First the bad news: the securities valuation office of the US National Association of Insurance Commissioners (NAIC) has ruled that the very first Lehman Brothers ECAP is equity. Insurers would be required to hold greater amounts of capital against ECAP structures that are regarded as equity rather than preferred securities.
Spreads on ECAP deals widened by up to 10 basis points in reaction to the news before bargain hunters emerged. Eventually the deals closed just 2bp to 3bp wider at plus 71bp to 76bp. When launched in August the 60 non-call five hybrid capital deal priced to offer a spread of three-month Libor plus 78bp, so investors are still in the money, while the tone of the whole hybrid market weakened.
The good news is that some informed observers believe this decision is likely to be reversed in the coming weeks once the regulators get a proper handle on the structure.
“The NAIC have made a mistake. They did something similar with Rabobank last year,” says one banker. He suggests that, as in the case of Rabo’s pref deal, the ECAPs structure will be eventually classified as preferred.
JPMorgan’s Kabir Caprihan says: “We believe that the ECAPs will be classified as preferred securities... the ECAP is definitely not debt or common equity.” JPMorgan believes that it might have been the replacement language in the ECAP structure that persuaded the NAIC committee to classify it as equity. The replacement language requires the borrower to replace ECAPs with capital that has similar properties.
However, an essential point is the way the security ranks in the event of liquidation or winding up. ECAPs is senior to Lehman’s perpetual preferred stock – securities already classified as such by the NAIC. It seems unlikely therefore that ECAPs can remain equity as equity always ranks last.
Originators and issuers will be hoping that this is indeed the case, otherwise investors will require equity returns to justify the extra capital hit and the US yankee tier 1 market will suffer greatly as a consequence.
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