulting downgrades would likely be limited to one notch and to non-cumulative hybrids with strong mandatory coupon skip triggers.
In assigning equity credit to a hybrid under the revised approach it is proposing, Moody's would ask three questions:
1) Does the hybrid absorb losses well in advance of a broad, company-wide default?
2) Does the hybrid only absorb losses when a broad, company-wide default is imminent?
3) Is the hybrid likely to be part of the capital structure when needed to absorb losses?
This approach would replace a detailed scoring system that compared the hybrid's features to the features of common equity.
"Our revised approach is more direct and makes it unlikely that relatively minor adjustments to a hybrid's structure would result in a higher score on the equity spectrum," says Havlicek.
Moody's describes in detail the proposed changes and the rationale for making the changes in the request for comment, "Proposed Changes to Moody's Hybrid Tool Kit," which is available on Moodys.com. Moody's is specifically requesting feedback on its proposed framework and how it would classify various hybrids within this context. Moody's invites market participants to send comments to [email protected] no later than April 23, 2010.
In conjunction with the request for comment, the rating agency has also published a frequently asked questions document, which is also available on moodys.com.