Moody’s and other analysts have warned that a Hungarian law allowing foreign currency mortgages to be repaid in forints at a discount of up to 22% could be credit negative for covered bonds and raises the prospect of event risk in Hungarian issues.

HSBC Trinkaus head of covered bond research Johannes Rudolph said that the law could have a “huge impact” on Hungarian covered bonds (jelzáloglevél). According to Rudolph, the law gives private borrowers the option to repay foreign exchange mortgages in full at an exchange rate far away from current market rates.

“Due to the fixed exchange rates, Hungarian banks are at risk of realising a loss of 10%-13% of their HUF5400bn (as of July 1011 according to central bank data, equal to around Eu21bn) foreign exchange household loan portfolio,” he said on Monday. “For covered bonds, there is a certain risk of under-collateralisation, should all borrowers execute their option.

“The Hungarian central bank has criticised the law and described it as a risk for the stability of the banking system, according to a Reuters interview with the central bank deputy Kiraly on 22 September.”

Moody’s said yesterday (Tuesday) that the value of loans will be substantially reduced as a result of the new law, which was passed on 19 September and which borrowers have until year-end to take advantage of.

“The fact that Hungarian legislators have chosen to alter contractual rights to reduce the value of mortgage loans as security may lead to ‘event risk’, whereby actual or potential future legal changes would need to be factored into assessments of collateral value,” it said.

Having decided to make this law change, Moody’s said, the Hungarian legislators may now be pre-disposed to make further changes reducing the value of mortgage loans as security for covered bonds. Moody’s AVP analyst, covered bonds, Patrick Widmayer said it would particularly affect refinancing risk if it reduces the future sale value of the mortgage loans.

“The perception that such changes are now more likely may be enough to increase the risk premium on these assets as market participants become concerned that future changes in law may impact the value of the assets,” he said, adding that this may make it more difficult and expensive to raise cash against the assets in the cover pool to repay outstanding covered bonds.

“The law change may also increase the risk of currency mismatches following issuer default and negatively impact bank credit quality by exposing banks to additional capital costs,” he added.

But the rating agency noted borrower credit quality may improve if borrowers refinance onto lower LTV loans that are not subject to currency fluctuations.

Moody’s added that while the value of mortgage loans will be reduced under the new law, as foreign loans are replaced with forints denominated mortgage loans the impact is mitigated in covered pools. The rating agency said this is because “whilst issuers remain performing, the covered bond law offers protection through the asset-coverage tests that require issuers to ensure that the value of assets exceeds the value of liabilities”.

A borrower being able to only take advantage of the law until year-end was also seen as a positive as it was unclear how many borrowers would end up participating in the scheme. However, if an issuer were to default before or soon after the year-end, or the FX mortgage scheme is extended or repeated in the future, this could have a much more direct impact on the value of the relevant cover pool assets backing covered bond programmes, said Moody’s.

Moody’s rates two Hungarian covered bond programmes, those of OTP Jelzálogbank Zrt and FHB Mortgage Bank. As of 30 June, around 50% and 35%, respectively, of their outstanding covered bonds were denominated in euros and for both about 50% of cover pool assets were denominated in foreign currencies, mainly Swiss francs.

HSBC Trinkaus’s Rudoph said that the problem of such loan exchanges is not limited to Hungary and highlighted a new challenge for covered bond collateral: the “timing of collateralisation.”

“Since, in a financial crisis, bond and loan exchanges can be offered, the question arises as to when a cover asset should be re-evaluated: with the announcement of the exchange, with the borrower’s acceptance or on settlement of the transaction?” he said. “Covered bond laws have typically not regulated this.

“Mortgagors would prefer to see re-evaluation at the earliest possible moment, as all other approaches could lead to a temporary under-collateralisation.”