UPDATE 3-S&P puts 1.46 tln euros of covered bonds on watch

Published: 16 Dec 2009 11:02:15 PST

* New S&P criteria focuses on asset-liability mismatch

* 98 covered bond programmes put on watch

* Ratings unchanged for 59 issues

LONDON, Dec 16 - Standard & Poor's on Wednesday put about 1.46 trillion euros ($2.127 trillion) worth of covered bonds on credit watch negative or developing, based on new criteria for rating such securities.

S&P's move could mean a raft of downgrades for these asset-backed bonds, which are a cheap funding tool for banks.

The agency's revisions to its methodology for rating covered bonds link the rating on the bond to the rating of the bank or entity issuing them if the covered bond programme has an asset-liability mismatch.

S&P's agency's original proposals had prompted concerns they could cause increased ratings volatility and turn some investors into forced sellers of covered bonds.

"There were some expectations S&P would be less severe because of negative feedback from investors on its original plans," said one debt capital markets banker.

"But it seems to have stuck to its guns."

S&P had originally requested feedback from the industry on its proposed changes in February.

The banker said with low liquidity at the moment in the secondary market and a lack of new issuance because of the approaching Christmas holidays, it was difficult to gauge any immediate impact.

"Downgrades will probably come but the question is how much importance investors put on ratings versus their own internal analysis," he said.

The European Central Bank has bought about 27 billion euros of covered bonds since the summer to help revive the market after the credit crisis. The ECB was not immediately available to comment on S&P's move.

GERMAN MARKET

"There are clear improvements over the first draft," said Henning Rasche, president of Germany's covered bond banking association in a statement.

The association also noted that requirements for the "cover" to back a triple A-rated bond could rise considerably.

"The only reason for the placing of Pfandbriefe on the credit watch list was the methodological changes. It is in no way due to a qualitative worsening of the (collateral) cover," Rasche said. (Pfandbriefe are German covered bonds)

S&P said 98 covered bond programmes would be put on credit watch as a result of its new ratings system.

"On the basis of the information available at the time of the analysis, we found that about 15 percent of programmes in our sample could not be assigned a maximum potential rating of AAA," it said.

Covered bonds, usually rated triple-A, are regarded as low risk because they are backed by mortgage assets or loans that remain on the issuing bank's balance sheet, but the credit crisis prompted S&P to revisit the way it rated them because of concerns over what would happen in a bank default.

The bonds have relatively short maturities, but the pool of underlying mortgages backing them are usually 25-30 years. This raised concerns that in a default the mortgages would not raise enough to repay the bonds.

"The unprecedented dislocation of credit markets has demonstrated to us that one of the key considerations in our analysis of covered bonds -- the ability to refinance or sell assets in the event of bank failure -- can be compromised in a highly stressed environment," the agency said.

BOND-BANK LINK

S&P said this was why it had decided to introduce a link between a covered bond's rating and the rating of the issuing bank, if there was a mismatch between the bonds and the programme's underlying assets.

Moody's Investors Service and Fitch Ratings already have covered bond ratings systems that include a link to the underlying bank's rating.

"The Pfandbrief (German covered bond) won't lose its position as a secure refinancing instrument as a result of the possible ratings adjustment," said NordLB covered bond analyst Tobias Meier, adding that it was a good idea for all agencies to use the same method for valuing covered bonds.

S&P said under its new system it would leave ratings unchanged and have stable outlooks on four covered bond programmes as well as 59 issues of Spanish covered bonds, known as structured cedulas.

Those bonds put on credit watch affect programmes rated in rated in Europe, Canada and the United States, S&P said.

"In programmes in which we see asset-liability mismatch risk has been addressed by structural features, we can rate the programme on a de-linked basis from the issuer," S&P said.

Covered bond issuance is estimated to have reached about 130 billion euros in Europe in 2009, according to Societe Generale.

The French bank has predicted supply could reach at least 168 billion euros in 2010, which compares with about 179 billion in 2006, before the credit crisis.

The market for jumbo covered bonds had a volume of around 900 billion euros in 2009, with Germany and Spain the largest issuers, according to NordLB's Meier. ($1=.6864 euros)