Morningstar DBRS Revises Trend on pbb to Negative, Confirms BBB (high) Long-Term Issuer Rating

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Long- and Short-Term Issuer Ratings of Deutsche Pfandbriefbank AG (pbb or the Bank) at BBB (high) / R-1 (low). The trend on all credit ratings was changed from Stable to Negative. pbb's intrinsic assessment (IA) was maintained at BBB (high). The support assessment for the Bank is SA3. A full list of ratings can be found at the end of the press release.

KEY CREDIT RATING CONSIDERATIONS

The trend change to Negative from Stable is based on Morningstar DBRS's expectation that pressure on earnings and capital ratios from lower revenues, elevated loan loss provisions and rating migration will persist for some time, as the current commercial real estate (CRE) downturn especially in the US, but increasingly in Europe, might go beyond a typical cycle. In addition, a decline in market confidence has reduced pbb's access to capital markets and has made funding more costly. With the loss of the TLTRO benefit, pbb has experienced a drop in revenues, and in the absence of a large retail deposit base, has not been able to benefit from the rise in interest rates. Given pbb's earnings concentration in CRE, only limited revenue offsets are available. At the same time, higher interest rates and reduced demand for office space has caused asset quality to deteriorate, adversely affecting earnings through increased loan loss provisions. In addition, risk-weighted assets have increased as a result of rating migration. Morningstar DBRS considers a quick recovery of CRE markets is unlikely and therefore, expects nonperforming loans to remain high and potentially increase further.

pbb's credit ratings continue to reflect the stringent lending policies with conservative loan-to values (LTV), debt service coverage ratios and a focus on high quality property in good locations. Also reflected is the Bank's prudent funding structure focused on term-funding and solid liquidity metrics. We acknowledge pbb's recent initiatives regarding funding and capital. A significant increase in term deposits has helped secure the Bank's liquidity and offset higher funding costs from other sources. In addition, the decision to suspend dividend payments preserves capital and improves the Bank's loss absorption capacity.

CREDIT RATING DRIVERS

An upgrade of pbb's credit ratings is unlikely, given the most recent rating action. The trend would revert to Stable if the Bank can demonstrate an improvement in asset metrics and profitability while maintaining solid capital cushions.

pbb's credit ratings would be downgraded in case of continued high provisioning needs and weakness in earnings, or pressure on the Bank's liquidity. A material decline in capital cushions and a lack of access to unsecured funding over an extended time period could also lead to a negative rating action.

CREDIT RATING RATIONALE

Franchise Combined Building Block (BB) Assessment: Good / Moderate

pbb has a well-established franchise in CRE lending and public finance lending. However, the Bank is de-emphasising public finance and is gradually winding down the portfolio. While this increases the concentration in the cyclical CRE segment, we note that the profit contribution from public finance has been relatively small. pbb's CRE exposure is mainly to Europe, but the Bank has also significant operations in the U.S., a market currently under stress.
The Banks intends to expand its fee generating business by offering real estate investment management services in partnership with established fund managers. The goal is that fee revenues should account for 5-10% of total revenues by 2026, up from 1.5% in 2022. Given the currently challenging operating environment for CRE, it is not clear how long it will take for this business to meaningfully add to earnings. Overall, pbb's high reliance on CRE lending has made the Bank vulnerable in the currently challenging environment.

Earnings Combined Building Block (BB) Assessment: Moderate / Weak

pbb's profitability is generally weaker when compared to international peers. In addition, income streams lack diversification due to a business model centred on commercial real estate lending and public finance, and consisting almost entirely of net interest income. pbb reported significantly lower 2023 earnings and the quality of earnings also declined. Net profit was EUR 91 million from EUR 187 million a year earlier, and the ROE was 2.2% compared to 5.5% in 2022. Results were adversely affected by a EUR 168 million increase in loan loss provisions (LLP), the loss of EUR 70 million in TLTRO III benefits and floor income and higher costs due to investment into IT and business expansion. We note that pbb, unlike predominantly deposit funded banks, has not been able to benefit from the rate hikes due to its "margin plus" business model. However, in 2023 the Bank reported significant contributions from income from realisation and other income, which combined amounted to EUR 117 million. These categories include line items such as gains from asset sales of the non-core portfolio and debt repurchases, the release of litigation provisions and unredeemed interest coupons and they are non-recurring by nature. The Bank expects a materially higher profit for 2024 based on a significant reduction in loan loss provisions. Although we acknowledge the slow-down in NPL inflows in the US, in our view, there is a high degree of uncertainty attached to the assumption of lower credit impairments, and as a result there is significant downside risk to net profit.

Risk Combined Building Block (BB) Assessment: Moderate

The Bank's main risk is its high exposure to the cyclical CRE market in a weak operating environment. As of end-2023, 51% of pbb's EUR 33 billion CRE exposure is to office properties - a market currently experiencing stress, as the rise in rates and higher vacancies have led to significant price drops in an illiquid market. Reflecting the weakness in these markets, the overall NPL ratio for CRE loans increased to 4.7% from 2.7% at year-ed 2022. EUR 4.5 billion or 16% of pbb's CRE lending is in the U.S., and of this 80% is to office properties a market of particular concern. For U.S. loans the NPL ratio has increased to 11.9% from 6.1% a year earlier, but down from 14.1% a quarter earlier as inflows have slowed significantly. The portfolio has been appraised in 2023 and incorporates price drops for underlying properties of 19% for the performing portfolio and 35% for the nonperforming portfolio. Post revaluation approximately EUR 100 million of US loans have LTVs above 70%, and EUR 24 million have an LTV above 100%. During Q4 2023 pbb experienced a significant NPL inflow in the German construction & development segment. However, given the nature of the loans we expect losses to remain manageable. We note that a certain proportion of NPLs result from covenant breaches due to price declines or lower debt service coverage ratios, and borrowers may still be servicing their debt, however, no break-down has been provided by the Bank.

Given that real estate cycles tend to be long and the structural changes due to hybrid work models, we do not expect a swift recovery in the office markets. We expect to see continued loan defaults, as borrowers may not be not able to provide further equity or cover their increasing debt service. However, we note that pbb's focus on prime locations and relatively conservative loan-to-values (LTVs) provide downside protection. Also, an NPL coverage ratio of 38.4% at year-end, taking in into consideration the price declines that are already incorporated, offers some buffer.

Funding and Liquidity Combined Building Block (BB) Assessment: Moderate / Weak

We believe that pbb's funding profile is prudent and aligned with its business model as it relies on longer-term funding, matching the maturities of its assets. Around 50% of funding comes from covered bonds. The Bank also relies on unsecured debt, customer and retail deposits, and repos. Costs for unsecured funding have increased considerably. This, in combination with the loss of the TLTRO III funding advantage, prompted the Bank to expand its retail deposit franchise since early 2022. The deposit volume increased from EUR 3.2 billion to EUR 6.9 billion as of February 2024. The weighted average term is 3.8 years, as 88% are term deposits. In our view, this was prudent as it secures pbb's liquidity and helps offset higher funding costs from other sources. pbb still has EUR 800 million in TLTRO III outstanding, which will be repaid in 2024, but will not affect liquidity as the collateral can be used for ECB funding. The Bank does not plan to access the unsecured market in 2024 and has already largely pre-funded its secured funding needs. The Liquidity Coverage Ratio was above 200% as of February 2024 and the Net Stable Funding Ratio was 111% at end-2023.

Capitalisation Combined Building Block (BB) Assessment: Good / Moderate

We view pbb's capitalisation as solid, though it has somewhat weakened over the course of 2023, as both capital ratios and the Bank's capital generation capacity declined. This has been partly compensated by the Bank's decision not to pay a dividend for 2023. At end-2023, the Bank's phased-in Common Equity Tier 1 (CET1) ratio was 15.7%, down from 16.7% a year earlier as RWAs increased considerably to EUR 18.5 billion from EUR 17.0 billion, reflecting asset growth and rating migration. However, this is an increase from the 15.2% at end Q3 2023, as the Bank decided to retain the entire profit for 2023. The CET1 ratio already incorporates regulatory changes with regards to Basel IV, and compares to a 2024 CET1 SREP ratio requirement of 9.64% (including an anticipated additional buffer of 95 basis points (bps)). This provides the Bank with a CET1 buffer of around 600 bps. Given the concentration risk and the cyclicality of the CRE business, maintaining healthy capital cushions is an important rating factor. In the currently deteriorating environment for CRE, we continue to monitor the maintenance of the Bank's capital cushions closely.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/429330.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

Morningstar DBRS notes that the above press release was amended on 30 September 2024 to incorporate the office address of the lead analyst.

Notes:
All figures are in euros unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (22 June 2023) https://dbrs.morningstar.com/research/415978/global-methodology-for-rating-banks-and-banking-organisations In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include Morningstar Inc. and company documents, pbb 2019-2022 Annual Reports, pbb H1 2023 and 9M 2023 Interim Reports, pbb H1 2023, 9M 2023 and 2023 Presentations. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: NO
With Access to Internal Documents: NO
With Access to Management: NO

Morningstar DBRS does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS's outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/429331.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Sonja Forster, Vice President, Global FIG
Rating Committee Chair: Elisabeth Rudman, Managing Director, Head of Global FIG
Initial Rating Date: July 19, 2006
Last Rating Date: May 25, 2023

DBRS Ratings GmbH
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Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
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For more information on this credit or on this industry, visit dbrs.morningstar.com.