Fitch announced an update to its covered bond criteria yesterday (Monday) and will in the next two weeks be detailing how these apply to different countries and regions before giving issuers a month to detail any actions that may be necessary in light of rating reviews that accompany these.

The criteria incorporate proposals contained in an exposure draft released at the end of May and their implementation comes after a six week consultation period.

Fitch said that it will publish country or region-specific rating action commentaries and place or maintain on Rating Watch Negative (RWN) any ratings that cannot be sustained based on the updated criteria and current characteristics of the programme, such as liquidity measures, overcollateralisation (OC) and public OC commitments.

Fitch said in May that 22 programmes would likely have their ratings cut by one or two notches if the proposed changes were implemented (see article here), but the rating agency said yesterday that a smaller number than that will be placed on RWN.

“The major reason for the decrease is that the agency has taken certain rating actions in the meantime, for example due to sovereign downgrades, which mean that the current ratings are now consistent with the updated criteria,” it said. “A few additional ratings are expected to be placed on RWN due to the level of OC Fitch takes into account being inconsistent with the current rating.

“This may occur, for example, if additional credit for recovery uplift would be needed to reach the current rating or if Fitch assesses the programme as being dormant or in wind-down and therefore only takes into account a publicly stated OC level or the minimum possible under the programme’s framework.”

Issuers facing RWNs will have a month from the publication of the respective country/regional commentary to give feedback to Fitch on any planned changes to their programmes and, if these are likely to impact the rating, the rating agency will consider these. If no plans are proposed, the covered bonds will be downgraded.

Fitch will also assign outlooks to covered bonds that are not on RWN, and publish new Discontinuity Caps (D-Caps) for programmes as well as assessments of each of five components of D-Caps.

Some specialised covered bond issuers will have their IDRs withdrawn, notably in France, Norway and Ireland, said Fitch.

“This is not expected to lead to any change in covered bonds ratings, although the rating rationale will start from the IDR of another institution within the same banking group,” said the rating agency. “Separate commentaries for the concerned programmes will be published in early Q412.”

The main elements of the update to Fitch’s criteria, which were contained in the exposure draft, are, in Fitch’s words:

Introduction of D-Caps

Fitch has simplified its ‘discontinuity’ framework, which addresses the likelihood of covered bonds surviving an issuer default without an interruption of payments. The agency has replaced Discontinuity Factors (D-Factors) with D-Caps. D-Caps between 0 and 8 correspond to the maximum notch uplift from the Long-term Issuer Default Rating (IDR) to the covered bond rating on a probability of default (PD) basis.

D-Caps driven by the weakest link

D-Caps are driven by the highest risk component.

Revised assumptions for mortgage cover pool liquidity

A D-Cap of 4, which is in line with moderate risk, is expected to be the most favourable assessment that would be applied to apply to mortgage programmes where asset liquidation is likely to be needed to repay covered bondholders post-issuer default. This has increased the minimum IDR to ‘A-’ to achieve a ‘AAA’ covered bond rating. The change was driven by the continued lack of precedent for mortgage liquidations, particularly following an issuer default, and the view that a ‘BBB’ category IDR can be too volatile to support the expected stability of a ‘AAA’ covered bond rating.

Approach for assessing systemic issues established

The liquidity gap and systemic risk component will be driven by the sovereign rating, alongside other systemic risk indicators. If a programme is substantially exposed to local assets that would need to be liquidated to repay covered bondholders after issuer default, sovereign ratings in the category ‘A’ and below are likely to lead to lower D-Caps.

Wind down and dormant programmes considered in D-Cap analysis

Instead of considering the potential for cover pool deterioration for wind-down and dormant programmes in its asset and cash flow analysis, Fitch will consider the risk of lower commitment to such programmes in the cover pool-specific alternative management component of the D-Cap. In most cases, this will lead to an assessment that is one category worse than for a comparable programme that continues to be actively used by the issuer.