Scope Ratings (Scope) has today affirmed its AAA rating with Stable Outlook on Deutsche Bank AG’s mortgage-covered bonds (Hypothekenpfandbriefe). The covered bond rating incorporates the support provided by the cover pool.

On 16 November 2017 Scope downgraded Deutsche Bank’s issuer rating to BBB+. Any negative impact on the bank’s mortgage-covered bonds has been mitigated by the cover pool, which Scope analysed based on public information as of 30 September 2017. The covered bond ratings are driven by the bank’s credit quality, further enhanced by:

1. fundamental credit support factors, which provide a six-notch uplift above the bank’s credit quality; and
2. overcollateralisation, which fully mitigates credit and market risks under stressed assumptions, supporting a seven-notch uplift above the bank’s credit quality. 

Issuer downgrade to BBB+ prompted by less reassuring financial recalibration

The issuer downgrade reflects that Deutsche Bank’s business-model and financial recalibration remains less reassuring and is taking longer than anticipated. In addition, Scope considers that the implementation of a less complex business model would take longer to result in higher sustained profitability and the ability to pursue organic capital formation.

However, Scope notes that increased capitalisation has shored up confidence, further supported by improved transparency on the part of the management. For further details see ‘Scope downgrades Deutsche Bank’s ratings (Issuer Rating to BBB+); Stable Outlook’ and the issuer report.

Legal framework and resolution regime assessment provides six-notch credit differentiation

Fundamental credit support factors provide the covered bond ratings with a six-notch uplift above Scope’s issuer rating. Two notches of the uplift are driven by the agency’s analysis of the German legal covered bond framework; 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 and fulfils most of the European Banking Authority’s best-practice provisions. In addition, Scope does not expect to change this assessment once regulations based on European Commission principles are published in Q1 2018, as these will broadly reflect standards already met today.

Scope assigns 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 the Deutsch 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 the highest-quality fixed income instrument.

Cover pool adds additional support, but uplift limited

Scope’s covered bond ratings also incorporate one additional notch of cover pool support. Scope has analysed the covered bond programme’s credit and cash flow characteristics based on public reporting as of 30 September 2017 issued in accordance with the German Covered Bond Act.

Credit risk in the cover pool
The largest part of the EUR 9.2bn cover pool comprises residential and fixed-rate assets (60% and 98.6% respectively) with an average weighed loan-to-value ratio of a moderate 53.5%. In addition, 30% of the pool also consists of commercial assets, including about 26% of multifamily housing, as well as 2.8% of substitute assets. Based on comparable German cover pools rated by Scope, the agency has established conservative projections of cover pool default, 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 13.5% and a coefficient of variation of 55%. In order to support maximum cover pool uplift Scope applied a stressed recovery rate of 67%. This translates into a mean loss rate of 4.4% in stressed recovery scenarios. 11% of the cover pool can absorb the impact of projected losses arising from the application of stresses supporting the maximum achievable uplift, i.e. seven notches above the credit quality of the issuer.

Cash flow risk assessment
The covered bond programme benefits from overcollateralisation of 26.5% on a nominal basis. Scope has established that a minimum 18.5% of overcollateralisation provides a one-notch cover pool-based rating uplift. As Scope used public information to assess credit and cash flow risks, the cover pool-based uplift is limited to one notch above that provided by fundamental support factors. This reflects, among other things, the absence of public statements on the bank’s minimum overcollateralisation and a more detailed information on the bank’s cover pool management strategy. Scope views positively that overcollateralisation has generally remained well above the level commensurate with the one-notch uplift.

Scope observes a moderate maturity mismatch between the assets and covered bonds of about two years (1.3 years on a duration basis). Interest rate risk is low in the cover pool as most assets and liabilities are fixed rate (98.6% and 93.7% respectively). In addition, assets and liabilities are fully euro-denominated and do not, therefore, pose foreign exchange risk.

Scope uses expected cash flows and applies credit- and market-risk stresses commensurate with the highest possible uplift. In the event that redemptions are insufficient to repay interest or principal due, Scope assumes remaining assets will be sold. For the asset sale, Scope has added to its discount rate a blended liquidity premium of 200 bps and servicing fee of 27 bps.

Stable Outlook

The Stable Outlook on the covered bonds reflects Scope’s expectation of a stable credit performance for both the bank and its mortgage assets. The Outlook also reflects Scope’s belief that the issuer will maintain overcollateralisation in line with past levels and not materially change the cash flow maturity structure of the covered bonds.

Rating-change drivers

The rating cannot be further improved by positive changes to the issuer rating, reduced credit or market risks, or higher overcollateralisation.

The covered bond rating could be negatively impacted by changes to Scope’s credit view and Outlook on the issuer. The covered bond rating incorporates the maximum uplift for covered bonds as supported by a cover pool analysis based on public information.

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.

Fundamental support factors effectively provide a floor for the covered bond rating. Credit-negative changes in the cover pool’s risk profile would, at most, result in a one-notch downgrade, assuming an unchanged issuer rating.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.

The rating analysis has been prepared by Karlo Fuchs, Executive Director. Responsible for approving the rating: Guillaume Jolivet, Managing Director

The rating was first assigned by Scope on 22 September 2015.

Methodology
The principle methodology applicable for the covered bond rating is the ‘Covered Bond Rating Methodology’, published July 2017. Scope also applied the principles listed in the ‘Rating Methodology for Counterparty Risk in Structured Finance Transactions’, published August 2017, and the ‘General Structured Finance Rating Methodology’, published August 2017.

Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.

The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Stress testing & cash flow analysis
No stress testing was performed.

In order to establish the rating uplift supported by the cover pool, Scope performed a cash flow analysis to determine an expected loss for the covered bonds. The cash flow analysis uses the scheduled cash flows of the cover assets and covered bonds as a starting point. Scope applied rating distance-dependant stresses to simulate the impact of increasing credit and market risks on these cash flows. The cash flow analysis also incorporates the impact of stressed asset sales or other variables such as changing prepayment speeds or servicing costs.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following substantially material sources of information were used to prepare the credit rating: public domain, third parties and Scope internal sources.

Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.

Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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