OREANDA-NEWS. Fitch Ratings has affirmed Newcastle Building Society's (NBS) Long - and Short-Term Issuer Default Ratings (IDRs) at 'BB+'/'B', its Viability Rating (VR) at 'bb+', its Support Rating at '5' and its Support Rating Floor at 'No Floor'. The Outlook on the Long-Term IDR is Stable.

The rating actions are part of Fitch's periodic review of the UK building societies.

KEY RATING DRIVERS

IDRS, VR AND SENIOR DEBT RATINGS

NBS's IDRs, VR primarily reflect the society's limited franchise and the concentration of its business on the UK housing market. The ratings are also based on low profitability, weak capital generation and the limited ability to absorb unexpected losses as a result. The ratings also consider the society's healthy asset quality, adequate capitalisation, stable funding and sound liquidity.

Asset quality is healthy, with an impaired loans/gross loans ratio of 1.8% at end-2015, but lending is concentrated in UK mortgages. Fitch has revised its assessment of asset quality upwards due to the reduction of impaired loans and conservative levels of provisioning. As a result, the tail risk from unreserved impaired loans has fallen. We consider this to be an important development given the society's still weak internal capital generation.

NBS maintains a strong appetite for high loan-to-value (LTV) mortgages, where spreads are higher. Fitch considers this risk to be well managed with all mortgages with an LTV of over 80% covered by a Mortgage Indemnity Guarantee. While we expect loan-impairment charges (LICs) to rise, we expect them to be maintained at low levels due to sound underwriting standards. The society no longer has any appetite for specialist mortgages or commercial loans and both these books are in run-off.

Fitch believes there will be a gradual return to profitability of the society's member business. While it remains loss-making, losses continue to narrow and we expect this trend to continue over the medium term. NBS has generated weak profitability and capital since the financial crisis as a result of high LICs related to the society's legacy commercial loans, and its large stock of low-risk but low-yielding housing association loans.

The recent improvement in profitability has been driven by lower funding costs and lower LICs. The latter have been falling since 2012, underpinned by a supportive operating environment, sound underwriting and deleveraging of legacy commercial loans. However, underlying profitability is still well below the sector average. As a result, LICs continue to absorb a much higher proportion of pre-impairment operating profit than its peers.

As a fee-driven business, NBS's savings management business, Strategic Solutions, adds diversification to the core member business. Although revenue was negatively affected by lower demand for retail funding in 2014 and 1H15 due to the availability of the UK government's Funding for Lending Scheme (FLS), it has recovered, driven by a larger client base and an increase in deposits as FLS balances reduce. Fitch expects this to continue in 2016 due to a strong pipeline of new business.

Capitalisation is adequate given the society's rating level. Although regulatory capital ratios are in line with higher-rated peers, we consider capitalisation to be weaker at NBS due to the low absolute size of capital and weak internal capital generation. On a non-risk-weighted basis, the society compares well with peers, with a reported leverage ratio of 4.9% at end-2015. Given the society's extremely limited access to capital, the society's capital flexibility will depend on stronger capital generation, aided by the member business returning to sustainable profitability.

Liquidity is sound, although we expect it to gradually reduce as the balance sheet begins to grow. High-quality liquid assets mostly comprise cash at the Bank of England, highly rated RMBS and covered bonds. The society also benefits from access to contingent funding from the Bank of England. Customer deposits account for the majority of the society's funding. The society's loan-to-deposit ratio is low by sector standards, reflecting its limited use of wholesale funding and slow loan growth.

SUPPORT RATING (SR) AND SUPPORT RATING FLOOR (SRF)

NBS's SR and SRF reflect Fitch's view that senior creditors cannot rely on extraordinary support from the UK authorities in the event the society becomes non-viable. In our opinion, the UK has implemented legislation and regulations that provide a framework that is likely to require senior creditors to participate in losses for resolving NBS.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

NBS's subordinated debt is notched down once from the VR for loss severity.

RATING SENSITIVITIES

IDRS, VR AND SENIOR DEBT RATINGS

The society's ratings could be upgraded if its member business returns to sustainable profitability. The extent of any upgrade is limited by the society's small franchise, below-average profitability and, in Fitch's view, an above-average appetite for high LTV lending. An increase in lending to higher-risk segments could put pressure on its ratings or if capitalisation weakens, for example, due to a material deterioration of asset quality.

The VR and IDRs could also be affected by materially adverse developments following the UK decision to leave the EU. A negative rating action could be triggered by a severe and structural deterioration of the UK's operating environment, leading to material downward pressure on profitability, through tighter margins and higher LICs, and weaker asset quality.

SUPPORT RATING AND SUPPORT RATING FLOOR

An upgrade of NBS's SR and upward revision of the SRF would be contingent on a positive change in the sovereign's propensity to support its banks or building societies. This is highly unlikely, in Fitch's view.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

The rating is primarily sensitive to changes in the VR from which it is notched. The rating is also sensitive to a change in Fitch's assessment of the instrument's loss severity, which could reflect a change in the expected treatment of liability classes during a resolution.

The rating actions are as follows:

Long-Term IDR affirmed at 'BB+'; Outlook Stable

Short-Term IDR affirmed at 'B'

Viability Rating affirmed at 'bb+'

Support Rating affirmed at '5'

Support Rating Floor affirmed at 'No Floor'

Subordinated notes affirmed at 'BB'