Morningstar DBRS Downgrades the Long-Term Issuer Rating of Deutsche Pfandbriefbank AG to BBB From BBB (high), Trend Now Stable

DBRS Ratings GmbH (Morningstar DBRS) downgraded the Long-Term Issuer Rating of Deutsche Pfandbriefbank AG (pbb or the Bank) to BBB from BBB (high). Morningstar DBRS also changed the trends on all credit ratings to Stable from Negative. The Bank's intrinsic assessment (IA) is BBB. 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 credit rating downgrade mainly reflects the sustained weakening of pbb's profitability metrics, driven by high provisioning needs because of increased challenges in the commercial real estate (CRE) market. Nonperforming loans (NPLs) have been rising, and the Bank's gross NPL ratio is higher than that of its domestic peers. While pbb has adopted a conservative balance sheet strategy in response to elevated asset quality risks, Morningstar DBRS expects asset quality and profitability to remain under pressure in the medium term as some borrowers may not be able to cover their increased debt service amid still high interest rates. The downgrade also takes into account high earnings concentration in the CRE sector, which leads to relatively limited earnings capacity to cover potential credit risks.

The Stable trends largely reflect Morningstar DBRS' expectation that the credit risks will likely remain manageable given pbb's cautious business strategy and conservative underwriting standards. In Morningstar DBRS' view, the Bank will benefit from the expected lower interest rates and slow recovery in the CRE market. Furthermore, the credit ratings consider pbb's adequate capital position, with sound buffers to absorb stressed levels of loan losses. The Bank has a sound funding profile with sizeable liquidity buffers.

The Bank's Intrinsic Assessment of BBB has been assigned at the midpoint of the Intrinsic Assessment Range, as Morningstar DBRS views pbb's credit fundamentals and performance as commensurate with those of similarly rated peers.

CREDIT RATING DRIVERS
Over the longer term, the credit ratings would be upgraded if the Bank can demonstrate a sustained improvement in asset quality and profitability.

Morningstar DBRS would downgrade the credit ratings in the case of sustained asset quality deterioration combined with a material negative impact on profitability or capital. A sharp deterioration in liquidity position would also result in a negative rating action.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Moderate
pbb is a real estate financing specialised bank with total assets of EUR 44.2 billion at YE2024. It has a solid franchise in CRE lending mainly in Europe but with notable exposure in the U.S. pbb's high exposure to the CRE sector, in particular to the troubled office segment, has led the Bank's performance to weaken in recent years. Morningstar DBRS notes that the Bank has adopted a conservative strategy in response to ongoing challenges in the CRE market, such as active deleveraging of its U.S. office portfolio, pre-emptive restructuring of potentially problematic exposures, and a selective growth model. While the Bank also has a sizeable public finance business, its contribution to profits is very low, and pbb has been gradually downsizing its public finance operations. The Bank's limited business diversification, which has led to high earnings concentration in CRE lending and interest income, represents a constraint to franchise strength.

Earnings Combined Building Block (BB) Assessment: Moderate/Weak
In Morningstar DBRS' view, pbb's overall earnings capacity is relatively weak, mainly reflecting limited revenue diversification because of the high concentration in CRE lending and very high dependence on interest income. The Bank's income has been adversely affected by elevated provisioning costs resulting from the ongoing challenges in the CRE sector. Net income before tax was EUR 104 million at end-2024, which has increased from EUR 90 million a year earlier, mainly because of lower loan loss provisions reflecting slow stabilisation in the CRE sector and, to a lesser extent, lower operating expenses. This translates into a low return on equity before tax of 2.6%, which increased from 2.1% in 2023. In the medium term, the Bank's net income could increase slightly, mainly because of lower credit provisions reflecting gradual recovery in CRE lending. In addition, given its relatively high dependence on wholesale funding, pbb has benefitted less from the high-interest rate environment compared with other banks in Germany. Morningstar DBRS expects a more favourable cost of wholesale funding in 2025 given the interest rate cuts in the EU, which would remain another supportive factor for earnings.

Risk Combined Building Block (BB) Assessment: Moderate/Weak
The Bank's risk profile has weakened along with increased challenges in the CRE sector, mainly in the U.S. office market. At YE2024, around 50% of pbb's CRE exposure is to office properties¿a market that has been under strong pressure, mainly because of high interest rates and higher vacancies that have led to significant price drops in an illiquid market. This has resulted in an increase in the NPL ratio for CRE loans to 5.1% at YE2024 from 3.7% at YE2023. Morningstar DBRS sees early signs of recovery in the CRE market, including price stabilization, which also positively affected pbb's cost of risk in H2 2024. This could be further supported by expected interest rate cuts in 2025, especially in the EU market. However, Morningstar DBRS still expects to see continued loan defaults, as some borrowers may not be able to cover their high debt service. Still, the risks will likely remain manageable for the Bank, given its cautious balance sheet strategy, active portfolio management (loan sales, pre-emptive restructuring), and conservative loan-to-value ratios.

Funding and Liquidity Combined Building Block (BB) Assessment: Moderate/Weak
pbb's funding profile is sound and aligned with its business model as it relies on longer-term funding, largely matching the maturities of its assets. Around 50% of funding comes from covered bonds. The Bank is also funded by unsecured debt, deposits, and repos. Costs for unsecured funding have increased considerably since 2023, reflecting high interest rates and increased challenges in the CRE sector. Retail deposits continued to increase in 2024 following a strong jump in 2023, mostly through the Bank's online platform (pbb direct) to EUR 7.6 billion as of December 2024 from EUR 6.6 billion a year earlier. The weighted-average term is 3.7 years, as 92% are term deposits. In Morningstar DBRS' view, this is prudent as it secures pbb's liquidity and helps offset higher funding costs from other sources. Liquidity remains sound, and liquid assets accounted for around 14% of total assets at YE2024. The Liquidity Coverage Ratio was 200% and the Net Stable Funding Ratio was 116% at end-2024.

Capitalisation Combined Building Block (BB) Assessment: Good/Moderate
Morningstar DBRS views pbb's capitalisation as adequate. Morningstar DBRS notes that the Bank has prudently managed its capital position so far, evidenced by its decision not to pay a dividend for 2023. At YE2024, the Bank's phased-in CET1 ratio was 14.4%, down from 15.7% a year earlier as risk-weighted assets increased considerably to EUR 20.6 billion from EUR 18.5 billion, reflecting rating migration as well as the transition to a foundation advanced internal credit ratings-based approach. The CET1 ratio is well above the minimum regulatory requirement (including anticipated additional buffer) with a buffer of around 460 basis points. Given the concentration risk and the cyclicality of the CRE business, maintaining adequate capital cushions is an important rating factor.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://dbrs.morningstar.com/research/449823.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant 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 Factors in Credit Ratings (13 August 2024) at https://dbrs.morningstar.com/research/437781.

Notes:
All figures are in euros unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (4 June 2024; https://dbrs.morningstar.com/research/433881). In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (https://dbrs.morningstar.com/research/437781) 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. Other sources include pbb 2020-2023 Annual Reports, pbb H1 2024 and 9M 2024 Interim Reports, pbb H1 2024, 9M 2024, and 2024 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 trends 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://dbrs.morningstar.com/research/449822.

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

Lead Analyst: Halil Senturk, Assistant Vice President
Rating Committee Chair: Elisabeth Rudman, Managing Director
Initial Rating Date: July 19, 2006
Last Rating Date: March 14, 2024

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