Investors Brace for Losses on Hybrids

By NEIL SHAH LONDON -- Global investors, already stung by a litany of financial innovations gone wrong, are facing a fresh round of losses on yet another product of the credit boom: so-called hybrid securities. Hybrids grew into a $700 billion market by offering investors higher yields for what was often believed to be the same level of risk as other securities. Now, those risks are coming back to haunt investors. As the U.S. and European banks that issued most hybrids run into increasing financial troubles and in some cases teeter on the brink of nationalization, the likelihood of delayed payments and flat-out losses is rising. As a result, the prices of some hybrid securities, such as those issued by part-nationalized U.K. banks Lloyds Banking Group PLC and Royal Bank of Scotland Group PLC, have fallen by 25% to as much as 75% over the past two months. The potential losses have ricocheted to the big holders of these securities, the most prominent of which are major insurance companies such as the U.S.'s Aflac Inc., Britain's Prudential PLC and Switzerland's Swiss Reinsurance Co., which have seen their shares slammed on worries about losses. "Investors are getting beaten up," says Scott MacDonald, director of research at hedge fund Aladdin Capital in Stamford, Conn. A glimpse of the potential damage could come Monday evening, when Aflac reports fourth-quarter results. Morgan Stanley estimates Aflac holds some $8 billion of hybrids among its investments. "If even a small portion of these losses are realized, the hit to Aflac's capital could be substantial," analyst Nigel Dally wrote in a report. Aflac on Jan. 23 said it was confident with its capital position. Prudential declined to comment. Swiss Re says its exposure is minimal. Losses on hybrids may not show up immediately in the profit statements of insurance companies, which can in many cases choose not to write the securities down, said Richard Hewitt, an analyst at Dresdner Kleinwort in London. Hybrids, which combine characteristics of both debt and equity, took off in 2005, a time when markets were awash in cash and investors were scrambling to get a little extra return. The securities often offered a yield 0.6 to 0.7 percentage point higher than comparable corporate bonds, but still tended to carry investment-grade credit ratings. As with many securities issued during that boom time, investors tended to ignore the risks. One was that while the principal on the securities was typically repaid on a specific date, issuers had the option to extend the repayment, often for another five years or more. Issuance around the globe jumped from some $32 billion in 2000 to $175 billion in 2007, according to Dealogic. At the height of the boom, insurance companies were buying some 30% to 40% of the securities. In recent months, though, the perils of hybrids have become evident. Investors received a shock in December when Germany's Deutsche Bank AG became the first major bank not to repay a popular kind of hybrid when expected. The reason: Borrowing money had become so expensive that it was cheaper simply to leave the debt outstanding. Suddenly, investors realized that hybrids could mature much later than they had anticipated -- in some cases, never. They dumped the securities, causing prices to fall sharply. Hybrids took another big hit last month when the U.K. government announced a second bailout package for its banks, underscoring the depth of the crisis facing Britain's financial industry. Since then, fears of bank nationalizations in the U.K. have dissipated somewhat, pulling some hybrid prices higher. But investors aren't optimistic. "If I were owning hybrids right now, I'd be looking for an exit strategy," said Aladdin's Mr. MacDonald. Write to Neil Shah at neil.shah@dowjones.com