Scope Ratings has today assigned first-time AAA ratings with a Stable Outlook to the Norwegian covered bonds (obligasjoner med fortrinnsrett) issued by the fully owned mortgage subsidiary of Totens Sparebank, Totens Sparebank Boligkreditt (TSBB). Covered bond ratings reflect the A- issuer rating assigned to TSBB, further enhanced by support provided by the cover pool analysis supporting an at least six notch credit uplift to TSBB's rating allowing the covered bonds to be rated AAA. Fundamental credit support factors provide five notches of uplift above the bank’s rating effectively providing a rating floor at AA+.

Key rating drivers for the covered bond ratings

• Sound issuer credit rating (positive)
• Cover pool support of at least six notches reflecting:
  Sound credit quality: low credit risk even at the highest rating stresses (positive);
  Substantial asset liability mismatch (negative): slow scheduled amortisation of cover assets compared to a relatively fast redemption profile for the covered bonds;
  Overcollateralisation (positive): available overcollateralisation has historically remained well above the regulatory minimum and above the rating-supporting overcollateralisation level determined by Scope.
• Fundamental credit support resulting from the strength of the Norwegian legal and BRRD framework, which supports a five-notch uplift to the issuer rating (positive)

Fundamental credit support: the Norwegian legal framework and resolution regime provide a five-notch uplift

Two notches of uplift are driven by the agency’s positive view of the Norwegian legal covered bond framework. Another three notches are based on Scope’s assessment of the support the resolution regime affords the issuer and the systemic importance of Norwegian covered bonds.

Analysis of the Norwegian covered bond legal framework

In Scope’s view, Norway has one of the strongest European covered bond frameworks. It meets the rating agency’s criteria for protecting covered bond investors in a going or gone concern of the bank and allows the assignment of the highest credit differentiation.

• Segregation of cover pool upon insolvency: the relevant section on covered bonds in the Financial Institutions Act and a related regulation on mortgage credit institutions gives bondholders a preferential claim over the cover pool if the issuer is placed under public administration. In this case, the assets in the pool remain with the estate, but the bondholders and derivative counterparties have an exclusive, equal and proportionate preferential claim on the cover pool.
• Ability to continue payments after issuer insolvency: under the act, covered bond issuers cannot be declared bankrupt but have to be placed under public administration if facing solvency or liquidity problems. This will give the authorities more flexibility to deal with covered bond companies, while maintaining the rights of covered bond holders. The liquidator must ensure the proper management of the cover pool and ensure that holders of covered bonds and derivative counterparties receive agreed and timely payments.
• Programme enhancements remain available: Norwegian obligasjoner med fortrinnsrett have a mandatory minimum overcollateralisation requirement of 2% (nominal). All voluntary overcollateralisation is part of the cover pool.
• Key eligibility criteria: the definition of eligible assets follows European standards. There is a maximum loan-to-value (LTV) ratio of 75% for the main collateral type (residential mortgages) and 60% for commercial, holiday and leisure properties. Further, the act permits the inclusion of substitute assets (maximum 20% of the cover pool).
• Liquidity and other risk management guidelines: the covered bond programme’s risks are generally managed as part of the group’s liquidity and risk management. There are no requirements in terms of available reserves to buffer upcoming redemptions. However, given that the covered bonds are soft bullet with a one-year extension, the final legal maturity provides an additional buffer to reduce maturity mismatches.
• Covered bond oversight: TSBB is supervised by both an independent inspector and the Financial Supervisory Authority of Norway (Finanstilsynet). Upon solvency or liquidity problems of the issuer, a public administrator would take control to ensure timely payment to the covered bond holders. 

Resolution regime and systemic importance considerations for TSBB’s covered bond programme

TSBB’s covered bonds benefit from an additional three-notch uplift reflecting the benefit of a bail-in exemption and support from a strong stakeholder community. The uplift reflects a combination of: i) a moderate to high likelihood that the covered bond issuer will be maintained in a resolution scenario; and ii) the high systemic importance of covered bonds in Norway. However, the agency recognises the low visibility and limited importance of TSBB as a covered bond issuer. Scope believes that, in general, Norwegian covered bonds of resolvable and very visible issuers could benefit from four additional notches of support.

• Exclusion from bail-in: the March 2018 translation of the BRRD into Norwegian law exempts covered bonds and related derivatives from write-downs affecting an issuer’s other debt instruments.
• The rating agency believes that the current sound capital structure will allow regulators to restructure the group using available resolution tools. However, given the high number of retail banks, even in the more rural areas such as the Mjoes region in which Totens Sparebank (TSB) is active, retail banking could be considered a non-critical business which either would be subject to an orderly wind-down or transferred to another bank in a resolution scenario. As a result, the current covered bond issuer structure might not be maintained as a going concern.
• Scope considers TSBB’s covered bond issuing activities and market share to only result in a low to moderate systemic importance. TSB has only recently started to become more active in using TSBB to refinance residential mortgage loans. The bank only issues on the domestic market which would be likely to reduce negative repercussions on other issuers in the event of a failure. The low to moderate systemic importance also reflects the fact that most of the 25 Norwegian covered bond issuers are also subsidiaries of small to midsize banks. A failure of a covered bond issuer with the size and setup of TSBB could thus result in contagion, effectively creating systemic problems for issuers reliant on this refinancing channel for their core product, residential mortgage lending.
• Scope generally classifies Norwegian covered bonds as a systemic refinancing product, particularly for residential mortgages. This is supported by Norwegian issuers’ strong footprint, with Norway being the sixth largest issuer by new issuances in 2017 worldwide and the seven largest covered bond country by total outstanding covered bonds.
• Proactive stakeholder community: the country’s covered bond issuers actively cooperate under the umbrella of the Norwegian Covered Bond Council to promote the product and initiate any changes to the framework. Domestic covered bond investors such as banks and insurers actively use covered bonds not only as a substitute for long-dated, NOK-denominated government debt, but also to manage liquidity. Moreover, Norway’s central bank has demonstrated its support for covered bonds by using them in its repo operations and running a covered bond to government debt ‘swap programme’ during 2008-2014. 

Cover pool supports highest rating achievable

As of 30 September 2018, TSBB’s NOK 2,078.3m cover pool supports a rating uplift of six notches on top of the A- issuer rating to the NOK 1,705.0m of covered bonds outstanding. Based on total issued covered bonds, the available overcollateralisation is 21.9%. The cover pool predominantly comprises mortgage loans, but also registered substitute assets which can be split between cash of NOK 101m and highly rated bonds of NOK 110m.

Assets in the fully domestic, NOK-denominated and floating rate cover pool have a sound credit quality. The credit quality of the cover pool does not make a significant risk contribution to the 8% of supporting overcollateralisation which Scope considers commensurate with a six-notch cover pool uplift. The covered bond programme is not materially exposed to market risk as the covered bonds as well as the cover assets are fully denominated in NOK and interest referenced to floating rates.

However, risks resulting from the programme’s high asset liability mismatch explain the majority of the overcollateralisation needed to support the rating. The mismatch is 9.0 years, resulting from a weighted average life of the cover pool (11.6 years, based on the legal maturities of the mortgage loans), and the weighted average life of the outstanding covered bonds (2.6 years, taking into account the soft-bullet structure). Asset liability mismatch risk is partially mitigated by the soft-bullet structure (a contractual 12-month maturity extension if the issuer is unable to service a maturing covered bond) together with sufficiently high overcollateralisation.

Cover pool composition

The cover pool is secured by Norwegian granular residential mortgage loans denominated in Norwegian kroner. As of September 2018, the loans were granted to 1,384 obligors. Scope assesses the cover pool as granular, with an average loan size of NOK 1,389,608 (around EUR 146,600). The largest obligor accounts for 0.6% with a total balance of NOK 12.3m.

The average whole loan LTV is 53.1%. The pool predominantly contains first lien mortgage loans while for around 10% of the mortgage loans Scope observes prior ranking liens granted to another covered bond funding platform used by TSBB. Scope understands that TSB will mainly use its own mortgage bank to refinance mortgage lending going forward. The collateral is primarily located in Oppland (47%), Akershus (26%) and Hedmark (12%) as well as Oslo (11%) – the south eastern regions of Norway.

The substitute assets are either held in cash or highly rated bonds maturing in 2019.

Quantitative analysis and assumptions for the cover pool analysis

Scope’s projections of default on mortgage loans use an inverse Gaussian distribution. Based on credit performance data provided by the bank (historical delinquencies and loan level default probabilities) and benchmarking, Scope has derived an effective, weighted average lifetime mean default rate of 9.5% and a volatility of defaults (weighted average coefficient of variation) of 50%. The agency also assumed an asset recovery rate ranging between 99% in the base and 66.5% in the most stressed scenario

Scope applies rating distance-dependent market value declines to establish recovery rates. Assumptions are based on an analysis of Norwegian housing market developments and their unique characteristics. Scope established security value haircuts for the properties securing the mortgage loans of 52.5%-60% (depending on the location of the property). For the most stressful scenario Scope also applies an additional illiquidity adjustment of 5% for properties above NOK 5m, 13% for properties above NOK 10m and 20% for properties above NOK 20m. No additional haircut was applied under base case stresses.

Scope analysed the credit risk of the substitute assets. The NOK 101m held as cash were assumed to have the same default and recovery rates as assumed for the mortgage loans because Scope presumes that cash is reinvested in mortgage loans. The liquid assets of NOK 110m consists of sovereign exposure and other domestic covered bonds. The agency estimated the sub-portfolio’s default characteristics using a portfolio analysis framework. The respective non-parametric distributions can be described with a mean default rate of 0.11% and a coefficient of variation of 1,375%. The low default rate and high coefficient of variation reflect high individual credit quality and also the very high obligor concentration in the respective sub portfolio.

Scope used the resulting loss distribution and default timing to project the covered bond programme’s losses and reflect the programme’s amortisation structure. The rating agency also incorporated the impact of rating distance-dependent interest rate stresses in its analysis. The covered bond programme was most sensitive to a scenario in which interest rates increased after two years and plateaued at 10% thereafter.

To calculate a net present value for the cover pool in the event of an asset sale, a liquidity premium for Norwegian residential mortgage loans of 150 bps and 100 bps for the substitute assets (bonds) was added to the rating distance and scenario-dependent discount curve. Scope derived this liquidity premium by analysing the long-term development of trading spreads for Norwegian and other ‘core country’ covered bond spreads.

Scope tested for low (0%) and high prepayments (up to 25%) to stress the programme’s sensitivity to unscheduled repayments. The programme is most sensitive to low prepayments as the large maturity mismatch requires asset sales in order to make timely payments on the bonds.
Scope assumed a recovery lag of 24 months for residential loans originate by TSBB and 48 months for the substitute assets (bonds). The recovery timing for the mortgage loans was based on an analysis of the Norwegian enforcement processes. The collateral’s regionality and the fact that 10% of the loans have prior liens, which may lengthen the overall recovery process, was also taken into consideration.

Scope applied country- and asset-type-specific servicing fees to be paid by the cover pool annually. For the residential mortgage loans, Scope assumed a servicing fee of 25 bps and 10 bps for the substitute assets (bonds).

Scope calculated security value haircuts for properties for which the agency was not provided with detailed regional information by conservatively assuming them to be located in the Oslo region for which haircuts are highest.

As Scope was not provided with line by line information on the repayments status, interest only loans have been approximated based on the cash flows provided for each individual loan.

The asset margins on the mortgage loans were compressed down to 1% reflecting potential basis risk and the likelihood of prepayments or the refinancing of loans with current margins above the average.

Stable Outlook assigned to the covered bonds

The Stable Outlook on the covered bonds reflects the expected stable credit performance of TSB, TSBB and its mortgage borrowers. Scope’s covered bond outlook also reflects its expectation that the issuer will maintain its prudent covered bond programme risk profile. The agency expects that both the parent and the direct issuer will remain willing and able to continuously provide the overcollateralisation needed to support the very strong credit quality of the covered bonds.

Provided that the covered bond programme risk structure does not change materially, current covered bond ratings supported by the cover pool could remain unchanged up to a two-notch downgrade of the issuer – also supporting the Stable Outlook on the covered bonds.

Covered bond rating-change drivers

The covered bond ratings are already at the highest level. Covered bond ratings could be negatively affected by a more than two-notch downgrade of the issuer, a changed view on the issuer’s resolvability and lower cover pool support. Scope does not, however, expect such an outcome at present. Fundamental credit support factors effectively provide a floor for the covered bond rating at AA+ based on the A- issuer rating.

A detailed rating report with the agency’s assessment of Totens Sparebank and Totens Sparebank Boligkreditt is available on www.scoperatings.com or under the following link: Totens Sparebank rating report. The detailed rating report on the covered bonds can be accessed here.

Stress testing
No stress testing was performed for the covered bond rating.

Cash flow analysis
In order to determine the cover pool supported rating uplift Scope performed a cash flow analysis to establish an expected loss for the covered bonds. The cash flow analysis uses the scheduled cash flows of the cover assets and covered bonds as a starting point. Scope applies rating distance-dependent stresses to simulate the impact of increasing credit and market risks on these cash flows. The cash flow analysis also includes the impact of stressed asset sales or other variables such as changing prepayment speeds or servicing costs.

Methodology
The methodology used for the covered bond ratings and outlook is the Covered Bonds Rating Methdology and the General Structured Finance Rating Methodology. The methodologies are available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rated entity participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, third parties and Scope internal sources.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and outlook and the principal grounds on which the credit rating and outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst: Karlo Fuchs, Executive Director.
Person responsible for approval of the rating: David Bergman, Executive Director.
The ratings/outlooks were first released by Scope on 30.10.2018.

Conditions of use / exclusion of liability
© 2018 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5 D-10785 Berlin.

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