Fitch Affirms 3 German CRE Lenders
A full list of rating actions is available at the end of this commentary.
KEY RATING DRIVERS AND SENSITIVITIES - PBB'S IDRs, SUPPORT RATING (SR), SUPPORT RATING FLOOR (SRF) AND SENIOR DEBT
The affirmation of PBB's support-driven ratings reflects our view that extraordinary support from the German government would be available if needed. This reflects PBB's indirect 100% state ownership and its status as the largest active Pfandbrief issuer. The 'AAA'-rated German government's strong ability to provide short-term support drives PBB's Short-term IDR of 'F1', which is the higher of two possible Short-term ratings compatible with its Long-term IDR of 'A-'.
The Negative Outlook reflects our view that the propensity of Germany to support PBB will diminish when it sells its stake (planned by end-2015) and that the cost of resolving a failed EU bank is increasingly likely to be taken by shareholders and creditors, including senior creditors if necessary, rather than governments/taxpayers.
PBB's IDRs, SR, SRF and senior debt ratings are also sensitive to any change in our assumptions about the availability of extraordinary sovereign support. The Bank Recovery and Resolution Directive (BRRD), which was implemented in Germany in early 2015, will become an overriding factor in Fitch's support-driven ratings and senior creditors will no longer be able to rely on sovereign support for full repayment.
PBB's SR and IDRs could benefit from institutional support if it becomes majority-owned by a strategic buyer with solid investment-grade ratings and a proven strong ability and credible strong willingness to support. However, this is not our base case. A sale to a financial investor is highly unlikely to bring any benefits in terms of SR as we generally view such investors' ability and commitment to support distressed investments as unreliable.
Consequently, if PBB's re-privatisation materialises as required by the European Commission (EC), we expect to revise its Support Rating to '5' and downgrade its Long-term IDR to the level of its VR of 'bb+'. This would also trigger a downgrade of its Short-term IDR to 'B'.
If the re-privatisation does not materialise by end-2015, we expect the government to opt for an orderly wind-down of PBB under the ownership of FMS Wertmanagement AoeR (FMS WM, AAA/Stable, the government-controlled institution managing the wind-down of HRE group's legacy assets), similar to the decision it took on Depfa Bank plc (BBB+/Negative), PBB's former sister bank, in 2Q14.
In this scenario, we expect state support to remain likely throughout PBB's wind-down process, albeit somewhat constrained by the BRRD and state aid considerations. This would probably trigger a downward revision of the bank's SRF and a downgrade of the Long-term IDR to the 'BBB' category. The new rating level would depend on details of the envisaged long-term wind-down plan, and Fitch's assessment of its feasibility and likely implications thereof for senior unsecured creditors.
KEY RATING DRIVERS AND SENSITIVITIES - PBB'S VR
PBB's VR reflects the bank's gradually improving performance and capitalisation but is constrained by its low profitability and Fitch's view of its earnings prospects. The VR takes into account the bank's track record of several years of solid and stable asset quality, driven by conservative underwriting standards and a focus on a fairly resilient CRE market. At the same time, asset quality still strongly benefits from the transfer of non-performing and legacy assets to FMS WM in 2010 and from unusually benign market conditions in Germany. PBB's VR also reflects improving but still high concentration risk in its large public-sector portfolios.
Solid asset quality has been essential to maintaining adequate risk-weighted capitalisation, as PBB's cash coverage of impaired loans is now significantly lower than its peers', although this is compensated by robust collateral in solid CRE markets, a high portion of restructuring loans and a fairly low non-performing loans (NPL)/total loans ratio. Leverage has also consistently improved, helped by shrinking legacy assets. Leverage remains high, however, and could somewhat constrain management's growth plans.
The VR also reflects Fitch's expectation that operating performance will continue to improve, but that margin pressure is likely to remain high and internal capital generation modest due to strong competition in German CRE lending and a high share of the low-margin public-sector business. A normalisation of loan impairment charges (LICs) from their currently low levels will add pressure to profitability.
While the run-off of legacy assets will provide substantial relief, Fitch is critical of PBB's intention to maintain significant public investment finance as part of its strategic activities. These assets' low margins structurally dilute the bank's overall modest return on assets and tie up significant regulatory capital.
PBB has also substantially consolidated its funding profile. We expect funding costs to remain low in the short term, driven by benign market conditions and PBB's ultimate state ownership. However, PBB's unusually large size as an independent monoline wholesale lender will make it significantly more reliant than its peers on large confidence-sensitive issuance in the public market, despite its fairly well-matched asset-liability maturity.
PBB's stand-alone profile does not yet fulfill all the main characteristics that we generally expect from specialised CRE banks to qualify for an investment-grade VR, especially robust recurring internal capital generation and a crisis-proof, standalone funding franchise. An upgrade of the VR to investment grade would be contingent on more evidence of PBB's long-term ability to successfully operate as an independent lender in the post-crisis environment without the backing of a strong owner.
Similar to most specialised CRE lenders, PBB's VR is primarily vulnerable to asset quality issues, and a reversal of the benign market trend seems unlikely in 2015. A significant increase of funding costs resulting from the re-privatisation could also put pressure on the VR in light of PBB's limited ability to pass them on to its clients amid a highly competitive domestic CRE market that is increasingly dominated by members of large German retail groups with privileged access to cheap and resilient retail funding.
KEY RATING DRIVERS AND SENSITIVITIES - BERLIN HYP'S IDRs, SR AND SENIOR DEBT
Berlin Hyp's IDRs are equalised with those of its ultimate owners, the German savings banks (Sparkassen-Finanzgruppe (Sparkassen), A+/Stable/F1+) and reflect Fitch's view that institutional support would be forthcoming, if needed. Following a reorganisation of Landesbank Berlin Holding AG (LBBH) at end-2014, Berlin Hyp's ownership was transferred from Landesbank Berlin (LBB) directly to LBBH, which is ultimately owned by the Sparkassen. As part of the restructuring, Berlin Hyp entered into a profit-and-loss transfer agreement with LBBH. Berlin Hyp remains a member of the mutual support scheme of the German Landesbanken and is not directly a member of the savings banks' scheme.
The strategic separation of Berlin Hyp and LBB and Berlin Hyp's clearer profile as a strategic partner and central provider of CRE lending within the savings bank group underpin its Long-term IDR as they make it a core subsidiary to the group, in Fitch's view. Berlin Hyp's access to the substantial funding resources of the savings banks underpins its 'F1+' Short-term IDR, the higher of the two possible ratings for an 'A+' Long-term IDR.
Berlin Hyp's IDRs, SR and senior debt ratings are sensitive to changes in our assessment of its ultimate owners' ability or propensity to provide support. A change in the IDRs of Sparkassen would likely be reflected in Berlin Hyp's IDRs and senior debt rating. Berlin Hyp's IDRs are also sensitive to changes in its ownership structure or relationships within the savings bank sector.
KEY RATING DRIVERS AND SENSITIVITIES - BERLIN HYP'S VR
Berlin Hyp's VR is constrained by its capitalisation, which we consider weak for a monoline CRE lender in a new regulatory environment. Despite measures to increase its capital in recent years it mainly relies on profit retention. Fitch expects forthcoming measures by the bank's owners to balance the impact of the portfolio transfer, which will result in higher risk-weighted assets. However, the agency recognises that allocation of capital by Berlin Hyp's direct owner, LBBH, could ultimately be constrained depending on the performance of its sister company, LBB.
The VR also reflects the bank's established company profile and business opportunities arising from its relationships with the savings banks. Its management is seasoned but strategic decision- making can be constrained by the requirement for LBBH's final approval and the need for Berlin Hyp to fit into the broader strategy of the savings bank group. The VR also factors in concentration risks from the monoline, cyclical CRE business. Fitch expects broadly stable performance in 2015 but sees headwinds from the risk of declining loan prolongations or early repayments due to a low interest rate environment. This could challenge Berlin Hyp's loan growth which relies on a continuous flow of new business given its fairly short duration.
Berlin Hyp's VR also reflects the further reduced size in its NPL portfolio and adequate coverage when considering its collateral. The net portfolio transfer of assets from LBB to Berlin Hyp, which is expected to be completed by end-1Q15, will in Fitch's view only have a moderate negative impact on asset quality but also reduce Berlin Hyp's larger exposure to the Berlin area. In Fitch's view, Berlin Hyp may not be able to preserve its conservative risk appetite if it is to overcome the challenging of an environment of lower margins and rising competition. There we expect its risk appetite could deteriorate over time, particularly if growth falls below expectations.
Berlin Hyp's profitability has benefited from stable net interest income and fee income and a low level of LICs in recent years. However, investments into staff and its repositioning mean that its cost base will be permanently higher even as one-off items drop off during the course of the coming year. Fitch nevertheless expects satisfactory earnings for 2015 while recognising that LICs have reached their cyclical low. Below-target growth could also impact Berlin Hyp profitability.
Berlin Hyp's wholesale funding is balanced by its diversified investor base and strong placement capacity in the savings bank sector and regular Pfandbrief issuance. Its share of unsecured funding issuance has risen in recent years and in 2015 is likely to exceed its covered bond issuance for the first time. This is mainly due to a higher volume of maturing unsecured bonds and demand from savings banks, which do not have to allocate risk capital to investments in Berlin Hyp issuance.
Berlin Hyp's VR is negatively sensitive to stress in related property markets, primarily offices and residential or large single credit events, which could feed directly into capital. However, Fitch does not see this as an immediate risk as long as interest rates remain low. Loosening of conservative underwriting standards could also negatively impact the VR.
Berlin Hyp's VR could benefit from business growth and revenue improvement in light of its higher cost base. Its VR could also be upgraded if Berlin Hyp increases its capital to bolster its loss-absorbing capacity.
KEY RATING DRIVERS AND SENSITIVITIES - DHB'S IDRs, SR, SRF AND SENIOR DEBT
DHB's SRF of 'BBB-' reflects the track record of systemic support available even to small specialised German Pfandbrief issuers. At the same time, the Negative Outlook on the bank's support-driven Long-term IDR reflects our view that implementation of the bank resolution framework in Germany will reduce sovereign support for banks in the country as in other EU member states. Germany has implemented the BRRD into national law including early adoption of the bail-in tool.
However, Fitch expects DHB to continue to benefit from German private sector banks' voluntary deposit protection fund's (DPF) extensive coverage even after DHB's planned change of ownership. In light of this, Fitch considers DPF to have strong incentives to extend support to DHB if necessary. Consequently, while Fitch expects a revision of DHB's SRF to 'No Floor' by end-1H15, sovereign support is likely to be replaced with potential institutional support from DPF, which will likely limit the downgrade of the bank's SR to '3' rather than '5'.
Given DHB's low VR of 'ccc', Fitch's view of the reduced support likelihood would trigger a downgrade of its Long-term IDR to as low as 'BB-'. Fitch will publish shortly a special report outlining its approach to factoring in potential support from the DPF for small German banks in the BRRD environment.
DHB's sale to a group of European financial investors was agreed in August 2014 and is still pending regulatory approval. In Fitch's view, it is highly uncertain whether this sale will address DHB's severe capital and funding weaknesses, and the agency generally considers financial investors' ability and propensity to support banks as unreliable. Therefore, Fitch does not expect the sale to affect the bank's ratings. The agency believes that the combination of the bank's weaknesses and the nature of the buyer could significantly delay the regulatory approval of the sale.
KEY RATING DRIVERS AND SENSITIVITIES - DHB'S VR
DHB's VR is primarily constrained by severe capital and funding weaknesses. The bank strengthened its thin regulatory capital in 2013 and 2015 by converting hybrid capital to equity. However, this measure has provided only temporary relief.
Fitch believes that DHB's recurring losses make a more significant capital injection necessary in the medium term to enable its transition to a viable CRE lender, and thus ensure its viability. Otherwise, the agency expects its Basel III risk-adjusted capitalisation to fall short of regulatory and market expectations in the next few years once its growing CRE loan book gradually increases risk weighted assets beyond capital growth. Leverage remains tight as the run-off of its low-risk-weighted public-sector assets is slowing, complicating the transition to Basel III.
DHB's VR also reflects its large exposure to the eurozone periphery, which drives large unrealised valuation losses and single-event risk, despite the bank's generally decreasing exposures to low-margin, long-term legacy financial- and public-sector assets and interest rate derivatives. Moreover, management will face considerable challenges in the medium term, notably due to margin pressure, as it attempts to establish a sustainable and profitable CRE lending franchise. DHB has made significant progress in focusing on CRE lending since 2010. Its realignment has been protracted due to the very long residual maturities of its legacy assets, which still account for about 75% of its total assets.
DHB's asset-based lending model ensures resilient access to the Pfandbrief market, repo and institutional deposits covered by the DPF. As a result, its unsecured, non-DPF covered funding needs are modest. Combined with its ongoing balance sheet shrinkage, this somewhat mitigates its reliance on wholesale market funds and its tight liquidity buffer. However, DHB remains heavily reliant on DPF's coverage to attract the unsecured funding necessary to fund its Pfandbriefe's over-collateralisation and non-Pfandbrief-eligible assets.
An upgrade of DHB's VR into the 'b' category would be contingent on a large capital injection and a restructuring of its unsecured funding mix toward longer-term maturities. However, the new owners have yet to declare their intention, and their ability to make such contributions remains untested. An upgrade would also be contingent on further significant risk reduction in DHB's legacy portfolio and a return of sustained profitable performance. Conversely, the absence of capital injection to compensate the expected continued erosion of DHB's capital makes failure a distinct possibility. Operations are also highly vulnerable to any reduced access to insured deposits by the DPF.
KEY RATING DRIVERS AND SENSITIVITIES - PBB'S SUBORDINATED AND HYBRID SECURITIES
PBB's lower Tier 2 subordinated notes are notched down from its VR once to reflect their higher loss severity relative to the bank's senior unsecured obligations. The affirmation at 'C' of the EUR350m legacy hybrid Tier 1 securities issued through Hypo Real Estate International Trust I reflects the uncertain likelihood and timing of these securities being serviced again. The EC's agreement to HRE group's 2008 bailout by the German government forbids voluntary profit-driven distribution on capital instruments (excluding SoFFin-related ones) prior to re-privatisation. The subordinated debt and hybrid ratings are sensitive to potential changes to PBB's VR.