Could SME-Backed Covered Bonds Gain ... - Standard & Poor's

Credit FAQ:Could SME-Backed Covered Bonds GainPopularity With Investors?At a time when public sector collateral for covered bonds is shrinking, issuers and investors are looking for new typesof collateral to back them. Increasingly, they are considering the possibility of using small and midsize enterprises(SMEs). Some Turkish banks have already issued SME-backed covered bonds, and last year the first SME-backedcovered bond program was announced in Germany. In the U.S., too, draft covered bond legislation also proposes theuse of SMEs as collateral for covered bonds. Here, we address some frequent investor queries regarding how we wouldrate SME covered bonds, and whether they have the potential to become widely accepted by the financial markets.Frequently Asked QuestionsWould Standard & Poor's need to establish a new rating methodology to rate an SME-backed coveredbond?Whatever the assets covered bonds use as collateral, we typically utilize our existing criteria to analyze the quality ofthese assets. Our aim is to ensure that, regardless of the structure of the collateral, we assess the asset risk in acomparable way. Depending on the type of SME exposures in SME-backed covered bonds, we would likely use ourmethodology and assumptions for assessing collateralized loan obligations (CLOs) backed by European SMEs (forfurther details see "European SME CLO Methodology And Assumptions," published Jan. 10, 2013, on RatingsDirect onthe Global Credit Portal). If the cover pool exhibited characteristics more akin to collateralized debt obligations(CDOs), we would likely use our CDO criteria (see "Update To Global Methodologies And Assumptions For CorporateCash Flow And Synthetic CDOs," published Sept. 19, 2009). We therefore believe we already have the appropriatecriteria in place to analyze the asset risk in SME-backed covered bonds.What would an SME covered bond structure look like?In Europe, most covered bonds are issued under a legislative framework, which we believe reflects investorpreference. Currently, we're not aware of any European legislation that allows unsecured exposures to SMEs to beeligible collateral for covered bonds. Any such covered bonds are therefore likely to be issued and structured similar toa standard SME transaction. To be considered a covered bond, we would expect such an issue to resemble an SMEsecuritization, with the added benefit of a guarantee from the sponsoring bank, making it a dual-recourse debtinstrument, which typically allows the covered bond to be rated higher than the issuer's senior unsecured debt.Do you consider SME collateral to be materially different from mortgage collateral?In SME securitizations, collateral provided by usual SME lending activities might not be as straightforward to value ascollateral in existing mortgage- and public sector-backed covered bonds. When we rate SME securitizations, wetypically only attribute modest recovery expectations, even for exposures for which security is granted. Indeed,depending on the classification of the country-specific insolvency regimes, we might only assume average recoveriesfor (typically not mortgage) secured exposures--that means a 45% recovery likelihood in Germany or Austria, or 39%for SME collateral located in France, Italy, or Spain. By contrast, for mortgage-backed covered bond programs, weWWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 4, 2013 21071666 | 300989331

Credit FAQ: Could SME-Backed Covered Bonds Gain Popularity With Investors?assume an average recovery of about 73%--almost twice the level of recoveries that we see for SME securitizations (forfurther details see: "Global Covered Bond Characteristics And Rating Summary Q3 2012," published Nov. 6, 2012).Do you see other risks beyond asset risk?When analyzing covered bonds under our existing covered bond criteria framework, we place a strong emphasis onasset liability mismatch (ALMM) risk--the risk that, if the original issuer defaults and is no longer able to makepayments on the bonds, the repayment profiles of the cover pool assets and the liabilities differ, resulting in potentialshortfalls to bondholders (for further details see: "Covered Bond Ratings Framework: Methodology And Assumptions,"published June 26, 2012). To allow us to rate the covered bonds based on the premise of full and timely payment ofinterest and principal according to their terms and conditions, we need to assess how likely and how expensive it is togenerate liquidity using the available collateral. This is particularly important if the amortization of the maturing bondis insufficient to repay interest and principal.To establish a likely price at which we believe cover assets can become monetized in a distressed environment, wetypically look at the widest observed spreads for securitizations or issuances of similar assets. However, we observethat SME covered issuances are currently not as liquid an asset class as collateral currently seen in covered bonds, andthat, furthermore, secondary market prices are not as readily available. Still, we believe that this might not necessarilyrepresent a constraint to rating SME covered bonds. In this new covered bond asset class, we've seen that issuers haveopted to differentiate not only by type of collateral, but also by payment structure. Indeed, the SME covered bondsseen to date feature a soft bullet structure, which, similar to securitizations, incorporates a "pass-through" mechanismthat reduces ALMM risk if the issuer defaults and fails to pay the bonds at maturity.In our analysis of traditional covered bonds, bullet repayments (where the covered bonds are repaid in full at maturity)typically result in a two-thirds attribution of required overcollateralization to market risk. Market risk results from theneed to liquidate/monetize covered assets within a relatively short timeframe to meet the scheduled redemptions. Asasset risk for SME transactions is typically higher than for pools of granular mortgages, reducing or even eliminatingmarket risk might no longer require us to factor it into our rating analysis. As a result, it's likely that theovercollateralization required to support the ratings in an SME transaction would not be dissimilar to that needed tosupport the ratings on current covered bonds with market risk.Given the challenges for SME covered bonds that you've outlined, do you believe they'll becomewidespread?We think it's likely that, over time, SME covered bonds could become as systemically important as traditional coveredbonds have become. First of all, SMEs form the backbone of most European economies--they comprise more than99% of all European business, account for 67% of private sector employment, and generate half of European GDP,according to an EC report ("Are EU SMES Recovering From The Crisis? Annual Report On EU Small And MediumSized Enterprises 2010/2011, published by the European Commission.) Given that senior unsecured funding isbecoming more expensive for bank issuers, we believe that covered bonds backed by SME collateral could help thebanks to achieve funding advantages. Furthermore, we believe that funding the economy--which in Europe can beequalized with funding SMEs--is high on the political agenda. Given that more "esoteric" assets are already eligiblecollateral, we consider it reasonable to expect that legislators may also introduce SMEs into covered bond frameworksover time.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 4, 2013 31071666 | 300989331

Credit FAQ: Could SME-Backed Covered Bonds Gain Popularity With Investors?We think investors may not find it as straightforward to compare the performance of SME-backed covered bonds withtraditional covered bonds. However, we believe that issuers' and rating agencies' regular, detailed, and transparentassessment of the composition of such covered bonds should facilitate a thorough understanding of SME-backedcovered bonds over time.Even more so than traditional covered bonds, SME-backed covered bonds will need to be established as a "creditproduct". With this in mind, investors are likely not to be as surprised if changes in the risks result in changes to theratings. We therefore believe SME-backed covered bonds have the potential to become widely accepted by investors,as has been the case for mortgage- and public sector-backed covered bonds.Related Criteria And Research• European SME CLO Methodology And Assumptions, Jan. 10, 2013• Update To Global Methodologies And Assumptions For Corporate Cash Flow And Synthetic CDOs, Sept. 19, 2009• Covered Bond Ratings Framework: Methodology And Assumptions, June 26, 2012• Global Covered Bond Characteristics And Rating Summary Q3 2012, published Nov. 6, 2012• Are EU SMES Recovering From The Crisis? Annual Report On EU Small And Medium Sized Enterprises2010/2011, published by the European Commission.(http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/performance-review/pdf/2010_2011/are_the_eus_smes_reAdditional Contact:Covered Bonds Surveillance; CoveredBondSurveillance@standardandpoors.comWWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 4, 2013 41071666 | 300989331

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