Expected Loss Covered Bond Model

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