Moody’s cut FHB Mortgage Bank covered bonds from Ba2 to Ba3 yesterday (Wednesday) after downgrading the Hungarian issuer in response to new and planned laws affecting foreign currency retail loans, with refinancing and foreign exchange risk constraining the covered bonds’ rating at below the maximum achievable level.

Moody’s downgraded FHB Mortgage Bank’s deposit ratings from B2 to B3 because it believes there is an increased risk of losses stemming from recently adopted and planned laws in Hungary that focus on local banks’ retail loans, and because of ongoing negative pressure on FHB’s financial fundamentals.

According to Moody’s the Hungarian parliament in July approved a law that aims to clarify and expand on a June 2014 Hungarian Supreme Court decision on the legitimacy of foreign currency retail loans. The bill states that the exchange rates applied by Hungarian banks for foreign exchange loans were void and requires them to use retroactively the central bank’s mid rate in all foreign exchange calculations for retail loans. It also requires that banks demonstrate that they disclosed in the loan contracts their right to unilaterally change interest rate charges and the associated costs to the borrowers, and, if they are unable to do so, the banks must compensate the retail borrowers.

Moody’s said that FHB Mortgage Bank (FHB MB) is more affected by the new laws than other banks it rates because of the impact on its capital and because FHB’s profitability is more limited. According to Moody’s, FHB estimates that potential losses from compensation charges for retail borrowers could reduce the bank’s regulatory capital adequacy ratio from 13.8% to below 10% at year-end 2013.

In addition to the July law, Moody’s expects that the Hungarian government will introduce new measures aimed at converting foreign currency retail loans into local currency-based on an exchange rate benefitting the borrowers. The rating agency expects these measures to be implemented in the fourth quarter of 2014 or the first quarter of 2015.

“Given that these loans constituted 57.2% of FHB MB’s total retail loans at year-end 2013, even a limited ‘haircut’ to the conversion rate could result in large losses for the bank,” said Moody’s. “The approximate level of such potential losses will likely become clearer later this year when the related legislation is drafted.”

The issuer downgrade prompted the downgrade of its covered bonds, from Ba2 to Ba3.

The covered bond anchor for FHB Mortgage Bank’s covered bonds is the issuer’s deposit rating plus one notch, as the bank has a debt ratio above 10%. The rating agency assigns a Timely Payment Indicator (TPI) of “very improbable” to the covered bonds.

Under the TPI framework the maximum achievable rating range for FHB’s covered bonds is Ba2-B1, according to Moody’s, which noted that the upper bound of the TPI range does not constrain the covered bond rating.

It said that the primary driver of the limited rating uplift above the issuer rating is due to covered bondholders’ significant exposure to refinancing and foreign exchange risk. According to Moody’s, foreign exchange denominated (Swiss franc and euro) assets account for 45.9% of assets in FHB Mortgage Bank’s cover pool. Foreign exchange-denominated covered bonds account for 18.9% of outstanding covered bonds.

“In this context Moody’s believes that recoveries for covered bondholders may be threatened by political and economic factors, such as devaluation, redenomination and a foreign exchange debt moratorium,” said Moody’s. “In this scenario, FHB may not be in the position to fulfil their obligations on their covered bonds, and in particular the foreign exchange denominated covered bonds.”

These uncertainties constrain the rating of FHB’s covered bonds at two notches above the covered bond anchor, said Moody’s.