Rating action

Scope Ratings GmbH (Scope) has today affirmed its AAA ratings with a Stable Outlook on the Norwegian covered bonds (obligasjoner med fortrinnsrett) issued by specialised mortgage bank Verd Boligkreditt AS (Verd), which is jointly owned by independent savings banks (hereafter referred to as the ‘owner banks’).

Key rating drivers

Sound issuer rating (positive)¹. Verd’s investment grade credit quality reflects the strong credit profiles of its owner banks. The owner banks are well-established in their local markets and have reassuring prudential metrics. Verd is a specialised residential mortgage institution with the right to issue covered bonds. Verd’s ownership structure is unusual as covered bond issuers tend to be a subsidiary of just one bank.

Cover pool support (positive)^2,3. Cover pool support is the primary rating driver and adds seven notches of credit uplift, reflecting:

1. Overcollateralisation (positive). Available overcollateralisation of 18.9% shields the covered bonds from market and credit risks and is well above the minimum 5.0% that supports the cover pool uplift.
    
2. Sound credit quality (positive). The granular and fully residential cover pool with a low loan-to-value ratio has low credit risk even under the highest rating stresses.
    
3. Asset-liability mismatches (negative). Asset-liability mismatch risk arises from the slow scheduled amortisation of the cover assets against the faster redemption of the covered bonds, all issued as soft bullet with a one-year extension option. The issuer regularly maintains short-term substitute assets to mitigate short-term liquidity risk.

Fundamental credit support (positive). The strength of the Norwegian legal covered bond and resolution framework supports up to four notches of uplift above the issuer rating and effectively provides a floor against a deterioration in the cover pool’s credit quality.

Rating-change drivers

Scope’s Stable Outlook on the covered bonds reflects: i) the continuous availability of high overcollateralisation, which provides a significant buffer against a rise in credit and market risks; ii) Scope’s view that European covered bond harmonisation will not negatively impact the fundamental support factors relevant for the issuer and Norwegian mortgage-covered bonds in general; and iii) Scope’s view of the stable credit quality of the issuer and its owner banks. The agency expects the owner banks and the direct issuer to remain willing and able to continuously provide sufficient overcollateralisation and equity to support the strong credit quality of the covered bonds.

The covered bond ratings may be downgraded if: i) the issuer’s credit quality deteriorates by one notch or more; ii) risk in the covered bond programme increases and the overcollateralisation provided no longer supports a seven-notch rating uplift; or iii) there is a deterioration in Scope’s view on fundamental support factors relevant to the issuer and Norwegian mortgage-covered bonds in general.

Scope’s credit view on the bank could be negatively impacted in the event of a deterioration in the credit quality of the mortgage loans available for transfer and in 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, which is a rating driver. Clearer details regarding support mechanisms (e.g. liquidity support) for Verd would be viewed positively.

Quantitative analysis and assumptions

Scope projected defaults on Verd’s mortgage loans using an inverse Gaussian distribution. The effective lifetime mean default rate remains unchanged from Scope’s last review, at 10.5% (annual 57 bps), derived based on credit performance data provided by the bank (IFRS 9 reporting, delinquency histories, and loan-level probabilities of default) and benchmarking. In addition, Scope used an average cure rate of 55%. The volatility of defaults (weighted average coefficient of variation) was assumed to be 55%. The asset recovery rate was calculated at between 98.1% in the base case and 77.2% (down from 81.3%) in the most stressed scenario. Scope’s loss-given-default analysis assumed that credit lines for flexible loans are fully drawn and would remain interest-only until their expected maturity.

Scope applied rating distance-dependent market value declines to establish recovery rates. Assumptions reflect the Norwegian housing market’s developments and unique characteristics. A fire-sale discount of 30% was applied to properties sold under non-standard market or distressed conditions. Scope’s stressed security value haircuts for the properties securing the mortgage loans range between 52.5% and 67.5%, depending on the location of the property.

Overall, credit risk accounted for 2.8 pp (up from 1.2 pp in the last review) of the 5.0% rating-supporting overcollateralisation. Credit risk has slightly increased since the previous analysis because house prices in Norway continue to increase beyond the point considered sustainable by Scope. The analysis reflects the increased risk of price correction through higher market value declines.

Scope analysed substitute asset defaults with a non-parametric distribution using a Monte Carlo method. A correlation factor of 25% was assumed on the covered bonds. Conservatively, Scope derived its default expectation based on the issuer’s credit assessments of all exposures. The low default rate of 0.1% and very high coefficient of variation reflect the high individual credit quality but also the very high obligor concentration. The asset recovery rate assumptions ranged between 100% in the base case and 57.9% in the most stressed scenario.

Scope used the resulting loss distribution and default timing to project the covered bond programme’s losses and reflect its amortisation structure. The amortisation calculation assumed all ‘flexible’ loans to be fully drawn.

The rating analysis also incorporated the impact of rating distance-dependent interest rate stresses. The covered bond programme is most sensitive to a scenario in which interest rates increase after two years and plateau at 10% thereafter. Scope did not give benefit to the hedges that swap the fixed rates on the bond coupons into floating rates because certain documented elements could add credit risk to the covered bonds. The impact of the hedges is marginal because only 4.8% of outstanding covered bonds pay a fixed coupon. The issuer has since addressed this limitation by revising the documentation. Scope will account for any new hedges implemented under the amended documentation.

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. The same premium was applied to substitute assets (predominantly Norwegian mortgage-covered bonds). 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 (up to 15%) prepayments to stress the programme’s sensitivity to unscheduled repayments. The programme is most sensitive to high prepayments that create a large amount of cash and reduce the transaction’s excess spread. In contrast, a low prepayment scenario in which assets need to be sold at a discount because of maturity mismatches from the long-dated assets produces lower overcollateralisation supported by the high asset margin.

Market risk accounts for 2.2% pp (down from 2.8%) of the 5.0% rating-supporting overcollateralisation. Market risks relate to both interest-rate and asset-liability mismatches.

Scope assumed a recovery lag of 24 months for residential loans originated by the owner banks. This is based on an analysis of Norwegian enforcement processes, which reflects that the collateral’s regionality and strong dependence on the highly volatile oil sector may cause delays in recoveries.

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 programme’s sensitivity was tested to reinforce Scope's calculation of the break-even overcollateralisation. Stresses were asset margins compressed down to 80 bps, a liquidity premium of up to 200 bps, prepayments of up to 25% and front-loaded defaults.

*Editiorial note: The Rating action release was changed on 9 April 2021 to remove confidential information

Rating driver references
1 Verd’s issuer ratings (Confidential)
2 Verd’s quarterly reporting
3 Cover pool reporting (Confidential)

Stress testing
No stress testing was performed.

Cash flow analysis
The cover pool-supported Credit Rating uplift is based on a cash flow analysis using Scope Ratings’ covered bond model (CobEL version 1.0). The model applies Credit Rating distance-dependent stresses to scheduled cash flows to simulate the impact of increasing credit and market risks. The model outcome is the expected loss for a given level of overcollateralisation as well as the impact of stressed asset sales or variables such as changing prepayment speeds or servicing costs.

Methodology
The methodologies used for this Credit Rating and Outlook (Covered Bonds Rating Methodology, 22 July 2020; General Structured Finance Rating Methodology, 14 December 2020; and Methodology for Counterparty Risk in Structured Finance, 8 July 2020) are available on https://www.scoperatings.com/#!methodology/list.
The model used for this Credit Rating and Outlook is (Covered Bonds Expected Loss Model version 1.0), available in Scope Ratings’ list of models, published under https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Rating if the Credit Rating were to change within the next 12 to 18 months. 

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit 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 Ratings’ internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Rating originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Rating and Outlook and the principal grounds on which the Credit Rating and Outlook are based. Following that review, the Credit Rating was not amended before being issued.

Regulatory disclosures
The Credit Rating and Outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Rating and Outlook is UK-endorsed.
Lead analyst: Mathias Pleißner, Director
Person responsible for approval of the Credit Rating: Karlo Fuchs, Managing Director
The Credit Rating/Outlook was first released by Scope Ratings on 15 May 2019. The Credit Rating/Outlook was last updated on 11 May 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures 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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