A gradual reduction in the available supporting overcollateralisation, along with a lack of explicit commitment to maintaining minimum overcollateralisation above legal levels going forward, may negatively affect the rating.
Scope Ratings has today placed its AA- rating on the public-sector covered bonds (Öffentliche Pfandbriefe) of Dexia Kommunalbank Deutschland GmbH (DKD) under review for possible downgrade.
Supporting overcollateralisation dropped and lacking guidance on sustainable levels
This rating action reflects a drop in supporting overcollateralisation (oc) to 4.3% from 7.6%, below a level supporting the current one-notch uplift factored by Scope into the ratings. It also reflects the absence of capital market communication regarding the levels DKD expects to maintain in its covered bond programme. Scope will resolve the review as soon as practical, by considering any additional information available following discussions with the issuer.
DKD’s covered bond ratings continue to benefit from fundamental credit support factors. These factors include: i) the credit quality of the issuer; and ii) the five-notch fundamental credit support applicable to German public-sector covered bonds issued by DKD.
Cover-pool quality has improved while asset-liability mismatch risk remains high
The overall credit profile of the cover pool has improved when measured by weighted average default risk, but portfolio concentration has increased. By 31 March 2018, DKD had removed Italian, Portuguese and some other international government and sub-sovereign exposures from the cover pool. The transferred assets were part of a portfolio sale to its 100% parent Dexia Credit Locale S.A. (DCL), with the aim of improving the financial position of the bank and reducing concentration risk on non-domestic exposures.
The portfolio changes have resulted in an improvement in the cover pool’s credit quality which Scope assesses, on average, as ‘aa-‘. The cover pool now comprises predominantly German public-sector exposures – with a significant concentration (72.8%) on the top 20 exposures, making credit performance susceptible to single name risk.
Based on scheduled maturities, the covered bond programme remains materially exposed to asset-liability mismatch risk. In a stand-alone scenario, cumulative shortfalls could amount up to EUR 2.6bn.
Assuming the sale of cover assets to mitigate such mismatches, additional cover pool support could no longer be incorporated in the available oc, amounting to 5.2% on a regulatory basis as of 31 March 2018 (equal to 4.3% if the face value of zero bonds is considered). This compares to 8.3% as of 31 December 2017 and similar levels before that. Further, the bank has removed statements on the adequacy of provided oc from its annual report. Scope has also analysed the development of the cover pool on a forward-looking basis, and expects ongoing volatility in the level of supporting oc.
At present, regulatory requirements mitigate existing short-term liquidity risk as the maximum cumulative shortfalls within the next 180 days need to be covered by highly liquid assets. Furthermore, as long as DKD has not been placed under a moratorium, medium-term liquidity risk is mitigated by a significant amount of cover pool assets which the bank could use for European Central Bank repo funding. Lastly, Scope notes that DKD benefits from a legally binding commitment from its parent DCL to make up any liquidity shortfalls.
Quantitative analysis and key assumptions
Scope determined the default distribution for DKD’s public sector pool using a Monte Carlo analysis. In the simulation, we use the individual exposures’ credit quality and apply a correlation framework. Our asset correlations consider a global correlation factor to which we add sector-specific factors reflecting differing transfer mechanisms, oversight and guarantee structures. Applied correlation assumptions range from 30% to 35%. We also consider concentration risk by adding an additional correlation stress for large obligors, namely those exceeding 1%. Scope has made asset per asset default and recovery assumptions, which result in a weighted average default risk equivalent to aa- rating, as well as a weighted average recovery rate of 72% in the rating relevant stress scenario. The resulting non-parametric distribution has a mean default rate of 0.72% with a coefficient of variance of about 283%.
The cash flow analysis incorporates the credit assumption to which we added market and refinancing stresses. We determined that the program is most sensitive to a non-reverting and increasing interest rate development to 10%. Identified foreign exchange risk sensitivities resulted in a depreciation of JPY, SEK and USD denominated cover assets against the EUR denominated covered bonds. Scope assumed currency depreciation stresses up to 77.5%, 35.0% and 88.0% respectively. The agency has also applied an average refinancing spread of 216 bps and a servicing fee of 10 bps. The cash flow analysis is most sensitive against a low prepayment stress (0%).
During the review, Scope will discuss with the issuer its oc management plans going forward and the extent to which investors can rely on oc levels over and above the regulatory minimum requirement of 2%. In the absence of sufficient comfort regarding supporting oc commensurate with the AA- rating, Scope’s rating may be downgraded by one notch.
A reduction of asset-liability mismatch risk or an increase in oc will only result in a maintenance of the current rating, if accompanied by additional public guidance on sustainable oc or risk levels as per above.
Further details, on both Scope’s credit view on the issuer and the fundamental credit support factors for DKD’s public-sector covered bonds, are provided in the 2016 rating report.