OREANDA-NEWS. Fitch Ratings has affirmed HSH Nordbank's (HSH) Long-Term Issuer Default Rating (IDR) at 'BBB-' and Support Rating (SR) at '2'. The Outlook is Negative. Its Viability Rating (VR) was affirmed at 'b', and removed from Rating Watch Positive (RWP). A full list of rating actions is available at the end of this rating action commentary.

The rating action follows the EU's final decision regarding state aid provided to HSH, which was published on 2 May 2016. Under the terms of the decision, the restoration of HSH's EUR10bn guarantee provided by its federal state owners has been finally approved and the bank has been relieved from part of its non-performing legacy assets by an asset transfer to its federal owners and sales to the market. The structure of its guarantee fee obligations has been revised, resulting in a significantly lower future burden but at the cost of a one-off payment of EUR260m.

HSH has undergone material organisational transformation due to a required split into a holding company and an operating subsidiary as a result of the EU's decision on state aid. The operating company will have to be privatised by February 2018 or, if the sale is unsuccessful, wound-down.

KEY RATING DRIVERS

IDRS, SENIOR DEBT AND SUPPORT RATING

The IDRs, senior debt and Support Ratings are driven by support from HSH's owners comprising the federal states of Schleswig-Holstein (AAA) and Hamburg (AAA), the regional savings banks and ultimately the Sparkassen-Finanzgruppe (SFG, A+/Stable) and the Sparkassen (savings banks) and Landesbanken-shared institutional protection fund (Sicherungseinrichtung).

HSH's Long-Term IDR is rated five notches below SFG's Long-Term IDR because the bank's intrinsic weaknesses - even after the measures imposed under the EU agreement - in Fitch's opinion, make support less likely given the private investor test under EU legislation.

Under the EU agreement the operating subsidiary will need to be privatised by end-February 2018. If the privatisation is successful HSH's federal state owners will no longer be majority shareholders and would only be allowed to own a combined share of up to 25% for a period of up to four years, and following a privatisation Fitch would likely consider the public sector owners' stakes in HSH no longer a strategic investment. Although the bidding process has not yet started, we believe that the scope of potential future investors will be limited particularly if the shipping crisis persists or even deteriorates over the next two years.

If a sale is unsuccessful, the bank will have to cease new business activities and manage the assets with a view of winding them down. In this scenario, we expect that the existing owners will have financial and reputational incentives to ensure that the wind-down is managed in a way that senior unsecured creditors do not incur any losses.

The Negative Outlook reflect Fitch's expectation that a sale could result in a downgrade of the IDRs if the new owners have a lower ability or propensity to provide support than HSH's current federal state owners.

VR

HSH's VR primarily reflects Fitch's view that profitability is weak and unlikely to materially improve until the bank's future business model has been decided in the event of a privatisation of HSH.

Profitability will benefit from lower fee payments made by the bank for the guarantee as agreed with the EC. However, HSH had to make a one-off payment of EUR260m to contribute to the establishment of the new holding company and its guarantee payment obligations. HSH's 2015 pre-tax profit of EUR450m was driven by positive one-off effects of the restructuring and the bank reported a pre-tax loss of EUR 36m in 1Q16. We believe that the core bank's profitability will remain low and constrained by uncertain growth prospects until privatisation. Profitability will also depend on the level of loan impairment charges, which could remain volatile given the sizeable shipping portfolio that remains in the core bank.

Asset quality has seen a moderate improvement as a result of increased reserve coverage of impaired loans and the support from the remaining underlying guarantee. According to the EU agreement, HSH has to sell at least EUR2bn assets investors and can transfer non-performing loans with associated exposure at default (EaD) of up to EUR6.2bn to its owners. Both transactions will occur at market prices and the resulting losses will be absorbed by the guarantee.

HSH announced on 30 June 2016 that it had transferred a EUR5bn portfolio of non-performing shipping loans to HSH Portfoliomanagement AoeR, the wind-down entity owned by the federal states, and the sale of a portfolio of currently EUR3.2bn is planned within one year. This portfolio includes shipping, real estate, energy and aviation loans.

Once these transactions have been completed, Fitch estimates that HSH's gross NPL ratio will decline to between 15% and 17% over the course of 2017 from about 26% at end-2015. Despite this improvement, HSH's NPL ratio will likely remain the weakest among the bank's German peers. Even the reduced shipping portfolio will continue to be a material burden on HSH's asset quality despite a significant rise in reserve coverage, which reached about 50% of impaired loans at end-2015, including the effect of the guarantee.

HSH's capitalisation has seen a modest benefit from lower risk-weighted assets (RWAs) and the release of provisions for certain components of the bank's guarantee fees that were converted into CET1 capital. HSH's 11.3% end-1Q16 fully-loaded CET1 ratio compares well with peers' but would be vulnerable to asset quality deterioration.

HSH's funding, particularly long-term US dollar funding, in our view could become more challenging for the bank, but the transfer of assets, many of which are US dollar-denominated, to the federal states will reduce funding requirements substantially. HSH's funding costs could increase as a result of the possible ownership change and become increasingly subject to changes in investor confidence. However, liquidity remains solid and benefits from the portfolio sales.

SUBORDINATED DEBT

HSH's subordinated debt is rated one notch below the bank's VR to reflect higher loss severity versus senior debt obligations.

STATE-GUARANTEED/GRANDFATHERED SECURITIES

The 'AAA' rating of HSH's state-guaranteed/grandfathered senior debt, subordinated debt and market-linked securities reflect the credit strength of the guarantor - the federal state of Schleswig Holstein and the City of Hamburg - and our view that they will honour their guarantees.

RATING SENSITIVITIES

IDRS, SENIOR DEBT AND SUPPORT RATING

HSH's IDRs, senior debt rating and SR are primarily sensitive to the likelihood of a successful privatisation. A sale of HSH or a successful public offering would result in the bank's IDRs being driven either by HSH's VR, in the absence of a sufficiently strong new institutional owner, or by institutional support from a new owner, if the owner is rated higher than HSH's VR at the time and shows a sufficient propensity to provide support.

HSH's IDRs and Support Rating would be downgraded if Fitch concludes that, in the event of a privatisation, institutional support from the new owner would not be sufficiently strong to warrant an IDR of at least 'BBB-'.

If the privatisation is not successful, HSH's shareholder structure will be unchanged and the bank will be wound down. In this case HSH is likely to remain a member of the protection scheme of the Landesbanken (Sicherungseinrichtung), which means that it could continue to receive support from its owners in combination with the SFG to protect senior unsecured bondholders. This would result in the affirmation of its IDR if we conclude that the likelihood of imposing losses on senior creditors during the run down of assets will remain low.

Fitch expects to review HSH's ratings once the bidding process has started to assess whether a sale of the bank is likely to be successful and what the bank's new ownership structure is likely to be. A sale to an individual Landesbank is possible but in Fitch's opinion increasingly unlikely given the sector's challenges and the weak financial profile of the northern German Landesbanken that is HSH, and NORD/LBand BremerLB. We also believe that a sale to a group of Landesbanken is becoming an increasingly remote possibility given the short remaining time to privatisation. We believe such a move could be politically motivated but would require strong political consensus and complex legal execution. We currently have no indication of this materialising.

VR

An upgrade of HSH's VR would be contingent on the confirmation of the long-term sustainability of the bank's business model that will allow the bank to generate adequate profitability. Fitch believes that this would rely on a successful privatisation, and a moderate improvement in the bank's asset quality, capitalisation or profitability alone would not be sufficient for an upgrade of the VR. If HSH is wound-down, we would likely withdraw its VR if we conclude that a stand-alone assessment of the bank is no longer possible, in line with our approach for other wound-down institutions.

STATE-GUARANTEED/GRANDFATHERED SECURITIES

The ratings of HSH's state-guaranteed/grandfathered senior debt, subordinated debt and market-linked securities are sensitive to changes in Fitch's view of the creditworthiness of the guarantors.

SUBORDINATED DEBT

As the ratings are notched off HSH's VR, the subordinated debt ratings are sensitive to a change in the VR or a change in their notching, which could arise if Fitch concludes that loss severity or incremental non-performance risk has increased.

The rating actions are as follows:

HSH Nordbank AG Bank

Long-Term IDR: affirmed at 'BBB-', Outlook Negative

Short-Term IDR: affirmed at 'F3'

Support Rating: affirmed at '2'

Viability Rating: affirmed at 'b', removed from Rating Watch Positive

Long-term senior debt, including programme ratings: affirmed at 'BBB-'

Short-term senior debt: affirmed at 'F3'

State-guaranteed/grandfathered senior and subordinated debt: affirmed at 'AAA'

State-guaranteed/grandfathered market-linked securities: affirmed at 'AAAemr'

Senior market-linked securities: affirmed at 'BBB-emr'

Subordinated debt: affirmed at B-', removed from Rating Watch Positive