Covered bond rating action follows corresponding action on Deutsche Bank’s issuer rating.
Scope Ratings has today affirmed its AAA ratings on Deutsche Bank AG’s mortgage-covered bonds (Hypothekenpfandbriefe).
The agency has also changed the Outlook to Negative.
Todays ratings action is driven by the seven-notch uplift above Deutsche Bank’s issuer rating (BBB+/Negative) justified by fundamental and cover pool support. The change to Negative of the Outlook on the covered bonds mirrors the Outlook on the issuer. Ceteris paribus, a negative change in the issuer rating could prompt a rating action on the covered bonds.
Scope changed its Outlook on Deutsche Bank’s issuer rating of BBB+ to Negative on 6 June 2018. The agency’s action on the long-term rating Outlook reflects its view that Deutsche Bank’s issuer rating remains fraught with uncertainties around its multi-year effort to recalibrate its business model (see ‘Scope changes Deutsche Bank’s rating Outlook to Negative from Stable (Issuer Rating at BBB+)’).
Scope’s updated analysis of Deutsche Bank’s mortgage-covered bond programme supports the current ratings. The covered bond ratings incorporate the higher uplift provided by:
- fundamental credit support factors, allowing for a six-notch uplift above the bank’s rating; and
- cover pool support of seven notches reflecting available overcollateralisation which mitigates credit and market risks under stressed assumptions. Scopes cover pool analysis is based on publicly available information and therefore only allows for an uplift one notch higher than fundamental credit support.
Supportive legal framework and resolution regime provide six-notch credit differentiation
Fundamental credit support factors provide the covered bond ratings with a six-notch uplift above Deutsche’s issuer rating. Two notches of the uplift are driven by the agency’s analysis of the German legal covered bond framework; and four notches by the benefits of the resolution regime combined with the systemic importance of both the issuer and the product.
Germany’s legal covered bond framework meets all provisions relevant to establishing and maintaining a high-quality cover pool that remains available after potential issuer insolvency, supporting the two-notch uplift. Scope notes that the German covered bond framework is among the most detailed and regularly updated worldwide. The rating agency does not expect potential amendments to comply with the European Commission’s covered bond harmonisation directive to impact this assessment.
The covered bond rating incorporates four additional notches of credit support for issuer- and country-specific benefits provided by the resolution regime and the systemic importance of covered bonds in Germany. This reflects: i) the covered bonds’ exclusion from a bail-in in the hypothetical scenario of the bank experiencing regulatory intervention; ii) Scope’s view on the bank’s resolvability, reflecting the ability of regulators to apply available resolution tools to the issuer’s liabilities and equity, combined with Deutsche Bank’s status as a globally systemically important bank; iii) the flagship status of German covered bonds, their importance to domestic banks as a refinancing tool and strong presence in investor portfolios; and iv) the active and combined efforts of the domestic stakeholder community to maintain German covered bonds as a fixed income instrument of the highest quality.
Cover pool support as primary rating driver but uplift limited
Deutsche Bank’s covered bond ratings incorporate one notch of cover pool support on top of fundamental credit support. Scope analysed the covered bond programme’s credit and cash flow characteristics based on public information as of 31 March 2018. The cover pool characteristics provided are based on 30 June 2018 reporting as no material changes had been made to the composition at the time of the analysis.
Limited credit risk in the cover pool and cash flow risks contained
The largest part of the EUR 9.9bn cover pool comprises residential mortgage loans (61%) followed by commercial assets (36% also including 26% of multifamily housing), as well as 2.8% of substitute assets. The cover pool is highly granular with 72% of the exposures below EUR 300,000 and an average weighted loan-to-value ratio of a moderate 53.3%.
As of 30 June 2018, the covered bond programme benefits from overcollateralisation of 28.6% on a nominal basis. Scope has established that a minimum 22.5% of overcollateralisation supports the cover pool-based rating uplift. Scope observes a maturity mismatch between the assets and covered bonds of about two years (2.5 years on a duration basis). Interest rate risk is low in the cover pool as most assets and liabilities are fixed rate (98.9% and 4.3%% respectively). In addition, assets and liabilities are fully euro-denominated and do not, therefore, pose foreign exchange risk.
Quantitative analysis and key assumptions
Scope established conservative projections of cover pool default, based on comparable German cover pools rated by the agency, using an inverse Gaussian distribution The consolidated segment-specific default and recovery assumptions used in the analysis consist of a weighted average mean default rate of 10% for the residential sub-portfolio and 20% for the commercial assets with a coefficient of variation of 60% and 50% respectively.
Scope applied a weighted average stressed recovery rate of 52%. This translates into a mean loss rate of 6.0%. For the asset sale, Scope has added to its discount rate a blended liquidity premium between 125bps for substitute assets and up to 300bps for commercial loans. Servicing fees were assumed to be of 23 bps. In the stressed analysis, Scope used a low prepayment rate scenario (0%) together with a rising interest rate scenario after the second year.
Scope analysed the substitute assets accounting for 10% of total assets by applying its portfolio model resulting into a non-parametric distribution with a mean default rate of 1.5% and a coefficient of variation of 323%.
Rating Change Driver
Considering the current fundamental and cover pool support, a downgrade of the issuer rating could cause a downgrade of the covered bond rating. The cover pool analysis-based uplift is currently limited to one notch above that provided by fundamental support factors because Scope used public information to assess credit and cash flow risks. Further, it reflects the absence of public statements on the bank’s minimum overcollateralisation and detailed information on the bank’s cover pool management strategy.
Negative rating changes could also be prompted by excessive increases in the cover pool’s risk profile or a reduction in overcollateralisation below the level needed to support the rating. Overcollateralisation has generally remained above the level commensurate with the one-notch uplift, which Scope views positively. Moreover, fundamental support factors provide a floor for the covered bond rating. Credit-negative changes in the cover pool’s risk profile would, in themselves, result in a one-notch downgrade at most, assuming an unchanged issuer rating.
Additional information regarding credit and cash flow risks as well as the management of of the cover pool risks could lead Scope to revise the analysis and consider higher cover pool support up to a maximum of nine notches above the issuer rating and up to three notches above the fundamental support.