OREANDA-NEWS. UK covered bond ratings are resilient to the new environment created by the decision of the UK to leave the European Union. This is because banks' ratings are compatible with a moderate deterioration in their operating environment and most UK covered bonds (by outstanding amount) have a cushion against their issuer's downgrade. Fitch Ratings expects these rating cushions to increase under new criteria proposals (see "Fitch Launches Exposure Draft on Enhancements to its Covered Bonds Rating Criteria"). In addition, issuers maintain large overcollateralisation (OC) buffers that could mitigate an increase in credit or refinancing risks for the programmes.

Out of the 13 UK covered bonds programmes rated by Fitch, totalling GBP 86bn, seven (representing GBP72bn) have a cushion against their issuers' downgrades. The rating cushions are expected to increase under our new criteria proposals, whereby the maximum uplift of UK covered bond ratings above the banks' Issuer Default Rating (IDR) could increase by two to four notches. The rating uplift of covered bonds is mainly dependent on the treatment of covered bonds in case of a bank's resolution (IDR uplift) and the liquidity gaps upon the enforcement of the security over the cover pool, reflected in the Discontinuity Cap (D-Cap).

We do not expect the vote to leave the EU to affect the favourable treatment of covered bonds in the resolution framework for UK banks. Regulated covered bonds in the UK are exempt from bail-in as they are secured debt. In addition, the UK regulatory framework for covered bonds and the strong supervision from the Financial Conduct Authority support our view that there is a low risk of covered bonds being undercollateralised at the point of resolution (see "Fitch's Jurisdictional Analysis of the Risk of Undercollateralisation of Covered Bonds"). Under our criteria proposals, this could translate into an IDR uplift of two notches for UK regulated covered bonds, from the current zero to one notch, thereby increasing the rating cushion for UK covered bonds.

All UK programmes have liquidity protection mechanisms of 12 months or more, with a reserve covering for short-term liquidity risk. Under our exposure draft, they could be eligible for a Payment Continuity Uplift of six notches compared with their current D-Cap of four notches (moderate discontinuity risk). If implemented as proposed, this would further increase the cushion of covered bonds ratings against a downgrade of their issuers.

In addition, the rating of the UK sovereign (downgraded to 'AA'/Negative on 27 June 2016) is not a constraint on UK covered bonds ratings as Fitch only factors in systemic risk in its payment continuity analysis once a country's rating falls to the 'A' category. We propose to address systemic risk via higher refinancing spread levels when sovereign spreads are under pressure, which is not the case for the UK sovereign.

Although we expect Brexit to have a negative impact on economic growth, employment and the UK mortgage market, the mortgage cover pools' credit quality is better than that of the banks' total residential mortgage books. The cover pool eligibility criteria (notably on maximum loan-to-value ratios), high seasoning and the low proportion of buy-to-let mortgages (2.8% on average, with a maximum at 13.8%) are credit positive. In addition, most issuers remove non-performing loans (90 days in arrears) from their cover pools, as they cannot be counted towards the OC.

In the case of another referendum on the independence of Scotland, the risk of redenomination of Scottish loans into a new currency could be mitigated by the issuer substituting these assets, which would be feasible given the generally low proportion of Scottish mortgages in cover pools (average 6.73%, maximum 22.4% but for a small pool of GBP1.5bn).

All cover assets are denominated in pounds and covered bonds are issued in pounds or swapped into pounds to hedge any foreign-exchange (FX) mismatches. However, in a recovery scenario where covered bonds have defaulted and swaps are terminated, recoveries on non-sterling covered bonds could be reduced by a depreciation of sterling. Under the new criteria, the recovery uplift would be limited to one notch from two notches for issuers with significant FX exposures (disregarding the swaps). For those programmes, the maximum rating uplift under the new criteria is still expected to be higher than it is now.

The levels of breakeven OC supporting the current ratings are mostly driven by the maturity mismatches between the cover assets and the covered bonds. Fitch assumes payments on covered bonds post-enforcement of the security could be met by selling parts of the mortgage assets in the pool. We do not envisage increasing our refinancing spread assumptions for UK mortgage loans, but such a review would take place should there be a marked increase in sovereign and RMBS spreads. The impact of any increase in spread assumptions could be mitigated by the current level of OC cushion. It would not necessarily affect the covered bonds ratings given that issuers maintain large OC levels (56% on average) above the level that supports the current ratings (12% on average).