Fitch has cut the rating of mortgage covered bonds issued off a former Washington Mutual programme to one notch above the rating of the programme sponsor, JP Morgan Chase Bank, because of a deterioration in collateral quality.

The rating agency downgraded the covered bonds from AA+ to AA, one notch above a AA- long term issuer default rating of the sponsor bank.

“The rating downgrade is driven by increased loss expectations assessed on the cover pool assets on account of the deterioration in observed performance of US payment-option and interest-only hybrid adjustable rate mortgages,” said Fitch. “As a result, the level of overcollateralisation in the programme is no longer sufficient to provide expected recoveries above 91% on defaulted covered bonds in an AA+ stress scenario.”

The cover pool has a weighted average (WA) loan-to-value ratio of 65.6%, a WA FICO (credit) score of 735, an average seasoning of 70 months, and included around 65.6% interest-only loans, according to Fitch.

The pool is highly concentrated in California (53.5%), with the top five states accounting for roughly 70% of the portfolio.

In addition to the rating of JP Morgan Chase, the rating of the covered bonds is based on a Discontinuity Factor (D-Factor) of 100%, which captures Fitch’s assessment that the bonds’ probability of default is aligned with that of the sponsor bank.

However, Fitch said that a contractual maximum asset percentage (AP) of 67% is commensurate with a AA stress scenario on a recovery basis.

The rating agency has assigned the 100% D-Factor to the WM Covered Bond Program because it believes that potential asset and liability mismatches after an issuer default cannot be bridged.

This is because as an institution insured by the Federal Deposit Insurance (FDIC) Act, JP Morgan Chase is subject to a 90 day automatic stay period upon insolvency, while two of three outstanding series of soft bullet covered bonds issued off the programme only provide for an extension period of 60 days.

This does not give the mortgage bond indenture trustee sufficient time to enforce its security over the cover pool and liquidate the portfolio prior to covered bond redemption, said Fitch, adding that the third soft bullet series, which has a 120 day extension period, would also be affected because the programme includes a cross-default provision on all of the bonds.