Fitch Comments on Equity Credit for U.S. Treasury Preferred Instruments

Business Wire, Oct 17, 2008

CHICAGO -- Fitch Ratings is actively assessing the appropriate equity credit for preferred instruments issued by U.S. banks to the U.S. Department of Treasury (Treasury) as part of the Troubled Asset Relief Program (TARP) as authorized by the Emergency Economic Stabilization Act of 2008.

Based on Fitch's initial view, these instruments will likely be afforded high equity credit, most likely 100% equity credit (class E). Moreover, Fitch would likely exclude these instruments from its overall 30% cap on hybrid instruments, so long as these instruments are held by Treasury. Fitch's hybrid capital criteria allow flexibility for analysts to look at the underlying substance of the capital investment. A distinguishing factor in Fitch's view of these securities is that the motivations of Treasury differ from those of a market investor seeking to maximize return, but rather recognize Treasury's motivations to instill broad confidence and financial stability for U.S. banks. Thus, while certain terms would ordinarily trigger reductions in equity content, many of these terms, taken within the context of this capital investment, would allow Fitch to recognize the significant loss absorption capacity of these instruments and, as a result, be treated as possessing high equity content.

For example, the Treasury preferred will have an initial dividend rate of 5%, stepping up to 9% after five years. While a step-up of this magnitude would normally result in a reduction in equity content, the absolute level of the stepped up dividend rate, 9%, is arguably at or below the market rate for perpetual preferred in the current environment, even considering the equity warrants attached. Thus, Fitch will view the initial five years at a lower rate as a special source of support, and will not view the rate of 9% after five years as a step-up.

Similarly, the preferred securities are likely to be cumulative, a feature that would normally reduce a capital instrument to no more than 75% equity content. Again, in this situation, Fitch believes that the overall attractive (below market) cost of these securities outweighs the potential hurdle of accumulated dividends in the event of dividend deferral. Fitch recognizes that the step-up after five years may be an incentive for banks to retire the preferred, thus eroding its permanence feature. However, repurchase of the preferred would require regulatory approval suggesting that the preferred would either be refinanced with another capital instrument or the institution would have sufficient capital flexibility at such time in the future that it seeks to repurchase the preferred.

Fitch's view for this treatment is reinforced by the Federal Reserve Board's interim final rule, subject to public comment, that would treat these securities as fully eligible Tier 1 instruments, without limitation.

The Treasury preferred will be excluded from the Fitch core capital denominator so that the base case capital is not inadvertently raised so as to artificially raise the amount of additional hybrids that can be included in capital. Moreover, to the extent that Treasury sells any preferred securities to external investors, Fitch would revert treatment under its standard methodology.

Fitch recognizes that the speed with which this capital program has been implemented has resulted in some details needing to be further determined and defined by the government. Fitch intends to continue its assessment of these instruments, including having dialogue with the key parties to ensure all the plan specifics are finalized and understood. While this evaluation may take a few weeks, Fitch believes the substantive remaining issues can be addressed in the very near-term. More detailed commentary is planned for early next week that will further articulate Fitch's view and add any additional insight on program particulars as needed. Fitch does not believe the incremental information it expects to gather will alter its primary view on the equity credit that this security warrants.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.