OREANDA-NEWS. Fitch Ratings has placed Banca Popolare di Milano's (BPM; BB+/RWN/B) EUR3.68bn 'BBB+' mortgage covered bonds (Obbligazioni Bancarie Garantite; OBG) on Rating Watch Negative (RWN).

The rating action follows the RWN that Fitch has placed on BPM's Issuer Default Rating (IDR) on 21 April 2016 (see "Fitch Places BPM on RWN; Changes Popolare's Outlook to Negative" dated 21 April 2016 available on www.fitchratings.com). Fitch will resolve the RWN on BPM's covered bonds following the resolution of the RWN on the bank's IDR.

The RWN on BPM's outstanding OBG directly reflects that on the bank's IDR. The current rating of the covered bonds does not have any buffer against a downgrade of the IDR: all else being equal, if the IDR of BPM is downgraded, the rating of the covered bonds would also be downgraded.

The 'BBB+' rating is based on BPM's Long-term IDR of 'BB+', an unchanged IDR uplift of 0, an unchanged Discontinuity Cap (D-Cap) of 2 (high risk) and the 88% asset percentage (AP) that Fitch takes into account in its analysis, which provides more protection than the unchanged 89% 'BBB+' breakeven AP.

The 88% AP that BPM publicly discloses in its latest monthly test performance report (as of March 2016) allows the covered bonds to achieve a three-notch recovery uplift from the 'BB+' tested rating on a probability of default basis, which is also the rating floor for the covered bonds. This level of AP provides for at least 91% recoveries on the covered bonds assumed to be in default in a 'BBB+' scenario but prevents timely payments above the 'BB+' rating floor.

The greatest contributors to the 'BBB+' breakeven AP (equivalent to an overcollateralisation (OC) of 12.4%) remain asset disposal and cash flow valuation (unchanged at 10.4% and 9.6% respectively). The asset disposal represents a stressed valuation of the cover pool and is driven by the refinancing spreads assumed for Italian residential mortgage loans (375bp at BBB+) and maturity mismatches between assets and liabilities. The weighted average (WA) life of the assets is 9.9 years versus that on the bonds of 3.1 years.

The cash flow valuation is also driven by open interest rate positions, which account for 35% in an increasing interest rate scenario. Fitch assumes optional loans (24.8% of the pool) to switch to a fixed-rate and floating-rate loans with cap (35.3% of the pool) to reach their WA cap. On the liabilities side, the EUR0.88bn fixed-rate covered bonds are hedged via fixed to floating swaps and the cash flows are modelled after the swap.

The cover pool composition is unchanged compared since the last periodic review of the programme (November 2015) and the credit loss component is unchanged at 3.3%.

The D-Cap is unchanged at 2 notches, driven by what Fitch assesses as high risk in the liquidity gap and systemic risk component. The IDR uplift for BPM's covered bonds, which takes into account the exemption of fully collateralised covered bonds from bail-in, remains at 0 as the covered bonds currently do not qualify under Fitch criteria for a higher IDR uplift (see "Covered Bonds Rating Criteria" for more details).

The 'BBB+' rating of the covered bonds would be vulnerable to downgrade if any of the following occurs: (i) Banca Popolare di Milano's Issuer Default Rating is downgraded by one or more notches to 'BB' or below, or (ii) the asset percentage (AP) that Fitch gives credit to increases above the 89% 'BBB+' breakeven AP.

The Fitch breakeven AP for the covered bond rating will be affected, among others, by the profile of the cover assets relative to outstanding covered bonds, which can change over time, even in absence of new issuance. Therefore the breakeven AP to maintain the covered bond rating cannot be assumed to remain stable over time.