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S&P raising some big questions

09 May 2014
Richard Kemmish

S&P have finally said that they will be amending their covered bond rating criteria to reflect the new Bank Recovery and Resolution Directive (aka the bail-in rules). In particular they are going to try to quantify the benefit that covered bond ratings get from being exempt from bail-in. Moodys and Fitch have already announced that they will be changing their criteria (several months ago, do try to keep up S&P).

Presumably this will result in an uplift of covered bond ratings relative to the same bank’s unsecured rating, as it did with the other two agencies. Nothing too controversial there. Senior bonds (the bonds formerly known as senior?) are for all practical purposes the same as capital in a bail-in scenario for everyone higher up the capital stack. If you have 10 of senior bonds and 10 of capital its as if the covered bonds were being issued by a bank with a 20% capital ratio – and that’s before the covered bond mechanism is even put to the test.

Simple, except that it isn’t.

The new European rules would have this impact if they existed in isolation. But they don’t. One of the main points of the directive is to stop tax-payers money from acting as capital – governments stepping in to rescue a failing bank. S&P quite rightly identified that the probability of governmental support for senior unsecured bonds will be substantially less post resolution directive than it is now. So ‘senior’ bonds might be downgraded at the same time as the rating differential for covered bonds has increased.

But, what about systemic support for covered bonds? The German government explicitly and other governments more implicitly have always said that they couldn’t let a covered bond fail. In practice in every bank failure this was seen to be the case (even in Washington Mutual the cover pool and bonds were carved out and transferred to JP Morgan).  Has this also changed as a result of the new directive? Yes, because of the ‘no more tax payers money’ assumption, or no because covered bonds are still so systemically important?

For what its worth I think it is almost inconceivable that a covered bond could default in a bail in scenario, but that is only one of the resolution instruments available to regulators. It is just the scenario that has got the most media attention.

 One other significant implication of all of this has been largely overlooked by the market. Covered bond programmes are riddled with rating triggers (I counted 30 in one programme alone), ‘if the rating of the issuer falls below X, then the issuer must do the following...’. All of these refer to the unsecured rating of the bank because in the past that was more or less synonymous with the bank no longer being a going concern. Now it is easy to envisage a scenario where the bank continues to service the mortgages (provide the swaps, manage the bank accounts, etc) even when their senior unsecured bonds have defaulted.

So these triggers are far more likely to be hit now (often with huge expense and inconvenience), but are more or less irrelevant for the servicing of the covered bonds. A lot of covered bond programmes really need to be amended (and I know a very good covered bond consultant if you are interested).

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