Transaction Update: NORD/LB Luxembourg S.A. Covered Bond Bank (Public Sector Covered Bond Program)

Transcription

1 Transaction Update: NORD/LB Luxembourg S.A. Covered Bond Bank (Public Sector Covered Bond Program) 7. 5 Billion Public Sector Covered Bond Program (Lettres de Gage Publiques) Primary Credit Analyst: Casper R Andersen, London (44) ; casper.andersen@standardandpoors.com Secondary Contact: Judit O Woelk, Frankfurt (49) ; judit.woelk@standardandpoors.com Table Of Contents Major Rating Factors Outlook Rationale Program Description Rating Analysis Related Criteria And Research JANUARY 21,

2 Transaction Update: NORD/LB Luxembourg S.A. Covered Bond Bank (Public Sector Covered Bond Program) 7. 5 Billion Public Sector Covered Bond Program (Lettres de Gage Publiques) Ratings Detail Major Rating Factors Strengths Available credit enhancement exceeds target credit enhancement for maximum collateral-based uplift. Self-commitments by the issuer regarding liquidity risk management and maintenance of overcollateralization. Benefits of strong jurisdictional support in Luxembourg. Weaknesses High share of non-local and regional government public finance assets, which we estimate to have a lower creditworthiness on average than other public sector asses in the cover pool. Various counterparty risks that are either structurally addressed or cap the ratings on the covered bonds. JANUARY 21,

3 Outlook Standard & Poor's Ratings Services' outlook on its ratings on NORD/LB Luxembourg S.A. Covered Bond Bank's (NCBB) public sector covered bonds is stable. It reflects the current counterparty replacement language, which limits the rating uplift to one notch above the 'a+' jurisdiction-supported rating level (JRL) under our covered bonds criteria to reach the 'AA-' rating level. The covered bonds have a potential cushion of three unused notches of collateral-based uplift from the JRL. A lowering of the long-term issuer credit rating (ICR) would not necessarily trigger a rating action on the covered bonds, given the three unused notches and timely replacement of the counterparty. A positive rating movement would require a change to the downgrade replacement language in the swap documentation. A negative revision could occur if the group's standalone credit profile deteriorates and if a counterparty replacement is not timely. Rationale The publication of this transaction update follows our periodic review of NCBB's public sector covered bond program. Our covered bond ratings process follows the methodology and assumptions outlined in the article "Covered Bonds Criteria" published on Dec. 9, From our analysis of the public sector covered bond program of NCBB (BBB/Negative/A-2), we have concluded that the assets in the cover pool are isolated from the risk of the insolvency of the issuer, NCBB. This asset isolation allows us to potentially assign a higher rating to the covered bond program than the long-term rating on NCBB. NCBB's covered bonds are subject to refinancing risk due to mismatches between the maturities of the cover pool assets (which comprise public sector assets in Europe and the U.S.) and the covered bonds. As a result, we link the covered bond rating to the issuer's creditworthiness and determine a maximum achievable covered bond rating above the long-term ICR by analyzing the factors set out in our criteria. We have determined NCBB's rating reference level (RRL), and attributed notches of uplift from the RRL through our assessments of jurisdictional support and collateral-based support. Based on NCBB's ICR and our assessment of jurisdictional support, we assess its RRL at 'a-' and its JRL at 'a+'. The available credit enhancement, 25.7%, is above the 17.0% target enhancement needed for the maximum collateral-based uplift. There are no notches of negative adjustment for liquidity risk management or uncommitted overcollateralization, given that NCBB has issued a relevant self-commitment. However, the current counterparty replacement language supports a maximum rating of 'AA-'. Therefore, we add one notch to reflect the maximum collateral-based uplift from the JRL to 'aa-'. There are no rating constraints relating to legal, country, or administrative and operational risks. We base our analysis of NCBB's covered bond program on the criteria articles referenced in the "Related Criteria" section at the end of this report. JANUARY 21,

4 Program Description Table 1 Program Overview* Jurisdiction Luxembourg Covered bond type Legislation-enabled Outstanding covered bonds (bil. ) Redemption profile Hard bullet Underlying assets Public sector Jurisdictional support uplift 2 Unused notches for jurisdictional support 0 Target credit enhancement for maximum potential uplift (%) Available credit enhancement (%) Collateral support uplift (actual uplift) 1 Unused notches for collateral support 3 Total unused notches 3 *Based on data as of September Following the merger of NORD/LB Luxembourg with its subsidiary company NORD/LB Covered Finance Bank on May 31, 2015, the merged bank operates under the name of NORD/LB Luxembourg S.A. Covered Bond Bank. NCBB operates as a specialized covered bond bank in accordance with Luxembourg law and focuses on the refinancing of the NORD/LB Group's core business by issuing covered bonds "lettres de gage" (LdG). The special bank principle in Luxembourg prohibits certain business activities such as consultancy and asset management, and these activities have therefore been demerged from NCBB. Under its covered bond program, NCBB issues LdG that are direct, unconditional, and unsubordinated obligations of the issuer. As such, they provide bondholders with dual recourse, first to NCBB and then to the assets in the cover pool. NCBB issued the outstanding public sector covered bonds under its 7.5 billion medium-term note program, or stand-alone documentations. All of the covered bonds rank pari passu with each other, and rank senior to all of the issuer's other unsecured obligations. These covered bonds are secured by an internationally diversified portfolio. Assets are restricted to the public sector in countries that are members of the EU, the European Economic Area, or the Organisation for Economic Co-operation and Development, or other highly-rated countries, and are eligible under the Luxembourg LdG law, and confirmed by the trustee. The issuer focuses on credit exposure to the public sector in the major currencies, with market risks mainly hedged. Table 2 Program Participants Role Name Rating Rating dependency Issuer NORD/LB Luxembourg S.A. Covered Bond Bank BBB/Negative/A-2 Yes Parent of the issuer Norddeutsche Landesbank Girozentrale (NORD/LB) - Yes Swap counterparty Confidential - Yes JANUARY 21,

5 Table 2 Program Participants (cont.) Bank account provider Banque et Caisse d'epargne de l'etat, Luxembourg AA+/Stable/A-1+ Yes Rating Analysis Legal and regulatory risks From our analysis of the legal and regulatory framework for covered bonds in Luxembourg, we have concluded that the assets in NCBB's cover pool are isolated from the risk of bankruptcy or insolvency on the part of the issuing bank. This asset isolation allows us to assign a higher rating to the covered bond program than the long-term ICR on NCBB. We have assessed legal risk using our "Europe Asset Isolation And Special-Purpose Entity Criteria--Structured Finance," published on Sept. 13, The Luxembourg LdG law is included as a special article in the Luxembourg banking Law. Only banks with a special-purpose banking license, "Banques d'émission de lettres de gage," are allowed to issue LdG. Furthermore, the law does not permit banks with a mixed status or public sector banks to issue such LdG. The special status limits banks' activities to originate and manage eligible loans and securities, and to pursue a narrowly defined range of JANUARY 21,

6 property related services. On June 11, 2013, the Luxembourgian parliament adopted changes to the Luxembourg covered bond law. The changes provide for improved disclosure, as well as clarity regarding the consequences of an insolvency of the issuing bank (see "Luxembourg's Covered Bond Law Amendments Increase Clarity For Investors, But Have No Rating Impact," published on June 19, 2013). Operational and administrative risks In our opinion, there is no operational risk from the cover pool's management and loan origination of the NORD/LB Group's core business that would limit the covered bond ratings to the same level as the long-term ICR. NCBB has a track record of managing risks prudently and maintaining overcollateralization within the covered bond program. We also believe that it is highly likely that a replacement cover pool manager could be appointed if the issuer became insolvent. We consider Luxembourg to be an established covered bond market and we believe that the public sector assets in NCBB's cover pool do not comprise product features that would materially limit the range of available replacement cover pool managers or servicers. NCBB is fully integrated into the NORD/LB Group, relying on the operational support of its group parent, Norddeutsche Landesbank Girozentrale. In October 2015, following the deterioration in creditworthiness of the issuer, the existing replacement swap framework was amended to incorporate a lower minimum eligible rating for the derivative counterparty. We therefore lowered to 'AA-' from 'AA+' our ratings on the covered bond program and related issuances (see "NORD/LB Luxembourg Covered Bond Bank Public Sector Covered Bond Ratings Lowered For Counterparty Reasons" published on Oct. 1, 2015 on RatingsDirect.). We apply our "Covered Bond Ratings Framework: Methodology And Assumptions", published on June 30, 2015, in our analysis of operational and administrative risks. Resolution regime analysis NCBB's covered bonds are subject to refinancing risk due to mismatches between the maturities of the cover pool assets and the covered bonds. As a result, we link the covered bond ratings to the issuer's creditworthiness and determine a maximum achievable covered bond rating that exceeds the long-term ICR by analyzing the factors set out in our criteria. The starting point for any uplift in our analysis is the RRL. For NCBB, the RRL is 'a-'. We consider that the issuer is subject to the EU's Bank Recovery And Resolution Directive and we view public-sector covered bonds as having "strong" systemic importance to Luxembourg (see "Assessments For Jurisdictional Support According To Our Covered Bonds Criteria," published on Dec. 22, 2015). Therefore, the RRL is currently two notches above the long-term ICR on NCBB. Jurisdictional support analysis The JRL for NCBB's public sector covered bonds is 'a+', given that it is eligible for two notches of uplift from the RRL. This uplift is based on our assessment of jurisdictional support for Luxembourg's public sector covered bonds as "strong". We also consider that NCBB's cover pool continues to comply with legal and regulatory minimum standards JANUARY 21,

7 in Luxembourg and that there are no limitations linked to the foreign currency long-term rating on Luxembourg. Collateral support analysis For NCBB's public sector covered bonds, the maximum collateral-based uplift from the JRL is four notches at 'aaa', given that we believe an active secondary market exists for the assets held in the cover pool. Based on our analysis of the covered bond program's credit and cash flow data as of Sept. 30, 2015, the available overcollateralization of 25.7% exceeds the target credit enhancement (TCE) of 17.0%, which we consider to be commensurate with the maximum uplift. The actual overcollateralization level for the current 'AA-' rating is 15.80%. The TCE is equivalent to credit risk coverage at a 'AAA' stress level and 100% of refinancing costs related to asset-liability maturity mismatches. For NCBB, credit risk is the main factor driving the TCE. There are no negative adjustments in our collateral-support analysis for liquidity risk management or uncommitted overcollateralization. This is due to the fact that NCBB has stated on its website that it will maintain overcollateralization of at least 22%. It also states that the cover pool will hold assets that are eligible for repurchase with the European Central Bank (ECB), amounting to at least the same level as the peak negative liquidity for each upcoming 180-day period. Credit risk. We have analyzed the portfolio and applied stresses that are commensurate with a 'AAA' rating scenario to estimate the level of defaults, as shown by our risk measure, the scenario default rate (SDR); and the related level of recoveries. For NCBB's cover pool, we calculate an SDR of 27.3% (26.8% as of Dec. 31, 2014), and a recovery rate of 53.9% (51.4% as of Dec. 31, 2014). We base our loan level analysis of NCBB's cover pool on our methodology and assumptions for public finance assets (see "Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities," published on Dec. 9, 2014). The pool primarily consists of European and U.S. public-sector assets. For a public sector cover pool, the pool is fairly granular by obligors and industries. Nevertheless, while the share of the largest 20 exposures has remained constant, the largest geographic concentrations have increased in recent years, which negatively affects our default assumptions. The SDR of 27.3% over the portfolio's weighted-average maturity of about six years corresponds to a 'BBB-' weighted average loan rating. In part, this reflects the increase in non-local and regional governments (LRGs), which represent about 28% of cover pool assets (non-lrgs are public-sector obligors that are owned, in full or in part, by one or more LRGs that do not guarantee their liabilities, according to our public finance asset criteria, and for which operating revenues are typically the primary source of funds to service their debt). We estimate their creditworthiness on average as lower than many other public sector assets in the cover pool. The recovery rate has improved to 53.9%, but remains negatively affected by these non-lrg exposures, as well as by sovereign obligations and exposure to German savings banks, which together account for about 50% of cover pool assets. Our recovery rate assumptions for these exposures are lower than for LRGs and U.S. public sector entities in the pool. Those exposures benefit from high recovery rate assumptions and have increased to 45% from 40% of the cover pool. JANUARY 21,

8 Table 3 Key Credit Metrics Sept. 30, 2015 Dec. 31, 2014* Weighted-average cover pool asset rating BBB- BBB- Weighted-average loan asset maturity (years) Largest obligor (% of the cover pool) largest obligors (% of cover pool) Credit analysis results: Scenario default rate (SDR) (%) Weighted-average recovery rate (%) Weighted-average time to recovery (years) Largest obligor test result (% of covered bonds) Largest industry test result (% of covered bonds) *Results under previous criteria. Based on loan-by-loan credit data. S&P aggregates some assets insured by the same monoline insurer. Table 4 Asset Distribution By Geography Sept. 30, 2015 Dec. 31, Percentage of cover pool-- Germany U.S Canada Poland U.K Italy Other Table 5 Recovery Assumptions For Cover Pool Assets* Borrower type 'AAA' recovery rate (%) Time to recovery (years) Percentage of cover pool (%) Non-local & regional government public finance assets 13 / 16 / 18 / 32 /37 / 41 / U.S. municipal debt Local & regional governments 90 / Sovereigns Covered bonds Total *As of Sept. 30, Table 6 Asset Distribution By Rating Sept. 30, 2015 Dec. 31, Percentage of cover pool-- AAA JANUARY 21,

9 Table 6 Asset Distribution By Rating (cont.) AA A BBB BB or lower* *We consider conservative rating assumptions for obligors not rated by S&P. Refinancing costs. Since amortization of the assets can be insufficient to make timely payments on the covered bonds, we model refinancing costs that the cover pool might incur if it directly accesses the market to obtain funding or liquidate the assets to meet covered bond payments. For this purpose, we analyze the cash flows under our credit stresses, as explained in the credit section, as well as liquidity and interest rate stresses. We also run different default timing patterns. By applying our credit and cash flow stresses to NCBB's covered bonds' cash flows, we calculate a TCE of 17.0%, which we consider to be commensurate with the maximum collateral-based uplift. In our cash flow analysis, we apply a weighted-average target asset spread of basis points (343.5 as of Dec. 31, 2014) on NCBB's cover pool assets. This is based on the assumptions outlined in our article "Assessments For Target Asset Spreads According To Our Covered Bonds Criteria," published on Dec. 22, The lower target asset spread is driven by an increase in the percentage of non-lrg/lrg assets. We also assume a relatively quick time to recovery of 1.88 (1.7 as of Dec. 31, 2014) years, which has increased slightly due to the higher share of LRG exposures for which we assume a longer recovery based on our public finance methodology. Table 7 Collateral Uplift Metrics Sept. 30, 2015 Dec. 31, 2014 Asset WAM* (years) Liability WAM (years) Available credit enhancement Required credit enhancement for first notch of collateral uplift (%) Required credit enhancement for second notch of collateral uplift (%) Required credit enhancement for third notch collateral uplift (%) Target credit enhancement for maximum uplift (%) Potential collateral-based uplift (notches) 4 4 Adjustment for liquidity (Y/N) N N Adjustment for committed overcollateralization (Y/N) N N Collateral support uplift (notches) 1 4 *Based on CF data. WAM--Weighted-average maturity. Y/N--Yes/no. Counterparty risk We have identified several counterparty risks for the covered bonds, which we consider to be either structurally addressed or to constrain the rating on the program. Bank account risk. Borrowers make payments to accounts held with Banque et Caisse d'epargne de l'etat, Luxembourg (BCEE) for the cover pool's benefit. The account exposure could potentially exceed 5% of the pool balance depending on repayments made by the borrowers. As such, we would classify the exposure as limited under our counterparty criteria framework. JANUARY 21,

10 There is no bank account agreement including a replacement framework. For the purpose of our analysis, we have not sized account risk as we consider that long-term ICR on BCEE is currently high enough to support our ratings on the covered bonds. Should BCEE be downgraded, bank account risk will need to be sized or the ratings on the covered bonds may be capped at the long-term rating on the counterparty. Commingling risk. NCBB manages the funds centrally as long as the bank is solvent. We understand that legally, if NCBB became insolvent, the funds would not be commingled with its remaining estate. In our view, this neutralizes commingling risk. As both account bank risk and commingling risk are structurally addressed or cap the current ratings, we do not include these risks in our cash flow analysis. Derivatives. NCBB uses swap agreements and natural hedging to manage interest rate and foreign exchange risk. Swap termination costs in Luxembourg rank pari passu to payments on the covered bonds, and we consider that the issuer's RRL is at least 'bbb'. We therefore believe that the issuer will be able to seek a replacement counterparty before the risk of a termination payment is likely to affect the covered bonds' creditworthiness. The swap agreements are in line with our current counterparty criteria and support a 'AA-' rating. The issuer documents replacement option 1 under our criteria and the counterparty is currently posting collateral to remain in the covered bonds program. The issuer is investing the collateral posted in eligible investments in accordance with our criteria "Global Investment Criteria For Temporary Investments In Transaction Accounts," published on May 31, Therefore, we give benefit to the swaps in our cash flow analysis, and they do not constrain our covered bond ratings. We analyze counterparty risk using our "Counterparty Risk Framework Methodology And Assumptions," published on June 25, 2013 and "Counterparty Risk Analysis In Covered Bonds" published on Dec 21, Country risk Country risk is not a rating constraint for NCBB's covered bond program, given that it includes obligors in multiple jurisdictions, and with a focus on countries with highly rated sovereigns (42% in Germany and 25% in the U.S.). When assigning covered bond ratings for multijurisdictional pools that exceed the ratings of sovereigns within the European Economic and Monetary Union (EMU), we apply our nonsovereign ratings criteria (see "Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology And Assumptions," published on June 14, 2011). For NCBB, we consider that our credit default stresses already appropriately capture sovereign default risk in line with paragraph 42 of these criteria, such that the covered bond ratings are not capped by any sovereign rating. Related Criteria And Research Related Criteria Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015 Counterparty Risk Analysis In Covered Bonds, Dec. 21, 2015 Covered Bonds Criteria, Dec. 9, 2014 Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014 Group Rating Methodology, Nov. 19, 2013 Europe Asset Isolation And Special-Purpose Entity Criteria--Structured Finance, Sept. 13, JANUARY 21,

11 Counterparty Risk Framework Methodology And Assumptions, June 25, 2013 Global Derivative Agreement Criteria, June 24, 2013 Global Investment Criteria For Temporary Investments In Transaction Accounts, May 31, 2012 Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology And Assumptions, June 14, 2011 Methodology: Credit Stability Criteria, May 3, 2010 Understanding Standard & Poor's Ratings Definitions, June 3, 2009 Related Research Global Covered Bond Characteristics And Rating Summary Q4 2015, Dec. 29, 2015 Assessments For Jurisdictional Support According To Our Covered Bonds Criteria, Dec. 22, 2015 Assessments For Target Asset Spreads According To Our Covered Bonds Criteria, Dec. 22, 2015 NORD/LB Luxembourg Covered Bond Bank Public Sector Covered Bond Ratings Lowered For Counterparty Reasons, Oct. 1, 2015 Additional Contact: Covered Bonds Surveillance; JANUARY 21,

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