Hybrid Bank Capital 
Tuesday, October 6, 2009, 08:09 AM
Posted by Richard Senior
I had a discussion recently with a fund manager which intends to offer hybrid bank capital to investors. Sounds good on the surface: a well-recognised name and a yield of 7-8%. And the bank gets a tax deduction as if it had issued debt. Doubles all round!

Scratch that same surface, however, and big problems are apparent:

*The Bank for International Settlements (BIS) issued a press release last month in which they state "The predominant form of Tier 1 capital must be common shares and retained earnings". You can't get much clearer than that. As Euroweek put it, the BIS's statement "...is the strongest indication yet that hybrids are history".

*Rating agencies are not keen either. S&P wrote back in 2006 "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".

*It's not long since too-clever-by-half banks were issuing this stuff and buying back their own shares. Here's a quote from 2005 "On average, the cost of this kind capital is only 50 to 75 basis points more than senior term debt," said Erin Callan, head of global finance solutions at Lehman Brothers. "Historically, that is the all-time tightest level it has ever been." You can see why the BIS is concerned.

What sort of people were buying this overstructured and overpriced paper?

Finally, why would any rational person buy paper with equity-type risks for a yield lower than you can get on very solid RMBS paper with the highest AAA rating?

Efficient markets, anyone?

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