Fitch Ratings has updated its criteria for analysing counterparty risk in covered bond programmes. The updated criteria report follows the feedback received on the exposure draft published on 13 March 2012 and the publication of the updated counterparty criteria for structured finance (SF) transactions on 30 May 2012. Fitch obtained comments on its exposure draft from a number of market participants from various backgrounds including investors, covered bond issuers, issuer associations, arrangers and derivative counterparties. The agency had invited market participants to provide comments in particular regarding netting of collateral positions, treatment of termination payments and extended rating eligibility thresholds. Additionally, it was proposed to adopt all changes incorporated in the updated SF counterparty criteria.
Regarding netting of collateral positions, the agency sought feedback on the impact of replacement prospects of privileged asset and liability swaps. The feedback received supported the assumption that netting might hamper individual replacement prospects for swaps concluded with internal counterparties. In these cases, it might lead to increased default risk of the covered bonds after an issuer default. Additionally, following the feedback received, Fitch clarified the treatment of volatility cushions (VCs) and liquidity adjustments in an example. Fitch also put the treatment of pari passu or senior-ranking termination payments to discussion. The agency primarily views these as a potential liquidity stress. The respondents agreed with the proposal. Additionally, feedback requested that Fitch should clarify the difference between the treatment of termination payments in a scenario where only the counterparty defaults and in a scenario where the cover pool is liquidated, which has been done in the updated criteria report.
Consistent with the updated SF criteria, the agency proposed the establishment of additional rating eligibility thresholds. The majority of respondents agreed that the extension of rating eligibility thresholds for covered bonds rated below 'AAA' would offer more flexibility for counterparty selection while maintaining sufficient protection. Fitch further proposed adopting all changes incorporated in the updated SF criteria, such as the changes to collateral posting formulas including the updated approach for determining VCs for cross-currency swaps. No negative feedback was received on this proposal. Fitch does not expect the criteria update to have any direct rating impact on existing covered bond programmes. However, the amendments may have limited indirect impact in the following scenarios: If previously documented triggers are set higher than Fitch's criteria, and the documented triggers are breached, as long as a counterparty's arrangements continue to be consistent with Fitch's criteria, the agency would not expect to downgrade the covered bonds' ratings exclusively due to the breach of any triggers specified in programme documentation which no longer reflect Fitch's current criteria. Nevertheless, the consequences under the programme documentation of such a breach would be a matter for the parties to the programme to address as a matter of contract. Fitch would expect to be notified of any action taken by the programme parties in response to such a breach and what future actions might be expected to be taken in response to breaches of the new criteria thresholds.
Where parties to a covered bond programme choose to amend existing documentation to incorporate aspects of the updated criteria (e.g. updated collateral posting calculations), Fitch will not take rating actions on the covered bonds for this reason as long as the programme remains consistent with criteria. Fitch expects to be notified of any such amendments however, in light of this statement, Fitch will not expect to provide programme-specific rating confirmations with respect to proposed changes.