Credit Rating Agency S&P Will Get Tougher On Hybrids

The riskiness of hybrid securities -- debt securities that institutions can use to meet capital requirements thanks to features that make them look more like equity shares -- has risen sharply in recent months. Several banks have deferred or could soon defer interest payments. Dresdner Bank, for instance, has already deferred payments on hybrid securities (here's a crude Google translation from the original German).

In the U.S., large banks like Citigroup and Bank of America could be next. At least, that's what the distressed prices of Citi's hybrids -- not to mention their recent downgrade to junk -- seem to indicate. Investors clearly undervalued the risks involved in these Certainly investors, but also credit ratings agencies, undervalued that risk when hybrids were issued.

Standard & Poor's recently warned it may be less complacent in the future when banks want to start issuing them again. "In retrospect, they were overplayed," said Scott Sprinzen, an analyst at S&P who covers financial institutions and new financial instruments. "I attended the session where he spoke, which was part of a seminar on financial institutions organized Thursday morning by the law firm Morrison Foerster.

"We feel good we were never as enthusiastic as other constituents," Sprinzen added. Still, S&P, like Moody's and Fitch, worked hard in 2005 and 2006 to ensure that banks could issue equity-like capital in the cheapest possible way without diluting their shares. At the same time, investors were happy to invest in hybrids and collect higher yields than they'd get with plain-vanilla bank debt. But they all disregarded the risk that banks could find themselves short of capital.

"The nature of the market [for issuing hybrids] is going to be different," said Sprinzen. "If anything, we'll be more skeptical going forward." Once again, however, this sort of newfound strictness may be too, little too late. Remember, it isn't the first mistake for ratings agencies. They also missed the boat and downgraded ratings too late when corporate scandals such as Enron erupted about 10 years ago, and again in the past year and a half when collateralized debt obligations began quickly losing value.