The problem with being too good

13 Apr 2015 | Richard Kemmish

The Swedes recently relaxed their covered bond rules to allow swap providers to be rated in the single A range. Previously only AA swap counterparties were eligible. I say ‘relaxed’, but Moody’s commenting on the law said that it was actually a credit positive. Huh?

The reason for the change and the reason that Moody’s viewed it in a positive light is the same: there aren’t enough AA rated counterparties to go round. Arguably in a stress scenario – a Swedish bank failing is the only relevant one here – the ‘AA only’ rule would preclude the insolvency administrator who has to manage the pool then from finding anyone who could do the swap. Better to have a swap with a poorly rated counterparty than one with none at all?

There are a couple of specific issues here that stop me from generalising. Firstly, this is Sweden, there are a limited number of counterparties who are able to credibly undertaken Swedish Krona to Euro swaps (the interest rate component is far less important) and whereas Swedish banks are generally well rated (currently), AA is a very high hurdle. Secondly, opening up swap eligibility to single A rated counterparties isn’t exactly opening the gates of Rome to the barbarian hordes. Particularly as there are plenty of mitigants in place to protect the cover pool from these lesser swap providers.
Setting that aside though, can you generalise from this? What other requirements in covered bond rules could be ‘relaxed’ to make the transactions better?

Firstly, just about anything that relates to a role that will survive a bank ‘failure’ thanks to the resolution directive. A bank that enters into resolution is very unlikely to stop being able to service the mortgages. Transferring the servicing of a portfolio of mortgages to a third party is likely to be far more disruptive than beneficial. It is also likely to precipitate the demise of the issuer – from a combination of bad publicity and loss of servicing income.
Secondly, anything esoteric. Swedish krona swaps aren’t exactly esoteric but there are only a limited number of potential counterparts. As issuers with other currencies increasingly come into the market this will increasingly be a requirement. Particularly from countries with lower credit ratings. If you want EM issuers, you need to set the swap counterparty bar lower.

Thirdly, for lower rated covered bonds. The vast majority of covered bond programmes were put in place when it was assumed that the bonds coming out of them would be AAA rated. Why have ratings rules in place sufficient to support a AAA rating when you are only aiming for single A rated covered bonds?

But all of this will require changes not just to programmes and national law but also to European law. AA- is a cut off point so frequently purely because that is equivalent to Credit Quality Step 1 in so much EU legislation. If EU legislation is really going to reduce its dependency on external rating agencies – as is the plan - maybe we need to find some smarter ways to think about these rules.

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