Rating action

Scope Ratings has today affirmed its AAA ratings with a Stable Outlook for the Norwegian covered bonds (obligasjoner med fortrinnsrett) issued by Landkreditt Boligkreditt AS (LKBol), the fully owned mortgage subsidiary of Landkreditt Bank AS (LK).
Additional programme-specific information and research is available on scoperatings.com

Key rating drivers for the covered bond ratings

• Sound issuer credit rating (positive) of A-/ Outlook Stable assigned to LK and LKBol
   
• Cover pool support reflecting:
   

1. Overcollateralisation (positive): available overcollateralisation of 16.1% shields the covered bonds from market and credit risks and is well above the minimum 7.0% that supports the cover pool uplift;
2. Sound credit quality (positive): granular, fully residential cover pool with low loan/value (LTV) exhibits low credit risk even under the highest rating stresses;
3. Maturity mismatches (negative): high asset-liability mismatch risk from slow scheduled amortisation of cover assets compared to a relatively fast redemption profile for the covered bonds
    

• 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).

Rating-change drivers

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

Provided that the covered bond programme’s risk structure does not change materially, the 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.

Cover pool supports highest rating achievable

As of 31 December 2018, LKBol’s NOK 4.03bn cover pool supports a rating uplift of at least six notches on top of the A- issuer rating for the NOK 3.47bn of covered bonds. The available overcollateralisation is 16.1% based on outstanding covered bonds.

The overcollateralisation required to provide a six-notch cover pool uplift and to support the AAA ratings has decreased to 7% from 11%. The lower overcollateralisation reflects changes to Scope’s repayment assumptions for redrawable mortgage loans and to Scope’s Norwegian security value haircuts.

Maturity mismatches, accounting for 5.4 pp of the 7% supporting overcollateralisation, are the main risk contributor. They arise from the weighted average life (WAL) gap of 7.3 years between the assets’ WAL of 11 years (based on their legal terms) and the bonds’ WAL of only 3.7 years (taking the soft bullet structure into account). The rating agency assumes that assets will be sold at a discount if their amortisation is insufficient to pay timely interest and principle on the covered bonds.

Credit risk accounts for 1.4 pp and is not a major driver of supporting overcollateralisation. This is reflected by an annual term default probability of 62 bps, a stressed recovery rate of 88.5% and a coefficient of variation of 50%.

Market risk is minimal as all bonds and assets are floating and denominated in NOK.

Cover pool composition

The cover pool comprises granular, Norwegian, first lien residential mortgage loans denominated in Norwegian kroner. As of December 2018, the loans were granted to 2,607 obligor groups with an average loan size of NOK 1,545,000 (around EUR 158,000). The top 10 largest obligors account for 2.7%.

The weighted average whole loan LTV is 45%. This LTV is calculated based on the maximum drawable amount for re-drawable loans (flexible loans) which make up 32% of the cover pool. These loans have an embedded credit line which can be redrawn without new credit approval. Flexible loans will only be granted if the loan’s LTV does not exceed 60%. Existing flexible loans may only draw up to a level of 60%. Another 17% of the mortgage loans have an interest-only period. The remaining loans are normal amortising loans.

The collateral is primarily located in the Oslo and Akershus regions, together accounting for around 63%. The rest of the portfolio is spread across Norway, supported by LKBol’s online distribution channel. Norway’s oil regions (Rogaland, Hordaland and Vest Agder) are less well represented, accounting for 7.9% compared to the country average of 22%.

Around two thirds of the portfolio is made up of single-family houses and another quarter of flats or apartments. Holiday homes account for only 0.6% and agricultural property for another 0.3%.

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

Two notches of fundamental 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 covered bond frameworks in Europe. It meets the rating agency’s criteria for protecting covered bond investors in a going or gone concern of a bank and allows the assignment of the highest credit differentiation.

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

LKBol’s covered bonds benefit from an additional three-notch uplift reflecting 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. Scope recognises the low visibility and limited importance of LKBol as a covered bond issuer. In general, Norwegian covered bonds from resolvable and very visible issuers can benefit from up to four additional notches of support.

Quantitative analysis and key assumptions

Scope’s projections of default on LKBol’s mortgage loans used an inverse Gaussian distribution. Based on credit performance data provided by the bank (historical delinquencies, portfolio loss rates) and benchmarking, Scope derived an effective lifetime mean default rate of 10% (annual 62 bps) and a volatility of defaults (coefficient of variation) of 50%. The agency assumed an asset recovery rate ranging between 99% in the base case and 88.5% in the most stressed scenario. In its loss given default analysis, Scope assumed that the credit lines for flexible loans are fully drawn and pay interest only until their expected maturity, assuming a loan term of 15 years.

Scope applied rating distance-dependent market value declines to establish recovery rates. Assumptions reflect the agency’s analysis of Norwegian housing market developments and their unique characteristics. Scope’s stressed security value haircuts for the properties securing the mortgage loans range between 45% and 57.5% (depending on the location of the property).

The rating agency used the resulting loss distribution and default timing to project the covered bond programme’s losses and reflect the programme’s amortisation structure. Scope also incorporated the impact of rating distance-dependent interest rate stresses in its analysis. The covered bond programme is most sensitive to a scenario in which interest rates increase after six years and plateau 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 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 18 months for residential loans originated by LKBol. The recovery timing for the mortgage loans is based on an analysis of Norwegian enforcement processes, considering that the collateral is most exposed to the Oslo and Akershus regions for which liquidity is higher than Norway’s rural regions.

Scope applies country- and asset-type-specific servicing fees which the cover pool needs to pay annually. The rating agency assumed a servicing fee of 25 bps for the residential mortgage loans.

The agency also tested the programme’s sensitivity to compressed asset margins (down by 30 bps), a liquidity premium of 200 bps and front loaded defaults in order to reinforce the programme’s break-even overcollateralisation.

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-dependant 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.

Stress testing
No stress testing was performed.

Methodology
The methodology used for the covered bond ratings and outlook was the Covered Bonds Rating Methodology. The methodology is 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale.
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 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 outlook is issued by Scope Ratings GmbH.
Lead analyst: Mathias Pleissner, Associate Director
Person responsible for approval of the ratings: Karlo Fuchs, Executive Director
The ratings/outlooks were first released by Scope on 04.04.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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