Covered Bond Market Expands "Despite Challenging Conditions"

Fitch Ratings Wednesday (May 6) released a "global special report" titled "Comparative Study of Covered Bonds 2008/09."  Here are some of the highlights (with page numbers in parentheses):

• The total number of covered bond programs that Fitch publicly rates rose to 105 (issued by 90 institutions) as of April 31—almost twice the number from mid-2007. (p1)  Most of the new additions were mortgage (MO) programs, not public-sector (PS). (p2)  Fitch attributes the rise in large part to increased use of covered bonds as collateral in repo business with central banks. (pp1-2)

• The amount of rated covered bonds outstanding in programs publicly rated by Fitch is now more than €1.17 trillion-up by 11.7%. (p1)  The assets in cover pools rose somewhat more, by 15.4%.

• Non-euro denominated cover assets and covered bonds has increased as the number of issuers from non-euro countries has risen. (p13)  A compensating variable, however, is that currency hedging arrangements are in place with most contractual programs.

• Traditional distinctions between contractual and legislative covered bonds are blurring. (p3)  As an example, Fitch points to a Greek legislative bond that nonetheless uses a Special Purpose Vehicle as the issuer (rather than guarantor).

• The Discontinuity Factor (D-Factor) under Fitch's rating methodology varies more among MO covered bonds than PS. (p4)  On the MO side, the highest (worst) possible score of 100% belongs to the Washington Mutual covered bond program (now sponsored by J.P. Morgan).  The best scores have been for certain programs in Portugal and the UK, which Fitch explains in terms of the liquidity enhancements used in those countries.

• In Fitch's view, the "most efficient way to prevent maturity mismatches is to employ a pass-through program, whereby covered bonds amortize in line with the assets." (p10)  So-called "partial" pass-throughs kick in only in case of issuer default; with "full" pass-throughs, redemption begins from day one on a pass-through basis.   

• All of the covered bond programs that Fitch names in the context of pass-throughs are from the UK: two with partial pass-throughs (Norwich & Peterborough Building Society and Newcastle Building Society) and one with a full pass-through (from the Bank of Scotland). (p10)  (Of course, a third program with a partial pass-through should now be added to the list—from the UK's Britannia Building Society.)

• Fitch's report poses a question for itself: "how much cushion is there against an IDR [Issuer Default Rating] downgrade before the current covered bond rating can no longer be maintained?" (p5)  The current answer: on average, the IDRs fall 3.1 notches before the covered bond ratings would be capped-but ranging from 1.7 notches (for Spanish programs) to 5.0 (for the French).  The future answer: the cushion is expected to become less plump after Fitch completes its review of the "liquidity gaps" section of its D-Factors.

• In the UK and Netherlands, passage of covered bond legislation has meant that legislative covered bonds now share the market with purely contractual ones. (p3)

To read Fitch's 16-page special report, log in (free) at www.fitchratings.com, then click here.