Expected Loss Covered Bond Model

STRUCTURED FINANCE/BANKING
RATING METHODOLOGY
Moody’s Rating Approach to European Covered Bonds
AUTHORS
Nicholas Lindstrom
VP – Senior Credit Officer
London
(44) 20 7772 5332
Nicholas.Lindstrom@moodys.com
Saul Greenberg
VP – Senior Analyst
London
(44) 20 7772 5354
Saul.Greenberg@moodys.com
CONTRIBUTORS
Jose de Leon
AVP - Analyst
Madrid
(34) 91 702 6697
Jose.Deleon@moodys.com
David Rosa
VP – Senior Analyst
London
(44) 20 7772 5341
David.Rosa@moodys.com
Henry Tabe
VP – Senior Credit Officer
London
(44) 20 7772 5482
Henry.Tabe@moodys.com
CONTACTS
Juan Pablo Soriano
Managing Director
Madrid
(34) 91 702 6608
Juanpablo.Soriano@moodys.com
Detlef Scholz
Managing Director
Frankfurt
(49) 69 707 307 37
Detlef.Scholz@moodys.com
EMEA Investor Liaison
Edward Bowden
London
(44) 20 7772 5454
Edward.Bowden@moodys.com
TABLE OF CONTENTS
• Summary
• Moody’s Rating Approach to Covered Bonds
• Issuer
• Credit Quality of the Cover Pool
• Refinancing the Cover Pool
• Market Risks
• Appendices
• Combining the Analysis of the Issuer and Cover Pool
• Issuer
• Credit Quality of the Cover Pool
• Refinancing the Cover Pool
• Market Risks
• Other Appendices
SUMMARY
“Covered Bonds” are defined as debt instruments that have recourse to either the
issuing entity (the “Issuer”) or the group to which it belongs, or both, and, upon
Issuer Default 1 , to a pool of collateral (the “Cover Pool”). 2
Moody’s rating methodology for European Covered Bonds focuses on the expected
loss to investors. The rating model employed is thus referred to as the “Moody’s
Expected Loss Covered Bond Rating Model” (or “Moody’s EL Model”).
The Moody’s EL Model employs a so-called ‘joint default’ approach which takes into
account both the credit strength of the Issuer and the value of the Cover Pool. While
the Issuer is performing, there will be no loss under the Moody’s EL Model. In the
event of an Issuer Default, the final loss will be determined by the value of the Cover
Pool, which will be impacted by various factors, notably the credit quality of the
Cover Pool, and refinancing and market risks. These in turn will be impacted by the
strength of the legal framework and any contractual commitments, as applicable.
Moody’s is now employing this method for all new Covered Bond issuances and
programmes, and intends to migrate ratings on existing Covered Bonds to the new
method over the coming year. This process will include a further review of all primary
legislations and a more detailed analysis of collateral in the Cover Pools and hedging
arrangements. We anticipate that during this review some aspects of this
methodology are likely to be further updated, in particular when making country-bycountry
adjustments for specific market or legislative features.
This Rating Methodology Report comprises two key sections. The first provides an
overview of Moody’s rating approach for Covered Bonds, whilst the second provides
a set of appendices that describe particular aspects of Moody’s rating approach in
greater detail.
WEBSITE
www.moodys.com
1
2
See the following page for a definition of “Issuer Default”.
In many jurisdictions, covered bonds are instruments defined by statute; in others, they are structured
to resemble such instruments.
13 June, 2005

MOODY’S RATING APPROACH FOR COVERED BONDS
Moody’s EL Model looks at each Covered Bond issued on a month-by-month basis from its date of issue through
to its legal final maturity. For each month, Moody’s calculates the probability of an Issuer Default (defined below)
based on its senior unsecured rating 3
and the loss (if any) to the Covered Bonds following such default. The
probability of Issuer Default in each month is then multiplied by the relevant loss (if any) for that month to give the
expected loss to Covered Bond investors for each such month. These amounts are then discounted and the
discounted numbers summed for each month from the time of issue of the Covered Bond to its legal final maturity.
The resulting number gives the expected loss to the Covered Bond on which Moody’s rating is based (see
Appendix A1 for a worked example of how Moody’s EL Model combines the benefit of an Issuer’s probability of
default with the value of the Cover Pool to reach a rating on the Covered Bonds).
In Moody’s approach, “Issuer Default” is assumed to have the effect of creating a stand-alone Cover Pool that may
need to be administered by a newly appointed party. 4 It should be noted that Issuer Default does not necessarily
mean there has been a default on the Covered Bonds. Moody’s expects that an administrator (or a party delegated
by the administrator) would run the Cover Pool following an Issuer Default.
The loss following Issuer Default will depend on (i) the value of the Cover Pool in relation to the outstanding Covered
Bonds and (ii) any outstanding claim against the Issuer. The analysis of the value of the Cover Pool will be
considered in the context of the Issuer Default and thus assumes a stressed environment. In assessing the value of
the Cover Pool, Moody’s considers (i) the credit quality of the Cover Pool, (ii) the refinancing risk if funds need to be
raised against the Cover Pool, and (iii) any interest and currency rate risk to which the Cover Pool is exposed.
Analysis of (i) to (iii) will include consideration of any impact of legislative provisions and contractual commitments,
which includes the role of the administrator (appointed following Issuer Default) in administering and servicing the
Cover Pool as well as any incremental cost of such process.
Moody’s rating approach thus comprises the following four key categories, which are each briefly discussed below
as well as in more detail under similar headings in the Appendices.
Prior to Issuer Default
• Issuer.
and following Issuer Default
• Credit quality of the Cover Pool.
• Refinancing the Cover Pool.
• Market risks.
Issuer
The minimum rating that a Covered Bond should achieve is equivalent to the senior unsecured rating of the Issuer. 5
During the life of the Covered Bond, Moody’s EL Model calculates the probability of Issuer Default based on the
Issuer’s senior unsecured rating. Moody’s EL Model assumes that when the Issuer performs these obligations
throughout the life of the Covered Bond, there will be no loss to investors. However, in the event of Issuer Default,
the analysis switches to the Cover Pool and, if applicable, any unsecured claim against the Issuer. 6
When rating Covered Bonds, the Moody’s EL Model takes into account various Issuer and Issuer group-related
benefits in addition to the senior unsecured rating of the Issuer. These are discussed in Appendix B1, and
Appendices A1 and A2 demonstrate with examples the practical application of such benefits in Moody’s EL Model.
Credit Quality of the Cover Pool
The credit quality of the Cover Pool will determine the amount of loss due to credit deterioration on the assets in the
Cover Pool that Moody’s EL Model assumes will impact the Cover Pool after Issuer Default.
The credit quality of the Cover Pool is measured by the Collateral Score. The definition of and method for calculation
of the Collateral Score are set out in Appendices C1 to C3. Moody’s aims to publish Collateral Scores, where
sufficient information on the Cover Pool is provided, and with the Issuer’s approval.
3
4
5
6
Moody’s calculates the monthly default rates by interpolating from our published idealised default tables, which are reproduced in Appendix
F1.
“Issuer Default” may be defined as the removal from the Cover Pool of: 1) support provided by other entities within the Issuer group; 2)
ancillary activities of the Issuer (i.e. those not related to the Cover Pool); and 3) usually, the management functions of the Issuer.
These ratings continue to be assigned and monitored by Moody’s Financial Institutions Group. In many cases, the Issuer will benefit from
either direct or indirect support from the group of which it is a part. In addition to the credit strength derived from the group of which it is part,
the Issuer may benefit from specific aspects of the legislation, which may, for example, limit the business activities of the Issuer and thus offer
investors incremental protection from event risk.
An Issuer Default will not normally lead to an acceleration of the Covered Bonds. In many cases, the Cover Pool is expected to survive Issuer
Default, which will typically trigger the appointment of an administrator to administer and service the Cover Pool. Following Issuer Default, and
pending sale of the Cover Pool where applicable, the administrator may manage the Cover Pool or delegate its servicing to other parties. One
restriction on the power of the administrator to run the Cover Pool to legal final maturity of the Covered Bonds may be the failure of any
matching test, which may lead to acceleration (a more detailed description of the matching tests is set out in Appendix E3).
2 • Moody’s Investors Service European Covered Bond Rating Methodology

Within the Moody’s EL Model, the Collateral Score plays a key role in determining the cash flow that is assumed
will be received by the Covered Bonds following Issuer Default. The use and impact of Collateral Scores in
Moody’s EL Model are described in Appendices C4 and C5.
Refinancing the Cover Pool
Following an Issuer Default, the timely repayment of principal may rely on funds being raised against the Cover
Pool. The reason for this is that the duration of the assets in the Cover Pool will generally be longer than that of the
Covered Bonds. In other words, the “natural” amortisation of the Cover Pool assets may not be sufficient to repay
principal under the Covered Bonds.
Where the “natural” amortisation of Cover Pool assets alone cannot be relied on to repay principal, Moody’s EL
Model assumes that funds must be raised against the Cover Pool, most likely at a discount to the notional value of
the Cover Pool. Little pricing data is available for this type of fund-raising, and accordingly, Moody’s will calculate
refinancing margins based on the price history seen for similar asset pools in the securitisation and other markets.
Under Moody’s EL Model, the following three key considerations are taken into account in determining the
refinancing risk for any Cover Pool:
• The refinancing margin that is required to refinance the Cover Pool remaining after adjustment for any
write-off following Issuer Default. Refinancing margins assumed in Moody’s EL Model are described in
Appendix D1, and the method for their calculation is explained in Appendix D3. Refinancing margins are
also impacted by the Collateral Score, and this is discussed in Appendix C5.
• The size of the Cover Pool that is required to redeem in full all Covered Bonds prior to their legal final
maturity. A further description is set out in Appendix D2.
• The average life of the Cover Pool that is expected at the time of refinance.
A simplified example in Appendix D4 shows how the loss on the Cover Pool due to refinancing risk may be
calculated, and in particular how this is impacted by the refinancing margin and average life of the Cover Pool.
Market Risks
Following Issuer Default, investors in Covered Bonds may be exposed to interest and currency rate risk, which
may arise from the different payment promises and durations made on the Cover Pool and the Covered Bonds.
Under Moody’s EL Model, the following two key considerations are taken into account in determining the interest
and currency rate risks for Covered Bonds:
• The level and length of exposure to these market risks. The level and length of exposure depends on the
specific characteristics of the Covered Bonds and the Cover Pool backing the Covered Bonds, and in
addition, the hedging arrangements in place. The main market risks to which a Cover Pool is exposed are
discussed in Appendix E1, while Appendix E3 discusses how the Moody’s EL Model considers hedging
arrangements. A simplified example which shows how the loss on the Cover Pool due to interest rate risk
may be calculated at time of refinancing of the Cover Pool is discussed in Appendix E5.
• The stress imposed by the Moody’s EL Model on any exposure to these market risks. These are
discussed in Appendix E3, and the method of calculation is explained in Appendix E4.
European Covered Bond Rating Methodology Moody’s Investors Service • 3

APPENDICES: Table Of Contents
Combining the Analysis of the Issuer and Cover Pool
Appendix A1: The joint default approach
Appendix A2: The relative contribution of the Issuer and Cover Pool to a Covered Bond rating
Issuer
See Appendix A1 and A2
Appendix B1: Modelling the credit strength of the Issuer
Credit Quality of the Cover Pool
Appendix C1: Defining and calculating the Collateral Score
Appendix C2: Meaning of haircut to Collateral Score
Appendix C3: Calculation of haircut to Collateral Score
Appendix C4: Using the Collateral Score in Moody’s EL Model
Appendix C5: Impact of the Collateral Score on refinancing margins in Moody’s EL Model
Refinancing the Cover Pool
See Appendix C5 above
Appendix D1: Refinancing risk – the refinancing margins
Appendix D2: Refinancing risk – the portion of a Covered Bond that must rely on refinancing to be repaid on a
timely basis
Appendix D3: Refinancing risk – calculation of refinancing margins
Appendix D4: Simplified example to show how to translate a stressed refinancing margin into
a loss on the Cover Pool
Market Risks
Appendix E1: Market risks – key risks
Appendix E2: Market risks – Moody’s EL Model’s analysis of hedging arrangements
Appendix E3: Market risks – the levels of stress applied by Moody’s EL Model
Appendix E4: Market risks – calculation of interest and currency rate stresses
Appendix E5: Simplified example to show how to translate a stressed interest rate movement into
a loss on the Cover Pool
Other Appendices
Appendix F1: Moody’s idealised probability of default and expected loss tables
Appendix F2: Rating a Programme: the impact
Appendix F3: Over-collateralisation: what value when “not committed”
Appendix F4: Probability of default of a Covered Bond
4 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX A1: THE JOINT DEFAULT APPROACH
Under Moody’s EL Model, the credit strength of the Covered Bonds is determined by the combination of (i) credit
strength of the Issuer, and (ii) the value of the Cover Pool. The contribution from the Issuer includes the three
components listed in Appendix B1, and the first of these is the Issuer’s probability of default. The aim of this
Appendix is to show how Moody’s EL Model combines the benefit related to an Issuer’s probability of default with
the value of the Cover Pool through a number of worked examples. It should be noted that the examples below
are not intended to be a reflection of specific/particular circumstances, but rather illustrative of how these two
components are combined in the Moody’s EL Model.
The examples are based on a number of assumptions which include the following, amongst others.
• The Issuer will either have a senior unsecured long-term rating of A2 or Baa2.
• Following Issuer Default, recovery will arise only from the Cover Pool (i.e. no recovery is assumed from a
full-recourse unsecured outstanding claim against the Issuer, and if relevant, other group companies or
guarantors).
• The Covered Bonds issued are ‘bullet bonds’ which have a three-year maturity.
• At the time of issue, the nominal balance of the Cover Pool matches the nominal balance of the Covered
Bonds outstanding (i.e. there is no over-collateralisation).
• Cash flows which arise at a future date have not been discounted back to present value.
• For the purposes of the example, following Issuer Default, losses in respect of the Cover Pool are
assumed at a level, respectively, of 3% and 12% of the Cover Pool. 7
• The examples will make use of Moody’s idealised tables, respectively for probability of default (“Moody’s
PD Tables”) and expected loss (“Moody’s EL Tables”) which are included in this report in Appendix F1.
The results of the following four examples are shown below.
Example 1: assumes Issuer rated A2 and, following Issuer Default, losses on the Cover Pool 3%
Example 2: assumes Issuer rated A2 and, following Issuer Default, losses on the Cover Pool 12%
Example 3: assumes Issuer rated Baa2 and, following Issuer Default, losses on the Cover Pool 3%
Example 4: assumes Issuer rated Baa2 and, following Issuer Default, losses on the Cover Pool 12%
To show how these results were obtained, example 1 is considered.
The first step is to calculate the probabilities of default of the Issuer over the life of a three-year covered bond.
These are taken from Moody’s PD Tables which are found in Appendix F1. As seen from this table, the probability
of default of an A2-rated Issuer in one year is 0.011%, and the probability of this Issuer defaulting in year two is
0.059% (the probabilities in the Moody’s PD Tables are cumulative, i.e. 0.070% - 0.011% = 0.059%).
For this example, the loss of the Cover Pool following Issuer Default is simply assumed to be 3%. To calculate the
expected loss for each of the years of the life of the Covered Bond, the product of this 3% and the probability of
default for each year is calculated. The aggregate expected loss is then calculated by summing the expected
losses for each of the three years of the life of the Covered Bond.
This example is reproduced in table form below.
Year
Probability of
Issuer Default
Loss on Cover Pool following
Issuer Default
Expected Loss
on Covered Bond
1 0.011% 3% 0.000%
2 0.059% 3% 0.002%
3 0.152% 3% 0.005%
Cumulative Expected Loss of the Covered Bond 0.007%
The cumulative expected loss of the Covered Bond is then mapped to the corresponding three-year rating in the
Moody’s EL Tables. In this case this results in a Aa1 rating, which is four notches above the Issuer rating.
7
These percentages are assumed to be the aggregate of the following categories of loss: (i) loss due to credit quality of the Cover Pool, (ii) loss
as a result of refinancing risk, and (iii) loss arising from market risks (or exposure to unhedged market risks).]
European Covered Bond Rating Methodology Moody’s Investors Service • 5

Accordingly the following results arise from applying these steps to each example.
Example 1
a) Issuer senior unsecured rating A2
b) Loss in respect of Cover Pool 3%
c) Rating of Covered Bonds based on expected loss Aa1
d) Number of notches between a) and c) 4
Example 2
a) Issuer senior unsecured rating A2
b) Loss in respect of Cover Pool 12%
c) Rating of Covered Bonds based on expected loss Aa3
d) Number of notches between a) and c) 2
Example 3
a) Issuer senior unsecured rating Baa2
b) Loss in respect of Cover Pool 3%
c) Rating of Covered Bonds based on expected loss Aa3
d) Number of notches between a) and c) 5
Example 4
a) Issuer senior unsecured rating Baa2
b) Loss in respect of Cover Pool 12%
c) Rating of Covered Bonds based on expected loss A2
d) Number of notches between a) and c) 3
The above examples show how both the credit strength of the Issuer and the quality of the Cover Pool can impact
the number of notches achieved between the senior unsecured rating of the Issuer and the rating on the Covered
Bonds.
These examples have assumed a loss on the Cover Pool following Issuer Default. The primary focus of the
remaining appendices is to describe in more detail how Moody’s calculates this loss.
6 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX A2: THE RELATIVE CONTRIBUTION OF THE ISSUER AND COVER POOL
TO A COVERED BOND RATING
This section illustrates the relative importance of one of the Issuer benefits when targeting a covered bond rating –
the benefit of the “probability of Issuer Default” (item 1 under Appendix B1). The conclusion of the section is that
the further the Covered Bond rating is from the rating of the Issuer, the lower the importance of this benefit – and
this is particularly the case when a Aaa rating is targeted. When a Aaa rating is targeted and the Covered Bond
rating is more than four notches away from the Issuer rating, the probability of Issuer Default provides less than 1%
of the overall protection to investors.
To illustrate the importance of the role played by the probability of Issuer Default and the Cover Pool in enabling
programmes to achieve the target rating, the table below shows by how much the probability of default of a highly
rated Issuer can reduce the amount of collateral that would otherwise be required to achieve a Aaa rating.
In the preparation of this table, the following assumptions are made.
• Independence between the Issuer and the collateral.
• A 7-year horizon.
• €100 of collateral is required to rate €100 of Aaa bonds (i.e. the collateral comprising the Cover Pool has
no credit risk associated with it).
The table below gives the reduction in the amount of collateral possible when taking into account the probability of
Issuer Default for Issuers with different rating levels assuming different Covered Bond rating targets.
Issuer’s Rating
Rating Target
Aaa Aa1 Aa2 Aa3
Aaa
Aa1 9.6%
Aa2 4.7% 48.6%
Aa3 2.3% 23.8% 48.9%
A1 1.3% 13.3% 27.3% 55.9%
A2 0.7% 7.6% 15.6% 32.0%
For example, instead of €100 collateral being required to rate €100 bonds Aaa, when the benefit of the probability
of Issuer Default is incorporated into the analysis from an A2-rated Issuer, the amount of collateral required falls to
€99.3. This result is a best case as it assumes independence between the rating of the Issuer and the
performance of the collateral.
All the numbers in the above table can be calculated in the same way – and an example of how one of these
numbers can be calculated follows.
Example of Calculation in Table
The number selected is the 0.7 for an A2-rated Issuer wishing to secure a Aaa rating for its covered bond
programme. The following formula has been used:
Issuer Expected Loss * (1 – recovery on assets) = Aaa Expected Loss
Thus, from the Moody’s idealised expected loss table (found in Appendix F1) and assuming a 7-year horizon:
= .39% * (1 – recovery on assets) = 0.003%
Therefore the required recovery against the Cover Pool = 99.3%
So the A2 Issuer support is worth c.0.7% enhancement (100%-99.3%).
European Covered Bond Rating Methodology Moody’s Investors Service • 7

APPENDIX B1: MODELLING THE CREDIT STRENGTH OF THE ISSUER
Moody’s EL Model will take into account various Issuer or Issuer group-related benefits when rating Covered
Bonds. The following may be considered in this respect.
• The minimum rating that a Covered Bond should achieve is equivalent to the senior unsecured rating of
the Issuer. Moody’s EL Model calculates the probability of Issuer Default during the life of the covered
bond, and assumes prior to Issuer Default that where the Issuer performs these obligations throughout the
life of the Covered Bond, there will be no loss to investors.
The way this benefit is incorporated into the Moody’s EL Model is discussed in Appendix A1. The relative
contribution of this strength versus the value of the Cover Pool is analysed in Appendix A2.
• One of the key inputs into Moody’s EL Model is the credit quality of the Cover Pool. The Cover Pool credit
quality will be assessed as part of Moody’s analysis, and a score (“Collateral Score”) calculated and
determined based on a number of assumptions and considerations. For a more detailed description of the
determination and meaning of the Collateral Score, see Appendix C1 below.
In particular circumstances and under certain conditions, the Collateral Score may be reduced for an
issuance of Covered Bonds – and this is related to the rating of an Issuer and the extent to which the
performance of the Issuer is correlated with the performance of the Cover Pool. A further description of
this potential reduction of collateral stress and the corresponding haircut to the Collateral Score are set out
in Appendices C2 and C3.
• Under Moody’s EL Model, loss following Issuer Default will take into account, amongst other
considerations, any full-recourse unsecured outstanding claim against the Issuer (and, if relevant, other
group companies, or guarantors), if applicable. This claim will be assumed to follow after any realisation of
the Cover Pool. In those instances where the issuer may be part of a larger financial group or the covered
bond issuance activity is only part of the activities of the Issuer, under Moody’s EL Model, this unsecured
claim may reduce losses by up to 45%.
8 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX C1: DEFINING AND CALCULATING THE COLLATERAL SCORE
One of the key inputs into Moody’s EL Model is the credit quality of the Cover Pool. The Cover Pool credit quality
will be assessed as part of Moody’s analysis, and a score (“Collateral Score”) calculated and determined based on
a number of assumptions and considerations. The better is the credit quality of the Cover Pool, the lower will be
the Collateral Score.
The Collateral Score is calculated by Moody’s using techniques routinely used in structured finance transactions.
The method of calculation will vary depending on the type of collateral in the Cover Pool, and also the jurisdiction
or market in which it is located. 8
The Collateral Score can be seen as a representation of how much risk-free credit enhancement may be required
to protect the Aaa rating of the Covered Bonds against a credit deterioration of the assets in the Cover Pool.
Limiting the analysis to the credit deterioration of the assets in the Cover Pool means that:
• There is no support from Issuer and Issuer group;
• No forced sale is required to make timely payments on the Covered Bonds (i.e. the assets in the Cover
Pool are allowed to amortise naturally over their term); and
• There are no market risks between assets and liabilities (i.e. no mismatches between the underlying
collateral in the Cover Pool and the Covered Bonds).
So, for example, assuming that the risk-free credit enhancement required for such a Cover Pool to achieve a Aaa
rating is 5%, the Collateral Score would be 5%. The higher the credit quality of the Cover Pool, the lower the riskfree
enhancement required to protect against a credit deterioration of the assets and therefore the lower the
Collateral Score.
The rank-ordering of Collateral Scores between different asset types will typically be as follows (ranging from
Collateral Scores of highest credit quality to lowest credit quality).
• Public sector obligations.
• Residential mortgages.
• Commercial mortgages.
However:
• Cover Pools made up of high-quality residential mortgages may have a Collateral Score which is lower
than that for a Cover Pool made up of public sector obligations; and
• Cover Pools made up of high-quality commercial mortgages may have a Collateral Score which is lower
than that for a Cover Pool of residential mortgages.
Each transaction and asset type (and, where applicable, each jurisdiction and market) will be considered on its
own merits and a Collateral Score determined accordingly.
8
Moody’s has published a number of methodology reports covering residential and commercial mortgages, and collateralised debt obligations.
European Covered Bond Rating Methodology Moody’s Investors Service • 9

APPENDIX C2: MEANING OF HAIRCUT TO COLLATERAL SCORE
Following Issuer Default, for certain investment-grade regulated Issuers, Moody’s may reduce the stress (or
Collateral Score) imposed on the Cover Pool below the stress used for a structured finance transaction targeting
the same rating level. So, for example, if a Covered Bond targets a Aaa rating, Moody’s may assume a stress on
the Cover Pool lower than a “Aaa” stress.
Reasons for the assumed reduction in stress for certain Cover Pools include the following, amongst others.
• Prior to Issuer Default, most Issuers are likely (and in some cases required by legislation) to support the
Cover Pool, e.g. by replacing defaulting assets in the Cover Pool with similar performing assets.
Accordingly prior to Issuer Default some of the losses that would have otherwise arisen on the Cover Pool
will have been made whole by the Issuer. Moody’s is of the view that the higher the senior unsecured
rating of the Issuer, the greater is its capacity to protect the Cover Pool from credit deterioration and other
similar sources of loss.
• Moody’s is of the view that not every Issuer Default should be assumed to expose the Cover Pool to a
Aaa stress scenario. Moody’s has considered the probability that a Aaa stress on the Cover Pool
immediately follows an Issuer Default. Moody’s has concluded that, whilst this probability will depend on
the correlation between the Issuer and the Cover Pool, it expects a typical probability of less than 10%.
• Moody’s will give value in determination of the stress to the Issuer’s status as a regulated entity. This is the
case even where Moody’s considers the Issuer to be highly correlated to the Cover Pool.
The method for calculation of the Collateral Score haircuts is further described in Appendix C3. The following
summary may be considered.
• A Covered Bond that has (i) an Issuer that targets a Aaa rating, (ii) a “standard” level of correlation
between Cover Pool and Issuer (the expected case for Covered Bonds issued with Cover Pools
comprising non-public sector collateral) and (iii) an Issuer with a senior unsecured rating which is no lower
than A3, may benefit from a Collateral Score haircut that ranges from 25% to 35%.
• A Covered Bond that has (i) an Issuer that targets a Aaa rating, (ii) a low level of correlation between Cover
Pool and Issuer (the expected case for Covered Bonds issued with Cover Pools comprising public sector
collateral), and (iii) an Issuer with a senior unsecured rating which is no lower than Baa3, may benefit from
a Collateral Score haircut that ranges from 25% to 35% (and for Issuers with senior unsecured ratings of
no lower than A3, a Collateral Score haircut that ranges from 40% to 50%).
• In circumstances where the targeted ratings are below Aaa, these haircuts may increase. In any event no
haircut will exceed 60%.
10 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX C3: CALCULATION OF THE HAIRCUT TO COLLATERAL SCORE
In determining the reduction of the collateral stress (as described in Appendix C2), and when considering Cover
Pools which enjoy a good degree of diversity, Moody’s may make use of the following grids based on assumptions
which include the following amongst others:
• The first grid applies to the majority of Covered Bond transactions and assumes a standard (high) level of
correlation between Issuer and Cover Pool.
• The second grid applies to Covered Bond transactions issued in respect of a Cover Pool of public sector
obligations.
Grid 1
standard correlation
Rating of Issuer
Rating of Issuer
Rating of Cover Pool
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
Aaa Aaa
Aa1 Aaa Aaa
Aa2 Aaa Aaa Aa1
Aa3 Aaa Aaa Aa1 Aa1
A1 Aaa Aaa Aa1 Aa1 Aa1
A2 Aaa Aaa Aa1 Aa1 Aa1 Aa1
A3 Aaa Aaa Aa1 Aa1 Aa1 Aa1 Aa2
Baa1 Aaa Aa1 Aa1 Aa1 Aa1 Aa2 Aa2 Aa3
Baa2 Aaa Aa1 Aa1 Aa1 Aa2 Aa2 Aa3 Aa3 A1
Baa3 Aaa Aa1 Aa1 Aa1 Aa2 Aa3 Aa3 A1 A1 A2
Grid 2
low correlation
Rating of Cover Pool
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
Aaa Aaa
Aa1 Aaa Aaa
Aa2 Aaa Aaa Aaa
Aa3 Aaa Aaa Aaa Aa1
A1 Aaa Aaa Aaa Aa1 Aa1
A2 Aaa Aaa Aaa Aa1 Aa1 Aa1
A3 Aaa Aaa Aaa Aa1 Aa1 Aa1 Aa1
Baa1 Aaa Aaa Aa1 Aa1 Aa1 Aa1 Aa1 Aa2
Baa2 Aaa Aaa Aa1 Aa1 Aa1 Aa1 Aa2 Aa2 Aa3
Baa3 Aaa Aaa Aa1 Aa1 Aa1 Aa2 Aa3 Aa3 A1 A1
Reading the grids
The ratings in the grids are the target rating of the Covered Bonds and show the combination of Issuer and Cover
Pool ratings required to achieve a given rating on a Covered Bond.
By way of an example, the following may be considered in respect of grid 1.
• It will be possible to achieve a Aaa rating for Covered Bonds in circumstances of an Issuer’s senior
unsecured rating of A3 and a Cover Pool rating of at least Aa1.
• If the Issuer has a senior unsecured rating of Baa1, in order to achieve Aaa rating for Covered Bonds, the
Cover Pool must be rated a stand-alone Aaa.
What is a Cover Pool rating?
If the Cover Pool must be rated Aaa for a Covered Bond to achieve its Aaa rating target, the Moody’s EL Model
will not apply any haircut to the Collateral Score. However, if a lower rating on the Cover Pool is sufficient to
achieve a given rating target, then a haircut may be applied on the Collateral Score. The following are haircuts that
may be applied for a given Cover Pool rating.
• Aaa 0%
• Aa1 25-35%
• Aa2 40-50%
• Aa3 45-55%
• A1 55-60%
• A2 60%
European Covered Bond Rating Methodology Moody’s Investors Service • 11

These haircuts have been calculated by looking at what the percentage of the Collateral Score is required to
enhance the Cover Pool to its target rating. For example, if the Cover Pool rating that is required to achieve the
target covered bond rating is Aa1, then a 25-35% reduction in the Collateral Score may be applied in the Moody’s
EL Model.
The haircut to the Collateral Score is subject to a maximum of 60%. The reason for this is that a certain level of
losses might be expected to impact the Cover Pool following Issuer Default, and also this is approximately the
amount of equity that would be required to fund the Cover Pool if it were refinanced as a structured finance
transaction.
How the grids were prepared
There are two key inputs in the generation of the grid tables above.
• A minimum asset correlation for any pair of ratings. For the standard correlation table this minimum is
higher than for the low correlation table. 9
• The “theoretical asset correlation”. This is used where this is higher than the minimum asset correlation
inputs mentioned above. The theoretical asset correlation was calculated by considering the maximum
and minimum correlation levels which in turn were derived with the help of the following well-established
formula. 10 P(
A I B)
− P(
A)
P(
B)
Corr(
A,
B)
=
,
P(
A)(1
− P(
A))
P(
B)(1
− P(
B))
where P(X
) denotes the probability that entity X defaults during the horizon of interest, and
Corr( A,
B)
denotes the default correlation between entities A and B .
The theoretical maximum correlation between two entities based solely on ratings (hence default probabilities) is
obtained by setting the expression P( A I B)
in the above equation to the default probability of the higher rated
entity.
By contrast, the theoretical minimum is obtained by first observing that the lowest joint default probability for any
pair of entities is equal to the lowest historically observed default probability for any entity; that is, this quantity is
equal to the probability of default of a single Aaa-rated entity. In practice, for all pairs of entities, we therefore set
P( A I B) equal to P (A)
in the above equation, where A in this instance denotes a Aaa-rated entity.
The impact of taking the higher of the key inputs above is that the “average” asset correlation used when achieving
a Aaa rating using the standard correlation grid is over 50%, while the asset correlation using the low correlation
grid is in region of 40%.
9
To calculate these asset correlations, Moody’s has studied the historic observed correlations of rating movements between corporate and
financial institution issuers. For more information, see Moody’s Revisits Its Assumptions Regarding Corporate Default (and Asset) Correlations
for CDOs November 2004.
10
See Default Correlation and Credit Analysis, Douglas J. Lucas, March 1995.
12 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX C4: USING THE COLLATERAL SCORE IN MOODY’S EL MODEL
The preceding Appendices provide a description in respect of Collateral Score as follows.
• Defining and explaining a Collateral Score.
• Method of calculation and determination of a Collateral Score.
• Haircuts that may be applied to the Collateral Score.
This Appendix and Appendix C5, describe how the Collateral Score, after any haircut if applicable, will impact the
Moody’s EL Model.
The Collateral Score determines, amongst others:
• The level of losses due to the credit deterioration of the assets in the Cover Pool following Issuer Default.
This ignores any losses on the Cover Pool arising from refinancing or market risks. In Moody’s EL Model
these losses will be equal to the Collateral Score, after any haircut if applicable, and are assumed to be
spread equally over the four years following Issuer Default. In scenarios where the Cover Pool is refinanced
prior to the all losses materialising (i.e. within four years following Issuer Default), Moody’s will assume no
value is attributed to an amount of the Cover Pool equal to the amount of the remaining losses (i.e. not yet
written off).
• The refinancing margin assumed for the Cover Pool. The lower the Collateral Score, and thus the stronger
the credit quality of the Cover pool, the lower the assumed cost of refinancing in respect of the remaining
Cover Pool. This is further described in Appendix C5.
The foregoing may be summarised as follows:
Following Issuer Default, the lower the Collateral Score, the lower the write-off for losses against the Cover Pool,
and the lower the refinancing margin applicable to the remaining Cover Pool. A corresponding result arises for
higher Collateral Scores, with higher write-off and refinancing margins.
European Covered Bond Rating Methodology Moody’s Investors Service • 13

APPENDIX C5: IMPACT OF THE COLLATERAL SCORE ON REFINANCING MARGIN
IN MOODY’S EL MODEL
At time of refinance the Moody’s EL Model assumes the Cover Pool is apportioned into various tranches, each
with a specific risk profile. The main reason for this tranching is to calculate the refinancing margin for the portion of
the Cover Pool against which finance is being raised. The Collateral Score is the key driver in determining the
amount of the Cover Pool that is allocated to any tranche. A lower Collateral Score will imply that a greater amount
of the remaining Cover Pool will be allocated to tranches with low risk, and correspondingly result in a lower
refinancing margin.
Moody’s EL Model usually takes into account the following three factors in making determination of what amounts
should be apportioned into each of the tranches.
• The Collateral Score (prior to any haircut).
• Expected loss on the Cover Pool, which is determined from an analysis of the Cover Pool.
• An assumption that losses on the Cover Pool will follow a lognormal distribution.
A loss distribution will be constructed for the Moody’s EL Model based on the information in respect of the above
three drivers. On the basis of this loss distribution, the required level of enhancement will be determined for each
tranche. The following broad tranches are used.
• Aaa tranche.
• High investment-grade tranche.
• Low investment-grade tranche.
• Sub-investment-grade tranche.
Under the Moody’s EL Model, refinancing margins are lowest in the Aaa tranche and will increase for each tranche
below the Aaa tranche. Further discussion on refinancing margins follows in Appendices D1 and D4.
14 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX D1: REFINANCING RISK – THE REFINANCING MARGINS
Under Moody’s EL Model, determination of refinancing margins will take into account the following considerations,
amongst others:
• The time period available for completion of the refinancing. Higher refinancing margins are assumed in the
Moody’s EL Model, if the time period to complete refinance is six months or less. This may arise in case of
Issuer Default within a period of six months of the legal final maturity of any Covered Bonds.
• The time period between the time of issue of a Covered Bond and the time of refinancing. The shorter the
time period (or closer the time of refinancing is to the time of issuance), the greater certainty in respect of
refinancing margins required to refinance the Cover Pool.
• The Collateral Score, and more generally the credit quality of the Cover Pool. In general it may be
concluded that all else being equal, a lower Collateral Score (and the lower the Collateral Score the higher
the credit quality of the assets) will lead to lower refinancing margins.
• The type of collateral in the Cover Pool. In Moody’s experience and as shown in historical data, certain
types of collateral in the Cover Pool will trade at lower refinancing margins than others, under similar
trading conditions and circumstances. Examples may include ‘repo-eligible’ collateral (often included
within Cover Pools made up mainly of public sector obligations), in respect of which the Moody’s EL
Model may assume a refinancing margin of zero.
• Legislation and contractual-specific considerations. For those jurisdictions where the legislation is
more/less supportive than others of the process of sale of collateral in the Cover Pool following Issuer
Default (i.e. presenting obstacles to any refinancing), refinancing margins may be correspondingly
lowered/increased. Similar consequences may be considered in circumstances of contractual-specific
provisions that have a similar effect.
Refinancing required to be completed within a short time period (six months)
The following data represents examples of refinancing margins (in basis points) which may be applied in the
Moody’s EL Model if refinancing is required to be completed within a time period of six months.
Refinancing Margins (in bps)
Residential
Mortgages*
Commercial
Mortgages
Public Sector
Loans**
1 73 108 27
2 79 105 32
3 86 117 36
4 91 126 39
5 95 133 41
* these are examples of refinancing margins that may apply for prime residential mortgages
** these are examples of refinancing margins that may apply for ‘non-repo eligible’ public
Years
The following may be considered in respect of the above data.
• The three columns represent the three most prominent collateral types found in Cover Pools.
• The rows refer to the time period in years from the time of issuance of Covered Bonds to Issuer Default.
By way of example from the data, consider the following scenarios and conclusions:
• In circumstances of an Issuer Default that occurs five or more years after issue of Covered Bonds,
Moody’s EL Model will apply a refinancing margin at the time of Issuer Default to the Cover Pool of
residential mortgages in an amount of around 95 basis points.
• In circumstances of an Issuer Default which occurs two years after issue of Covered Bonds, Moody’s EL
Model will apply a refinancing margin at the time of Issuer Default to the Cover Pool of residential
mortgages in an amount of 79 basis points.
As described at the top of this appendix refinancing margins will be different from deal to deal and jurisdiction to
jurisdiction.
European Covered Bond Rating Methodology Moody’s Investors Service • 15

A further stress may be applied to refinancing margins for those Cover Pools that require refinancing within a
period of less than four months following Issuer Default. In these circumstances, the refinancing margins may
increase by up to the following amounts:
Refinance
Stress
Time Available to complete
Refinancing
100% One Month
75% Two Months
50% Three Months
25% Four Months
If an Issuer Default occurs a very short period before a Covered Bond is due, it might be concluded that timely
refinancing is not possible. However, it may be possible that an investor could sell its Covered Bonds on the
secondary market to realise payment. Such a sale may incur substantial additional costs, and these are partly
reflected in the stresses above.
Refinancing required to be completed within a longer time period (more than six months)
The following data represents examples of refinancing margins (in basis points) which may be applied in the
Moody’s EL Model if refinancing can be completed over a period exceeding six months.
Years
Refinancing Margins (in bps)
Residential
Mortgages
Commercial
Mortgages
Public Sector
Loans
1 60 91 20
2 64 85 23
3 69 94 26
4 73 101 28
5 76 107 29
The following may be considered in respect of the above data.
• The three columns represent the three most prominent collateral types found in Cover Pools.
• The rows refer to the time period in years from the time of issuance of Covered Bonds to Issuer Default.
By way of example from the data, consider the following scenarios and conclusions.
• In circumstances of an Issuer Default which occurs five or more years after issue of Covered Bonds,
Moody’s EL Model will apply a refinancing margin to the Cover Pool of residential mortgages in an amount
of around 76 basis points.
• In circumstances of an Issuer Default which occurs two years after issue of Covered Bonds, on refinance
Moody’s EL Model will apply a refinancing margin to the Cover Pool of residential mortgages in an amount
of 64 basis points. It should be noted that this 64 basis points is not increased if following Issuer Default
the Cover Pool is not promptly refinanced.
As discussed above these refinancing margins will be different from deal to deal and jurisdiction to jurisdiction.
16 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX D2: REFINANCING RISK – THE PORTION OF A COVERED BOND THAT
MUST RELY ON THE REFINANCING TO BE REPAID ON A TIMELY BASIS
Post Issuer Default, the portion of a Covered Bond that must rely on refinancing in order to be repaid on a timely
basis depends on the level of principal collections (or “natural amortisation”) prior to any refinancing. Under the
Moody’s EL Model from the following considerations amongst others it is possible to determine the amount of
principal collections against any Covered Bonds following Issuer Default.
• Following Issuer Default the length of time available to collect principal collections (the “Collection Period”).
In Moody’s EL Model, where there is a single Covered Bond in a programme the Collection Period runs
from Issuer Default up until earlier of the legal final maturity of the Covered Bond (or, where applicable, the
later extended legal final maturity), or following acceleration, any refinance date which is earlier than the
legal final maturity. When considering the Collection Period for a programme under which there are many
Covered Bonds issued, the start date for the Collection Period may change. When there is more than one
Covered Bond in issue under a programme, the start date for a specific Covered Bond in Moody’s EL
Model is:
• Prior to acceleration, a date between the date of Issuer Default and the legal final maturity date of the
immediately preceding maturing Covered Bond.
• Following acceleration, the acceleration date.
• The principal payment rate under the Cover Pool during the Collection Period. The higher the principal
payment rate from collateral under the Cover Pool, the greater the principal cash flows collected during
the Collection Period.
• The number of Covered Bonds issued under a programme. For mature programmes, the Covered Bond
that matures first following Issuer Default may be a fraction of the size of the overall Cover Pool at the time
of Issuer Default. This may lead to a leveraged effect on principal collections during the Collection Period
as principal collections will be based on the principal payment rate on a Cover Pool which may be many
times the size of a specific Covered Bond. Later-paying Covered Bonds in a mature programme may not
benefit from this leveraged effect to the same extent. However, another consequence of a mature
programme is that there will be additional Covered Bonds maturing on various dates, therefore potentially
reducing the length of the “Collection Period”.
• The amount of over-collateralisation in the Cover Pool. Where a Covered Bond programme has a
substantial amount of over-collateralisation, all Covered Bonds in the programme may benefit from the
“leverage” effect discussed in point three above.
It may be concluded that in the Moody’s EL Model:
• the longer the Collection Period;
• the higher the principal payment rate; and
• the greater the amount of over-collateralisation,
the greater the level of cash flow that will be collected from principal payments under the Cover Pool in the
Collection Period. The greater the amount of cash flow collected during the Collection Period, the lower the
amount of the Cover Pool that will be subject to refinancing risk.
European Covered Bond Rating Methodology Moody’s Investors Service • 17

APPENDIX D3: REFINANCING RISK – CALCULATION OF REFINANCING MARGINS
Moody’s has built a refinancing margin generator which calculates the refinancing margins used in the Moody’s EL
Model. The generator is defined as (the “Formula”):
dS = η(ζ − S)dt + σdW
Where:
dS is the spread change;
η is the speed the time series reverts to its long term meanζ ;
dt is the change in time;
2
σ is the volatility of the spread time series; and
dW represents the standard Wiener process. 11
The parameters of the Formula (adjusted for timing) were set by minimising the differences of the results produced
for parts of the Formula and the data historically observed on refinancing margins. This exercise was repeated to
calculate the long-term mean and standard deviation for each rating category for each collateral type. 12
The
Formula is then run for a large number of simulations. From these simulations refinancing curves are generated by
working to the desired confidence levels. The confidence levels used for calculating refinancing margins are:
• 99% for margins used when refinancing must be completed within six months; and
• 95% for margins when more than six months is available for refinancing.
The following graph illustrates the refinancing margins produced when working to a 99% confidence level. The
main assumptions used are broadly in line with those used to calculate the refinancing margins for Aaa-rated
residential mortgage pools. The assumptions used include a standard deviation of 20 bps, and a long-term
average refinancing margin of 30 bps.
Refinancing Margins for a Aaa-rated Pool of
Prime-Quality Residential Mortgages
1.20%
1.00%
0.80%
0.60%
0.40%
0.20%
0.00%
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58
Months
For a discussion of the meaning of these refinancing margins, see Appendix D1.
11
For further information, refer to “The Moody’s Capital Model Version 1.0, January 2004”.
12
Moody’s has not used the calculated factor for mean reversion. Instead Moody’s has used a fixed parameter for mean reversion. This is
because an analysis suggests that using the limited available data would overestimate the rate of mean reversion. Moody’s has used the
same fixed parameter for mean reversion when calculating refinancing margins for each rating category of each major asset class.
18 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX D4: SIMPLIFIED EXAMPLE TO SHOW HOW TO TRANSLATE A
STRESSED REFINANCING MARGIN INTO A LOSS ON THE COVER POOL
This Appendix presents an example to show what effect the stressed refinancing margin in Appendix D1 may have
on the value of the Cover Pool. It should be noted that the example below is a simplification of the corresponding
calculation in Moody’s EL Model.
The example is based on the following assumptions, amongst others.
• A single Covered Bond is outstanding under a “programme” of Covered Bonds.
• Issuer Default takes place one month prior to legal final maturity of the Covered Bond.
• The remaining average life of the Cover Pool at the time of its refinancing is two years.
• The refinancing takes place five years after the Covered bond was issued.
• The Cover Pool consists of prime residential mortgages (and matches the sample pool used to create the
refinance margins in Appendix D1).
The impact of the refinancing margin stress on the value of the Cover Pool may be calculated as follows:
Refinancing margin * liquidity stress *average life of the Cover Pool = reduction in the value of the Cover Pool
95 * 2 * 2 = 380 bps reduction in the value of the Cover Pool
Amongst others, this example highlights the importance of the average life of the Cover Pool. If the example were
repeated with an average life of the Cover Pool at time of refinance of four years, the reduction in the value of the
Cover Pool would be doubled. Conversely, if the example were repeated with an average life of the Cover Pool at
time of refinance of one, the reduction in the value of the Cover Pool would be halved.
European Covered Bond Rating Methodology Moody’s Investors Service • 19

APPENDIX E1: MARKET RISKS – KEY RISKS
For purposes of the appendices which describe market risks, the expression “market risks” will be reference to the
mismatches between Covered Bonds and the Cover Pool that arise from the different payment promises and
durations made on the Cover Pool and the Covered Bonds. Specific examples of some of the material market risks
to which Covered Bonds are exposed are discussed below.
Under the Moody’s EL Model analysis of market risks following Issuer Default will be undertaken in respect of two
time periods as follows.
• Market risks that arise after Issuer Default and prior to any refinancing of part or whole of the Cover Pool.
• Market risks that arise on refinancing of part or whole of the Cover Pool.
Market risks that arise after Issuer Default and prior to any refinancing of the
Cover Pool
During this period prior to any refinancing of part or the whole of the Cover Pool, Moody’s EL Model will assess
whether market risks materialising may lead to an acceleration of the Covered Bonds. This may arise as follows.
• Cash flow deficiencies may result from market risk materialising. For example, interest or currency rate
movements might lead to collections being below that required to pay interest (in the case of interest and
currency rate differences) and principal (in the case of currency rate differences) on the Covered Bonds. A
missed payment could in turn lead to acceleration of all payment obligations under the Covered Bonds,
whether or not then due.
• Market risk materialising may affect matching test compliance under the Covered Bonds, failure of which
may lead to acceleration of payment obligations under the Covered Bonds. The applicable approach to
calculating any matching tests will be set out in the relevant legislation or contractual arrangements for the
Covered Bonds. Methods of calculation may include:
• Notional value matching, which will not be affected by any changes in interest rates (but may be
affected by changes in currency rates).
• Net present value matching, which may be affected by both interest and currency rate changes.
Where net present value matching is applicable, the Moody’s EL Model will recalculate the net present value of the
Cover Pool and Covered Bonds on monthly or quarterly basis to check for failure of the matching test.
Market risks arising on refinancing of the Cover Pool
Under the Moody’s EL Model, if part or whole of the Cover Pool is subject to refinancing either to meet the principal
payment due on a Covered Bond or following acceleration payment of all Covered Bonds outstanding, then various
market risks may be crystallised.
The Moody’s EL Model will measure the extent of the risk to the Covered Bonds in different ways depending on the
nature of the market risk.
Interest rate risks
The exposure to interest rate movements at time of refinance will depend on the mismatch that exists between the
Covered Bonds and the Cover Pool. Material levels of exposure to interest rate movements will arise in the following
circumstances amongst others:
• Interest rates applicable to (i) the collateral in the Cover Pool are based on a fixed rate with a long maturity
(assuming no reset), and (ii) the Covered Bonds are based either on a short maturity or floating rate.
• Interest rates applicable to (i) the collateral in the Cover Pool are based either on a short maturity or are
floating rate, and (ii) the Covered Bonds are based on a fixed rate with a long maturity (assuming no reset).
In the first bullet above, a loss on the Cover Pool may arise in respect of a rising interest rate environment. By
contrast, in the second bullet above, the loss to the Cover Pool may arise in respect of a falling interest rate
environment. Moody’s EL Model considers scenarios of both rising and falling interest rate environments and
assumes application of the scenario with the more stressed result. Appendices E3 and E4 describe further the
levels of stress considered in Moody’s EL Model as well as setting out the relevant workings of Moody’s EL Model
for exposure to interest rate risks. Appendix E5 provides an example of the impact of interest rate risk on the Cover
Pool.
Currency rate risks
Currency rate risks are less commonplace in respect of Covered Bonds than interest rate risk. However,
increasingly, collateral in Cover Pools is originated, and Covered Bonds are issued, respectively in currencies other
than the currency of the Issuer. Appendices E3 and E4 describe further the levels of stress considered in Moody’s
EL Model for exposure to currency rate risks as well as setting out the relevant workings of the Moody’s EL Model.
20 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX E2: MARKET RISKS – MOODY’S EL MODEL’S ANALYSIS OF HEDGING
ARRANGEMENTS
Moody’s EL Model will analyse the market risks that may arise between the Covered Bonds and the Cover Pool
following Issuer Default. Consideration will be given under Moody’s EL Model to which of the following market riskrelated
scenarios may arise after Issuer Default:
• Structured finance-compliant arrangements are in place to cover all relevant market risks. The meaning of
the expression “structured finance-compliant arrangements” will include the following requirements,
amongst others:
• Hedging arrangements are designed to survive Issuer Default (reasons for this requirement are described
in the next following paragraph).
• Moody’s swap-related criteria will be fulfilled in all respects for all hedging arrangements. 13
• Arrangements are in place to cover market risks, though these do not comply with all requirements of
structured finance-compliant arrangements in one or more respects. These hedging arrangements do,
however, survive Issuer Default.
• No suitable arrangements in place, or if there are arrangements in place, these will terminate on Issuer
Default.
Under Moody’s EL Model, any market risk not covered by arrangements that are designed to survive Issuer Default
may negatively affect the Covered Bonds. Reasons for this approach include the following considerations, amongst
others:
• An administrator will be assumed to be appointed to manage the Cover Pool following Issuer Default.
• However, it is Moody’s view that an administrator may experience difficulty in trying to cover market risks
following Issuer Default. 14
Under Moody’s EL Model, account may be taken of any legislation- or contractual-specific features that mitigate
any of the above considerations as well as any other market risks taken into account.
The remainder of the appendices which describe market risks focus attention on stresses that are applied by
Moody’s EL Model in the event that hedging arrangements do not constitute structured finance-compliant
arrangements.
13
See Swaps in European Term Securitisations, May 2002 and Impact of Swap Counterparty Risks on Global Structured Finance Transactions
Moody’s Revised Methodology - Call for Comments, March 2005.
14
In support of its view, Moody’s expects that, in considering entering into hedging arrangements with an administrator, a hedge counterparty
may require collateralisation of the arrangements. This may include frequent posting of collateral, dependent on the evolution of the exposure.
An administrator may not always be permitted following Issuer Default to enter into additional or replacement hedging arrangements.
Furthermore, if entering into hedging arrangements is permitted, an administrator may either additionally not be permitted to provide
collateralisation to hedge counterparties, or have sufficient funds available for this purpose.
European Covered Bond Rating Methodology Moody’s Investors Service • 21

APPENDIX E3: MARKET RISKS – THE LEVELS OF STRESS APPLIED BY MOODY’S
EL MODEL
Interest rate stresses
The Moody’s EL Model uses a series of interest rate curves, which effectively means there are ten different interest
rates for every month of what is defined below as the Interest Exposure Period. The “Interest Exposure Period” can
be defined as the period of time during which it is assumed that Covered Bonds will be exposed to changes in
interest rates (see footnote for more complete definition). 15
Accordingly to simplify the communication of the interest rate stresses used in the Moody’s EL Model, Moody’s has
come up with “average” interest rate movements during different Interest Exposure Periods. These simplified
stressed interest rate movements for interest rates are as follows:
Interest Exposure
Cumulative Interest Rate
Period (in years)
Increase/Decrease
1 1.65%
2 2.25%
3 2.75%
4 3.00%
5 3.00%
>5 3.00%
To understand two particular results from the table:
• Moody’s EL Model will increase and decrease interest rates by an “average” of around 3% when the
Interest Exposure Period is five years.
• Moody’s EL Model will increase and decrease interest rates by an “average” of around 2.25% when the
Interest Exposure Period is two years.
The Moody’s EL Model looks separately at the impact of the increasing and decreasing interest rates on the
expected loss of the Covered Bonds, and takes the path of interest rates that leads to the harsher result on the
expected loss on the Covered Bonds. This is because different Covered Bonds will be impacted differently by
different interest rate environments, dependent on whether the Cover Pool and/or Covered Bonds are subject to
fixed or floating rates of interest, and the duration gap between Covered Bonds and the Cover Pool.
To understand the impact of the interest rate changes in the table above on the Moody’s EL Model, Moody’s has
prepared a simple illustration in Appendix E5 of how these might be seen to affect the loss on the Cover Pool at
time of refinancing. 16
Currency rate stresses
The stress applied by Moody’s EL Model to currency rate market risks will depend on the length of time assumed
for the “Interest” Exposure Period (see definition above, and in footnote 13, except that for the purpose of currency
rate risks this should be the period between Issuer Default until the time of refinance of the Cover Pool if a matching
test is in place to ensure currency rate risks are hedged up to Issuer Default). Examples of stresses that may be
applied are as follows:
“Interest” Exposure Cumulative Adverse Currency
Period (in years)
Rate Movements
1 15%
2 25%
3 30%
>3 30%
As for interest rate movements, the Moody’s EL Model assumes that currency rate movements do not increase
linearly over time. Given this tendency, the Moody’s EL Model caps exposure to currency rate risk at the three-year
stress.
15
In the environment of Covered Bonds, the Interest Exposure Period will usually be determined by the type of matching test that is being run by
the Issuer. So, for example:
a) In those circumstances where the matching test that is applied prior to Issuer Default is based on net present values (or an equivalent
approach), the Interest Exposure Period will extend from Issuer Default until the time of refinance of the Cover Pool.
b) In those circumstances where the matching test that is applied prior to Issuer Default is not based on net present values (or an
equivalent approach), the Interest Exposure Period will extend from the time of issue of Covered Bonds until the time of refinance of
the Cover Pool.
16
The interest rate increases and decreases above were extracted from the future term structures (see Appendix E4) which are generated by
the Moody’s EL Model. The future term structures in practice have the following effect in Moody’s EL Model:
c) For the Interest Exposure Period, they project cash flows in respect of Covered Bonds and the Cover Pool to the extent these are not
subject to fixed interest rates.
d) As at the time of refinancing of the Cover Pool, they enable calculation of the market risks by providing rates for discounting all future
cash flows under the Cover Pool.
22 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX E4: MARKET RISKS – CALCULATION OF INTEREST AND CURRENCY
RATE STRESSES
Interest rates
Spot Rate Curves
To build a picture of interest rate risk, Moody’s has constructed a series of curves from a series of spot rates which
are defined by upper and lower boundaries of possible interest rate movements. Each of these curves represents a
distribution of possible interest rate changes in either direction (i.e. increasing and decreasing) over periods of time
and covering changes to a confidence level of 95%.
An example of curves created for spot rates with different terms are shown below.
Spot Rates Boundaries for Different Risk Horizons
% IR
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
0 5 10 15 20 25 30 35 40 45 50 55 60 65
Risk Horizon (months)
1 yr 1 yr 2 yr 2 yr 3 yr 3 yr 4 yr 4 yr 5 yr 5 yr
6 yr 6 yr 7 yr 7 yr 8 yr 8 yr 9 yr 9 yr 10 yr 10 yr
The curves above show the interest rate stresses do not increase linearly over time, and instead, the cumulative
movements over time start converging. Given this tendency, the Moody’s EL Model caps exposure to interest rate
risk at the five-year stress.
The spot rate curves above are derived from application of the following steps:
• Analysis of relative changes in historical interest rates.
• Scaling interest rates based on a confidence level.
• Analysis of relative changes in historical interest rates. Under the Moody’s EL Model a factor will be
calculated (“µ”) based on historical data for spot rates of various maturities of between one year and 10
years. This calculation is repeated for monthly periods ranging from one month to 60 months.
µ is calculated using the following formula:
ri
− r
µ =
r
i−1
i−1
Where:
µ = the relative change in spot rates between period i and i-1
r i
- r i-1
= the absolute change in spot rates over the period
r i-1
= the spot rate in the previous period
Moody’s EL Model will calculate µ for each maturity of between one year and 10 years and for each month up to
five years. For each series of µ the Moody’s EL Model will calculate a standard deviation. A “volatility surface” will be
calculated plotting these resulting 600 standard deviations.
European Covered Bond Rating Methodology Moody’s Investors Service • 23

• Scaling interest rates based on a confidence level. Using the volatility calculated above, the spot rates are
increased or decreased to a 95% confidence level. 17
Future Term Structure
From the spot rate curves calculated above, Moody’s has prepared a future term structure 18 for each month of the
Interest Exposure Period (see Appendix E3 for definition). The future term structures determine the interest rate
stresses used in the Moody’s EL Model.
As a starting point for the future term structure, the Moody’s EL Model uses spot rates based on average rates and
not those calculated from the current interest rates. These levels are currently set at an average rate. The reason
Moody’s has set these rates as constants, as opposed to using current interest rates, is to prevent Covered Bond
ratings being overly sensitive to interest rate changes in the market.
Currency rates
Under Moody’s EL Model, a similar approach is applied in respect of currency rates as for interest rates. This
includes the analysis of historical currency rates.
17
The distribution used to calculate the confidence level is based on the normal as it has been observed that µs have been shown to be
normally distributed.
18
At each point in the simulation the model generates a set of Nelson-Siegel parameters describing the entire spot rate curve. The model
calibrates the Nelson-Siegel parameters by using Newton-Raphson method. The advantage of the Nelson Siegel formulation is that it provides
a parsimonious model of the yield curve. Thus it is computationally very efficient and any point in the curve can be obtained with few
parameters. For further information please refer to “The Moody’s Capital Model Version 1.0, January 2004”.
24 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX E5: SIMPLIFIED EXAMPLE TO SHOW HOW TO TRANSLATE A
STRESSED INTEREST RATE MOVEMENT INTO A LOSS ON THE COVER POOL
This Appendix presents an example to show what effect the stressed interest rate movement calculated in
Appendix E3 may have on the value of the Cover Pool. It should be noted that this is a simplification of the
corresponding calculation in Moody’s EL Model and assumes no hedging arrangements are in place to protect
against interest rate exposure.
The example is based on the following assumptions, amongst others;
• There has been an Issuer Default.
• A single Covered Bond is outstanding under a “programme” of Covered Bonds.
• The remaining average life of the Cover Pool at the time of its sale is two years.
• The Cover Pool comprises collateral which is all based on fixed rates of interest until respective maturity
(which means for this example the average life of Cover Pool is also the period of interest rate exposure).
• No principal payments will be made in respect of the collateral in the Cover Pool.
• The Interest Exposure Period (see Appendix E3) is one year.
• The increase in interest rates during the Interest Exposure Period is 165 basis points (as described in
Appendix E3).
The impact of market risk stress on the value of the Cover Pool may be calculated as follows:
Interest rate increase * average life of the interest rate exposure = reduction in the value of the Cover Pool
165bps * 2 = 330bps reduction in the value of the Cover Pool
European Covered Bond Rating Methodology Moody’s Investors Service • 25

APPENDIX F1: MOODY’S IDEALISED PROBABILITY OF DEFAULT AND EXPECTED
LOSS TABLES
Table 1
Moody’s Idealised Cumulative Probability of Default
Rating 1 2 3 4 5 6 7 8 9 10
Aaa 0.00005% 0.00020% 0.00070% 0.00180% 0.00290% 0.00400% 0.00520% 0.00660% 0.00820% 0.01000%
Aa1 0.00057% 0.00300% 0.01000% 0.02100% 0.03100% 0.04200% 0.05400% 0.06700% 0.08200% 0.10000%
Aa2 0.00136% 0.00800% 0.02600% 0.04700% 0.06800% 0.08900% 0.11100% 0.13500% 0.16400% 0.20000%
Aa3 0.00302% 0.01900% 0.05900% 0.10100% 0.14200% 0.18300% 0.22700% 0.27200% 0.32700% 0.40000%
A1 0.00581% 0.03700% 0.11700% 0.18900% 0.26100% 0.33000% 0.40600% 0.48000% 0.57300% 0.70000%
A2 0.01087% 0.07000% 0.22200% 0.34500% 0.46700% 0.58300% 0.71000% 0.82900% 0.98200% 1.20000%
A3 0.03885% 0.15000% 0.36000% 0.54000% 0.73000% 0.91000% 1.11000% 1.30000% 1.52000% 1.80000%
Baa1 0.09000% 0.28000% 0.56000% 0.83000% 1.10000% 1.37000% 1.67000% 1.97000% 2.27000% 2.60000%
Baa2 0.17000% 0.47000% 0.83000% 1.20000% 1.58000% 1.97000% 2.41000% 2.85000% 3.24000% 3.60000%
Baa3 0.42000% 1.05000% 1.71000% 2.38000% 3.05000% 3.70000% 4.33000% 4.97000% 5.57000% 6.10000%
Ba1 0.87000% 2.02000% 3.13000% 4.20000% 5.28000% 6.25000% 7.06000% 7.89000% 8.69000% 9.40000%
Ba2 1.56000% 3.47000% 5.18000% 6.80000% 8.41000% 9.77000% 10.70000% 11.66000% 12.65000% 13.50000%
Ba3 2.81000% 5.51000% 7.87000% 9.79000% 11.86000% 13.49000% 14.62000% 15.71000% 16.71000% 17.66000%
B1 4.68000% 8.38000% 11.58000% 13.85000% 16.12000% 17.89000% 19.13000% 20.23000% 21.24000% 22.20000%
B2 7.16000% 11.67000% 15.55000% 18.13000% 20.71000% 22.65000% 24.01000% 25.15000% 26.22000% 27.20000%
B3 11.62000% 16.61000% 21.03000% 24.04000% 27.05000% 29.20000% 31.00000% 32.58000% 33.78000% 34.90000%
Caa1 17.38160% 23.23416% 28.63861% 32.47884% 36.31374% 38.96665% 41.38538% 43.65696% 45.67182% 47.70000%
Caa2 26.00000% 32.50000% 39.00000% 43.88000% 48.75000% 52.00000% 55.25000% 58.50000% 61.75000% 65.00000%
Caa3 50.99020% 57.00877% 62.44998% 66.24198% 69.82120% 72.11103% 74.33034% 76.48529% 78.58117% 80.70000%
Table 2
Moody’s Idealised Cumulative Expected Loss
Rating 1 2 3 4 5 6 7 8 9 10
Aaa 0.00003% 0.00011% 0.00039% 0.00099% 0.00160% 0.00220% 0.00286% 0.00363% 0.00451% 0.00550%
Aa1 0.00031% 0.00165% 0.00550% 0.01155% 0.01705% 0.02310% 0.02970% 0.03685% 0.04510% 0.05500%
Aa2 0.00075% 0.00440% 0.01430% 0.02585% 0.03740% 0.04895% 0.06105% 0.07425% 0.09020% 0.11000%
Aa3 0.00166% 0.01045% 0.03245% 0.05555% 0.07810% 0.10065% 0.12485% 0.14960% 0.17985% 0.22000%
A1 0.00320% 0.02035% 0.06435% 0.10395% 0.14355% 0.18150% 0.22330% 0.26400% 0.31515% 0.38500%
A2 0.00598% 0.03850% 0.12210% 0.18975% 0.25685% 0.32065% 0.39050% 0.45595% 0.54010% 0.66000%
A3 0.02137% 0.08250% 0.19800% 0.29700% 0.40150% 0.50050% 0.61050% 0.71500% 0.83600% 0.99000%
Baa1 0.04950% 0.15400% 0.30800% 0.45650% 0.60500% 0.75350% 0.91850% 1.08350% 1.24850% 1.43000%
Baa2 0.09350% 0.25850% 0.45650% 0.66000% 0.86900% 1.08350% 1.32550% 1.56750% 1.78200% 1.98000%
Baa3 0.23100% 0.57750% 0.94050% 1.30900% 1.67750% 2.03500% 2.38150% 2.73350% 3.06350% 3.35500%
Ba1 0.47850% 1.11100% 1.72150% 2.31000% 2.90400% 3.43750% 3.88300% 4.33950% 4.77950% 5.17000%
Ba2 0.85800% 1.90850% 2.84900% 3.74000% 4.62550% 5.37350% 5.88500% 6.41300% 6.95750% 7.42500%
Ba3 1.54550% 3.03050% 4.32850% 5.38450% 6.52300% 7.41950% 8.04100% 8.64050% 9.19050% 9.71300%
B1 2.57400% 4.60900% 6.36900% 7.61750% 8.86600% 9.83950% 10.52150% 11.12650% 11.68200% 12.21000%
B2 3.93800% 6.41850% 8.55250% 9.97150% 11.39050% 12.45750% 13.20550% 13.83250% 14.42100% 14.96000%
B3 6.39100% 9.13550% 11.56650% 13.22200% 14.87750% 16.06000% 17.05000% 17.91900% 18.57900% 19.19500%
Caa1 9.55988% 12.77879% 15.75124% 17.86336% 19.97256% 21.43166% 22.76196% 24.01133% 25.11950% 26.23500%
Caa2 14.30000% 17.87500% 21.45000% 24.13400% 26.81250% 28.60000% 30.38750% 32.17500% 33.96250% 35.75000%
Caa3 28.04461% 31.35482% 34.34749% 36.43309% 38.40166% 39.66107% 40.88169% 42.06691% 43.21964% 44.38500%
26 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX F2: RATING A PROGRAMME: THE IMPACT
There are a number of specific adjustments that have been made to the Moody’s EL Model to accommodate a
programme of Covered Bonds, where applicable. These adjustments are intended to provide a certain amount of
flexibility to an Issuer of Covered Bonds and ultimately also for the ratings produced by the Moody’s EL Model.
These adjustments include the following, which are divided into two categories.
The cushion enjoyed by Covered Bonds
There are many ways flexibility has been built into Moody’s EL Model, and examples include the following:
• Moody’s EL Model will assume that in the future Covered Bonds with a certain variety of maturities may be
issued, and will check that the rating of existing Covered Bonds will not be adversely affected as a result. It
is assumed that, unless advised otherwise, the Issuer will require flexibility to issue Covered Bonds of
different maturities over time.
• The Collateral Score may be adjusted to assume a certain limited deterioration in Cover Pool quality. This
will, for example, be the case as follows:
• An Issuer communicates to Moody’s ahead of time that lower-quality collateral may be included in the
Cover Pool in the future.
• If the Collateral Score benefits from recent house price growth which is greater than average, Moody’s
may ignore the majority of this benefit on the basis that this benefit might not be enjoyed by collateral
added to the Cover Pool in the future.
• The Moody’s EL Model may limit the benefit from the gross margin generated by the Cover Pool to
Moody’s current view on the long-term sustainable margin.
Other adjustments that might be credit positive or negative
These will include the following:
• In the Moody’s EL Model each Covered Bond is modelled to rely on only its share of the overcollateralisation
available to the programme. However, following Issuer Default, an administrator of the
Cover Pool might have the power to use all programme-wide over-collateralisation to pay down a single
Covered Bond, even though there may be later-maturing Covered Bonds.
• When assessing market risk, the Moody’s EL Model assumes that the base interest rate is set at a longterm
“average” level. The level of interest rate stress that a Covered Bond programme will experience under
the Moody’s EL Model is a function of this base interest rate. The reason Moody’s has set this base interest
rate as a constant, as opposed to using the current interest rate, is to prevent Covered Bond ratings being
overly sensitive to interest rate changes in the market.
Moody’s will continue to review the level of flexibility being built into the Moody’s EL Model and make amendments
to increase or reduce flexibility. A number of assumptions made will also be determined on an Issuer-specific basis.
For example, if an Issuer expects a certain improvement or deterioration in the quality of the collateral to be included
in the Cover Pool in the future, Moody’s would take this into account in its rating of the Covered Bonds.
European Covered Bond Rating Methodology Moody’s Investors Service • 27

APPENDIX F3: OVER-COLLATERALISATION: WHAT VALUE WHEN “NOT
COMMITTED”
Moody’s distinguishes between over-collateralisation in the Cover Pool which is (i) committed or (ii) “not committed”.
Moody’s regards committed over-collateralisation as an amount required to be added to the Cover Pool pursuant
to legislation or in terms of the Covered Bonds’ terms and conditions. 19 Any other over-collateralisation is regarded
as “not committed”.
Moody’s is concerned that over-collateralisation that is “not committed” may not be available to the Covered Bonds
at the time of Issuer Default. Accordingly the Moody’s EL Model will only give value to over-collateralisation that is
“not committed” subject to the following conditions:
• The short-term senior unsecured rating of the Issuer is Prime-1.
• The Issuer agrees on a non-binding basis that the agreed amount of over-collateralisation will be included in
the Cover Pool.
• The Issuer provides quarterly updates to Moody’s confirming the amount of over-collateralisation in the
Cover Pool.
An Issuer should be aware that if its short-term senior unsecured rating falls below Prime-1 then in its analysis the
Moody’s EL Model will only continue to give value to over-collateralisation which is committed.
19
or reaches other arrangements.
28 • Moody’s Investors Service European Covered Bond Rating Methodology

APPENDIX F4: PROBABILITY OF DEFAULT OF A COVERED BOND
Under Moody’s EL Model the rating target is the expected loss on a Covered Bond. However, probability of default
on a Covered Bond may also be taken into account by Moody’s to ensure that it is consistent with the rating
assigned.
There is a margin of difference which will be acceptable under Moody’s rating approach between the expected loss
rating of Covered Bonds and probability of default rating of the Covered Bonds. Accordingly all Issuers rated A1 or
above have the ability to achieve a Aaa rating for Covered Bonds, subject to the expected loss analysis confirming a
Aaa rating. This means that, even if a default on a Covered Bond is expected following Issuer Default, while the
Issuer is rated A1 or above, the Covered Bonds can still be rated Aaa.
Issuers with senior unsecured ratings below A1 can achieve Aaa ratings on a Covered Bond issued if the Covered
Bond are expected to be paid on a timely basis following Issuer Default (again subject to the expected loss analysis
confirming a Aaa rating). The higher the level of support offered by either the legislation of the jurisdiction or a
contractual promise (or both) in terms of ensuring timely payments under Covered Bonds, the lower the rating level
the Issuer will need to attain in order to achieve a Aaa rating for the Covered Bonds in question.
Moody’s does not currently view any Covered Bond as de-linked from the rating of the Issuer. Probability of Issuer
Default is a significant consideration in the analysis in that it could lead to a late payment on the related Covered
Bonds. After Issuer Default, a delayed payment under the Covered Bonds may occur for a number of reasons
including the following:
• Failure to raise sufficient finance against the Cover Pool to pay principal when due on a Covered Bond.
• Failure to secure timely servicing of the Cover Pool at a cost that is manageable by the Cover Pool.
• Failure to make the first interest payment due on the Covered Bonds following Issuer Default.
• Failure to transfer hedging arrangements to a replacement counterparty.
Under Moody’s EL Model the majority of Covered Bond ratings are not expected to be constrained by their
probability of default. However, the likelihood that the probability of default of a Covered Bond could constrain its
rating increases with the number of notches between the Issuer rating and the rating of the Covered Bond.
European Covered Bond Rating Methodology Moody’s Investors Service • 29

SF57011isf
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30 • Moody’s Investors Service European Covered Bond Rating Methodology