There's no doubt rating agencies do complex credit work, but there's definitely a value in being understood by the market.
This week, DBRS proposed a refreshingly straightforward approach to rating covered bonds, and which contrasts vividly with the Big Three agencies, and particularly Fitch.
Like the others, DBRS has wheeled out a new methodology to take account of the European Bank Recovery and Resolution Directive (BRRD), the piece of legislation allowing senior bail-in and regulatory resolution across Europe. It issued the new methodology for market comment on Tuesday.
DBRS proposes to look at the senior debt of a bank, and grade covered bonds up to two notches higher, depending on the systemic importance of the bank and the importance of covered bonds in the financial system of the relevant country.
Covered bonds from a systemically important bank operating in a regime in which covered bonds are an important instrument get rated two notches higher. A less important bank from the same country should get a one notch higher and a small bank from a country where covered bonds do not play a vital role may get nothing.
Fitch, by contrast, is a couple of steps further ahead than DBRS in working out how it responds to resolution.
Having finalised its new rating approach to take account of BRRD it is already well on the way to implementing it. The problem is, nobody seems to know how it is supposed to work.
Analysts at BBVA and Crédit Agricole were both wrong footed last week, along with the rest of the market in their expectation that the covered bonds of Banca Carige and Banca Monte Dei Paschi to would be downgraded to sub-investment grade.
The parent banks were junked, and as far as the analysts could tell, the covered bonds would follow, a move which led some of these issuers’ deals 50bp wider.
As the majority of investors are not permitted to hold sub-investment grade bonds, and since the European Central Bank can’t buy them either, the market was expecting a bloodbath.
However, Fitch’s multi-dimensional methodology offered enough wobble room for it to change the rating outcome.
One aspect of its approach is the D-Cap, or discontinuity cap, score. This measures the risk of a payment disruption caused by a mismatch between the flow of income from the assets and the repayment of liabilities.
In February Fitch had given the affected banks one notch of D-Cap rating uplift and expected “a deterioration of the sovereign’s creditworthiness to be associated with diminishing interbank liquidity”.
Fast forward three months to last Wednesday and Fitch improved the affected banks D-Cap to two notches due to “the enhanced liquidity and funding profile of the Italian banking system.”
The decision, which averted a downgrade to junk, came out the blue and while it will have come as a welcome relief to the many investors that would have been forced to sell bonds, it wasn’t exactly expected.
Moody’s approach also has a lot of moving parts and Standard & Poor’s has at times been difficult to follow.
It’s understandable that agencies are struggling to make sense of the upheaval in banking regulations and apply these to various instruments throughout the capital stack.
The complexity of D-Caps, TPIs and other arcana doubtless produce a subtler, more nuanced picture of covered bond credit than DBRS's simple system, but at the cost of being harder to comprehend and less predictable.
Investors can surely do their own credit work on an institution, including whether its cover pool includes maturity mismatches or other issues. What they want from the agencies is a backstop and a broad framework to categorise their investments. Most importantly, they do not want surprises.
Covered bonds are now driving to become one of the most transparent capital markets products in Europe, so much so that their preferential regulatory treatment depends on it. Covered bond ratings should follow suit, and that means simplicity.