How Pool Enhancements Helped Save Ratings in 2008

[Editor’s note: Because covered bonds are just getting started in the U.S., many here are just beginning to learn about them.  This article is the first in an occasional series treating various aspects of the topic at a basic level.]

Discussing potential advantages of covered bonds, observers like to say that the “cover pool” structure allows unique flexibilities to deal with financial stress over time.  Issuers’ enhancements to cover pools for existing European issuances in 2008 illustrate how this can work.

The stress has come from the downward pressure that many issuing financial institutions have experienced on their own credit ratings.  Investors rely on the issuer’s direct liability for covered bond payments, in addition to recourse to the cover pool assets as collateral in the event of an issuer’s default.  For that reason, if an issuer’s perceived creditworthiness declines, the rating of its covered bond issuance(s) can also suffer.

But there is another side to the equation.  To the extent an investor can be confident that the assets in the cover pool will be sufficient to pay all covered bond obligations even if an issuer defaults, the issuer’s own financial standing has relatively less importance.

That is where enhancements to a cover pool can make the difference.  Improving the assets in an existing covered pool can increase the probability that pool assets will be sufficient for payment regardless of an issuer’s default.  Taking such action can therefore help preserve the credit rating of a covered bond issuance even where the issuer’s own rating has declined (or is in danger of doing so).

The positive effect of covered pool enhancements is noted in Moody’s “2008 Review & 2009 Outlook” on the covered bonds sector (Jan. 23).   Although the credit strength of covered bond issuers came under “severe pressure” last year, many issuers added “additional protection when ratings were under stress or if prompted by asset tests.”

“This commitment to protect covered bond ratings was further shown in the revision of refinancing stresses carried out in early 2008,” the report states.  “[D]uring this exercise no covered bond rating was negatively affected, with several Issuers choosing to add further  enhancements to their programmes rather than suffer a negative rating action.”

Covered Bond Investor™discussed such enhancements further with one of the report’s authors, Jörg Homey, an assistant vice president and analyst at Moody’s Investor Service.  What follows is an edited version of our interview.

CBI: I want to help people understand better the function of a cover pool—what a difference it can make when an issuer is under stress in comparison with a securitization, for example.  You mentioned in your report that issuers have added additional protection.  What were the types of additional protection that you were referring to?

HOMEY: A covered bond, unlike a securitization deal, is a direct claim to the financial institution—the bank.  This is fundamentally different from a securitization, where you don’t really have a direct claim against the bank. In the unlikely event that the bank goes bankrupt, the claims of the covered bond holders are secured by a pool of assets—they will have a priority claim on that pool.

In the Moody’s covered bond rating approach, we take this structure into account.  Our covered bond ratings are driven based on the expected loss, so the credit strength of the issuer goes into our analysis quite directly.  If the issuer rating comes under stress or pressure, then the covered bond rating may come under pressure as well.  But if the issuer would like to offset such pressure, it may be  able to (or even be required to) add further enhancement to the structure. Examples for further enhancements include adding further assets to the cover pool.  Unlike in a securitization deal, a covered bond transaction is on balance sheet. This means an issuer has the ongoing ability (or even might be required) to support its covered bond transaction.

When you say adding additional assets, do you mean actually simply increasing the total number of assets in the cover pool, or a substitution of deteriorated assets with better assets?

There are different ways for an issuer to support a covered bond transaction. One example would be to add further assets to the cover pool. Another example would be replacing low quality assets with high quality assets.  

Are there any other common types of ways in which an issuer could enhance its covered bond program?

Yes, there are many different ways.  Another example would be implementing derivatives which may offset currency and interest risk in the structure.  Any amendment which improves the credit quality of the assets, reduces refinancing or market risks, or improves liquidity, may enhance a covered bond program.

In your experience, is there much difference in the way cover pools are enhanced or the bond programs are enhanced among various countries in Europe when the program is under stress?

Adding further over-collateralization is the most common approach to enhancing a transaction to date, across all jurisdictions.