Legislators in Hungary put mortgage borrowers’ interests ahead of those of covered bondholders’ last month, raising questions over the extent to which covered bond credit quality can be delinked from the respective sovereign. The Covered Bond Report asked rating agency analysts how such risks can be accommodated in their methodologies and whether investors should be worried about similar moves elsewhere.

Hungary enacted a law on 19 September that permits foreign currency mortgages to be repaid in forints at a discount of up to 22%, which led to covered bonds issued by OTP Jelzálogbank and FHB Mortgage Bank being placed on review for downgrade by Moody’s last Wednesday.

“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,” said the rating agency in an initial reaction to the law that presaged its rating actions.

The threat to the covered bonds’ ratings comes as the asset class had been holding up relatively well amid the sovereign debt crisis, with some market participants arguing that the protection offered by covered bonds made them a safer bet than governmetn debt.

The Hungarian legislators’ action therefore came as something of a rude awakening.

“The new Hungarian mortgage law (directly intervening in cover pool loans in favour of the borrowers) shows that there is a reason for the term ‘sovereign’,” said Bernd Volk, head of covered bond research at Deutsche Bank.

However, Volk said that while it makes people nervous that governments can make such changes, he did not believe it to be an issue in western Europe.

“I don’t think investors need to rethink governments’ commitment in western European countries,” he said, “because there is such a big lobby highlighting the importance of the product.”

But Richard Kemmish, head of covered bond origination at Credit Suisse, was more negative.

“If you’re in a world where governments can step into private sector contracts and set them aside because they’re unfair to somebody else,” he said, “then maybe governments can do other things, which can be extremely difficult to quantify in a rating.”

However, he also said that he did not think the government would ever dream of enacting this law if it was going to bring down a bank, and ultimately the problem would be solved by adding more collateral.

“So, yes, the assets in the cover pool are a little bit worse off than they used to be, and yes, this has established a precedent that they might get worse again,” he said, “But Moody’s and whoever else rates them will ask for more collateral to be thrown at the problem, which will solve the problem – though it’s not exactly an elegant solution.”

Patrick Widmayer, Moody’s AVP analyst, covered bonds, said he was not aware of such a change in law anywhere else in Europe at the moment. However, the recently implemented law increases the risk of further adverse legal developments.

Widmayer said that this kind of “event risk” is hard to anticipate.

“Before the event you do not know it will actually happen,” he said.

However, he said Moody’s takes event risk into account in two ways, one of which is through the Timely Payment Indicator framework.

“In Hungary we assess the likelihood of timely payment under the covered bonds after issuer default, as ‘very improbable’ and this assessment takes legal risks into consideration,” he said. “The consequence of a TPI of ‘very improbable’ under our TPI framework is to strongly limit the uplift of the covered bond ratings above the issuer rating.”

Secondly, said Widmayer, Moody’s takes “event risk” quantitatively into account by looking at refinancing margins seen in a market, which, amongst others, drive refinancing risk.

“Refinancing risk is part of total market risk and crystallises when the natural amortisation of cover assets may not be sufficient to repay principal under the covered bonds,” he said, “which would therefore need to be refinanced.”

S&P does not rate Hungarian covered bonds, but Karlo Fuchs, analytical manager for covered bonds at S&P, said the change to the Hungarian law is the kind of change that would theoretically be considered in the rating agency’s country classification system. Above and beyond that, such law changes are aspects considered in the determination of transfer and convertibility risk that determines how high above the sovereign a covered bond can ultimately be rated, added Fuchs.

He noted this was not a one-dimensional issue.

“It’s something that would be discussed more on an issuer-by-issuer basis,” he said, “but also be included in issuer support.”

Fuchs also said this kind of event risk was difficult to consider in the methodology.

“Changes in political landscape and changes to legal frameworks are not something that you can take into account in ratings,” he said. “It’s nothing you can foresee.”

The question of how seriously a country’s regulators takes covered bonds was another issue that Fuchs said the rating agency tries to address in the countries S&P rates.

“Some are very supportive, while others are less so,” he said. “However, more and more issuers are using the product now, which shows more worldwide support.”