Rating Action

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.

Rating Rationale

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%).

Rating-change drivers

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. 

Stress testing
No stress testing was performed.

Cash flow analysis
In order to determine the cover pool supported rating uplift, Scope performed a cash flow analysis to establish 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 applies rating distance dependant stresses to simulate the impact of increasing credit and market risks to these cash flows. The cash flow analysis also includes the impact of stressed asset sales or other variables such as changing prepayment speeds or servicing costs.

Methodology
The methodologies used for this rating and outlook are: “Covered Bond Rating Methodology”, published July 2017; “General Structured Finance Rating Methodology”, published August 2017 (for the translation of the expected loss into ratings) and Methodology for Counterparty Risk in Structured Finance, published August 2017 (for account banks).
For the private credit rating of the issuer we also applied the principles contained in the “Bank Rating Methodology” dated 9 May 2018. The methodologies are available on www.scoperatings.com.
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.

Solicitation, key sources and quality of information
The rated entity participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
The rating analysis was prepared by Karlo Fuchs, Executive Director.
Responsible for approving the rating: Guillaume Jolivet, Managing Director.
The rating was first released by Scope on 04.05.2016.

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
© 2018 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5 D-10785 Berlin.

Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Director: Torsten Hinrichs.