TEXT-Fitch:Sovereign risk a key element in covered bond credit risk

Mon May 28, 2012 8:53am EDT

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(The following statement was released by the rating agency)

May 28 - The fact that covered bonds can sometimes achieve higher ratings than the relevant sovereign should not obscure the impact of sovereign risk on mortgage covered bond ratings as well as those of public sector covered bonds, Fitch Ratings says.

Sovereign creditworthiness affects covered bonds through worsening macro-economic conditions and weaker banking systems. Interbank liquidity can dry up and become more costly. These negative factors have had a significant impact across our covered bond ratings (including public sector programmes) since the eurozone sovereign debt crisis began. In 2010 and 2011, we downgraded 39 covered bond programmes (around 30% of those we rate) many of them several times. Most downgrades were caused by issuer downgrades or a review of liquidity risk following sovereign downgrades.

In terms of collateral quality, exposures to public sector entities can be put at risk directly from difficulties encountered at their sovereign level. Where we rate public sector covered bonds higher than the sovereign, Fitch already applies conservative assumptions for default rates and recoveries given default of public sector debt.

For mortgage covered bonds, the deterioration in macro-economic conditions caused by the sovereign crisis has increased our expected losses for mortgage cover pools in all European countries. As a result, we have increased our assumptions for borrower default risk and market value declines of properties, and made our stress scenarios more severe.

The downgrades of banks that can accompany sovereign downgrades result in a lower floor for covered bond ratings. More broadly, a deteriorating economic environment can dent performance by financial institutions, damaging their viability rating.

And if capital markets funding becomes more uncertain and expensive for banks in weaker countries, it can have an impact on the maintenance of covered bond ratings at higher levels than issuer ratings.

First, potential buyers of cover pool assets might be less willing or able to purchase them, making continuity of covered bond payments after an issuer default less certain. As a result, in some cases we have compressed the maximum differential between an issuer rating and a covered bond rating.

Secondly, higher funding costs for purchasers would lead to lower proceeds from the liquidation of cover pool assets, as buyers increase the discount applied to future revenue streams.

This lowers the cover pool's stressed valuation, but issuers have so far proven mostly willing to increase overcollateralisation to counteract this. Of the covered bond programmes downgraded by Fitch in 2010 and 2011, insufficient overcollateralisation was only invoked in 10% of cases.

Fitch will release an exposure draft on criteria changes this week that will discuss increasing the role of sovereign ratings in our discontinuity analysis.

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