Standard & Poor's Proposes Major Change to Covered Bond Rating Methodology

A controversial new change in rating methodology, proposed in a “Request for Comment” from Standard & Poor's  (Feb. 4), could potentially result in a lower rating for up to 60% of existing covered bond programs that S&P evaluates.

According to the agency, the key change would be to establish “an explicit ‘soft link’ between certain covered bond ratings and the issuing bank’s ratings.” 

Historically, covered bond programs often have enjoyed significantly higher ratings than the rating held by their issuer.  The reasoning for this is that covered bonds offer greater security because the cover pool associated with them will be sufficient to fulfill all obligations to investors even if the issuer becomes insolvent.

But in today’s financial climate, many of those existing cover pools no longer look so comforting.  In many cases, the market value of assets contained in the pools (such as mortgage loans) has declined.  Often there is greater doubt that the asset pool alone, under current structures,  could be relied on to fulfill all investor obligations.

Under its proposed methodology, S&P would divide covered bond programs into three new categories.  The degree of linkage between the credit rating of the covered bond and its issuer is different for each category:

• Only in the case of “Category 1” (“Match-Funded”) programs could an issuer’s credit rating be completely disregarded when setting the rating of its covered bonds.  Category 1 programs would be limited to those that S&P has awarded a top score on various risk factors—the crème de la crème.

• Covered bonds in Category 2 (“Minimal Risk”) could receive a credit rating that is no more than six notches above the long-term credit rating of its issuer.  Eligibility for this category would be limited to programs from countries where covered bonds have long been governed by statute—basically Germany, France, and Denmark (with some exceptions for subsidiaries).  In addition, certain risk guidelines must be met—which Barclay’s believes many German mortgage bonds would fail.  Bonds from the UK and the United States, which lack the required statutory history, would be excluded.

• Category 3 covered bond program (“Heightened Risk”) could never receive a credit rating more than four notches above the issuer’s long-term rating.  For an issuance to be rated AAA, the permitted difference is even smaller—no more than three notches above the long-term rating of the issuer.  All programs that do not qualify for Categories 1 or 2 would be classified as Category 3.

One result of this proposed new methodology is that U.S. bonds would be classified as Category 3 unless their risk profile was so pristine as to leapfrog them all the way up to Category 1.   Absent elevation to Category 1, only issuers rated AA- or above could obtain an AAA rating for their covered bond program.

In the only two covered bond programs so far in the U.S., the issuer was technically a “special purpose vehicle” (SPV) set up by a parent institution rather than the parent itself.  S&P’s “Request for Comment” does not make clear how the proposed changes will be applied in those circumstances.  Currently, Bank of America’s long-term credit rating by S&P is AA, while its covered bonds are rated AAA.  JPMorgan Chase’s rating is also AA, while its covered bond program (formerly WaMu’s) is rated AAA(neg).

Beyond the new “soft link” element, the discussion in the S&P “Request for Comment” raises the likelihood that many residential covered bond programs will need to increase the over-collateralization of their cover pools in order to avoid or minimize a negative impact on their ratings.

S&P’s twelve-page “Request for Comment,” which describes the proposed methodology changes in detail, can be downloaded from the Standard & Poor’s website.  S&P requires (free) registration and login to access the site.  Once you have logged in, you can access the document by clicking here.  (Or look under “S&P Viewpoint” in the “Research & Knowledge” pull-down menu.)

See also:

Bloomberg: “S&P Hangs ‘Sword of Damocles’ Over Europe’s Covered Bond Market”

Reuters: “Covered bonds face rating pressure from S&P plans”

“Zero Hedge” blog: “European Mortgage Market Also About To Get Nuked”