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Calling it like they see it

19 December 2014
Richard Kemmish

As if the weeks before Christmas weren’t busy enough S&P have to add to the burden by publishing not one but two consultation papers on covered bond rating methodologies.
The first is largely about making their commercial mortgage assumptions more draconian, as is appropriate given the state of the Eurozone economy. The fact that they are expecting relatively few rating actions (less than 10%) as a result of the change I think reflects the fact that programmes with commercial mortgages in them don’t typically have that many commercial mortgages – residentials predominate - and that those that do generally have higher over-collateralisation already to reflect the more stringent criteria of one of the other agencies.

The second consultation is a long over due response to the resolution directive (do try to keep up S&P, Fitch and Moodys were out with theirs months ago). Contrasting it with the other two responses (which are remarkably similar) S&Po put less emphasis on the amount of bailin-able debt protecting covered bond holders and more on the systemic importance of the product.

This is in line with their general philosophy but I wonder if there isn’t a risk of a double count of systemic importance? Their covered bond analysis starts at a rating level which takes into account the senior unsecured rating of the bank plus the probability of bail-in being sufficient, plus the probability of state support. This then gives the probability that the covered bond mechanics will actually need to be tested.

Their appraisal of the covered bonds uplift from this starting point, as ever takes into account the systemic importance of the covered bond product in the country. But if senior debt has already been bailed in and the government has declined to provide state aid to the rest of the bank (which by then is covered bonds and other preferred creditors), hasn’t the government effectively set-aside the systemic importance of covered bonds already? 

I also think there may be an overlap with their first consultation.  Why are covered bonds systemically important? There are of course many reasons but the one that only appeals to the more anti-market inclined politicians is the importance of funding people’s homes and the public sector.
Using tax payer funds to supporting the financing of aircraft, ships or commercial mortgages is not a vote winning strategy. I think it is difficult to argue that systemic importance is uniform within one country when different asset classes are taken into account.

There is one other aspect of the resolution directive that I feel isn’t taken into account properly yet, the fact that the operational failure of a bank now, whilst a more remote risk is a more catastrophic one. In both special law and general law based bonds the working assumption seems to be that there will be some form of early warning system of a bank failure (for example rating downgrades triggering remedial actions). 

I’m not so sure that is the case any more.

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