OREANDA-NEWS. Fitch Ratings has affirmed the 'AAA' rating with a Stable Rating Outlook on the Bank of Nova Scotia's (BNS; 'AA-'/'F1+'; Outlook Stable) structured mortgage covered bonds following Fitch's annual review. The program remains in wind-down following the 2012 introduction of covered bond legislation prohibiting issuance of covered bonds secured by insured mortgages.

KEY RATING DRIVERS

The 'AAA' rating on BNS' structured mortgage covered bonds is based on the banks's 'AA-' Issuer Default Rating (IDR), Fitch's unchanged Discontinuity Cap (D-Cap) of 3 (moderate high risk) and the program's contractual asset percentage (AP) of 95%, which is equal to the 'AAA' breakeven AP supporting Fitch's rating. The current contractual AP supports the rating on an 'AAA' probability of default (PD) basis.

The 95% 'AAA' breakeven AP, corresponding to a breakeven OC of 5.3% is driven by the cover pool's asset disposal loss of 5.9%, followed by the credit loss component of 0.7%. The cash flow valuation component leads to a lower 'AAA' breakeven OC by 1.2%. The 0.7% 'AAA' credit loss represents the impact on the breakeven OC from the 20.0% weighted average (WA) default rate and the 96.5% WA average recovery rate for the mortgage cover assets, which takes into account the benefit of the Canadian Mortgage Housing Corp. (CMHC) insurance on the mortgage loans. The breakeven AP considers whether timely payments are met in an 'AA' scenario and tests for recoveries given default of at least 91% in an 'AAA' scenario.

Fitch's breakeven AP for a given covered bond's ratings will be affected by, among other factors, the profile of the cover assets relative to outstanding covered bonds, which can change over time, even in the absence of new issuances. Therefore it cannot be assumed to remain stable over time.

Under the current Canadian banking legislation bail-in is not an explicit provision; therefore, in Fitch's view, the IDR remains a satisfactory indicator of the likelihood that the recourse against the cover pool would be enforced, and no IDR uplift is applicable.

Canadian covered bond program documents include a feature called the Selected Assets Required Amount (SARA) clause, which places some conditions on the sale of assets in the event of an issuer default. Fitch has considered the impact of this clause by modelling an issuer default in each of the first six quarters and in every quarter with a covered bond maturity date to ensure that overcollateralization would be sufficient for all possible sale periods under a given rating scenario.

There may be some scenarios not considered in Fitch's current analysis of the SARA clause in Canadian covered bond programs. Fitch is currently in the process of fine-tuning its approach to the SARA clause. Following this review, expected to be completed in the third quarter of this year, Fitch will re-run the cash flow modelling on these programs to evaluate any impact on the break-even AP for the ratings.

Lastly, BNS' program documents contain rating agency removal language (RRL), which allows the issuer to remove a rating agency and rating agency specific language from legal documents in lieu of taking certain actions to avoid a potential downgrade without consulting bondholders. In the event a downgrade of the bank's rating by Fitch breaches ratings trigger requirements, such as the account bank where monies are held is no longer rated above 'A-' (3 notches below current 'AA-' rating), the covered bonds could be downgraded below 'AAA' prior to Fitch's withdrawal of the rating. Because BNS' existing transactions restrict RRL provisions to having two other rating agencies retained on the transaction, Fitch does not believe the RRL introduces additional risk. Fitch will continue to monitor future use of RRL in future issuances and whether such language extends beyond its current restriction.

RATING SENSITIVITIES

For BNS' structured mortgage covered bonds, if CMHC lost the full backing of the Government of Canada, or if the Government of Canada's rating suffered a downgrade, Fitch would revise the credit given the insurance provided by CMHC on the mortgage loans in the cover pool. This could lead to weaker liquidity as well as higher credit risk expectations for the cover pool. As a result, the D-Cap would likely decrease and the breakeven AP for the current covered bonds' ratings would likely decrease as well.

BNS' structured covered bonds' rating would be vulnerable to a downgrade if any of the following occurred: (i) the IDR was downgraded by three notches to 'A-', (ii) the D-Cap is reduced to 0 (full discontinuity), or (iii) the AP that Fitch takes into account in its analysis exceeded 95%.