European Mortgage Market Also About To Get Nuked

Another really scary tidbit - first the fate of the CMBS market in the U.S. lies on Moody's not so broad shoulders, now, according to Barclays, the future of the $1 trillion covered bond market in Europe is about to depend on the shoddy analysis of S&P analysts. European covered bonds which date back to 18th-century Prussia, are Europe’s main source of funding for home lenders and have been promoted by the U.S. Treasury as a way of boosting the mortgage market. According to Bloomberg, banks in Europe sold €205 billion of the securities in 2008, down from €347 billion in 2007.

Per Barclays, S&P will "soft-link" the rating of the covered bond with that of the issuer. By the company's estimates, this type of redraw will result in at least 60% of covered bonds receiving a downgrade, which will force investors to start a fire-sale of massive proportions. A blurb from the Lehman report.

On Wednesday 4 February 2009, rating agency Standard and Poor’s (S&P) outlined plans to substantially amend its existing covered bonds rating methodology, which will supersede essentially all major covered bond criteria reports that the rating agency has published in the past 12 years. In short, S&P will introduce a so-called “soft-link” between the issuer rating and the covered bond rating. In addition, asset-liability mismatches, institutional support for the covered bond product and stress assumptions to the market value of cover pool collateral will play a more important role. S&P has warned that the implementation of these changes may lead to rating revisions (=downgrades) to a large number of covered bonds. Downward pressure comes from two sources. First, approximately 60% of the programmes to which the agency assigned a rating will not fulfill the minimum rating guidelines for covered bond issuers. Second, owing to higher market value stress assumptions, a large number of programmes will be subject to increased over-collateralisation requirements and may be downgraded in case issuers fail to comply with the new standards.

And the Conclusion:

We would expect the announcement of such an erratic change in S&P’s rating approach to reflect in further selling pressure. Many investors will struggle to digest the news that 60% of the whole universe of S&P rated covered bonds will very likely be subject to negative rating pressure. While a number of covered bonds are already quoted at quite distressed spread levels, such a material change in S&P’s rating framework not only limits the prospect for spread tightening, but also increases the selling pressure on some covered bond classes, which so far have fared relatively well. For example, we would expect those programmes that are issued by banks with a senior rating below A and which are backed by mortgage pools that are subject to challenging secondary market conditions to come under renewed selling pressure. Furthermore, even the performance prospects for Spanish Multi-Cédulas might be limited, as the classification of these products in Category 1 is subject to further review.

Full Barclays report here.