New counterparty criteria released by Standard & Poor’s yesterday (Thursday) will make it less difficult than would have been the case under RFC proposals for issuers to achieve higher covered bond ratings after S&P made a key change to how counterparty risks are built into its notching.

S&P nevertheless said that up to 50% of its ratings of covered bonds could be affected unless issuers make changes to their programmes.

Under proposals included in a request for comment (RFC) released in March 2011, S&P would have worked out the maximum possible covered bond rating under its asset-liability mismatch (ALMM) criteria, and then applied any notching down it determined necessary to reflect counterparty risk to arrive at the final covered bond rating.

However, after “having considered feedback from market participants and further developed certain aspects of our analysis”, S&P has announced changes to its previous proposals including a change to this method.

It will now calculate the maximum possible uplift under its ALMM criteria, then based on its view of counterparty risk will lower the number of notches of uplift possible, to arrive at a new maximum uplift from an issuer rating (see example below).

“In the event that a derivative counterparty needs to be replaced and the covered bond issuer is in financial difficulties, we consider that the higher the systemic importance of the covered bonds in that jurisdiction, the greater the likelihood a solution may be found,” said S&P. “Since the programme categorisation in the ALMM criteria factors in systemic support and how governments and regulators are likely to support financial stability, the criteria now apply the adjustment to the maximum potential uplift.”

Florian Hillenbrand, senior analyst at UniCredit, said that S&P had rectified the “most obvious” deficiency in its previous proposals.

“In the case of a highly rated issuer, the deductions taken from the AAA instead of the maximum theoretical up-notch could have technically resulted in a covered bond rating below the senior unsecured level,” he said.

However, he said that overall the rating agency’s methodology is still overcomplicated, in particular with regards to the analysis of each swap contract.

“And we consider this to be an overestimated type of risk,” he added.

The number of notches by which uplift will be curtailed to reflect counterparty risk will depend on counterparty concentration risk and ratings, with programmes either being assigned to Bucket 1 or 2. Compared with its RFC, S&P has made changes to how it considers concentration risk and amended the rating brackets for each.

Whereas previously to qualify for Bucket 1 single unrelated counterparty concentration would have had to be less than 30% and at least 11 unrelated derivative counterparties present, now there is only a single unrelated counterparty concentration threshold of 25%, implying at least four counterparties, which S&P said “in our view represents adequate diversity, given the depth of the market”.

S&P has also altered two ratings bands from AAA to A and A- to BBB- to become AAA to A- and BBB+ to BBB.

“The reason for the change is that an ‘A’ rating indicates our view that ‘the obligor’s capacity to meet its financial commitment on the obligation is still strong’,” said the rating agency. “BBB- ratings are excluded, since they represent creditworthiness that is closer to speculative grade.”

Among other changes from the RFC, S&P noted that the criteria apply no adjustment to the maximum potential rating uplift when the notional amount of derivatives with “variant” features is less than 5% of the covered bonds outstanding.

“At this level of derivative exposure, counterparty risk is considered to be less important to a covered bond’s credit quality,” it said.

S&P said that up to 50% of its ratings of covered bonds could be affected unless issuers make changes to their programmes. Those programmes potentially affected will be placed on CreditWatch negative on 12 July, when the criteria become effective.

“A CreditWatch placement on the effective date may not apply if an issuer submits an action plan that enables its covered bond program to meet the rating criteria within the subsequent six months (i.e. by January 11, 2013, the transition date),” said S&P. “The assessment of such a plan would generally involve analysing: (i) the feasibility of the issuer completing the planned actions by the transition date and (ii) the plan’s effectiveness in mitigating the covered bond’s exposure to relevant counterparties.”