Fitch released proposed changes to its covered bond criteria today (Wednesday) that could affect up to almost 20% of the programmes it rates. The proposals include replacing its Discontinuity Factor with an approach that would make it more difficult for mortgage programmes to hit AAA.

The rating agency will publish an exposure draft later this month detailing the changes, which it said are aimed at increasing transparency and reflect the rating agency’s view of systemic risk and cover pool liquidity.

“These enhancements are based on observations and analysis of sector performance since the last major criteria update in 2009,” said Fitch. “If all of the proposals are adopted into its criteria, Fitch expects changes of one to two notches to less than 25 or 20% of Fitch-rated covered bond programmes.”

The rating agency said that it expects the number of programmes to be affected by the proposals to be modest and negative rating actions to be mostly downgrades by one notch and in a small number of cases two notches. Those most likely to be affected include non-pass through programmes with issuers rated BBB+ and below, and programmes with weak liquidity gap protection, said Fitch.

Under the proposals, Fitch’s Discontinuity Factor (D-Factor) framework, which addresses the likelihood of covered bonds surviving an issuer default without an interruption of payments, would be replaced by Discontinuity Cap (D-Cap) categories “to better reflect the quantitative analysis”, said the rating agency. D-Caps of 0 to 8 will represent the maximum uplift that can be achieved above Issuer Default Ratings (IDRs) by issuers for their covered bond programmes on a probability of default basis.

D-Caps will be based on a “weak link” analysis, said Fitch, with D-Caps being driven by the highest risk component among factors considered by Fitch rather than a weighted view of their components, as was the case with D-Factors. The rating agency will publish its qualitative Discontinuity Risk assessment for each component.

“The tightening of criteria will increase transparency and highlight any perceived weakness within the components,” it said.

Fitch outlined how the move will raise the minimum IDR usually necessary for a AAA mortgage covered bond rating from BBB+ to A-. It will propose a D-Cap of 4 – in line with “moderate” risk – that it said should be the best assessment to apply to current mortgage programmes.

“The change is driven by the continued scarcity of mortgage liquidations, particularly following an issuer default,” said Fitch, “and the view that a ‘BBB’ category IDR can be too volatile to support the expected stability of a ‘AAA’ rating.”

Jan King, senior covered bond analyst at RBS, identified the mortgage covered bond programmes of NIBC, SNS Bank, Wüstenrot and Yorkshire Building Society as likely to be affected by the changed criteria based on their having IDRs below A-.

He said that Fitch’s move was surprising.

“At first glance it seems like a step back,” said King, “replacing the D-Factor with these rather strict D-Caps. Instead of having a range of 0%-100% under the D-Factor, you have this discrete scale of 0-8.

“To make their methodology more transparent they didn’t have to change it,” he added.

Bernd Volk, head of covered bond research at Deutsche Bank, said that the move was in line with rating agencies’ increasing concerns about cover pool liquidity.

“The fact that pass-through programmes are not (or are least) impacted suggests that asset liability mismatches and cover pool liquidity are an ongoing concern,” he said.

“At the end of the day, covered bonds are bank bonds and this is what is currently hitting their rating most,” added Volk. “While rating consequences would be limited at this stage, there seem a lot of minor adjustments at agencies and altogether they add up, again showing increasing rating pressure for covered bonds.”

Fitch is also proposing to create a formal link between the liquidity D-Cap component and sovereign ratings as well as “other systemic indicators”.

“If a programme is substantially exposed to local assets that would need to be monetised to repay covered bondholders post issuer default, sovereign ratings in the category ‘A’ and below are likely to lead to higher D-Risk levels,” it said. “Fitch will propose to cap covered bond ratings at six notches above the sovereign rating, in line with its structured finance criteria.”

Fitch will hold a six week feedback period after releasing its exposure draft later this month, with the publication of final criteria expected in August.