DCM 2006 - NAIC casts long shadow
The NAIC threw the US subordinated market off line at the start 2006. Underwriters are said not to be earning fees from advising insurers on their appeals against its decisions, but many are already working on strategies to place the securities with retail accounts, albeit at the wider levels this requires. Andrew Stein reports.
A lengthy appeal of Lehman Brothers' ECAPS classification as common equity rather than preferred stock represents a significant hurdle for underwriters who were looking to hybrid securities as a major generator of fees this year. The appeal process, combined with a backlog of additional securities before the National Association of Insurance Commissioners (NAIC), has also put a crimp in the broader subordinated market as issuers wait for some clarity.
Of the securities submitted for review, a few issues were repeatedly mentioned, including hybrids from Zurich Financial Services, International Lease Finance Corp and Wachovia.
A check of the NAIC database containing securities filed in late March showed the ZFS securities still classified as bonds. However, the document contained a note indicating that the issues were filing exempt with the NAIC and that classification was not from the SVO, the Securities Valuation Office, the NAIC's department responsible for such decisions.
Once the database was back online after quarter-end processing, an inquiry regarding a group of recent subordinated issues from Zurich Financial, ILFC, Stanley Works, Wachovia and Burlington Northern that the SVO may or may not have reviewed was returned with a filing exempt note, and the comment that the database was flooded with requests.
Even officials from those institutions were not positive if their securities had been filed with the NAIC. Morgan Murphy, the head of funding for Zurich Financial Services, said recently that he had been told that the firm's hybrids were under review, but could not confirm it.
ZFS would not comment on a possible strategy should its hybrids be classified as common stock, but did comment on its decision to issue the securities.
"The market goes through cycles. We got quite a bit done in December and didn't anticipate this bump in the market," said Murphy. "We have a strategy to go to the market when it is available, and it was available at the time."
Amid the lack of clarity, underwriters are also exploring whether securities can be evaluated by the NAIC prior to pricing, thus avoiding a retroactive classification.
While that proposal would alleviate some of the confusion in the market, it would also slow down deal flow as the SVO wades through a backlog of 100 securities, which could grow as more insurers, or the New York Department of Insurance, become more concerned about their holdings.
For its part, the New York Department of Insurance released a statement regarding the Lehman Brothers' ECAPS classification. "The New York State Insurance Department supports the [SVO] analysis, which was requested by the Department, because the security exhibits characteristics of both debt and equity, and the filing as debt did not appear warranted…We recognise that the decision means insurers will have to set aside more capital to meet the risk-based capital (RBC) standards as set forth by the NAIC."
While insurers have to set aside capital of 0.3% against preferred stock, this swells to 30% for common equity.
Most on Wall Street are adamant that the classification should, and will, be overturned. Merrill Lynch and Lehman Brothers are said to be leading the appeals process, with Goldman Sachs, Morgan Stanley and Citigroup also participating. While an official from one involved firm said there are no fees being generated from advising the insurers in the appeals process, it will be interesting to see how that service translates into underwriting mandates once the market is back on track.
Although it did not explicitly comment that it believes the ECAPS classification should be overturned, Moody's recently stated that an issue's structure will dictate its price volatility. It added that the framework it uses to assess the relative debt and equity characteristics of a hybrid security considers the potential price volatility of such instruments.
Despite the turbulence in the broader market, the hybrid market is open for some trades, although pricing levels have undoubtedly been affected. US Bancorp continued its Tier 1 capital raising in early April with a US$500m retail-targeted hybrid trade. The 60NC5 structure was identical to the one the credit used in a December transaction, 99% of which went to retail accounts.
While retail accounts are not directly affected by NAIC classifications, the pricing paradigm for any subordinated trade still seems to have shifted, albeit against a backdrop of rising rates. USB's first 60 non-call five hybrid priced at 6.35%, inside of initial guidance at 6.375%, and the latest offering printed at 6.50%.
USB's Aa3/A securities carry a 50% equity weighting from Moody's and 100% from S&P. Citigroup was physical bookrunner on the trade, with Merrill Lynch serving as structuring adviser and joint lead. Morgan Stanley was also a joint lead on the transaction.
Following Lincoln National's US$1bn recent senior trade, Moody's stated that its A3 rating of the offering was contingent upon several factors, one of which was that the company will issue near term equity-like hybrids to permanently fund the Jefferson-Pilot acquisition. Although the issuance environment may not have been ideal, "the hybrid could be equity-linked, retail or a preferred stock offering. They are not hamstrung by that commitment [to issue hybrids]," said a banker that has recently worked with the credit.
Lincoln emerged in mid-April with a 60NC5 offering that contained some slight differences to the one US Bancorp had used, including a mandatory payment trigger and a replacement capital covenant that is not legally binding. Morgan Stanley was the physical bookrunner with Citigroup, Merrill Lynch, UBS and Wachovia serving as joint leads. Price talk on the Baa2/A- issue surfaced in the 6.75% area.
A preliminary timeline for insurers looking to appeal against the Lehman Brothers' ECAPS evaluation was also said to have recently emerged. A group of insurers reportedly stated that they would appeal against the ECAPS rating, and that appeal has 30 days to be filed with all its arguments. The SVO then has 60 days to respond.
The single most uniform response from buyside and sellside participants regarding the classification process has been the opaqueness demonstrated by the NAIC. The lack of information ranges from the specific securities queued up for review to the structural traits of an issue that may or may not be the catalyst for a common equity rating.
"It's a fair disclosure issue," said one global syndicate head. "The NAIC is certainly releasing information that moves markets, but only to a single source."
While a handful of banks active in the subordinated space are collaborating to advise the group of insurers bringing the appeal, some that have not been historically involved are said to be enjoying the trading volatility of the securities in question.
Bankers active in the space are also increasing the rhetoric concerning perceived trading advantages accounts may receive through the limited dissemination of information when the NAIC evaluates a security.
While the expanding NAIC review has cast a shadow over the broader subordinated market, it has not yet translated into major portfolio liquidations. "The surge in requests is more a reflection of wanting to know how these securities are classified," said a fund manager who has some insurance clients.
Prior to the NAIC situation, the Yankee Tier 1 market had been very active with more than US$7bn in supply pricing this year. Credits including Deutsche Bank, Shinsei Finance, Bank of Ireland, Mitsubishi UFJ, Mizuho and Commonwealth Bank of Australia cited resounding demand and solid execution as part of the rationale for tapping the US dollar market with Tier 1 securities. Most of the deals were multiple times covered and several credits returned to the market on the back on reverse enquiries.
As far as the current situation goes, however, one insurer will reportedly learn a lot in the coming weeks, as it submitted 35 securities across the spectrum for review by the NAIC's Securities Valuation Office (SVO) at the behest of the New York Department of Insurance.
There is precedence for the NAIC looking at a Yankee Tier 1 deal, as the Rabobank 5.245% issue was classified as common stock in October 2005. That ruling was quickly reversed, however, once the information the NAIC had requested was provided by the underwriters. Rabo itself was required to do nothing.
"That's what makes the Tier 1 inclusion interesting: it dwarfs the hybrid market," said the fund manager. "I would guess that the SVO looked at Rabobank based on its five criteria, and it will proceed to look at the rest on a case-by-case basis."
The SVO has released details of these five criteria it looks at when evaluating securities. They are: the holder's legal claim as creditor or residual interest: whether the holder has the right to influence issuer management: whether there is a promise to make periodic payments and if so, whether they are deferrable and/or cumulative/non-cumulative: whether there is a stated maturity date or an agreed upon basis for establishing maturity or redeeming the claim: and the nature of an investor's claim in an involuntary bankruptcy, liquidation or reorganisation.
While these are now known quantities, just what the outcome will be when they are applied remains far from clear.