Fitch Affirms PBB at 'A-' & Upgrades VR to 'bb+'; Withdraws HRE Holding's Ratings

FRANKFURT & LONDON--()--Fitch Ratings has affirmed Hypo Real Estate Holding AG's (HRE Holding) and its subsidiary Deutsche Pfandbriefbank AG's (PBB) Long-term Issuer Default Ratings (IDR) at 'A-' with Negative Rating Outlooks. Fitch has also upgraded PBB's Viability Ratings (VR) to 'bb+' from 'bb' and withdrawn HRE Holding's ratings. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS - IDRs, SUPPORT RATINGS, SUPPORT RATING FLOORS (SRF) AND SENIOR DEBT

The affirmation of PBB's and HRE Holding's support-driven ratings reflects Fitch's 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 one of the largest active Pfandbrief issuers. HRE Holding's ratings were aligned with PBB's since Fitch believes that capital support from the state to PBB until its planned reprivatisation would flow through HRE Holding.

The 'AAA'-rated German government's strong ability to provide short-term support drives both banks' Short-term IDRs of 'F1', which is the higher of two possible at the Long-term IDR of 'A-'.

The Negative Outlook reflects Fitch's view that the propensity of Germany to support HRE and 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.

KEY RATING SENSITIVITIES - IDRs, SUPPORT RATINGS, SUPPORT RATING FLOORS (SRF) AND SENIOR DEBT

PBB's IDRs, Support Rating, SRF and senior debt ratings are sensitive to any change in Fitch's assumptions about the availability of extraordinary sovereign support.

The Bank Recovery & Resolution Directive (BRRD), which will be implemented in Germany in 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 Support Rating and IDRs could benefit from institutional support if it becomes majority-owned by a strategic buyer with solid investment-grade ratings and which Fitch estimates to have a proven strong ability and credible strong willingness to support. However, this is not Fitch's base case.

A sale to a financial investor is highly unlikely to bring any benefit in terms of Support Rating as Fitch generally view such investors' ability and commitment to support distressed investments as unreliable.

Consequently, if PBB's reprivatisation materialises as required by the European Commission (EC), Fitch expects to revise its Support Rating to '5' and downgrade its Long-term IDR to the level of its VR. This would also trigger a downgrade of its Short-term IDR to 'B'.

If the reprivatisation does not materialise, Fitch expects the government to opt for an orderly wind-down of PBB under the ownership of FMS Wertmanagement AoeR (FMS WM, 'AAA'/Outlook Stable, the government-controlled institution which manages the wind-down of a large share of HRE group's assets), similar to the decision it took on Depfa Bank plc ('BBB+'/Outlook Negative), PBB's sister bank, in 2Q14. In this scenario, Fitch expects 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 Long-term IDR to the 'BBB' category, subject to sufficient details on the envisaged long-term wind-down plan and likely implications thereof for senior unsecured creditors.

HRE Holding is a financial holding company without any banking operations of its own. Through HRE Holding, SoFFin (the government's Financial Market Stabilisation Fund) controls the HRE group's two main operating subsidiaries, PBB and Depfa.

The withdrawal of HRE Holding's ratings reflects Fitch's opinion that the ratings are no longer relevant to Fitch's coverage. Depfa's transfer to FMS WM from HRE Holding is planned to take place by end-2014 (see 'Fitch Affirms Depfa at 'BBB+' On Announced Transfer to FMS WM', dated 20 May 2014) and the government intends to privatise PBB in 2015. Therefore, Fitch expects HRE Holding to be eventually wound down. HRE Holding has no debt outstanding.

KEY RATING DRIVERS - VRs

The upgrade of PBB's VR reflects the gradual improvement of the bank's business profile in the last three years as Fitch expects further normalisation in 2015.

PBB has built up a track record of several years of solid and stable asset quality. Fitch believes this is partly driven by disciplined adherence to conservative underwriting standards and a focus on relatively resilient markets for new CRE business. At the same time, asset quality still strongly benefits from the transfer of a large share of PBB's non-performing and legacy assets to FMS WM in 2010 and from the unusually benign market conditions (strong demand supporting asset valuation) prevailing in Germany, which accounts for half of total CRE exposure.

Fitch expects the currently extremely low and clearly unsustainable loan impairment charges (LICs, close to nil for the fourth consecutive year) to normalise in the medium term considering the cyclical nature of property markets, even though Fitch's base case is not a rapid or severe deterioration.

The upgrade of PBB's VR also reflects a significantly improving concentration risk in its large public-sector portfolios (both legacy and strategic). Concentration remains very high, however, with single exposures equivalent to a high share of its Fitch Core Capital. But this does not constrain the VR at the current level as the largest single exposures are to national or local public authorities in investment-grade rated countries.

Solid asset quality has been essential to maintain adequate risk-weighted capitalisation, as PBB's cash coverage of impaired loans by loan loss provisions is now significantly lower than those of its German peers, although this is adequately compensated by robust collateral coverage in solid CRE markets and by the solid NPL ratio.

Fitch's view that PBB's loss-absorption buffer is adequate is confirmed by HRE group's solid outcome in the ECB's recent comprehensive assessment despite a severe impact (580bp) on the group's CET1 ratio in the adverse stress scenario, reflecting conservative stress assumptions regarding CRE assets.

PBB's leverage has also constantly improved, helped by shrinking legacy assets, although these will continue to represent a large share of the bank's exposures at default in the foreseeable future. Leverage remains high, however, and could somewhat constrain management's growth plans. Inefficient allocation of regulatory capital driven by large CRR-driven CVA surcharges applying to the low-margin public-sector portfolio since 2014 may also add to this constraint, although the shrinkage of legacy public-sector assets will provide gradual relief.

The VR upgrade also reflects Fitch's expectation that operating performance will continue to improve, even though internal capital generation is likely to remain modest due to margin pressure driven by strong competition in German CRE lending, the high share of very low-margin public-sector business, and a normalisation of LICs.

While the run-off of legacy assets will provide substantial relief, Fitch views critically PBB's intention to maintain significant public investment finance as part of its strategic activities. As PBB intends to focus on lending with full recourse to public-sector sponsors, Fitch expects credit risk to be limited but margins to remain low. This will structurally dilute the bank's overall modest return on assets and tie in significant regulatory capital. In the context of PBB's reprivatisation, Fitch also views as questionable the appetite of potential buyers for low-yielding public-sector assets, which, in Fitch's view, are unlikely to be able to earn their cost of capital in a post-crisis regulatory environment that generates constantly increasing demands on capitalisation.

PBB has also made substantial progress in consolidating its funding profile in the last few years. Fitch expects funding costs (unsecured and, particularly, Pfandbriefe) to remain very low in the short term, driven by benign market conditions.

However, Fitch would expect PBB to build up a track record of substantial long-term unsecured issuance under its new owner as one of the conditions to envisage an upgrade of its VR into the investment grade category. PBB has a well-established Pfandbrief franchise and a large share of its unsecured funding is raised via private placements. However, the bank's unusually large size as an independent monoline wholesale lender will make it significantly more reliant than its domestic peers on large confidence-sensitive issuance in the public market.

The extent to which PBB will be able to attract sufficient demand for unsecured funding (and, by extension, subordinated or additional tier 1 issuance if ever envisaged) under sustained unfavourable conditions while maintain funding spreads that do not jeopardise its modest profitability is therefore uncertain. This, however, is mitigated by PBB's fairly well-matched asset-liability maturity profile, which should allow it to withstand realistic disruptions of the unsecured funding markets. PBB has also issued unsecured debt in the public markets (including benchmarks) since 2013 with maturities beyond its reprivatisation deadline of end-2015, albeit not yet on a regular basis or under favourable market conditions.

KEY RATING SENSITIVITIES - VRs

PBB's stand-alone profile does not yet fulfill all the main characteristics that Fitch generally expects from specialised commercial real estate (CRE) banks to qualify for an investment-grade VR. In particular, its internal capital generation remains modest, partly due to its low-margin legacy public-sector assets and despite benign market conditions, especially in Germany. In addition, the bank has yet to demonstrate that its funding franchise is crisis-proof on a standalone basis. Similarly, its asset base has yet to be tested by a first cyclical downturn in Germany since the 2010 balance sheet clean-up.

Fitch would require 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 before considering an upgrade of the VR to investment grade.

Similar to most specialised CRE lenders, PBB's VR is primarily vulnerable to asset quality issues. A reversal of the current benign market trend seems unlikely in 2015, even though the combination of several drivers might increase risk in the medium term in the domestic CRE market: low interest rates disconnect from the solid economy; strong inflows of foreign investments; strong demand from households for residential assets, which increase the risk of overheating in some German urban areas; and cheap funding, which creates an incentive to underprice credit risk.

A significant increase of funding costs resulting from the reprivatisation 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 increasingly dominated by members of large retail groups with privileged access to cheap and resilient retail funding. Fitch expects PBB's online retail deposit collection initiated in 2013 to remain merely a source of diversification rather than becoming a key pillar of its funding mix.

KEY RATING DRIVERS - SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

The upgrade of the LT2 subordinated debt instruments mirrors the VR upgrade as Fitch notches these instruments from the VR once to reflect their higher loss severity, in line with the relevant criteria.

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 of the HRE group's 2008 bailout by the German government forbids voluntary profit-driven distribution on capital instruments (excluding SoFFin-related ones) prior to reprivatisation.

RATING SENSITIVITIES - SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

Subordinated debt ratings and hybrid ratings are sensitive to potential changes to the banks' respective VRs.

Fitch has taken the following rating actions:

Deutsche Pfandbriefbank AG:

Long-term IDR: affirmed at 'A-', Outlook Negative

Short-term IDR: affirmed at 'F1'

Viability Rating: upgraded to 'bb+' from 'bb'

Support Rating: affirmed at '1'

Support Rating Floor: affirmed at 'A-'

Commercial paper: affirmed at 'F1'

Debt Issuance Programme: affirmed at 'A-'/'F1'

Senior unsecured notes: affirmed at 'A-'

Short-term debt: affirmed at 'F1'

LT2 Subordinated debt: upgraded to 'BB' from 'BB-'

Hypo Real Estate International Trust I (XS0303478118) Tier 1 securities: affirmed at 'C'

Hypo Real Estate Holding AG:

Long-term IDR: affirmed at 'A-', Outlook Negative and withdrawn

Short-term IDR: affirmed at 'F1' and withdrawn

Support Rating: affirmed at '1' and withdrawn

Support Rating Floor: affirmed at 'A-' and withdrawn

Additional information is available at 'www.fitchratings.com'.

Applicable criteria, 'Global Financial Institutions Rating Criteria' and 'Assessing and Rating Bank Subordinated and Hybrid Securities', dated 31 January 2014 are available at www.fitchratings.com.

Applicable Criteria and Related Research:

Global Financial Institutions Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397

Assessing and Rating Bank Subordinated and Hybrid Securities Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732137

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=957215

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Contacts

Fitch Ratings
Primary Analyst
Patrick Rioual, +49 69 76 80 76 123
Director
Fitch Deutschland GmbH
Taunusanlage 17
60325 Frankfurt am Main
or
Secondary Analyst
Sebastian Schrimpf, +49 69 76 80 76 136
Analyst
or
Committee Chairperson
Erwin van Lumich, +34 93 323 8403
Managing Director
or
Media Relations, London
Elaine Bailey, +44 203 530 1153
elaine.bailey@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Patrick Rioual, +49 69 76 80 76 123
Director
Fitch Deutschland GmbH
Taunusanlage 17
60325 Frankfurt am Main
or
Secondary Analyst
Sebastian Schrimpf, +49 69 76 80 76 136
Analyst
or
Committee Chairperson
Erwin van Lumich, +34 93 323 8403
Managing Director
or
Media Relations, London
Elaine Bailey, +44 203 530 1153
elaine.bailey@fitchratings.com