DBRS Confirms Hypo Real Estate at A (high), Changes Trend to Negative

DBRS has today confirmed its ratings for Hypo Real Estate Holding AG (HRE Holding) including the A (high) Senior Unsecured Long-Term Debt rating of HRE Holding, as well as the A (high) Senior Unsecured Long-Term Debt & Deposit ratings of the Group entities Hypo Real Estate Bank AG, Hypo Real Estate Bank International AG and Hypo Public Finance Bank. Concurrently, the trend on all long-term ratings has been revised to Negative from Stable. The trend for the Group’s short-term ratings of R-1 (middle) remains Stable, as these would not be affected by a one-notch downgrade of the long-term ratings.

The rating confirmation reflects the Group’s diversified franchise, its sound risk management track record and its diverse earnings sources, which should enable the Group to continue coping with a challenging environment.

The change in the long-term ratings trend reflects the risk that rising loan loss provisions in commercial real estate (CRE) and further write-downs on structured investments may further pressure earnings in coming quarters. DBRS sees the potential of higher-than-expected credit costs in CRE lending, mainly due to the Group’s exposure to deteriorating real estate markets in the United States, the United Kingdom and Spain. Furthermore, the revised trend reflects DBRS’s opinion that the Group’s financial flexibility has been reduced, as persistent turmoil in the credit markets has made unsecured long-term funding more expensive and difficult to obtain.

DBRS views the Group’s earnings capacity as reduced in the near term, which could over time lessen its ability to protect its franchise. The Group has restricted its new CRE commitments so far in 2008, as management focuses on preserving liquidity and rebuilding its regulatory capital ratios. DBRS views this strategy as prudent, but notes that it limits growth in the Group’s CRE business. As such, DBRS expects earnings to remain under pressure in coming quarters and notes that the Group has limited capacity to absorb increased provisions and further write-downs out of current earnings. Pre-tax profit declined to EUR 17 million in Q2 2008, down from EUR 183 million in Q1 2008 and also down from EUR 190 million in Q2 2007.

DBRS views HRE Group’s liquidity as well managed, considering the challenging environment. CRE assets are match-funded and the Group has access to diverse funding sources, including covered bonds and promissory loans (Schuldschein-Darlehen), mitigating its dependence on wholesale funding. In its public sector and infrastructure finance operations, the Group faces some rollover risk, as more than 50% of public sector assets are funded on a short-term basis through repos and money market funding. This rollover risk is partly offset by the high credit quality of the Group’s public sector portfolio, which enables the Group to fund these assets on a secured basis. HRE Group also holds a substantial liquidity reserve of unencumbered assets.

In DBRS’s opinion, HRE Group’s capitalization is viewed as sufficient, with a solid tier 1 regulatory ratio of 8.6% under Basel II, as of June 2008. The Group has less robust capital metrics based on tangible book equity, due to substantial unrealized losses reflected in its available-for-sale (AFS) reserve and due to the significant intangibles taken on with the acquisition of DEPFA in 2007. DBRS recognizes that a large portion of the negative AFS reserve reflects unrealized valuation losses on sovereign assets from issuers such as Spain, Greece and Japan. Actual defaults on these assets appear unlikely, which somewhat mitigates the Group’s less robust tangible book equity capitalization.

DBRS views the Group’s risk profile as sound, taking into consideration the Group’s strong risk management track record and comprehensive risk management processes. In CRE, the Group faces exposure to deteriorating markets such as the United States, the United Kingdom and Spain. Credit risk in the Group’s public sector and infrastructure finance segment is viewed as limited, resulting mainly from its EUR 18.6 billion portfolio of infrastructure assets as of June 2008.

Currently, DBRS views the Group as one economic and risk unit, due to the various contractual, operational and financial links in place between its operating banks and, at this time, does not differentiate between the holding company rating and the operating banks. However, the slightly stronger credit risk profile of the public sector finance entities DEPFA and HPFB – compared to the CRE entities Hypo Real Estate Bank AG and Hypo Real Estate Bank International AG – could lead to a differentiation in ratings in the future.

DBRS sees several factors that could place negative pressure on the ratings. Persistent name-specific market concerns, market concerns about CRE lenders in general, or longer-term overall market disruptions could make HRE Group’s unsecured long-term funding incrementally more expensive or difficult to obtain so that it would harm the Group’s franchise. Moreover, a real estate downturn in Germany or a worsening of the current downturn in other key markets could drive loss provisions above a level that can be absorbed out of current earnings. DBRS will continue to closely monitor the Group’s financial flexibility, profitability, capitalization and provisioning going forward.

DBRS views HRE Group as systemically important in Germany. As such, DBRS believes the Group would likely receive some form of timely systemic support, if ever needed. HRE Group’s ratings are consequently positioned one notch above their intrinsic assessment.

HRE Group is headquartered in Munich, Germany, and reported assets of EUR 395 billion as of June 2008.

Notes: All figures are in euros unless otherwise noted.
This rating is based on public information.