DBRS Comments on Hypo Real Estate Q2 2009 Results – Senior at A (low), Under Review-Positive

DBRS has today commented on the interim results of Hypo Real Estate Holding AG (HRE or Holding). DBRS maintains senior long-term ratings of A (low) and short-term ratings of R-1 (low) for Holding and its main operating banks, Deutsche Pfandbriefbank AG (Pfandbriefbank) and DEPFA Bank plc (DEPFA). All ratings for these entities remain Under Review with Positive Implications.

HRE reported a net loss of EUR 750 million for Q2 2009 after a net loss of EUR 382 million in the prior quarter, as sharply higher loan loss provisions overshadowed improvements in underlying performance. Loan loss provisions rose to EUR 881 million, 4.5 times higher than in Q1 2009. The sharp increase primarily reflected weakness in commercial real estate (CRE) finance.

HRE’s underlying performance showed signs of improvement in Q2 2009; however, underlying earnings remain inadequate to absorb credit costs. Income before provisions and taxes turned positive for the second quarter at EUR 217 million, improving from a loss of EUR 210 million in Q1 2009. In DBRS’s view, the upturn was driven in part by favourable market conditions, which may not prove sustainable. Solid net interest income continued to benefit from low short-term rates. Trading income swung from a negative EUR 162 million in Q1 2009 to a positive EUR 135 million contribution in Q2 2009, as less disrupted financial markets helped stem write-offs on securities and on counterparty exposure to monoliners. Lower operating expenses bolstered results, as cost-cutting efforts start to show results. Net commission income continues to be pressured by the ongoing cost of liquidity guarantees from the German Financial Markets Stabilisation Fund (Soffin). HRE itself does not expect to return to profitability before 2012, as the Group anticipates significant charges on results which will lead to a continuing loss situation.

Credit quality in HRE’s CRE portfolio continues to deteriorate. Total problem loans increased 34% to EUR 7.5 billion from EUR 5.6 billion, driven by rising impairments in CRE. At 30 June, 2009, problem loans accounted for 2.1% of credit exposure, up from 1.4% at 31 March 2009 and 1.2% at year-end 2008. The ongoing weakness in HRE’s EUR 61 billion CRE portfolio will likely pressure earnings in the near term. The large EUR 262 billion public sector and infrastructure finance portfolio showed stable credit quality in Q2 2009. HRE increased its reserve coverage of CRE problem loans to 39.3% at quarter-end, up from 34.5% at year-end 2008. Reserve coverage of public sector and infrastructure problem loans was 36.3% at quarter-end compared to 35.8% at year-end 2008.

DBRS views HRE’s current capitalisation as insufficient, given its risk exposure. The Group reported a core capital (tier 1) ratio of 6.9% as of 30 June 2009. Consistent with German regulation, this figure excludes the negative impact from the EUR 1.1 billion net loss in H1 2009. Including this loss reduces HRE’s tier 1 ratio to 5.5% on a pro-forma basis. Importantly, Soffin injected EUR 3.0 billion in common equity into HRE during Q2 2009, demonstrating the government’s willingness to support the Group. However, the H1 2009 loss offset more than a third of the capital provided by Soffin, leaving only a small buffer above the 4% minimum to absorb further losses. The capital injection gave Soffin a 90% stake in HRE. Soffin has stated it plans to provide additional capital into HRE after gaining full control through a mandatory buy-out of minority shareholders.

HRE’s funding profile, while still weak, is showing early signs of improvement. The Group placed EUR 250 million in covered bonds so far in 2009 and also issued small amounts of unsecured debt in private placements. Still, HRE remains dependent on ongoing liquidity support. The Group had EUR 99 billion in external funding support available at 30 June 2009, of which EUR 52 billion expire on 19 August 2009.

The Group continues to make progress with its restructuring. DBRS views HRE’s simplified structure and declining non-core assets as critical steps towards building an efficient, viable organisation, which may ultimately allow the Group to regain its franchise strength. Group-wide assets declined by 8% from year-end 2008 to EUR 386 billion as of 30 June 2009, as non-core assets gradually roll off. During Q2 2009, HRE merged its subsidiary DEPFA Deutsche Pfandbriefbank into Hypo Real Estate Bank to form Deutsche Pfandbriefbank AG, which now contains all core operations and writes all new business. The Irish subsidiary DEPFA focuses on managing down its non-strategic public sector and infrastructure portfolios over time.

HRE’s ratings are underpinned by the strong support from the German government, which results in a significant rating uplift, as HRE’s intrinsic credit profile remains significantly weaker. The Under Review-Positive status reflects DBRS’s expectation that further government support will enable HRE to complete its restructuring and re-emerge as viable institution. DBRS continues to monitor the extent, form and timeliness of government support, particularly the announced capital injection and the expected replacement of the EUR 52 billion in Soffin guarantees that expire on 19 August 2009. Positive ratings momentum could result, if HRE improves its underlying earnings ability and franchise strength, while its capital and liquidity strengthen with government support. While not expected, any indication of reduced government support for a rated HRE entity would cause significant negative ratings pressure. Persistent weakness in underlying performance, continued lack of new business momentum and further accelerating credit losses could also cause negative ratings pressure.

Notes:
This rating is based on public information.

All figures are in Euros unless otherwise noted.

The applicable methodologies are Analytical Background and Methodology for European Bank Ratings, Second Edition and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.