Rating action

Scope Ratings has today assigned AAA ratings with a Stable Outlook to the Norwegian covered bonds (obligasjoner med fortrinnsrett) issued by Verd Boligkreditt AS (Verd), a specialised mortgage bank jointly owned by nine independent savings banks (owner banks).

Additional programme-specific information and research is available on scoperatings.com

Key rating drivers for the covered bond ratings

• Verd’s sound investment grade credit quality;
   
• Cover pool support reflecting:

1. Overcollateralisation (positive): available overcollateralisation of 19.5% is well above the minimum of 4.0% that supports the cover pool uplift and shields the covered bonds from market and credit risks;
    
2. Sound credit quality (positive): granular, and diversified, fully residential cover pool with low loan to value (LTV) exhibits low credit risk even under the highest credit stresses;
    
3. Maturity mismatches (negative): the programme is most vulnerable to high prepayments, accumulating cash and reducing the programme’s available excess spread.

• Fundamental credit support resulting from the strength of the Norwegian legal and BRRD framework, which supports a four-notch uplift above the bank’s credit quality (positive).

Covered bond rating anchored by bank’s good credit quality

Scope’s credit view on Verd reflects it focus on low risk business together with a 10-plus year relationship between Verd and its owner banks which has been highly cooperative and successful. The owner banks are well established in their local markets and maintain reassuring prudential metrics. Verd is a specialised residential mortgage institution with the right to issue covered bonds. Unlike most covered bond issuers, Verd is not a subsidiary of a single parent bank. Established in 2009, Verd is owned and used by nine independent savings banks in southern and western Norway.

Rating-change drivers

The Stable Outlook on the covered bonds reflects Scope’s expectation that the credit performance of Verd and its owner banks 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 owner banks and the direct issuer to remain willing and able to continuously provide sufficient overcollateralisation to support the strong credit quality of the covered bonds.

The AAA rating of the covered bonds is supported by the cover pool and is vulnerable to a downgrade if the issuer’s credit quality deteriorates by one or more notches.

Scope’s credit view on the bank could be negatively impacted by a deterioration in the credit quality of the mortgage loans available for transfer and the owner banks’ ability to meet obligations under the servicing and shareholder agreements. A change in the composition of the owner banks could also change the diversification of assets, a driver of Scope’s assessment of Verd. More explicit details regarding support mechanisms (e.g. liquidity support) for Verd could positively impact our credit view of the bank.

Cover pool supports highest rating achievable

As of 31 March 2019, Verd’s NOK 9.40bn cover pool supports a rating uplift of seven notches on top of the issuer’s credit quality for the NOK 7.87bn of covered bonds. The available overcollateralisation is 19.5% based on outstanding covered bonds net of retained bonds and above the 4% supporting the AAA ratings.

Maturity mismatches, accounting for 2 pp of the 4% supporting overcollateralisation, are the main risk contributor reflecting a stressed scenario in which Scope assumes prepayments of up to 25% per annum. This creates large amounts of cash and effectively reduces the available excess spread. A scenario in which prepayments are low is less severe for the supporting overcollateralisation. This is because the programme’s excess spread mitigates most of the agency’s discounts applied to asset sales should payments be insufficient to pay timely interest or principle on the covered bonds.

Credit risk accounts for 1.8 pp and is mainly based on the annual average term default probability of 25 bps (including cures of 55%), a stressed recovery rate of 76.6% and a coefficient of variation of 55% for the mortgage loans.

Market risk is minimal as most of the bonds and all of the assets are floating and account for 0.2 pp of overcollateralisation. Both asset and liabilities are denominated in NOK. As of 31. March 2019, 5.6% of outstanding bonds were fixed rate for which Verd has interest rate hedges in place. Scope has not yet given benefit to the hedges because certain features could introduce additional credit risk for the covered bonds.

Cover pool composition

The cover pool predominantly comprises domestic residential mortgage loans, but also registered substitute assets which can be split into bank deposits of NOK 256m and highly rated bonds of NOK 336m (predominantly Norwegian mortgage-covered bonds). The mortgage cover pool is secured by granular, first-lien residential mortgage loans denominated in Norwegian kroner. As of March 2019, the loans were granted to 5,718 obligor groups. Scope assesses the cover pool as granular, with an average loan size per obligor of NOK 1,518,000 (around EUR 152,000). The top 10 largest obligors only account for 0.7%. The loans are originated by nine saving banks that are part of De Samarbeidende Sparebankene (DSS), an alliance whose member banks jointly own Verd as a covered bond funding platform. The characteristics of the loans are relatively homogenous amongst the owner banks and the pooling of the collateral provides some regional diversification to the cover pool.

The average weighted indexed whole LTV is 53.3%. This LTV is calculated based on the maximum drawable amount for the 23% (also weighted by maximum drawable amount) flexible loans in the cover pool. Such loans have an embedded credit line that can be redrawn without a new credit approval. Flexible loans will only be granted if the loan’s LTV does not exceed 60%. Another 15% of the mortgage loans have an interest-only period. Such loans are normal annuity loans but are split into a cover- and an out-of-cover portion. The loan parts exceeding the LTV limit stipulated by the covered bond legislation are typically granted by the parent bank and amortise first. The eligible loan part only starts amortising when the out-of-cover pool loan is fully repaid. The remaining loans are normal amortising loans.

The cover pool composition is broadly in line with the equity contribution of the owner banks and their regional footprint. 91% of financings are exposed to Norwegian oil or oil related regions but are also home to diversified, export oriented businesses and sectors, like fisheries, ship building, tourism and hydro power. The cover pool exhibits its highest regional concentrations in the area around Haugesund (the coastal region in south-west Norway) and Kristiansand (the coastal region of southern Norway). Rogaland accounts for 41%, Vest Agder for 28% and Hordaland for 10% by allocated balance. 82% of the mortgage pool is secured by single-family or terraced houses and another 13% by apartments. Verd does not have any loans exposed to common debt from housing associations in the portfolio.

Fundamental credit support: the Norwegian legal framework and resolution regime provide a four-notch uplift to Verd’s covered bonds

Two notches of fundamental uplift are driven by the agency’s positive view of the Norwegian legal covered bond framework. Another two 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 Verd’s covered bond programme

Verd’s covered bonds benefit from an additional two-notch uplift reflecting a bail-in exemption and support from a strong external stakeholder community. The uplift is constrained by a combination of: i) the low likelihood that the covered bond issuer will be maintained in a resolution scenario; ii) the low visibility of Verd as a covered bond issuer; and iii) the support of the owner banks which provide investors with limited documented or public commitments regarding a minimum level of liquidity, capital or overcollateralisation. We understand that despite the absence of documented and legally enforceable support agreements, the owner banks are supportive – but only address potential risks when they become relevant.

Quantitative analysis and key assumptions

Scope’s projections of default on mortgage loans use an inverse Gaussian distribution. Based on credit performance data provided by Verd, its member banks (IFRS9 reporting and background documentation, static delinquency history and loan-level probabilities of default) and benchmarking, Scope derived an effective, weighted average lifetime mean default rate of 10.5% (annual 55 bps) using a 90 days past due definition. In addition, Scope considered an average cure rate of 55% which effectively reduces the annual default probability to 25 bps. The volatility of defaults (weighted average coefficient of variation) was assumed to be 55%. The agency calculated an asset recovery rate ranging between 97.3% in the base and 76.6% in the most stressed scenario. In its loss given default analysis, Scope assumed that the credit lines for flexible loans are fully drawn.

Scope applied rating distance-dependent market value declines in order to establish recovery rates. Assumptions reflect the agency’s analysis of Norwegian housing market developments and their unique characteristics. On top of this, Scope applied a fire-sale discount of 30% reflecting the value discount of properties sold under non-standard market or distressed conditions. The total stressed security value haircut for the properties securing the mortgage loans range between 52.5% and 62.5% (depending on the location of the property).

Scope analysed the substitute asset defaults with a non-parametric distribution by performing a Monte Carlo analysis. Scope assumed a correlation factor of 25% on the covered bonds and 100% on the sovereign/municipal exposure as well as the deposits with Vest. Conservatively, the issuer’s credit assessments were used for all exposures to derive a default expectation. The low default rate of 0.1% and very high coefficient of variation (1,030%) reflect the high individual credit quality but also the very high obligor concentration. The agency assumes an asset recovery rate ranging between 98.3% in the base and 67.0% in the most stressed scenario.

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 latter is calculated assuming that all flexible loans are fully drawn. The rating agency also incorporates 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 two 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 is added to the rating distance and scenario-dependent discount curve. The same premium is assumed for the substitute assets (predominantly Norwegian mortgage-covered bonds). Scope derives 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 30%) to stress the programme’s sensitivity to unscheduled repayments. The programme is most sensitive to high prepayments creating a large amount of cash and reducing the transaction’s excess spread. In contrast, a scenario in which assets need to be sold at a discount as a consequence of maturity mismatches from the long-dated assets produces lower levels of overcollateralisation supported by the high asset margins. The agency assumes that any available cash pays interest equalling the respective reference rate (no spread). This limits the programme’s sensitivity to negative carry, particularly in a high prepayment scenario.

Scope assumed a recovery lag of 24 months for residential loans originated by the owner banks and the substitute assets (mainly covered bonds). The recovery timing for the mortgage loans was based on an analysis of Norwegian enforcement processes, considering that the collateral’s regionality and strong dependencies on oil may temporarily lengthen the overall recovery process.

Scope applied country- and asset-type-specific servicing fees which the cover pool needs to pay. For the residential mortgage loans, Scope assumed a servicing fee of 25 bps and 10 bps for the substitute assets.
The agency also tested the programme’s sensitivity to compressed asset margins (down to 80 bps), a negative spread on cash reinvested, 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 used the scheduled cash flows of the cover assets and covered bonds as a starting point. Scope applied rating distance-dependant stresses to simulate the impact of increasing credit and market risks on these cash flows. The cash flow analysis also included 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 primary methodology for the analysis of the covered bond ratings and outlooks is the Covered Bond Rating Methodology. The secondary methodology used is our General Structured Finance Rating Methodology for the application of Scope’s idealised expected loss tables and the Methodology for Counterparty Risk in Structured Finance. Scope’s Bank Rating Methodology was used for its credit view on the issuer.
All rating methodologies are available on our website, 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, Managing Director
The ratings/outlooks were first released by Scope on 15.05.2019.

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
© 2019 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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