Moody’s upgraded The Co-op’s long term deposit rating from Caa2 to Caa1, on stable outlook, citing such improvements, but also noting that these are counterbalanced by persistent losses and very high operational risks.

The Co-op’s Counterparty Risk (CR) Assessment was simultaneously lifted from B3 to B2, resulting in the upgrade of the issuer’s covered bonds from Baa2 to Baa1. The covered bond rating is now constrained at Baa1, given the new CR assessment and TPI of “probable-high”.

Moody’s said that its positioning of the covered bond rating at Baa1 reflects their high credit strength indicated by its expected loss analysis as well as a high level of committed overcollateralisation (OC), 29%, and 97.4% OC in the programme as of end-2017.

It also cited the expected three years remaining until the next principal payment, noting that The Co-op has not issued since 2011, and Moody’s understanding that it does not plan to issue further covered bonds in the near future. Finally, Moody’s said that there is a high level of operational de-linkage of the covered bonds from The Co-op owing to third party sub-servicing, provisions for the replacement of servicing and cash management, external bank accounts and external provision of hedging.

The Co-op on 13 February announced that it was seeking a buyer and considering other ways to strengthen its capitalisation, including a potential liability management exercise of its public debt.

Fitch cut the issuer’s rating from B to B-, on Rating Watch Evolving, and its viability rating (VR) from ‘b’ to ‘cc’ yesterday (Tuesday).

“The downgrade of the VR reflects Fitch’s view that a failure of the bank appears probable as it likely needs to obtain new equity capital to restore viability,” the rating agency said. “Fitch believes there is a very high risk that this will include a restructuring of its subordinated debt that we are likely to consider a distressed debt exchange, which would result in a failure according to our definitions.”

The new, A, covered bond rating is based on the B- issuer rating, an IDR uplift of two notches, a payment continuity uplift (PCU) of six notches, and an asset percentage (AP) that Fitch relies on of 77.5%. It said the covered bonds’ 92.5% breakeven AP supports timely payment in a stress scenario equivalent to BBB+ and allows for a two notch recovery uplift to A.

Fitch noted the two notches of IDR uplift are supported by the programme’s exemption from bail-in in the UK, a low risk of under-collateralisation, and its view that a resolution of The Co-op is not likely to result in direct enforcement of the recourse against the cover pool. The rating agency also noted that the PCU is mainly driven by liquidity protection in the form of a 12 month extendible maturity on the covered bonds and a liquidity reserve to mitigate short term payment interruption risk. It said the AP of 77.5% used in the programme’s asset coverage test provides a “substantial cushion” compared with the A breakeven AP of 92.5%, which is equivalent to the minimum regulatory level of 8% overcollateralisation for UK covered bonds.

Moody’s cut The Co-op’s covered bonds to Baa3 last Thursday.

Moody’s on Friday assigned The Co-op a CR assessment of B2, citing the banks’ standalone assessment and considerable amount of bail-in-able deposit and debt in the liability structure that is likely to shield counterparty obligations from losses.

The covered bond anchor for the Moorland programme is the CR assessment plus one notch. With the assignment of the B2 CR assessment, the anchor is now four notches higher than before, meaning the covered bond rating can be raised by two notches from Baa3 to Baa1, said Moody’s.

Moody’s noted that the cover pool’s overcollateralisation of 82.5%, of which 29% is provided on a committed nominal basis, is consistent with the minimum 4% committed level required for the Baa1 rating.

The programme is assigned a Timely Payment Indicator (TPI) of “probable-high” and has zero notches of leeway. Moody’s said a lowering of the CB anchor by one notch could therefore lead to a downgrade of the covered bonds, all else being equal.

The rating agency has maintained a negative outlook on the ratings and affirmed the bank’s standalone financial strength rating (BFSR) at E, with a stable outlook.

Moody’s said its decision reflects its opinion that there is a “much reduced” likelihood of systemic support from the UK government in the event that additional capital is required for Co-op Bank, as the bank’s ongoing deleveraging process is “leading to a smaller and less systemically important financial institution”. It added that it believes any further capital requirements would need to be raised either from existing shareholders or in the market.

The rating agency considers that the bank continues to face “significant challenges to re-establish a sustainable business” despite plans for an imminent capital raise of £400m (Eu486m) that the bank has announced to maintain its core equity tier 1 ratio above 7%. The standalone ratings assigned to the UK issuer – a BSFR of E and equivalent baseline credit assessment of ca – reflect these challenges, according to Moody’s.

Under its methodology, the issuer’s senior debt and deposit ratings benefit from two notches of uplift from the standalone rating of ca to reflect the cushion for senior creditors provided by the planned additional capital raise and outstanding subordinated bonds. The Caa2 ratings also reflect Moody’s expectation of regulatory forbearance from the Prudential Regulation Authority, giving the bank several years to ensure that it can again meet regulatory capital requirements.

Moody’s currently rates Co-op Bank’s covered bonds at Baa3, and assigns them a Timely Payment Indicator of “probable”.

Cutting Co-op’s issuer rating from BB- to B, Fitch said its downgrade reflects the impact a revised strategy announced on 4 November is likely to have on the bank’s internal capital generation ability.

The covered bonds were downgraded one notch less than the issuer because under Fitch’s methodology the maximum uplift over covered bonds’ probability of default (PD) ratings rises from two to three notches when their PD rating is sub-investment grade, and Co-op achieved this extra uplift.

The BBB+ rating takes into account the B issuer rating, a Discontinuity Cap (D-Cap) of 4 (“moderate risk”) and asset percentage (AP) of 77.5%. The AP allows the covered bonds to be rated BB+ on a PD basis and BBB+ considering recoveries given default, said Fitch, as it is lower than the breakeven AP of 90%.

The rating agency noted that for issuers with a short term issuer default rating below F2, it takes into account any public or contractual issuer commitment to maintaining a certain level of overcollateralisation, and in Co-op’s case this is a 77.5% level used in its asset coverage test (ACT).

The covered bonds’ Rating Watch Negative matches that of the issuer rating. Fitch said, all else being equal, that any rating action on Co-op’s issuer default rating would likely translate into an action of the same magnitude on the covered bonds.

Fitch also noted that under the programme documentation, Co-op should within 60 days of being downgraded to below BBB- (which happened on 20 June) use reasonable endeavours to enter into a back-up servicing agreement with a third party as appropriate and appoint a suitable back-up cash manager on a best-effort basis. The rating agency said that 60 days have passed and that it is closely monitoring remedial action being put in place by the issuer.

The UK bank announced a new recapitalisation plan on 4 November and Fitch said that its downgrade reflects the impact the revised strategy is likely to have on The Co-op’s internal capital generation ability, as well as taking into account other new disclosures.

“Fitch considers that the new strategy, including the deleveraging of some non-core portfolios, while ultimately beneficial for senior debt-holders in the long term if successful, to pose significant challenges over the medium term and preclude the bank from being capital generative for some time,” it said. “In addition, Fitch believes that the reduction of the Co-operative Group’s stake to 30% as a result of the liability management exercise (LME) has the capacity to diminish Co-op Bank’s small but stable domestic franchise and loyal customer base.

“The ratings factor in some benefit from Co-op Bank’s acceptable liquidity and so far stable funding profile.”

It added that the Rating Watch Negative reflects “material risks” to the success of the LME.

An analyst at RBS said that according to Fitch’s criteria, the probability of default (PD) rating of The Co-op’s covered bonds should fall to BB+ (assuming an unchanged D-Factor of 4). As the maximum achievable recovery uplift above the PD rating will be three notches, because the PD rating is now sub-investment grade, rather than the previous two, the recovery uplift could be increased by one notch, according to the RBS analyst.

“Therefore we would assume the covered bonds to be downgraded by one notch to BBB+ as a base case, although there is a risk that they downgrade it by two notches in case stressed recoveries are lower than previously assumed (if Fitch came to the conclusion that the cover pool quality has deteriorated in the meantime for example),” he said.

The three notch cut to the covered bonds’ rating reflects that of the issuer, as does the new evolving status. Fitch said its downgrade of Co-Op mainly reflects its concerns that the bank’s capital requirements are higher than originally anticipated.

The A- covered bond rating is based on Co-Op’s BB- rating, a Discontinuity Cap (D-Cap) of 4 (moderate risk), and an asset percentage (AP) of 77.5%. The AP of 77.5% allows for a rating of BBB on a probability of default basis and A- considering recoveries given default, as it is lower than the breakeven AP for that rating level, which is 90%, said Fitch.

The rating agency said that any rating action on Co-Op is likely to translate into a rating action of the same magnitude for the covered bonds, all else being equal.

Fitch noted that according to Co-Op’s programme documentation, the issuer has to use reasonable endeavours to enter, within 60 days, into a back-up servicing agreement with a third party as appropriate, because of the downgrade of the issuer below BBB-.

“Also, a suitable back-up cash manager should be appointed within 60 days, on a best effort basis,” it said. “Fitch will closely monitor any remedial action put in place by the issuer and review the rating accordingly.”

The rating agency cut the senior debt’s rating after the announcement yesterday of a plan to bail-in subordinated bondholders to help recapitalise the bank.

Co-op’s covered bonds were downgraded from Aaa to Baa1 on 10 May when the bank was cut from A3 to Ba3, and were left on review for downgrade. The covered bonds’ rating was constrained by a combination of the programme’s Timely Payment Indicator (TPI) of “probable” and the previous Ba3 issuer rating.

RBS analysts said today that the rating of the programme will most likely be further downgraded following the latest downgrade of the bank.

“With a TPI of probable, we would expect the covered bond rating to be capped in the low ‘Ba’ or ‘single-B’ section,” they said.

Downgrading the issuer yesterday (Thursday), Moody’s cited potential further substantial losses, particularly from Co-op’s commercial real estate exposure, which could exert pressure on capital ratios that are already relatively low, as well as vulnerability to losses heightened by low levels of provisions, and slow progress in realising benefits related to its merger with Britannia. Co-op’s ratings and its covered bonds remain on review for downgrade.

The Co-operative Banking Group’s chief executive, Barry Tootell, resigned this (Friday) morning in the wake of the downgrade of Co-operative Bank plc. The group said that it was disappointed by Moody’s downgrade of the bank.

“We have a strong funding profile and high levels of liquidity, which are significantly above the regulatory requirements,” it said. “We do acknowledge, like the rest of our banking sector peers, the need to strengthen our capital position in light of the broader economic downturn and the pending introduction of enhanced regulatory requirements, and we have a clear plan to drive this forward throughout the coming months.”

The Co-operative Bank has only one benchmark covered bond outstanding, a £600m November 2021 issue launched in November 2011. According to a banker this had widened some 35bp to around 160bp over swaps after the issuer rating cut yesterday but before the covered bonds were downgraded late this morning.

The covered bonds were downgraded to Baa1 because the combination of the new Ba3 issuer rating and a programme Timely Payment Indicator of “probable” constrain the rating at that level. A covered bond analyst had suggested that under Moody’s methodology they could have been cut as low as Baa3.

Jan King, senior covered bond analyst at RBS, said that the downgrade of seven notches is one of the sharpest ever in covered bonds, with the covered bonds’ fate made even more exceptional by the issuance falling from a triple-A rating.

Another covered bond analyst said that he expected the levels of covered bonds of other UK issuers – which also have deals in euros – to be unaffected by Co-op’s problems, and that there is little risk of any others falling to even single-A in the medium term.

“Once more, the downgrade is mainly driven by the unsecured rating,” he added. “The cover pool quality hardly makes a difference.”

The rating agency said that the “transformational” deal would significantly alter Co-op Bank’s risk profile.

Moody’s review of the covered bonds will take into account any increased expected losses as a result of a downgrade of the issuer and the impact of any cut on the covered bond ratings under the rating agency’s Timely Payment Indicator (TPI) framework.

The TPI assigned to the Moorland covered bonds is “probable”, with any downgrade of the Co-op Bank’s senior unsecured long term rating, currently A3, leading to a cut of the covered bond ratings, according to Moody’s.

The rating agency has assessed the market risk in the Moorland cover pool to stand at 18% and the collateral risk at 3.9%. Overcollateralisation is 229.2%, according to Moody’s, of which it considers 29% to be committed. The minimum OC level consistent with a Aaa rating target is 25%, it added.

Moody’s noted that The Co-operative Group, the ultimate parent of the Co-operative Bank, has announced that it had agreed non-binding terms with Lloyds Banking Group for the Co-operative Banking Group to acquire the assets and liabilities (known as Verde) that Lloyds has been required by the European Commission to sell, and that this prompted the review for downgrade.

“If the deal proceeds as announced, the acquisition of Verde would be a transformational deal for the Co-operative Bank, potentially resulting in a significant change in the risk profile,” said Moody’s. “This reflects the size of the acquisition, which accelerates the already substantial growth of the bank following its 2009 acquisition of Britannia Building Society.”

The rating agency said that Co-operative Bank at completion expects the Verde balance sheet to be around £24bn, which would take the bank’s total balance sheet towards £75bn at the end of 2013, an increase of around 50% compared with the balance sheet size of the Co-operative Bank at the end of 2011.

Moody’s said that its review will consider:

• the steps that the Co-operative Bank would take to ensure the smooth integration of Verde;
• the composition and quality of the loan assets that would be acquired;
• the bank’s exposure to any further deterioration in the challenging UK economy, especially given its exposure to commercial property and its relatively high level of impaired loans;
• the impact that the acquisition could have on the bank’s profitability, which is currently subdued;
• the anticipated impact on the bank’s capitalisation under stress; and
• the anticipated development of the bank’s liquidity and funding profile.

However, Moody’s noted that the acquisition would substantially strengthen the Co-operative Bank’s franchise, and that the bank estimates that its market share of current accounts would rise to a level approaching 7%.

The rating agency said that although the acquisition of Verde would improve the position of the Co-operative Bank within the UK market, Moody’s would not expect to change its systemic support assumptions.