The newest toxic asset class made its debut last week, when
Morgan Stanley raised concerns over insurer Aflac Inc.'s (AFL)
outsized investments in so-called hybrid securities issued by
troubled European Union banks. Aflac and, to a smaller degree,
other insurers, hold investments in preferred share-like securities
called perpetual debentures. These securities are hybrid in nature
because they are in part equities - deriving some of their return
from preferred share-like dividends - but also have debt
characteristics.
Some insurance companies with these investments include American
International Group Inc. (AIG), MetLife Inc. (MET) and Principal
Financial Group Inc. (PFG). As a percentage of their book value,
other insurers hold far less of the securities than Aflac does.
The concern has been that European issuers of these securities
would come under government control, wiping out or diluting
shareholders and destroying the value of the securities. While some
of those fears have eased in recent days, the concerns haven't
evaporated entirely.
Aflac's shares fell more than 30% after the Morgan Stanley note
brought attention to the issue.
Standard & Poor's piled on with a one-notch downgrade of
Aflac to A- and put the insurer on watch for a potential further
downgrade. Investment losses on the securities of $400 million will
result in a further one-notch downgrade, and $800 million will
result in at least a two-notch cut, S&P said. Insurance rating
agency A.M. Best so far has kept the company at A+.
Aflac said in a Friday press release that it expects to report a
risk-based capital ratio of 425% to 475%, well ahead of an A credit
rating standard, and noted that virtually all of its debt
securities and perpetual debentures were rated investment grade by
ratings agencies at the end of the year.
Shares of Aflac surged Wednesday along with other financial
services stocks on reports that President Barack Obama and his team
were closing in on a "bad bank" plan that will have the government
taking on responsibility for some toxic assets.
Aflac draws the most attention because of its outsized exposure
to the securities, but the issue could come up on a smaller scale
for other insurers with investments in bank-issued hybrid
securities and preferred shares, said UBS analyst Andrew Kligerman.
In terms of dollar amount, the hybrid holdings of American
International Group and MetLife come close to the level of Aflac's
exposure, with MetLife holding around $7.2 billion and AIG holding
around $7 billion at the end of the third quarter - the latest
figures available - Kligerman said, though both of those insurers
have much larger overall investment portfolios. Aflac's hybrid
holdings at fair value were $8.1 billion at the end of 2008, around
11.8% of its consoldiated investment portfolio of $68.6
billion.
Other insurers with substantial exposure to hybrids as a share
of their book value are Principal Financial, Protective Life Corp.
(PL) and Phoenix Cos. (PNX). In terms of third-quarter adjusted
book value after AOCI (accumulated other comprehensive income),
These three companies' exposure levels are at 9%, 8% and 7%,
respectively, compared with 63% for Aflac, 5% for Metlife and 1%
for AIG, Kligerman said.
Principal Financial is "very comfortable with our preferred
portfolio exposure," said Susan Houser, a company spokeswoman, in
an emailed statement. "Our exposure is to high-quality companies,
including banks. We have stated in our recent investor day and
other forums that we continue to believe that where financially
possible, governments will support their banking systems and have
shown clear evidence of that."
Representatives for AIG, MetLife, Protective Life and Phoenix
didn't immediately respond to a request for comment on their hybrid
securities holdings.
The fear that banks that come under government control will stop
paying dividends on the securities was eased somewhat Tuesday and
Wednesday for U.S. banks. Citigroup Inc. (C) Chief Executive Vikram
Pandit reassured investors that the bank will keep paying dividends
on the company's preferred shares, while playing down the
likelihood that the U.S. government might nationalize a major
bank.
Hybrid securities rank ahead of preferred shares in line for
payment in case of a bank failure, but below subordinated debt that
carries a stated maturity date. The lack of a maturity date pushes
the hybrids closer to equity shares and raised fears that a
takeover would wipe them out along with other types of equity, such
as common and preferred shares.
The closest precedent so far would be the takeover of U.K.
mortgage lender Northern Rock in February. The government allowed
the bank to continue paying coupons on its perpetual debentures,
but "that was a long time ago, and things have changed," Kligerman
said. Future takeovers might follow different rules, he said.
Another precedent would be the seizure of U.S. mortgage
acquirers Freddie Mac (FRE) and Fannie Mae (FNM), said Nigel Dally
of Morgan Stanley in a note last week. Preferred shareholders were
wiped out in the U.S. government's rescue last year.
"I do think the market is concerned about coupon deferral for
U.S. banks and we have seen these securities sell off for these
banks as well, most particularly in Citigroup and Bank of America,"
said Timothy Compan, portfolio manager for Allegiant Asset
Management. "Most all of the money center U.S. banks have some form
of hybrid capital outstanding."
Generally, investors are counting on governments to take care of
securities holders, but confidence is slipping as the economic
picture grows worse, Kligerman said.
"Some of these bonds are trading at less than 35 cents on the
dollar, which indicates there is a reasonable possibility of
default," he said.
If there is a government bank takeover, prices may go yet lower,
Compan said. "It will depend on what signals government authorities
send with respect to the payment of dividends."
-By Lavonne Kuykendall, Dow Jones Newswires; 312-750-4141;
lavonne.kuykendall@dowjones.com