Market participants are calling for rating agencies to modify their methodologies in light of bail-in regulations so that issuers’ senior debt ratings are no longer the starting point for covered bond ratings, noting that Moody’s is already on the case.

In a bid to avoid further taxpayer bailouts of failing financial institutions the proposed Bank Recovery & Resolution Directive (RRD) gives authorities a range of tools to resolve such entities, with a bail-in of shareholders and unsecured creditors one such option. Covered bondholders are set to be generally exempt from haircuts.

From a ratings perspective, the possibility that unsecured debt holders could be forced to take a hit while covered bond structures and obligations remain untouched has prompted market participants – focusing on the traditional covered bond stronghold of Europe – to argue that a financial institution’s senior unsecured rating is no longer the appropriate starting point for a covered bond rating, an approach that the three main rating agencies have in common.

For Barclays analysts, the RRD “renders the direct linkage between senior unsecured and covered bond rating obsolete in most cases”.

They argue that a bail-in of senior unsecured debt, alongside forms of junior debt and shareholders, could improve the position of covered bond holders, assuming no senior debt of the issuing entity or sponsor bank is included in the cover pool.

“However, when the actual bail-in takes place, the senior unsecured rating is likely to be lowered to very low level (or even to Default if the write-down is extended to senior unsecured debt), with covered bond rating following due to the linkage to senior unsecured rating,” said the Barclays analysts. “This, in our opinion, exaggerates the risks of covered bond holders not being paid in time.”

Many others also see unjustified negative repercussions for covered bond ratings were rating agencies to stick to financial institutions’ senior unsecured ratings as the anchor for covered bond ratings.

“If a bail-in does not increase covered bond investors’ risk (and we see a good case why it shouldn’t, since there appears to be no intention to impose haircuts onto secured claims on banks, such as covered bonds, in future bank rescues), then we believe that purely mechanical downgrades of covered bonds would be an unfair response to the lower issuer ratings that banks will incur through the new bail-in rules,” said DZ Bank analysts.

Moody’s flagged this issue as early as December last year, spelling out how a downgrade of issuer ratings as a consequence of bail-in risk would, all else being equal, be negative for covered bonds, and saying that it might reposition its reference point for “an issuer default”. (See here for previous CBR coverage.)

“For core jurisdictions, therefore, we may review our typical assumption that “default” on the senior unsecured debt will mean investors are then left relying primarily on the value generated by the cover pool,” said the rating agency. “In core jurisdictions, where we would expect regulators to use resolution powers to benefit covered bonds, the likelihood that covered bonds will continue to be part of a ‘going concern issuer’ following the use of resolution powers means the issuer’s senior debt rating may no longer be the most appropriate reference point for ‘issuer default’.”

In non-core jurisdictions, however, issuers’ senior debt ratings are more likely to continue to be the correct reference point for issuer default, said Moody’s in December.

This, said DZ Bank analysts, means that Moody’s is saying that “the issuer rating has had its day” as the starting point for analysing covered bonds’ credit quality.

Jean-David Cirotteau, head of strategy, covered bonds and SSAs at Société Générale CIB, said that discussions with Moody’s and the rating agency’s comments in its 2013 outlook are a source of comfort that covered bond ratings in core jurisdictions will not be downgraded should senior unsecured ratings be lowered as a consequence of the new resolution regime.

DZ Bank analysts identify what they see as three viable alternatives to using senior unsecured rankings as the anchor for covered bond ratings: a “clean break” by evaluating the credit quality of cover pools without any reference to the issuer’s creditworthiness; increasing the possible uplift from an issuer rating to a covered bond rating; or developing a new bank rating that reflects the probability of the cover pool being separate from the rest of the bank.

However, each alternative has its weaknesses, they said.

“The perfect solution probably does not exist,” they said. “What matters most in our view is that ratings and their determinants should remain verifiable. Nor would it actually be a catastrophe were the covered bond market to change from being a AAA/AA segment to become more of a AA/A segment.”

The problem here, they add, is that “despite all the assurances from regulators and politicians that they intend the opposite, the new regulations tend to give an even more central role to ratings rather than reduce dependency on them”.

A two to three notch shift downward of covered bond ratings would therefore be “a far from inconsequential development”, they said.