Fitch’s view on Hybrid Securities Analytical Considerations and the Credit Impact

1. ISDASeminar Fitch’s view on Hybrid Securities Analytical Considerations and the Credit Impact Damir Bettini, Senior Director – Insurance September 21, 2005

2. Summary • Definitions • Issuance trends • Rating concepts • Governing criteria • Rating methodology • Equity credit for hybrid instruments • Examples

3. 1. Definitions • A hybrid security is anything that is neither plain senior debt or common equity • Hybrid characteristics: • Security combines debt- and equity-like features • Equity-like means long maturity, no fixed payment (i.e. deferrable coupon), junior ranking in liquidation • Debt-like means opposite of equity-like • Other debt-like features include; covenants, acceleration, cross-default, superior recovery characteristics, excessive complexity

4. Definitions(cont.) • Benefits of hybrids: • Offers flexibility of equity without shareholder dilution • In default provides protection to senior creditors and improves latter’s recovery prospects • Stable source of long-term funding for healthy companies • Can fulfill an important A&L role for banks • Helps meet regulatory and rating agency capital requirements for insurers and banks • Interest deferral feature provides some financial flexibility • Limitations of hybrids: • “Perpetual”, but not in practice; coupon step-ups/call features can act as effective maturity dates. • Deferral features can be extremely difficult to utilise in practice • Excessive complexity can exacerbate financial stress

5. 2. Issuance Trends • Strong increase in European hybrid issuance • Take advantage of low-interest rate environment • Diversify capital structures and sources • Increase risk bearing capital • Tax-advantaged • Reduce WACC • Convergence in regulation for banks and insurers • Solvency II, Insurance Groups Directive, Financial Groups Directive

6. Banks Tier 1 Euro & GBP Issuance - Volume

7. Banks Tier 1 Euro & GBP Issuance – Value (€m)

8. Insurance Euro & GBP Hybrid Capital - Volume

9. Insurance Euro & GBP Hybrid Capital – Value (€m)

10. Corporate Euro & GBP Hybrid Capital - Volume

11. Corporate Euro & GBP Hybrid Capital – Value (€m)

12. 3. Rating Concepts • For banks and corporates, debt ratings derived directly from fundamental credit analysis of issuer • Key rating is “Long-Term Rating” (LT rating) • LT rating is “Issuer” rating corresponding to senior unsecured obligations • For insurance sector, debt ratings derived from IFS (Insurer Financial Strength) rating of operating entities and holding company analysis • IFS rating measures capacity to meet policyholder obligations • LT rating for insurers then derived from IFS • Key comparable rating across sectors is the LT rating

13. 4. Governing Criteria • Two key concepts for rating agencies when assessing hybrids: • Rating of hybrid • Equity credit for hybrid • Key papers for corporates and insurers: • “The Relationship Between Insurer Financial Strength Ratings and Debt Ratings”, published February 2001 • “Hybrid Securities: Evaluating the Credit Impact – Revisited”, published April 2005 • Key papers for banks: • “Rating Preference Stock and Hybrid Securities of Financial Institutions”, published May 1999 • “Bank Hybrid and Preferred Securities: Evaluating Their Role in Capital Analysis”, published July 2005 • Hybrid rating criteria is consistent across sectors • Some difference in equity credit criteria across sectors • All criteria papers available freely on Fitch website: www.fitchratings.com

14. 4. Governing Criteria (cont) • Fitch equity credit criteria revised in 2005: • 12-month back-testing project • Revisions implemented for all sectors • Fitch notching (rating) criteria currently under review: • “The Role of Recovery Analysis in Ratings – Enhancing Informational Content and Transparency”, published February 2005 • “LT Rating” replaced by “Issuer Default Rating” (IDR) • Explicit recovery analysis for B+ rated and below, with R1-R6 recovery ratings published with IDR • Criteria revisions to be implemented over next 9 months • Potential notching impact for BBB+ and below

15. 5. Rating Methodology • Factors affecting a debt/hybrid rating include: • Subordination • Senior debt • Subordinated debt • Preferred stock • Common equity • Recovery characteristics • Credit quality compression / expansion • Financial leverage, coverage and cashflow • Leverage definition typically “debt / debt + equity” • Equity definition can vary by sector • Coverage definition typically “EBITDA / interest payable” • Other leverage / coverage metrics considered • Holding company risks and characteristics; less an issue for banks and corporates than insurers

16. 5. Rating Methodology(cont.) • Typical notching for differing types of issue: • Rating compression at higher levels of financial strength

17. 5. Rating Methodology(cont.) • Added layer of complexity for insurance companies: • Operating vs. holding company • Reinsurer vs. primary company Table assumes primary insurance group. For reinsurers generally no notching from IFS to LT for operating entities

18. 6. Equity Credit for Hybrid Instruments • Existing hybrids equity credit methodology in place for a number of years • Focus on • Subordination • Ability to skip or defer payments • Long tenor • Weak covenants • For convertibles mandatory conversion to equity • Allocation of equity credit summarised in Equity – Debt continuum table • So why change? • During 2004, Fitch‘s Hybrids committee conducted back-test • Goal: Empirically verify assumptions made in 2001 • Overall Outcome: Practically not many changes

19. 6. Equity Credit for Hybrid Instruments(cont.) • Details of back-test carried out in 2004 • Time period 2000-2003 • 89 Entites across all sectors • 209 Hybrid securities • Non-convertible (“straight”) preferred securities (35) • Deferrable securities (65) • Mandatory convertibles (13) • Optionally convertibles (90) • Other, e.g. equity linked loans, high tides (6) • Total volume of securities US$48bn • Credit profiles • Fallen angels (90+%) • Non-investment grade issuers for the entire test period (<10%)

20. 6. Equity Credit for Hybrid Instruments(cont.) • Key-Findings of Back Test – Positive: • Securities with no acceleration rights and some 10 plus years remaining to maturity provide substantial relief in stress times • Three years interest/dividend deferral sufficient • Securities with financial covenants, cross-default and/or cross acceleration clauses do not satisfy Fitch‘s requirements regarding financial flexibility

21. 6. Equity Credit for Hybrid Instruments(cont.) • Key-Findings of Back Test – Negative: • Some “Faulty Hybrids” increased cash flow stress or failed to absorb loss • Features that impaired corporate flexibility: • Credit enhancement in the form of the collateral of common shares at floating share price • Convertibles with floating exchange ratio, or ratios set within extremely wide bands • Synthetic “mandatory convertibles” without a collateralized contract to buy equity • Excessive complexity; multiple embedded options

22. 6. Equity Credit for Hybrid Instruments(cont.) • Key Changes: • Full available equity credit afforded to issuers with final maturities of 10 years or more • Equity credit is reduced by 20% as the time to maturity drops from 10 years to 5 years • 0% equity (100% debt) 5 years before maturity • Smaller difference in equity credit for securities with option to defer for 3 or 4 years versus 5 years • Amount of allowable hybrid in capital structure increased for all sectors, but ratings sensitive scale introduced for corporates and insurance

23. 6. Equity Credit for Hybrid Instruments(cont.) Fitch’s Equity–Debt Continuum (corporates/insurance)

24. 6. Equity Credit for Hybrid Instruments(cont.) • Structural Aspects of European Hybrids • Maturity • Deferral Options • Position vs. other stake-holders • Tolerance limits • Default Events / Acceleration Rights Aspects impact classification on debt-equity-continuum and allocation within the band-widths

25. 6. Equity Credit for Hybrid Instruments(cont.) • Structural Aspects: Maturity • Perpetual • Long-Dated (30 years / 100 years / 1000 years) • Effective maturity • Call-Option and step-ups can be effective maturity • Step-up conditions • Long-Term rating level • Strong replacement language can help extend effective maturity • For banks assume refinancing given regulated nature of industry (need regulatory approval to redeem) and liquidity of bank capital market

26. Interest Deferral Features in Corporate Hybrids Mandatory Optional Cumulative vs. Non-cumulative Cash-Flow Issuer‘s „sole discretion“ EBITDA „Provided that“ Other 6. Equity Credit for Hybrid Instruments(cont.) Structural Aspects: Interest deferral features

27. 6. Equity Credit for Hybrid Instruments(cont.) • Structural Aspects: Position vs. other stakeholders • Generally unchanged from back-test • Senior debt • Subordinated debt • Preferred stock • Common equity • Equity credit for convertibles reflects more emphasis on rank in bankrupcy pre-conversion

28. 6. Equity Credit for Hybrid Instruments(cont.) • Structural Aspects: Tolerance limits for hybrids • Used to be limited to 25% for all classes • Revised to a sliding scale for non-bank: • 15% for A- and above • 25% for BBB-range ratings • 35% for sub-investment-grade • For banks 25% limit for all categories • Reflecting generally more restrictive market and regulatory regime • Capital ratios already include quality of capital concepts • Extra 10% allowable for straight prefs for all sectors • Why a lower allowance for non-bank higher rated issuers? • Quality of capital considerations • At the lower end of the rating scale, equity-like features more likely to unfold their function

29. 6. Equity Credit for Hybrid Instruments(cont.) • Structural Aspects: • Default events • Covenant defaults • Interest and principal • Cross-default • Acceleration rights • Maturity • Acceleration of other loans / credit facilities

30. 7. Examples -Insurance &Corporates • Innovative Tier 1 • Preferred security with step-up after 10 years • Non-cumulative or cumulative stock settled coupon • Fitch treatment is to view instrument as Type 2 • Typically accorded 90% equity credit • Step-up likely to be viewed as effective maturity without replacement language • Upper Tier 2 • UK regulatory approach is same for preference shares and junior sub debt - Fitch differentiates • Sub debt with cumulative deferral – Fitch typical equity credit of 65% • Preference shares with cumulative deferral – Fitch typical equity credit of 80% • Lower Tier 2 • Sub debt with no interest deferral – Fitch typically gives no equity credit without interest deferral

31. 7. Examples - Banks • Barclays Non-cumulative Callable Preference Shares • Preferred security • 10 & 15 year calls • No step-up (fixed to float) • Non-cumulative deferrable feature • Fitch view: • No step-up and non-cumulative feature, meant these instruments received 100% equity credit • Rated one notch below Barclays’ senior unsecured rating • Regulatory view: • Lack of a step-up meant these instruments qualified as Core Tier 1

32. 7. Examples - Banks • Lehman Brothers Enhanced Capital Advantaged Preferred Securities (ECAPS) • Preferred security • 5 year call and 5 year step-up (100 bps) • Mandatory and optional deferrable feature, both cumulative but requires “all reasonable efforts” be made to issue common stock or new prefs to finance payments • Fitch view: • Aggressive call and step-up feature underlies our view that these types of instruments are term • Cumulative feature, but financed by new share issuance meant 100% equity credit. • Rated one notch below Lehman’s senior unsecured rating • Regulatory view: • In the US, may qualify as innovative Tier 1 • In Europe step-up date will need to be extended to 10 years from issuance for innovative Tier 1 treatment