Secure. Low risk. Triple-A. This is how covered bonds have come to establish themselves, but last year changes in the way the rating agencies approach the asset class threatened to disrupt the triple-A foundations on which the product has been based for so long.
The first blow was also the biggest, and hit the market in February last year when Standard & Poors announced a new rating methodology that it said would lead to an estimated 60% of programmes losing their AAA rating.
The new methodology attracted widespread criticism, with market participants for example calling it a "catastrophe" or "a danger for this whole market". The criticism was not so much aimed at the main thrust of the changes linking covered bonds ratings to those of the underlying issuers, which many market participants felt were long overdue but at the implementation thereof.
Criticisms of the proposed methodology ranged from general comments that it was overly prescriptive to questioning of more specific aspects such as the rating agencys proposed weighting of liquidity gaps and its categorisation of certain covered bond jurisdictions.
As stated by S&P, the key change was the introduction of an "explicit soft link between certain covered bond ratings and the issuing banks rating".
The three other main changes, as identified by S&P, involved placing greater analytical weight on asset-liability mismatches in programmes; allocating covered bond jurisdictions to different risk categories on the basis of legislation and assumptions about the importance of the asset class to a particular national market and the historical track record of that sector; and applying higher stresses to the market value of cover pool collateral.
Covered bonds, or rather the jurisdictions they are issued from, would be allocated to one of three risk categories that would determine how many notches higher a covered bond could be rated than the underlying issuer. Programmes allocated to the first category would not be restricted in terms of the maximum potential rating uplift although analysts said that hardly any covered bonds would qualify for this category and for category two and three programmes the potential uplift from an issuers long term credit rating would be capped at five and three notches, respectively. Analysts said that the majority of programmes would fall under the third category.
S&Ps proposed segmentation of countries was the focus of much criticism, with market participants disagreeing with the distinctions S&P drew between jurisdictions, arguing, for example, for Swedish covered bonds and French structured covered bonds to be assessed more favourably.
Fitch and Moodys take their turn
The request for comment that S&P issued at the end of February to accompany the proposed new methodology was widely taken up by the industry; the rating agency extended the deadline for comments by two weeks and in July announced that it would not be publishing its updated criteria before September at the earliest.
"The proposal and the following consultation period yielded significant levels of feedback from the market," it said. "We would like to take this opportunity to thank market participants for the numerous and detailed responses we received."
By this point, the other two main rating agencies had proposed revised covered bond rating criteria, although these, most clearly in the case of Moodys, did not represent a change in methodology. And Fitch stayed true to its Discontinuity Factor (D-Factor) framework when it introduced revised criteria for assessing liquidity risks in covered bonds in March 2009, although it did make qualitative changes that Moodys did not.
Fitchs qualitative adjustments consisted of increasing the weighting of liquidity gaps as part of the overall D-Factor score the rating agencys measure of the likelihood of an interruption in covered bond payments as a direct result of the default of the financial institution and revising how it scores the liquidity gaps. These changes had the effect of tightening the link between an issuer rating and the covered bonds rating.
On the quantitative side, Fitch increased its refinancing cost and price cap assumptions, a step that Moodys also took a few weeks later in April when it increased its refinancing margins for covered bonds. This was something that Moodys had already done before, in March 2008.
While Fitch was not immune from criticism of its proposed changes, which it opened up for discussion during a six week consultation period, the industrys response was more tempered than that following S&Ps proposals.
Fitch painted a less dramatic picture of the rating actions it estimated its revised criteria would lead to. The agency said that their main impact would be to increase overcollateralisation (OC) levels consistent with a given rating scenario, in some cases of up to 10% of the bonds outstanding.
In terms of downgrades, Fitch said that if all issuers increased OC to be in line with the highest achievable rating but did not take further steps to mitigate liquidity gap risk, a maximum of 5% of public sector and 10% of mortgage covered bond ratings would be downgraded as a result of revised D-Factors.
Moodys said that its higher refinancing margins would affect some 35% of the programmes it rates, with the majority (50 of 58) requiring a top-up of, on average, less than 5% collateral to maintain their ratings and the remainder an OC increase of more than 10%.
The grand finale disappoints
S&P published its long awaited final methodology in December, but although it included welcome changes from the original proposals, it left market participants disappointed.
On the positive side, the changes included increasing the number of asset-liability mismatch risk designations from three to four ("zero", "low", "moderate", and "high"), thereby allowing for greater differentiation; weighting mismatches depending on when they arise; increasing the maximum potential uplift from an issuer rating; and varying the degree of linkage between a covered bond rating and the issuer rating according to the degree of asset-liability mismatches.
But market participants were not satisfied with the final result.
"The new proposal is definitely better than the original, but it still isnt what we would envisage," says Reinolf Dibus, member of the board of managing directors at Eurohypo Luxembourg and chair of the European Covered Bond Council rating agency approaches working group.
He says that criticisms include S&Ps use of residential and commercial mortgage backed securities secondary market spreads as the basis for target asset spreads for cover pool assets in covered bonds, its categorisation of jurisdictions, and a lack of transparency about the rating agencys cashflow analysis, which determines the level of OC a programme needs to maintain a given rating.
Another market participant said that although S&P had taken feedback on board and addressed some obvious inadequacies of the original approach, the final criteria did not sufficiently differentiate the potential for uplift from an issuers rating and that this seemed "horribly mechanistic" and too reliant on the jurisdiction.
He questioned certain category allocations, such as Greece being placed in the basket with the least potential for rating uplift, and Sweden not being allocated to the top category.
"The main thing is that there is something to offend everyone," he said.
Issuers rise to the occasion
While market participants may be left unsatisfied by S&Ps final methodology, they also expect its impact on ratings and the market to be contained.
Firstly, the number of downgrades is likely to be considerably lower than the 60% figure with which S&P frightened the market just over a year ago.
The rating agency placed 98 programmes, representing around Eu1.46tr of issuance, on CreditWatch (95 on negative watch, two on developing and one preliminary rating on negative) when it published its new framework only four programmes escaped being put on the review list. S&P said that based on an impact analysis using a sample of 84 programmes, 15% would be cut to below AAA because the issuer rating was not high enough.
Of the remaining programmes, 38% would require issuers to increase OC to avert a downgrade. One covered bond analyst said that assuming that most of these issuers will do so, around 20%-30% of S&P-rated programmes may in the end face a downgrade.
At the time of writing, S&P had affirmed 25 programmes at AAA and downgraded three.
For the most part, market participants expect issuers to protect the AAA rating of their covered bonds, where methodologies permit. Danske Bank analysts said that the implementation of S&Ps new methodology could be "close to a non-event", with few downgrades and a very limited market reaction.
"The bottom line is that the work done by Moodys and Fitch probably will mitigate most of S&Ps expected requirements as to credit enhancements etc," they said. "If not already mitigated by Fitch and Moodys review, we would expect most issuers to [chip in additional collateral]."
The outcome of the implementation of Fitchs and Moodys adjusted criteria and/or assumptions would seem to support such confidence.
When Moodys announced its higher refinancing margins, it said that based on previous experience it did not expect negative rating actions for the majority of programmes all but one of the issuers whose covered bond ratings could have been affected by the new refinancing margins acted to stave off any downgrades of their programmes.
Fitch said that its criteria had a more limited impact than initially expected, resulting in only three downgrades. This was primarily due to programme restructuring and mandatory liquidity provisions that took effect during 2009, it said. And higher OC levels needed to support a given rating did not lead to downgrades because some programmes were already sufficiently overcollateralised to withstand the updated stresses, while other issuers chose to increase OC, said Fitch.
Ralf Grossmann, head of covered bond origination at Société Générale, believes that issuers will be able to cope with the higher demands placed on them as a result of S&Ps changed criteria.
"S&Ps requirements may lead to an increase in overcollateralisation or to a rethink of the cover pool," he says, "but at the issuer level this seems manageable, even though it involves a lot of hard work for those involved."
Tough decisions loom
But Florian Hillenbrand, senior covered bond analyst at UniCredit, says that issuers have to decide if injecting more collateral makes sense for them.
"Many issuers are at a crossroads," he says. "They have to consider the total costs of increasing overcollateralisation including negative impact on the senior ratings and compare that to the benefit of a triple-A versus sub-triple-A funding spread."
"A lot of lower rated issuers have to decide whether to drop a rating agency, or to accept a non-triple-A rating of their covered bonds in case of a further downgrade of their senior credit."
Three issuers have cancelled their covered bond rating contracts with S&P since it introduced its new methodology SNS Bank, NIBC and Landesbank Baden-Württemberg; the latter no longer has any of its debt rated by S&P. Deutsche Hypothekenbank and BayernLB forwent S&Ps rating of their Pfandbriefe last summer, and Lloyds TSB in December requested that S&P no longer rate its Eu15bn Registered Covered Bond Programme.
A survey of more than 60 market participants conducted by LBBW analysts at the occasion of a LBBW covered bond forum in Mainz in February found that the majority thinks covered bonds need two ratings; Moodys and Fitch emerged from the survey as the best combination.
The survey also provided some insight into the potential for forced selling as a result of covered bonds losing their triple-A ratings.
"Even if spreads generally show little immediate reaction to the loss of a triple-A rating (only about 13% of respondents have to sell), there could well be medium term effects, as the potential investor base shrinks (a further 25% then make no further new investments)," said the analysts. "The negative impact is likely to be felt the most in sub-markets already viewed as risky and by smaller issuers. In the case of jumbo Pfandbriefe for example, other factors shape the spread landscape and clearly overshadow the rating issue."
At the same time as issuers have been busy coping with the consequences of last years methodology flux for their triple-A covered bond ratings, the latter are expected to come under pressure from other directions.
"On the methodology side I believe that we have more or less reached a stable environment," says Grossmann. "However, what we are going to see in future from the rating agencies is adjustments in the inputs for their stress test scenarios. Its not necessarily around the corner, but it is something that we will have to face this year if indicators deteriorate further."
In addition, with rating agencies tightening the link or, in the case of S&P, introducing one between a covered bond rating and that of the underlying issuer, the fate of the former hinges commensurately closer on the development of the credit quality of financial institutions during the continuing restructuring of the financial markets.
When Fitch in January published an overview of the results of the implementation of its revised rating criteria, it said that at the time that 17 covered bond ratings would be downgraded should the applicable issuer default rating be cut by one notch.
Moodys painted a similar picture in a review of 2009 and outlook for 2010 that was published at the beginning of February. It said that as issuer ratings fall closer to Timely Payment Indicator (TPI) thresholds that cap covered bond ratings at lower levels than before, downgrades of issuers ratings mean that fewer of them will be able to prevent cuts to their covered bond ratings by adding collateral to cover pools.
A weakening of sovereign credit quality will also place covered bond ratings at risk, say market participants. In the case of Greece, it has already led to downgrades. Fitch in February cut the covered bonds of National Bank of Greece from AAA to AA, and those of Alpha Bank and Marfin Egnatia Bank from AAA to AA+ (only NBG has issued publicly outstanding issues).
"The rating actions reflects Fitchs opinion that the deterioration of public finances underpinning the sovereign downgrade and the measures being taken to reduce Greeces public deficit will negatively impact the Greek banking system, Greek households and as a consequence the performance of Greek mortgage loans," said Fitch.
Moodys has placed its Aaa ratings of Greek covered bonds on review for downgrade, also citing the deterioration of Greeces public finances.
Issuers have demonstrated a strong commitment to protecting their covered bond ratings, but as one analyst put it, "the entire bank and covered bond rating landscape is built on shallow ground".