Plato vs. Aristotle (the Greek version of Mr. T vs. Chuck Norris)
Ancient Greece, the cradle of Western civilization, lacked both bowling alleys and XBoxes. This forced citizens to spend their leisure time debating the nature of reality. On one side of the discussion were Platonists, who asserted that the physical world and all that is in it are imperfect copies of eternal, changeless and perfect Forms–the latter being the only truth. Aristotelians made up the other side. They believed that truth was to be found through observation of the actual characteristics of things in the physical world–that there were no otherworldly Forms that worldly things aspired to be.
considering hybrid bonds
In looking at hybrid bonds (see my post earlier this week for a definition), Moody’s originally fell on the Platonist side. In rating hybrids, the agency appears to have assumed that because the prospectuses called them bonds, that’s what they were. It didn’t matter that they might have quirky characteristics–for example, not looking much like a bond at all (remember, too, that like all rating agencies, Moody’s was paid for its opinion by the issuers).
During the credit crunch, bank regulators have revealed themselves to be firmly in the Aristotelian camp, to a greater or lesser degree. If it walks like an equity and quacks like an equity, they are saying, it is an equity and not a funny kind of bond.
Why does this make a difference? In a reorganization or liquidation, equity holders generally lose everything but bondholders retain at least a part of their original investment. Also, although I’m not aware that this issue has come up formally yet, investment management contracts with clients normally specify very clearly what kinds of assets a manager is permitted to buy. Bond managers, who appear to be the majority holder of hybrids, are supposed to buy bonds, not equities. If they buy a security outside their mandate and lose money on it, they expose themselves to possible lawsuits aimed at forcing the management company to compensate the client for those losses.
Moody’s has a new rating method for hybrids
Moody’s appears to have shifted to the Aristotelian side of the debate last week, although it is still referring to the securities as bonds. It announced that it has developed a new methodology for rating hybrids.
The new scheme (unlike the original one) incorporates the possibility that:
–the issuer might exercise its right to defer or eliminate payment of income on the hybrids and that
–in a reorganization an Aristotelian bank regulator would classify the securities, less favorably for the holder, as equities.
Individual hybrid results will be made known over the next three months. It appears that the vast majority will be downgraded, some by more than one notch. From the Moody’s announcement, it sounds like at least part of the downgrading will be a result of the differing behavior of bank regulators as to how they regard hybrids.
The press is now calling them CoCo bonds. Despite the cute acronym, the concept doesn’t appear to be going over well with bond buyers. Over the past few days, regulators have been eager to say that they aren’t solely focused on CoCos, but have lots of other ideas as well. Myself, I hope the other ones are better than this. It’s a little disconcerting, though, that they talked about this one first.
Just for the record: I think CoCos are non-starters in today’s world, where the chances of financial company restructuring are way higher than zero and where the scars of investor losses, in part due to carelessness, lack of analysis and excessive optimism, are still fresh. Give it a few years though. When the sun is shining every day and profits are rolling in, CoCos will likely come back–and be eagerly bought by bond investors with short memories (meaning almost everyone).