Fitch has rated Realkredit Danmark and mortgage covered bonds issued out of its Capital Centres S and T, and in doing so has for the first time shown its approach to rating bonds that were at the heart of a clash between Moody’s and Danish mortgage credit institutions.

The rating agency has assigned a long term issuer default rating of A to Realkredit Danmark, and AAA ratings to mortgage covered bonds issued out of Realkredit Danmark capital centres S and T. Fitch’s new ratings come after Realkredit Danmark terminated its relations with Moody’s in June 2011.

Realkredit Danmark, Aarhus

Klaus Kristiansen, executive vice president at Realkredit Danmark, said that with Fitch’s rating the issuer is now “back on track” with its strategy of having it and its issuance rated by two established rating agencies.

Fitch is currently seeking to make changes to its criteria for rating covered bonds and is in the middle of a consultation on its proposals. It said that if these are implemented without any modifications the rating of capital centre T will be one notch lower, allowing the respective bonds to reach AA+, while the proposed criteria changes would not have an impact on capital centre S covered bonds.

“We are a bit caught in the middle given that Fitch is changing its criteria,” said Kristiansen, “and although we don’t see any dramatic change we wanted to indicate expectations of the impact of the changes.

“We didn’t see Fitch modifying its criteria as a barrier.”

The break with Moody’s last summer was due to a disagreement over the way Moody’s rates covered bonds that finance adjustable rate mortgages (ARM) loans, which came at the same time as Moody’s has been downgrading Danish financial institutions. BRFkredit and Nykredit Realkredit also ceased working with the rating agency.

In rating Realkredit Danmark’s mortgage covered bonds (særligt dækkede realkreditobligationer, SDROs) Fitch has for the first time set out its approach to rating the ARM issuance that was at the heart of the disagreement between Moody’s and the aforementioned mortgage credit institutions. The only Danish covered bonds previously rated by Fitch are Realkredit Danmark parent Danske Bank’s, which are different to those at the centre of the Moody’s falling-out.

Realkredit Danmark uses capital centre S for issuance of bonds to fund fixed rate loans and capped floating rate loans, while capital centre T is used to finance interest reset loans and adjustable rate loans.

Fitch noted that Capital Centre T was created in 2011 to finance ARM loans only and that it is expected to grow when ARM loans in capital centre S will be refinanced at their next interest rate date, while Capital Centre S will still be used to fund other mortgage loans originated by Realkredit Danmark.

“Since the late 1990s, Danish mortgage banks have evolved from only issuing fixed rate pass-through bonds matching the underlying loans’ interests and maturities to issuing bonds with bullet maturities that only match the interest rate of the ARM loans they finance,” said Fitch. “This creates refinancing needs that are settled at yearly auctions, mostly in December. In particular, most ARM loans reset after one year, and are funded with one year bonds.”

Fitch said that its ratings of the SDROs issued out of capital centre S and T are based on a long term issuer default rating of A, a Discontinuity Factor (D-Factor) of 28.7% and overcollateralisation of 9.4% for capital centre S, and a D-Factor of 36.6% and OC of 11.5% for capital centre T, which support AA ratings on a probability of default basis and AAA taking into account recoveries.

The difference in D-Factor and supporting OC between the capital centres is driven by the characteristics of the assets and associated refinancing risk, which are unique to the Danish market, said Fitch.

It said that Realkredit Danmark has significant mortgage covered bond refinancing needs and that these could prove challenging if it entered into insolvency, even if the Danish law allows for an administrator to issue refinancing bonds. Fitch’s assessment of discontinuity risk analysis for Danish mortgage covered bonds is therefore driven by their exposure to refinancing risk.

“Due to the importance of the instrument for the domestic financial system, Fitch deems an intervention by the authorities very likely, in case of need,” it said.

A covered bond analyst in Copenhagen said that although Fitch appeared to be more concerned about refinancing risk than Standard & Poor’s, it was closer to S&P than to Moody’s.

“While the capital centre T covered bonds could be downgraded by one notch under Fitch’s new criteria, we won’t see the same multi-notch downgrades as at Moody’s,” she said.

Fitch said that, all else being equal, the rating of the capital centre S bonds could be maintained at AAA provided the issuer is rated at least A-, and at least A for the capital centre T under Fitch’s current criteria, but that the thresholds would be higher – A for the capital centre S and A+ for capital centre T – if the exposure draft proposals are implemented.

Both capital centres contain several asset types, according to Fitch. About 60% are residential mortgage loans and the remainder is made of commercial, multifamily and agricultural mortgage loans. As of June 2012, the outstanding amount of mortgage bonds in capital centre S was Dkr253bn (Eu34bn) and in T Dkr285bn.

In a triple-A scenario, Fitch calculated an expected loss of 5.2% and 6.4% for the residential mortgage portfolios in the capital centres S and T, respectively, and of 19.4% and 20.4% for the commercial portfolios.

Fitch compared the cashflows from the cover pool in a wind-down situation, subject to stressed defaults and losses, and under the management of a third party, to the payments due under the mortgage bonds. The rating agency said that it assumes that the liquidity gaps post-insolvency would be bridged by the issuance of refinancing bonds with stressed refinancing costs being passed on to the borrowers, which is reflected in higher expected losses associated with ARM loans.