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Rating Action:

MOODY'S COMMENTS ON PROPOSED FRAMEWORK FOR SWEDISH COVERED BONDS

24 Feb 2003
MOODY'S COMMENTS ON PROPOSED FRAMEWORK FOR SWEDISH COVERED BONDS

London, 24 February 2003 -- Commenting on the draft law pertaining to the issuance of Swedish covered bonds which is expected to come into force on 1 July 2004, Moody's Investors Service said that it expects the Swedish framework to be broadly comparable to existing covered bond legislation in other European countries, such as Germany, France and Ireland. Although the process of reforming Sweden's current mortgage bond market - the third largest in Europe - is still at an early stage, Moody's noted that the provisions of the draft law could ensure both a lower probability of default and a lower severity of loss for Swedish covered bonds relative to unsecured obligations of a given issuer. Consequently, Moody's expects that it will rate Swedish covered bonds above the senior unsecured obligations of a given issuer. The rating agency will issue a detailed report - including its final rating notching practices - for Swedish covered bonds once the legislation is passed and the attendant regulations issued by the banking supervisor.

According to the draft legislation for Swedish covered bonds, "banks and credit market companies [will be able to] issue covered bonds once a license has been received". While such a definition will in theory allow universal banks to apply for such a license, Moody's believes that in fact mainly mortgage companies and dedicated affiliates will be active issuers of covered bonds. In particular, Moody's expects that the existing mortgage companies - Stadshypotek, Spintab, SEBolån, Nordea Hypotek, The Swedish National Housing Corporation (SBAB) and Landshypotek - will be the major issuers of Swedish covered bonds. Moody's assigns unsecured ratings of Aa2 for Stadshypotek, Aa3 for Spintab, Aa3 for Nordea Hypotek and A1 for SBAB. These relatively high ratings already reflect the low-risk nature of these companies' mortgage business, well-established franchises, and sound financial fundamentals characterized by, among other things, a good base of recurring earnings, low cost bases and low level of risk expenses.

With respect to the key strengths of the draft law for Swedish covered bonds, Moody's notes:

(1) The credit quality of eligible and substitute assets backing covered bonds should be good. The Swedish framework currently envisions that covered bonds will be backed by either mortgage loans, public sector loans or a combination of the two. Moody's views positively the fact that both types of assets exhibit a comparatively moderate incidence of payment disruption;

(2) With respect to mortgage assets, the Swedish law envisions restricting the proportion of commercial mortgages to 10% of the cover pool - thereby substantially reducing the credit risk associated with mortgage covered bonds. Another positive is the proposed prescription of different loan-to-value limits depending upon the nature of the underlying asset;

(3) Moody's views positively the asset and liability management guidelines mentioned in the draft legislation and which target relatively good matching of cashflows. Like most European frameworks, the Swedish legislation is expected to require that the nominal value of cover assets be at all times superior to the nominal value of the covered bonds which they back;

(4) Other positive elements in the Swedish draft law mitigate interest rate and cashflow mismatching risks by requiring that (i) the "current value of the [ ] cover [assets] exceeds [that] of the [ ] covered bond[s]" and (ii) "the net amount of payments [due] in respect of the [cover] assets [ ], derivative [hedge] contracts and covered bonds [ ] be positive at all times";

(5) Another strength in the Swedish draft law is the provision for derivative hedge contracts to benefit from the same priority of claim as covered bonds: insolvency of the issuer would therefore not constitute a termination event for these operations. We see this as a key feature in reducing interest rate and currency exchange rate volatility-related risks for covered bonds.

In summary, Moody's said that it considers the draft law governing the issuance of Swedish covered bonds as providing for relatively strong credit and market risk mitigating factors. This is so because of the expected good quality of eligible assets and to the matching principles addressing currency exchange, interest rate, and cashflow and maturity mismatching risks. In Moody's opinion, these features should contribute to a lower severity of loss for Swedish covered bonds relative to the unsecured obligations of a given issuer. In addition, the rating agency views positively the specific protections afforded Swedish covered bondholders in case of issuer insolvency.

(6) Because the Swedish bankruptcy code excludes an affiliate from the bankruptcy estate of its parent, a Swedish covered bond issuer will be partially protected from credit risk contamination from the financial distress of a weakening parent. Consequently, the probability of default of a Swedish covered bond issuer could be lower than that of its parent.

(7) In case of insolvency of the issuer itself, the Swedish draft law - like most European frameworks - removes those cover asset pools meeting eligibility criteria, the covered bonds they back and the relevant derivative hedge contracts from the issuer's bankruptcy estate. This prescription should also reduce the probability of default of the covered bonds themselves;

(8) As regards the likelihood that Swedish covered bonds will perform to maturity after the insolvency of the issuer, Moody's believes that the presence of some degree of structural over-collateralization in the construct that is a Swedish covered bond issuer and the law's flexibility with respect to substitute assets are positive elements reducing substitution risk;

(9) However, should eligibility criteria be reached before maturity and liquidation of the cover assets and of the underlying collateral need to occur, holders of Swedish covered bonds will have a legally enforceable priority of claim over the proceeds from these assets' sale. The good quality of the collateral assets should at this point translate into a lower severity of loss;

(10) Finally, given that all mortgage bonds outstanding must be converted into covered bonds, the Swedish covered bond market should be liquid upon its very creation. Moody's views market liquidity as a positive as it would expect a deep market to facilitate the transfer of the segregated cover assets and covered bonds of an insolvent issuer to a healthy peer.

That being said, although the draft law addresses a very broad range of questions, certain issues presently not included in the proposed legislation - for example property valuation guidelines and financial risk management prescriptions - are expected to be dealt with in forthcoming regulations which will be published by the Swedish banking regulator. As these could potentially impact the strength of the overall framework, Moody's will wait for these regulations to be issued before finalizing its notching practices.

With respect to the valuation of the property collateral backing mortgages, Moody's understands that the Swedish framework will seek to eliminate any speculative element from the valuation process, calling for properties to be assessed in conservative terms. The draft law requires periodic reviews, the frequency of which will depend upon a property's latest market value. Moody's final analysis will also consider the qualifications and the track record of the real estate appraisers retained by the issuers.

As regards asset and liability management, Moody's will monitor closely the guidelines issued by the Swedish banking regulator in order to restrict Swedish covered bond issuers' exposure to cashflow mismatches. Moody's gives great weight to such guidelines because, insofar as cover assets mainly consist of amortizing loans, while liabilities are in the form of debt securities with bullet repayments, cashflow mismatches will inevitably occur between the cover assets and the covered bonds which they back.

London
Alexandra A. Sleator
Senior Vice President
Financial Institutions Group
Moody's Investors Service Ltd.
44 20 7772 5454

London
Anne Caris
Analyst
Financial Institutions Group
Moody's Investors Service Ltd.
44 20 7772 5454

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