Fitch is proposing to amend its criteria for residual foreign exchange exposures in covered bonds in a move it said will enhance the consistency and transparency of the relevant stresses it applies. The impact of the proposals would be limited, but an unidentified programme could face a three notch downgrade as its FX exposure would not be considered residual.

The rating agency published the exposure draft yesterday (Tuesday), noting that foreign exchange (FX) mismatches in covered bond programmes are usually limited, due to either contractual hedges or natural hedging between cover assets and covered bonds in the same currency.

Fitch is proposing to apply the criteria to the following types of FX exposures:

“Foreign currency cover assets and covered bonds in the absence of full contractual hedges, when the sum of foreign currency open positions between the assets and the bonds of the same currency is not more than 10%.”

“FX risk from cover assets with security based in a different currency than the loan. For example, a CHF-denominated commercial real estate (CRE) loan may be secured by a Eurozone property. FX rate volatility could lead to higher stressed default and lower stressed recovery rates for these loans. The proposed stresses would apply when the proportion of the cover pool backed by security in a different currency is not more than 10%.”

The rating agency said it has chosen two 10% limits rather than a single, 20% limit that could include both types of FX exposures because it considers the first type of FX exposure – open positions between cover assets and covered bonds – as a more prominent risk for covered bond programmes, and that were it to allow this to exceed 10% FX could become more than a residual risk.

Fitch said it expects that should either of the 10% limits be exceeded it will view FX exposures as more than residual, although there could be exceptions.

It said it expects that if the risk is not viewed as residual it will not give any credit in its analysis to assets that form the excess exposure. If the excess exposure is at the liability level, the rating uplift above the financial institution’s Issuer Default Rating (IDR), as adjusted by the IDR uplift, is expected to be limited to one notch and its approach for limited rating uplift applied.

“Fitch believes that FX risk should not be a primary risk for covered bond ratings,” it said, “because the risk associated with large FX exposures is not consistent with high, stable ratings given the uncertain magnitude of changes in FX rates.”

For FX exposures that are residual, Fitch has proposed having FX stresses that are distributed into four categories and split between three rating groups. It said that the proposed stresses are in the same range but are not the same as stresses used previously for individual programmes.

Fitch said it rates 13 covered bond programmes with either of the two types of FX exposure in question: nine public sector or commercial mortgage-backed programmes in Germany, one public sector programme in Luxembourg, one mortgage programme in France, and two mortgage programmes in Poland.

One programme is slightly above the 10% limit, according to Fitch, and would face a three notch downgrade if the proposals are implemented and mismatches do not fall below the limits.

The rating agency said breakeven overcollateralisation (OC) levels for seven programmes, which are mostly rated AAA, are likely to increase, but no rating impact is expected if issuers plan to maintain OC in their programmes at levels higher than any updated breakeven OCs for the ratings – Fitch noted that the level of OC it currently gives credit to would provide sufficient protection.

The two Polish programmes have FX exposures above the limits being proposed for consideration as residual, according to Fitch, which said that one is rated on a limited uplift basis and the other does not benefit from any uplift above the issuer’s IDR as adjusted by the IDR uplift. It said the proposed stresses would not affect the rating of the latter programme.

The rating agency is seeking feedback by 31 December.