S&P is proposing to reduce the maximum uplift above a sovereign rating from six to four notches for structured finance ratings, it announced when launching a consultation yesterday evening (Monday), a criteria change that would trigger downgrades of several peripheral covered bonds.

The methodology that the rating agency is seeking to amend is used for assigning ratings to single jurisdiction structured finance transactions that are above the sovereign foreign currency rating – covered bonds are affected by this.

Standard & Poor’s core proposal in the request for comment (RFC) is to “reduce the maximum rating differential between the sovereigns and most securitisations to four notches from six notches due to our evolving views on the effect of country risk and related tail risk across asset classes”.

It is also proposing to require a certain level of credit enhancement for ratings on securitisations to exceed the sovereign rating “by even one notch”, which it said is in line with its view of the severe level of stress that is likely to accompany a hypothetical sovereign default scenario.

S&P said the criteria change is being proposed because “we now believe certain sectors’ sensitivity to country risk is higher than we previously thought, particularly for entities in countries that are part of a monetary union, such as Greece, Portugal, Spain, and Ireland”.

In addition, it said that it has observed a greater degree of tail risk, i.e. low probability but high severity event risk, associated with sovereign distress and default scenarios that are not captured by the stress scenario when a country is experiencing severe economic stress or upon a sovereign default.

According to S&P, 50%-60% of Spanish RMBS, ABS, SME CLOs, covered bonds and multi-cédulas are likely to be affected, with a two notch downgrade likely for the majority. It said that it expects 95% of Italian covered bonds to be affected, most by a two notch downgrade. One Portuguese covered bond is expected to be affected, with a one notch cut.

According to a covered bond analyst, S&P rates covered bonds issued by two Italian issuers, Mediobanca (A) and UniCredit (AA), and of two Portuguese issuers, Banco BPI (A- for mortgage backed and BB- for public sector backed) and Banco Santander Totta (BB+).

The rating agency did not mention covered bonds when setting out the likely impact of its proposed changes on Irish RMBS. The analyst noted that AIB Mortgage Bank covered bonds are rated A by S&P. (Amended to remove comment about potential rating impact.)

Overall, the proposed changes will have hardly any market impact, he said, give that Italy is rated BBB and Spain BBB- by S&P and that a four notch uplift from the sovereign rating is still possible, although only two in cases where at least 12 months of liquidity are not covered.

S&P is proposing to base the maximum potential rating differential above the sovereign rating on the sensitivity of the asset type to country risk, distinguishing between “moderate” and “high”. For example, the maximum potential rating (MPR) differential where the sovereign rating is B or higher would be two notches for “high” country risk sensitivity and four for “moderate” sensitivity.

S&P said that it may limit the uplift for bullet covered bonds with an asset liability mismatch (ALMM) to below these levels unless refinancing risk is mitigated, noting that it would assess what liquidity coverage would be available to cover a 12 month period in a sovereign default scenario.

“However, where covered bonds are issued with an asset and liability mismatch resulting in a refinancing risk that we believe cannot be mitigated in full, we will likely restrict the MPR for such securities to a level that is lower than the maximum rating differential above the sovereign,” said S&P. “More specifically, we would assume a maximum rating differential of no more than two notches above the sovereign, depending on if the covered bond is issued within the EMU or outside of the EMU.”

For covered bonds issued within the EMU, the rating agency would cap the rating at the lower of two notches above the sovereign and the maximum rating uplift based on the application of its ALMM criteria – a reference to its base covered bond rating methodology.

For covered bonds issued outside the EMU, if the issuing bank is rated at the level of the sovereign or above S&P would rate the bonds one notch above the bank’s issuer credit rating subject to a cap of two notches above the sovereign, provided there is sufficient credit enhancement to cover certain credit risks. If the issuing bank is rated below the sovereign, S&P would rate the covered bond at the lower of the sovereign rating and the maximum uplift based on its ALMM criteria.

S&P is seeking feedback on its criteria until a 14 November deadline, including responses to certain specific questions. With specific respect to covered bonds these are:

• Do you agree with the proposal to consider refinancing risk resulting from the asset and liability mismatch in covered bonds as a factor restricting the maximum rating differential that can be achieved on covered bonds in a sovereign default scenario?

• Do you agree with the proposal to not consider the degree of the asset and liability mismatch when establishing the maximum rating differential for covered bonds in a sovereign default scenario?

The covered bond analyst said that in case of sovereigns rated BB- or lower, hard bullet covered bonds will struggle to remain rated at investment grade level as they could face a cap of BB+.

To achieve the maximum four notch uplift, liquidity must be covered for at least one year, he noted.

“This is hardly a problem in case of soft bullet covered bonds due to a 12 month extension and also multi-cédulas benefit from the potential extension in this respect,” he said. “However, hard bullet single cédulas may struggle to achieve a four notch uplift.”