An Italian decree allowing certain borrowers to switch a floating rate mortgage loan to a fixed rate loan and possibly combine this with a maturity extension could lead to higher overcollateralisation requirements for covered bond programmes, although there are no automatic rating actions, said Fitch yesterday (Wednesday).

Fitch said that it is monitoring the potential negative repercussions on RMBS and covered bonds of the decree (Decreto Sviluppo), which it said provides eligible borrowers with an eligible floating rate mortgage loan the right to switch to a fixed rate. Borrowers can also ask the lender to extend the loan maturity by not more than five years provided the final remaining term of the loan is not less than 25 years.

The decree was issued in May 2011, and became law in July. Loan modification requests can be submitted directly to lenders before 31 December this year.

A large take-up of the option could lead to more onerous overcollateralisation (OC) for covered bond issuers, although evidence from Italian originators shows a limited number of applications so far, said Fitch. The rating agency believes that a large portion of borrowers would take advantage of the interest rate switch option if interest rates increase sharply during the decree’s renegotiation window.

In covered bond programmes the switch from floating rate loans to fixed may create or increase interest rate mismatches between cover pools and rates payable on the respective bonds, which may not be covered by hedging, according to Fitch.

It said that assessing the impact of a large-take up of the switch option on the degree of interest rate mismatches is more complex for covered bond programmes than residential mortgage backed securitisations, because most Italian covered bonds are fixed rate and all structures rated by Fitch envisage two layers of hedging. These are a cover pool swap, which transforms the yield on the cover pool into the reference rate plus a spread, and a series of covered bonds swaps that transform the reference rate plus a spread into a fixed coupon, where needed.

In addition to interest rate mismatches Fitch said that switch could reduce the net present value of the fixed rate portion of the portfolio that does not benefit from a total return swap, and may also affect programmes with a pre-defined swap notional fixed-floating rate corridor.

“If the interest rate renegotiation is combined with a maturity extension, this may increase maturity mismatches between the cover pool and the outstanding covered bonds, in case of high take up,” added Fitch.

The rating agency said that it expects issuers to identify in portfolio reporting those borrowers benefiting from a renegotiation, and that such additional information would enable it to adequately assess the degree of implementation of the decree in each RMBS transaction and covered bond programme, and its potential distortion of the pool cashflows.