Fitch downgraded Depfa ACS Bank Irish covered bonds from AAA to A on Friday, primarily because of a deterioration in the credit quality of the cover pool and a lower level of overcollateralisation being taking into account by the rating agency.

It said that the main reason for the increased risk in the cover pool is the declining creditworthiness of public sector entities within the euro-zone, notably within Spain and Italy, which constitute around 14% of the cover pool.

“Taking this into account, Fitch has stress-tested the default of one non-AAA sovereign and a concomitant significant increase in the default rate of the exposures located in that country, combined with a low stressed recovery rate on these defaulted assets to simulate the potential impact that a sovereign default could have on the public sector entities located within that country,” said the rating agency. “As a result, the level of OC supporting a AA rating on a PD (probability of default) basis and outstanding recoveries given default in a AAA scenario has increased to 16.4% from 8.7% previously.”

Fitch said that with Depfa being in run-down mode, and as an exception to its criteria for entities rated F2 or above, it only gives credit to publicly committed OC, which currently stands at 5% on a nominal basis. Nominal OC stood at 9.3% as of March, according to the rating agency, with the lowest OC level in the past 12 months having been 8.8%.

Depfa ACS Bank is rated BBB+/F2 by Fitch and the rating agency said that the level of publicly committed OC allows for high recoveries on the asset covered securities (ACS) in the agency’s A scenarios, hence the ACS being able to be rated two notches above the issuer’s issuer default rating (IDR). Fitch said that, everything else being equal, the ACS can remain at A as long as Depfa is rated BBB+.

Depfa’s IDR of BBB+ and an updated Discontinuity Factor (D-Factor) for the ACS of 11.5% enable the Irish covered bonds to be rated as high as AA+ on a PD basis and AAA after taking into account stressed recoveries given default, the rating agency noted.

The D-Factor was increased from 9.5% to 11.5% in line with Fitch’s counterparty criteria to reflect the materiality of privileged derivatives with Depfa plc, it said. Among factors reflected in the D-Factor cited by Fitch were mitigants to liquidity gaps in the form of liquid assets registered in the pool.

“Considering the ACS’ hard bullet maturities, the proportion of liquid assets in the cover pool is a key driver of Fitch’s assessment of the covered bonds liquidity risk post issuer insolvency,” it said. “Class 1 assets, defined as assets deemed tradable within one week in a stressed situation, represented 29% of the pool as of end March 2012.”

The Eu28.8bn cover pool comprised 728 assets, according to Fitch, representing exposures to 360 counterparties that it said can be aggregated to 166 ultimate guarantors.

“It is highly concentrated with the 20 largest borrowers and guarantors accounting for more than 80% of the total,” said Fitch. “The largest exposures are the Federal Republic of Germany (AAA/stable, 28% of the pool) and the United States (AAA/ Negative, 15%).

“The exposure to the US sovereign comprises student loan ABS issued under the FFELP (Federal Family Education Loan Program) programme and ultimately guaranteed by the US Department of Education (12% of the pool).”