Italian cover pools are insulated from issuers’ high stocks of problem loans, Moody’s said yesterday (Wednesday), but the rating agency said OBGs are vulnerable to downgrades upon a potential weakening of banks’ asset quality. It also put Banca MPS covered bonds on review with direction uncertain.

In a comment published yesterday afternoon, Moody’s said that arrears levels in Italian cover pools remain low and collateral quality firm in spite of a high volume of problem loans in the banking system. The rating agency noted that at around Eu360bn, or 18.1% of overall outstanding customer loans as of 31 December, the stock of non-performing loans (NPLs) on Italian banks’ balance sheets is among the highest in Europe.

However, Italian covered bond law and contractual arrangements in effect limit the amount of problem loans used as collateral, Moody’s said, meaning that the performance of Italian cover pools differs from that of banks’ loan portfolios.

While Italian covered bond law does not require that NPLs be removed from cover pools, such loans are excluded from legal asset tests and are also excluded from the calculation of contractual overcollateralisation (OC) in practice, hence requiring that a minimum level of performing assets be maintained in the cover pool, Moody’s said. It added that some Italian issuers often buy back problem loans.

The rating agency also said that maximum loan-to-value ratios (LTVs) offer protection against collateral deterioration, and noted that the vast majority of Italian covered bonds may only be backed by residential mortgage loans, with commercial loans accounting for the largest proportion of NPLs in the Italian system.

Moody’s noted that over the year ended 31 March, the average arrears rate in Italian cover pools did not exceed 2.5%. It said that the credit quality of Italian cover pool assets also remained firm over 2015, ranging between 9.6% in Q1 and 8.9% in Q4.

Under Moody’s covered bond methodology, the credit quality of cover pools is reflected by a collateral score, which determines the level of losses expected in a cover pool after an issuer default – the lower the figure, the better. Moody’s average collateral score for Italian mortgage covered bonds was 8.9% at the end of Q4 2015, lower than the average collateral score of 10.8% for mortgage covered bonds that it rates globally and lower than for mortgage covered bonds in EU countries such as Greece (35.8%) and Spain (18.7%).

Banca Monte dei Paschi di Siena (MPS) has the highest stock of problem loans as a percentage of gross loans among the Italian banks supervised by the ECB, at 34.4%, but Moody’s noted that only 0.8% of loans in MPS’s cover pool were in arrears as of the end of the first quarter.

Moody’s said Italian covered bonds are nonetheless “highly sensitive” to a weakening of issuers’ creditworthiness.

“Even a moderate decline in the credit merit of issuers,” said Moody’s, “which may result from a further material deterioration in bank asset quality due to the high stock of problem loans, would likely have a negative effect on the credit quality of Italian covered bonds and likely result in negative rating actions.

“A weakening of the credit strength of issuers, rather than a decline in collateral performance, has to date been the main trigger for the credit deterioration of Italian covered bonds.”

The average Timely Payment Indicator (TPI) assigned to Italian covered bonds is “probable” and the average TPI Leeway – which measures the number of notches by which the issuer’s covered bond anchor can be lowered without the covered bond rating being affected – is 1. The covered bond anchor for all Italian covered bond programmes rated by Moody’s is the Counterparty Risk (CR) assessment plus one notch.

Moody’s yesterday placed on review with direction uncertain its A2 rating of the conditional pass-through (CPT) covered bonds of Banca MPS. This was prompted by a similar action on the issuer’s B2 CR assessment.

On Monday, Moody’s changed a review of MPS’s CR assessment, B2 deposit rating and B3 senior unsecured rating to direction uncertain, from review for downgrade, and also put on review with direction uncertain the bank’s ca standalone Baseline Credit Assessment (BCA).

On 29 July, MPS announced a plan to dispose of its bad loan portfolio, and raise Eu5bn of capital, having earlier announced that the European Central Bank was seeking a reduction of its problem loans.

Moody’s said the review with direction uncertain reflects the potential for improvements in the bank’s creditworthiness if its restructuring plan is successfully implemented, that there is considerable uncertainty as to whether the plan will be executed as outlined, and the anticipated negative consequences for the bank’s creditors if it is unsuccessful.

The rating agency had placed the OBG programme on review for downgrade on 18 July, having initially taken the same action on the issuer’s CR assessment on 15 July.

The TPI assigned to the CPT OBG programme is “very high”, and the TPI Leeway for the programme is “limited”. Moody’s said any reduction of the covered bond anchor may therefore lead to a downgrade of the covered bonds.

Fitch placed its BBB rating of MPS’s CPT OBGs on Rating Watch Evolving on Monday, and on the same day DBRS confirmed its ratings on MPS’s two OBG programmes and maintained them under review with negative implications. DBRS rates MPS’s Eu10bn CPT OBG programme A (high) and a second Eu20bn OBG programme A.

Analysts at UniCredit said the announced restructuring plan should be credit positive for MPS bonds, and said the reviews support their bullish stance on the OBGs.

“However, rating upgrades and a future outperformance of the bonds – up to now MPS bonds have underperformed the Italian sector since the announcement – is dependent on the successful implementation of the restructuring plan, which is our base case,” said Emanuel Teuber, credit analyst at UniCredit.