FINANCIAL INSTITUTIONS CREDIT OPINION 9 January 2018 Update RATINGS Deutsche Hypothekenbank (Actien- Gesellschaft) Domicile Germany Long Term Debt Baa3 Type Senior Unsecured - Dom Curr Outlook Negative Long Term Deposit Baa2 Type LT Bank Deposits - Fgn Curr Outlook Negative Please see the ratings section at the end of this report for more information. The ratings and outlook shown reflect information as of the publication date. Contacts Bernhard Held, CFA 49-69-70730-973 VP – Senior Analyst [email protected]Alexander Hendricks, CFA 49-69-70730-779 Associate Managing Director - Banking [email protected]Carola Schuler 49-69-70730-766 Managing Director - Banking [email protected]CLIENT SERVICES Americas 1-212-553-1653 Asia Pacific 852-3551-3077 Japan 81-3-5408-4100 EMEA 44-20-7772-5454 Deutsche Hypothekenbank AG Update to credit analysis Summary On 12 December 2017, we affirmed the Baa3 senior unsecured rating of Deutsche Hypothekenbank (Actien-Gesellschaft) (Deutsche Hypo) with a negative outlook. The rating action did not affect Deutsche Hypo's Baa2/P-2 deposit ratings, the bank's b2 Baseline Credit Assessment (BCA), ba3 adjusted BCA nor its Baa2(cr)/P-2(cr) Counterparty Risk (CR) Assessments. Deutsche Hypo's ratings reflect (1) its b2 BCA; (2) our assessment that Deutsche Hypo will benefit from affiliate backing from its sole owner in case of need, Norddeutsche Landesbank GZ (NORD/LB, Baa2 negative/Baa3 negative, b2) 1 , leading to the same adjusted BCA as NORD/LB's ba3; (3) the results of our Loss Given Failure (LGF) Analysis, which provide three notches of uplift for deposits and two notches for senior unsecured debt; and (4) our "moderate" government support assumption as part of NORD/LB group, resulting in one notch of rating uplift. Deutsche Hypo's BCA of b2 is capped at the level of the BCA of its parent NORD/LB reflecting the tight interlinkage of the two banks, for instance in the aligned b3 capital score. Deutsche Hypo's financial profile is based on the bank's combined solvency score of ba3 and combined liquidity score of ba2. In addition, Deutsche Hypo's BCA considers its limited diversification due to its monoline business model. Despite low problem loans in comparison with its peers, the bank's solvency score is driven by its sector concentration, vulnerable capital ratios and still low but improving earnings capacity, based on its Commercial Real Estate (CRE) focused business. Exhibit 1 Rating Scorecard - Key Financial Ratios 1.9% 14.3% 0.2% 48.4% 32.9% 0% 10% 20% 30% 40% 50% 60% 0% 2% 4% 6% 8% 10% 12% 14% 16% Asset Risk: Problem Loans/ Gross Loans Capital: Tangible Common Equity/Risk-Weighted Assets Profitability: Net Income/ Tangible Assets Funding Structure: Market Funds/ Tangible Banking Assets Liquid Resources: Liquid Banking Assets/Tangible Banking Assets Solvency Factors (LHS) Liquidity Factors (RHS) Deutsche Hypo (BCA: b2) Median b2-rated banks Solvency Factors Liquidity Factors Source: Moody's Financial Metrics
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FINANCIAL INSTITUTIONS
CREDIT OPINION9 January 2018
Update
RATINGS
Deutsche Hypothekenbank (Actien-Gesellschaft)Domicile Germany
Long Term Debt Baa3
Type Senior Unsecured -Dom Curr
Outlook Negative
Long Term Deposit Baa2
Type LT Bank Deposits - FgnCurr
Outlook Negative
Please see the ratings section at the end of this reportfor more information. The ratings and outlook shownreflect information as of the publication date.
Deutsche Hypothekenbank AGUpdate to credit analysis
SummaryOn 12 December 2017, we affirmed the Baa3 senior unsecured rating of DeutscheHypothekenbank (Actien-Gesellschaft) (Deutsche Hypo) with a negative outlook. The ratingaction did not affect Deutsche Hypo's Baa2/P-2 deposit ratings, the bank's b2 BaselineCredit Assessment (BCA), ba3 adjusted BCA nor its Baa2(cr)/P-2(cr) Counterparty Risk (CR)Assessments.
Deutsche Hypo's ratings reflect (1) its b2 BCA; (2) our assessment that Deutsche Hypo willbenefit from affiliate backing from its sole owner in case of need, Norddeutsche LandesbankGZ (NORD/LB, Baa2 negative/Baa3 negative, b2)1, leading to the same adjusted BCA asNORD/LB's ba3; (3) the results of our Loss Given Failure (LGF) Analysis, which providethree notches of uplift for deposits and two notches for senior unsecured debt; and (4) our"moderate" government support assumption as part of NORD/LB group, resulting in onenotch of rating uplift.
Deutsche Hypo's BCA of b2 is capped at the level of the BCA of its parent NORD/LBreflecting the tight interlinkage of the two banks, for instance in the aligned b3 capital score.Deutsche Hypo's financial profile is based on the bank's combined solvency score of ba3and combined liquidity score of ba2. In addition, Deutsche Hypo's BCA considers its limiteddiversification due to its monoline business model. Despite low problem loans in comparisonwith its peers, the bank's solvency score is driven by its sector concentration, vulnerablecapital ratios and still low but improving earnings capacity, based on its Commercial RealEstate (CRE) focused business.
» Sound asset quality characterised by low nonperforming loan share
» Well-established covered bond funding franchise
» Senior creditors benefit from the broader NORD/LB group's large volume of outstanding debt, as well as subordinated instrumentsin the unlikely event of resolution
Credit challenges
» Tight integration into NORD/LB bears downside potential for Deutsche Hypo's ratings
» CRE-focused business model limits the bank's solvency score
» Strong emphasis on market funding
Outlook
» Deutsche Hypo's ratings carry a negative outlook.
» This mirrors the negative outlook on the ratings of its parent NORD/LB. On 12 December, we affirmed Deutsche Hypo's Baa3senior unsecured rating with a negative outlook. This reflects our view that, once pending BRRD amendments are transposed intoGerman law, unsecured bonds that meet the definition of article 46f of the German banking act (§46f KWG) could rank pari passuwith future junior senior bonds. This may call into question the moderate probability of government support we currently considerwarranted for senior unsecured debt instruments.
Factors that could lead to an upgrade
» There is currently limited upward pressure on the ratings of Deutsche Hypo, as indicated by the negative outlook.
» Given the significant degree of integration into NORD/LB, an improvement in Deutsche Hypo's Financial Profile would not directlytranslate into a higher BCA and long-term debt and deposit ratings.
» Prospectively, Deutsche Hypo's ratings could be upgraded if ownership changes so that the BCA would not have to be cappedprovided other elements of the rating architecture (affiliate support, LGF analysis, government support) would result at least in thesame uplift as at present.
Factors that could lead to a downgrade
» As indicated by the negative outlook, we may downgrade the ratings of Deutsche Hypo if NORD/LB's BCA is downgraded.
» We may also downgrade Deutsche Hypo's BCA if its Financial Profile was to weaken significantly, however, we currently do notexpect this. In the case Deutsche Hypo's BCA is downgraded, we do not expect this to translate into a downgrade of the bank'slong-term ratings, unless its adjusted BCA was also lowered as a result of a BCA downgrade of its parent NORD/LB.
» Further, the long-term debt and deposit ratings of Deutsche Hypo may be downgraded if, at the level of its parent NORD/LB, theamount of equal-ranking or subordinated debt for an individual debt class was to decline beyond current expectations, leading to aless favorable outcome under our Advanced LGF analysis.
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.
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» We may also downgrade by one notch the senior unsecured debt instrument ratings that currently incorporate one notch ofgovernment support if German legislative changes rank outstanding senior unsecured debt instruments pari-passu with futureissuance of junior senior debt. For additional information, please refer to “Moody's affirms 22 German banks' senior unsecured debtratings; changes 16 outlooks to negative” and to “FAQ on credit impact of changes to EU insolvency hierarchy on German bankdebt”.
Gross Loans / Due to Customers (%) - 229.3 191.7 194.2 192.8 202.06
[1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel III - fully-loaded or transitional phase-in; LOCAL GAAP [3] Basel II; LOCAL GAAP [4] May includerounding differences due to scale of reported amounts [5] Compound Annual Growth Rate (%) based on time period presented for the latest accounting regime [6] Simple average ofperiods presented for the latest accounting regime. [7] Simple average of Basel III periods presentedSource: Moody's Financial Metrics
ProfileDeutsche Hypo is a German Pfandbrief bank as defined by the Pfandbrief Act2. Since 2008, the bank has been a wholly ownedsubsidiary of NORD/LB, a commercial bank in northern Germany, and acts as NORD/LB’s centre of competence for the commercialreal estate (CRE) finance business. As of 30 June 2017, Deutsche Hypo reported an unconsolidated asset base of €24.4 billion.
Although Deutsche Hypo operates mainly in Germany, it also conducts business activities in the UK, France, the Benelux countries3 andPoland. It provides a range of banking products and services primarily related to real estate finance, along with capital market activitiesthat include the bank’s reduced public-sector finance array and refinancing through the issuance of Pfandbriefe.
For more information, please see Deutsche Hypo's issuer profile.
Detailed credit considerationsTight integration into NORD/LB bears downside potential for Deutsche Hypo's ratingsNORD/LB currently explores its options for a sale of Deutsche Hypo and expects to decide on a possible sale in early 2018. Recentpress articles indicate that while a final decision by NORD/LB's owners remains pending, the bank's management is inclined to ratherkeep its ownership of Deutsche Hypo. In the case of a successful sale of Deutsche Hypo, we would reconsider the bank's ratingsarchitecture and rating levels according to the information available on its future owner, support arrangements and the bank'sstandalone profile.
Several linkage points currently connect Deutsche Hypo's ratings closely to those of its parent NORD/LB. As part of the BCA, weconsider Deutsche Hypo's capitalisation equivalent to that of its parent NORD/LB and therefore apply NORD/LB's b3 Capital score alsoin Deutsche Hypo's scorecard. Deutsche Hypo has been exempt from compliance with regulatory solvency requirements since 2013as a result of a waiver granted initially by the German Federal Financial Supervisory Authority (BaFin) and confirmed by the European
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Central Bank. Beyond the standalone perspective, the equalisation of Deutsche Hypo's Adjusted BCA to NORD/LB's Adjusted BCAand the assumption of a unique domestic resolution perimeter for the NORD/LB group, including Deutsche Hypo, lead to a closeconnection between NORD/LB's ratings and those of Deutsche Hypo.
NORD/LB's Tangible Common Equity, a key measure of a bank's core capital, slightly recovered to €5.8 billion as of 30 September2017 compared to €5.2 billion as of year-end 2016, before decline from €7.3 billion as of year-end 2015. Third-quarter figures similarlyshowed NORD/LB's regulatory transitional Common Equity Tier 1 (CET1) ratio increased to 12.4%, up 0.5 percentage points since theend of 2016.
Improving earnings and asset quality trendsWe expect Deutsche Hypo's net earnings in 2017 and 2018 to underpin the b1 Profitability score we assign on the basis of a sustainableprofit generation capacity of around 0.2% of tangible assets after taxes (which are centralised at the level of Deutsche Hypo's parent).
We assign a baa3 Asset Risk score to Deutsche Hypo, five notches below the a1 macro-adjusted score outcome of the scorecard. Thenegative adjustment reflects the pronounced focus of Deutsche Hypo on the cyclical segment of commercial real estate lending whichstood at €12.3 billion, as of 30 June 2017. The portfolio remains focused on the domestic market with 59% of overall CRE exposure. Thefact that the bank narrowly concentrates on commercial real estate lending and adjacent activities also leads us to deduct a full notchfrom its financial profile as a qualitative adjustment.
Compared with historic data, Deutsche Hypo's problem loans and associated risk costs remained at a very low level in the first half2017, supporting the reported semi-annual result of €31.2 million. Supported by this benign credit environment, Deutsche Hyporeported a further decline in its nonperforming exposures to €200 million as of end-June 2017 from €229 million as of year-end 2016.
Following the Brexit referendum in the United Kingdom (UK, Aa2 stable), Deutsche Hypo decreased its new CRE business generationin the UK, which accounted for about 12% of the total new CRE exposures in the first six months of 2017 compared to 17% in 2016.We believe the relatively unseasoned exposures underwritten prior to the Brexit vote may expose the bank to somewhat increasedcredit and loan extension risk which may give rise to potential asset quality and liquidity planning challenges in the event of weaker-than-anticipated economic growth. Over the past years, Deutsche Hypo de-risked its activities outside commercial real estate lending,its core area of expertise. The bank significantly reduced its credit derivatives (protection seller) to negligible amounts as of December2016 and its public-sector and financials portfolio, which included relevant exposures to particularly pressured EU countries, continuesto decline towards the range required for liquidity purposes.
Well-established market funding franchise supports net interest income, but Deutsche Hypo's funding diversification islimitedWe assign a Combined Liquidity score of ba2 one notch below the macro-adjusted score. The adjustment mainly reflects that DeutscheHypo is a specialised covered bond issuer with a high level of asset encumbrance. With a €24.4 billion balance sheet as of June 2017,around 53% of total assets are funded through covered bonds. We take comfort from the fact that the bank pursues a strategy oflargely matched funding, facilitated through an independent, domestically and internationally diversified funding franchise in terms offunding tools and regions, including German savings banks.
Deutsche Hypo's access to cost-efficient funding is a key requirement for the bank's business model. However, Deutsche Hypo'sfunding structure is in general geared towards confidence-sensitive wholesale funding sources, which renders the bank susceptible tochanges in investor sentiment and market risk appetite. In the current low yield environment, the bank's market funding franchise offerssignificant funding cost advantages over the deposit-based funding approach of German retail banks.
Deutsche Hypo ensures that it maintains a liquidity cushion that allows it to meet all obligations over at least six months withouthaving to access debt capital markets. The bank had a solid regulatory liquidity coverage ratio of 132% as of June 2017. In cases ofemergency, Deutsche Hypo also has access to short-term liquidity lines with its parent bank NORD/LB.
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Support and structural considerationsAffiliate supportBased on the profit and loss transfer agreement of Deutsche Hypo with its parent NORD/LB and based on the high degree ofintegration, including a regulatory exemption from capital reporting granted for Deutsche Hypo, we consider Deutsche Hypo to be"affiliate backed" by NORD/LB, resulting in its Adjusted BCA being equalised to the ba3 Adjusted BCA of NORD/LB.
Loss Given Failure analysisDeutsche Hypo is subject to the EU Bank Recovery and Resolution Directive, which we consider an Operational Resolution Regime. Weexpect Deutsche Hypo to be included in the resolution perimeter of its parent entity NORD/LB and we therefore apply NORD/LB's LGFanalysis, considering the risks faced by the different debt and deposit classes across the liability structure at failure. We assume residualtangible common equity of 3% and losses post-failure of 8% of tangible banking assets, a 25% run-off in “junior” wholesale deposits,and a 5% run-off in preferred deposits. These are in line with our standard assumptions. In line with the new German insolvencylegislation that effectively subordinates senior bonds and notes to deposits in resolution since January 2017, we base our calculation onthe assumption that deposits are preferred to most senior unsecured debt instruments.
Our LGF analysis of Deutsche Hypo's parent NORD/LB indicates an extremely low loss-given-failure for deposits and senior-seniorunsecured debt, leading us to position their Preliminary Rating Assessments three notches above the bank's ba3 Adjusted BCA.
Our LGF analysis of Deutsche Hypo's parent NORD/LB indicates a very low loss-given-failure for senior unsecured debt, leading us toposition its Preliminary Rating Assessments two notches above the bank's ba3 Adjusted BCA.
Our LGF analysis of Deutsche Hypo's parent NORD/LB indicates a high loss-given-failure for subordinated debt instruments.Accordingly, Deutsche Hypo's subordinated debt is rated at B1, which is one notch below the bank's ba3 adjusted BCA.
Government supportFollowing the introduction of the Bank Recovery and Resolution Directive, we have lowered our expectations regarding the degree ofsupport that the government might provide to a bank in Germany in the event of need. Because of its size on a consolidated basis,we consider Sparkassen-Finanzgruppe (S-Finanzgruppe, Aa2 stable, a24) as systemically relevant and therefore attribute a "moderate"probability of German government support for all members of the sector, in line with our support assumptions for other systemicallyrelevant banking groups in Europe. Therefore, we still include one notch of government support uplift in the senior debt and depositsratings of S-Finanzgruppe member banks that are incorporated in Germany, including Deutsche Hypo.
Counterparty Risk AssessmentCR Assessments are opinions of how counterparty obligations are likely to be treated if a bank fails and are distinct from debt anddeposit ratings in that they (1) consider only the risk of default rather than both the likelihood of default and the expected financial losssuffered in the event of default, and (2) apply to counterparty obligations and contractual commitments rather than debt or depositinstruments. The CR Assessment is an opinion of the counterparty risk related to a bank's covered bonds, contractual performanceobligations (servicing), derivatives (for example, swaps), letters of credit, guarantees and liquidity facilities.
Deutsche Hypo's CR Assessments are positioned at Baa2(cr)/P-2(cr).
The CR Assessment, prior to government support, is positioned three notches above the Adjusted BCA of ba3 based on the bufferagainst default provided to the senior obligations represented by the CR Assessment by more subordinated instruments, includingjunior deposits and senior unsecured debt, within the context of the group liability structure of Deutsche Hypo's parent NORD/LB.
Deutsche Hypo's CR Assessment benefits from one notch of rating uplift based on government support, in line with our supportassumptions on deposits and senior unsecured debt.
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About Moody's bank scorecardOur scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read inconjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our scorecardmay materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strongdivergence). The scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down toreflect conditions specific to each rated entity.
Rating methodology and scorecard factors
Exhibit 3
Deutsche Hypothekenbank (Actien-Gesellschaft)Macro FactorsWeighted Macro Profile Strong + 100%
Business Diversification -1Opacity and Complexity 0Corporate Behavior 0
Total Qualitative Adjustments -1Sovereign or Affiliate constraint: B2Scorecard Calculated BCA range b1-b3Assigned BCA b2Affiliate Support notching 2Adjusted BCA ba3
Balance Sheet is not applicable.
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De Jure waterfall De Facto waterfall NotchingDebt classInstrumentvolume +
Outlook NegativeBank Deposits Baa2/P-2Baseline Credit Assessment b2Adjusted Baseline Credit Assessment ba3Counterparty Risk Assessment Baa2(cr)/P-2(cr)Senior Unsecured -Dom Curr Baa3Subordinate -Dom Curr B1Other Short Term -Dom Curr (P)P-2
PARENT: NORDDEUTSCHE LANDESBANK GZ
Outlook NegativeBank Deposits Baa2/P-2Baseline Credit Assessment b2Adjusted Baseline Credit Assessment ba3Counterparty Risk Assessment Baa2(cr)/P-2(cr)Issuer Rating Baa3Senior Unsecured Baa3Subordinate B1Commercial Paper P-2Other Short Term -Dom Curr (P)P-2
Source: Moody's Investors Service
Endnotes1 The ratings shown are NORD/LB's deposit rating and outlook, its senior unsecured rating and outlook, and its Baseline Credit Assessment.
2 “Pfandbrief Bank” is the term used by the Pfandbrief Act for banks authorised to issue Pfandbriefe, which are debt securities covered by specific assets suchas mortgages on property or loans to local authorities.
3 The Benelux countries are Belgium, the Netherlands and Luxembourg.
4 The ratings reflect S-Finanzgruppe's Corporate Family Ratings and outlook and its baseline credit assessment
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