Primary Credit Analyst: Sean Cotten, Stockholm (46) ;

Transcription

1 Primary Credit Analyst: Sean Cotten, Stockholm (46) ; Secondary Contact: Helena Cederloef, Stockholm (46) ; Table Of Contents Major Rating Factors Outlook Rationale Related Criteria And Research SEPTEMBER 23,

2 SACP bbb+ + Support 0 + Additional Factors 0 Anchor Business Position bbb+ Moderate -1 ALAC Support 0 Issuer Credit Rating Capital and Earnings Strong +1 Risk Position Adequate 0 Funding Liquidity Average Adequate 0 GRE Support 0 Group Support 0 Sovereign Support 0 BBB+/Stable/A-2 Major Rating Factors Strengths: Weaknesses: Leading provider of financing to Denmark's agriculture industry. Loss-mitigating guarantee and commission-recovery agreements with owner banks. Robust capitalization. Concentration of revenues and credit risk from the narrow business model. Difficult economic conditions for milk and pork farmers in recent years. Relatively small liquidity buffers, given Danish mortgage funding model. Outlook: Stable The stable outlook on Danish mortgage lender DLR Kredit A/S reflects S&P Global Ratings' view that DLR Kredit's stand-alone credit profile (SACP) is unlikely to change over our two-year rating horizon. The outlook also assumes slow, but steady improvements in DLR Kredit's funding profile over the next two years. We could consider an upgrade if bail-in risks for senior unsecured creditors were reduced further, for example via the development of a significant additional loss-absorbing capacity (ALAC) buffer not otherwise recognized in our strong capital assessment or if there was a stronger-than-expected improvement in the risk-adjusted capital (RAC) ratio to levels sustainably exceeding 15%. We could consider a downgrade if DLR Kredit is unable to maintain progress in terms of extending the maturity profile of its funding over the next two years. In particular, we could revise downward our assessment of funding to below average and lower the ratings if the trend of improvement in the funding and liquidity profile were to stagnate. SEPTEMBER 23,

3 Rationale The ratings reflect our view of DLR Kredit's moderate business position, strong capital and earnings, adequate risk position, average funding, and adequate liquidity. Anchor:'bbb+' for banks operating only in Denmark Our bank criteria use our Banking Industry Country Risk Assessment's economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. Our anchor for a commercial bank operating only in Denmark is 'bbb+', based on an economic risk score of '3' and an industry risk score of '4'. We view Denmark as a politically stable, wealthy, and high-income country, which has suffered since the global financial market crisis. The economy is competitive and diverse and once again in an expansionary phase, with house price appreciation and credit growth expected to increase in the coming two years. Although decreasing, household debt remains high and a constraint to our assessment of economic risk. Consequently, we expect Denmark's economy will continue improving, supported by its balanced fiscal policy flexibility and strong external position following a decade of sizable current account surpluses. We view the regulatory environment in Denmark as in line with that of other EU countries. We observe an overall improvement in the banking sector's profitability that, in our view, should continue through cost-cutting and decreasing losses. This should enable the sector, including lower-yielding mortgage banks, to report a return on equity of 6%-7% for We also note the banking sector's higher reliance than peers' on functioning wholesale markets. However, we expect the stable funding profile to improve further, thanks to continuing measures of individual banks and the regulator. Table 1 DLR Kredit A/S Key Figures --Year ended Dec (Mil. DKK) 2016* Adjusted assets 150, , , , ,886.7 Customer loans (gross) 137, , , , ,970.0 Adjusted common equity 10, , , , ,944.5 Operating revenues , , Noninterest expenses Core earnings *Data as of June 30. DKK--Danish krone. Business position: Agriculture and commercial real estate lender owned by and supporting Denmark's local and regional banks DLR Kredit's business position is moderate, reflecting its comparatively narrow client base and revenues concentrated in lending to the Danish agriculture sector. DLR Kredit's primary market is first-lien mortgage loans in Denmark, mainly on agriculture properties, but also on commercial and residential real estate. The company has maintained a 30% share of lending to the agricultural sector, where its owner bank and borrower SEPTEMBER 23,

4 relationships are long term. Revenue generation is based almost exclusively on charging customers a margin in addition to funding costs, given the pass-through structure of Danish mortgage bonds. The margins increased significantly following the recent crisis, which has resulted in substantial improvement in DLR Kredit's earnings and efficiency metrics. DLR Kredit's business model is concentrated in the agriculture industry. The agriculture industry in Denmark has been under stress due to trade restrictions imposed by Russia, and decreased demand of milk products from China, which have resulted in difficult economic conditions for milk and pork farmers. However, a large part of DLR Kredit's portfolio--about Danish krone (DKK) 41 billion (about 5.5 billion) or slightly greater than 30% of loans--is effectively residential real estate lending to residential rental properties, owners of cooperative housing, and farms that have other stable income. We reflect this as mortgage lending in our calculation of DLR Kredit's RAC ratio. We consider DLR Kredit's owners' support as critical to our assessment of DLR Kredit's business position as moderate. DLR Kredit cooperates closely with its 62 owner banks and provides the banks' customers with mortgage loans and pays commissions to the banks. The owners provide first-loss guarantees on referred customers (described in the section "Risk Position"). The owners' support for the company has been illustrated by improvements to DLR Kredit's capital position and simplification of the guarantee structure in recent years. In our view, the owner banks' guarantees and the ability to compensate losses with future commissions and portfolio level guarantees support DLR Kredit's creditworthiness of. Jyske Bank, DLR Kredit's largest shareholder with a stake of almost 10%, acquired mortgage company BRFkredit (BRF) in April of Since the acquisition, Jyske's focus on residential mortgage lending has had little impact on Jyske's transfer of agricultural and commercial real estate (CRE) loans to DLR Kredit. Furthermore, we think the more capital efficient guarantee structure implemented in January 2015 (described in the section "Risk Position") could lead to owner banks increasing transfers of CRE lending to DLR Kredit. Table 2 DLR Kredit A/S Business Position --Year ended Dec (%) 2016* Total revenues from business line (mil. DKK) , , Commercial & retail banking/total revenues from business line Return on equity *Data as of June 30. DKK--Danish krone. Capital and earnings: Remain strong amid pressure on earnings We assess DLR Kredit's capital and earnings as strong. This is based on our projection that the bank's RAC ratio before diversification effects--an S&P Global Ratings measure for capital adequacy--will remain between 13.0% and 14.0% until year-end At midyear 2016, this ratio stood at 13.5%, comfortably above our 10.0% threshold for a strong assessment. Our view of DLR Kredit's capital and earnings as strong reflects the solid capitalization amid some pressure on DLR Kredit's earnings of for the next two years. The current RAC ratio is a considerable improvement from 8.2% in 2011, due to owner banks' providing hybrid and share capital as well as DLR Kredit's considerably higher SEPTEMBER 23,

5 retained earnings in recent years. DLR Kredit's recapitalization plan to meet forthcoming regulatory capital requirements has resulted in stronger capital and equity levels. The company's repayment of a state-owned hybrid of DKK1 billion in May 2014, the repayment of a 100 million hybrid in June 2015, and the repurchase of Financial Stabilitet's DLR Kredit shares via retained earnings are signs that DLR Kredit's capital generation has improved considerably. DLR Kredit has also announced that it will repurchase of the Central Bank of Denmark's DLR shares with retained earnings, effective Sept. 30, Considering the share repurchases and subdued credit demand, we forecast DLR Kredit's total adjusted capital will decrease slightly over the next months. We expect this will result in a RAC ratio in the 13.0%-14.0% range, sustainably, which is at the higher end of our 10%-15% range for our strong assessment. We note that administrative margins on DLR Kredit's mortgage loans could increase over the next few years, given market developments for retail mortgage margins, particularly at shorter interest rate fixings. In addition, the company's strong efficiency, with cost-to-income ratios at about 20%, allows over 50% of revenues to be converted into after-tax profits, which we consider outstanding. We expect this performance, and the risk reduction owing to owner banks' guarantees, will lead to strengthening of DLR Kredit's capital buffers after completion of the share repurchases. Table 3 DLR Kredit A/S Capital And Earnings --Year ended Dec (%) 2016* Tier 1 capital ratio S&P Global Ratings' RAC ratio before diversification S&P Global Ratings' RAC ratio after diversification Adjusted common equity/total adjusted capital Net interest income/operating revenues Fee income/operating revenues (18.6) (18.2) (14.1) (23.2) (21.2) Market-sensitive income/operating revenues 0.8 (27.5) (15.3) (31.0) (19.4) Noninterest expenses/operating revenues Preprovision operating income/average assets Core earnings/average managed assets *Data as of June 30. Table 4 DLR Kredit A/S Risk-Adjusted Capital Framework Data (Mil. DKK) Exposure* Basel II RWA Average Basel II RW (%) S&P Global Ratings'RWA Average S&P Global Ratings'RW (%) Credit risk Government and central banks 1, Institutions 16,443 3, , Corporate 77,573 69, , Retail 35,858 11, , Of which mortgage 35,858 11, , SEPTEMBER 23,

6 Table 4 DLR Kredit A/S Risk-Adjusted Capital Framework Data (cont.) Securitization Other assets 8,875 8, , Total credit risk 140,025 93, , Market risk Equity in the banking book Trading book market risk -- 3, , Total market risk -- 3, , Insurance risk Total insurance risk Operational risk Total operational risk -- 2, , (Mil. DKK) Basel II RWA S&P Global Ratings'RWA % of S&P Global Ratings'RWA Diversification adjustments RWA before diversification 99,706 90, Total Diversification/Concentration Adjustments -- 16, RWA after diversification 99, , (Mil. DKK) Tier 1 capital Tier 1 ratio (%) Total adjusted capital S&P Global Ratings'RAC ratio (%) Capital ratio Capital ratio before adjustments 12, , Capital ratio after adjustments 12, , *Exposure at default. Securitisation Exposure includes the securitisation tranches deducted from capital in the regulatory framework. Exposure and S&P Global Ratings'risk-weighted assets for equity in the banking book include minority equity holdings in financial institutions. Adjustments to Tier 1 ratio are additional regulatory requirements (e.g. transitional floor or Pillar 2 add-ons). RWA--Risk-weighted assets. RW--Risk weight. RAC--Risk-adjusted capital. DKK--Danish krone. Sources: Company data as of June 30, 2016, S&P Global Ratings. Risk position: Loss guarantees mitigate credit risk and concentration in the agriculture sector Our assessment of DLR Kredit's risk position as adequate reflects the strength of the guarantees provided by it owner banks, including the ability for DLR Kredit to reduce future commissions. In our view, this compensates for the degree of concentration in the agricultural and commercial real estate segments. The company's loss experience during the financial crisis was better than the industry average, based, in part, on its portfolio of first-lien mortgage loans, its right to refuse loan applicants distributed by its owner banks, and first-loss guarantees from the distributing banks. Although some agriculture businesses have been under significant pressure from economic conditions, in particular milk and pork farmers, we believe interest rates will likely stay low in the coming two years, helping to support the repayment capacity of most borrowers. In addition, we note tentative recent signs of recovery for the sector that would further support DLR's asset quality. Based on these considerations, we forecast effective loan-loss provisions of about 13 basis points annually for DLR Kredit for the next two years, excluding owner bank guarantees. If conditions were to worsen further, we would expect that a large portion of the losses will be borne by the owner banks, which generally hold second-lien loans and other financing, in addition to first-lien mortgages transferred to DLR Kredit. SEPTEMBER 23,

7 We note, however, that the reported credit losses overstate the total impact on DLR Kredit's bottom line. A key component of the owner banks' guarantees is the ability for DLR Kredit to recapture losses in excess of the guarantees via reductions in current and future years' commissions. In our view, this reduces the bottom-line impact of credit losses considerably, though some timing differences of the commission recovery could result in temporary reductions in equity during periods of extreme stress. The ratio of new loan loss provisions to average customer loans was at 0.07% in 2015, compared with 0.14% in 2014 and an average of 0.09% in However, these ratios do not capture the fact that, since 2012, risk deductions in the form of commission reductions have also benefitted DLR Kredit's bottom line. All new lending by DLR Kredit after January 2015 is subject to a simplified guarantee structure. For loans issued prior to 2015, the historical guarantee structures remain in place. We expect the transition to the new guarantee structure will be largely complete by For loans subject to the new guarantee policy, the recovery of loan provisions on a single-loss provision occurs in the following order. (1)First-loss guarantee by the owner bank on 6% of the outstanding principal of the loan. (2)Loss reductions by reducing commission payments on all loans for the owner bank for up to three years. (3)Portfolio level guarantee of 6% of the entire portfolio of the owner bank's transferred loans, effectively reducing the 6% guarantee for performing loans. Once these three options are exhausted, DLR Kredit incurs the remaining credit losses. Loans issued prior to 2015 are subject to a joint guarantee for the agricultural loans and a loan-by-loan bilateral guarantee scheme covering all non-agriculture lending. The pre-2015 guarantees on the agriculture portfolio (DKK69 billion at year-end 2015) stipulate that: DLR Kredit will incur a minimum first loss of 0.25% of agriculture loans (totaling about DKK200 million in 2014) or 1.5x the five-year average of losses. If losses exceed this threshold in any one year, a joint guarantee by the owner banks covers a maximum of 5x DLR Kredit's five-year average losses or 2.5% of the outstanding agriculture loans. The remaining pre-2015 loan portfolio is backed by guarantees covering exposures with loan-to-value ratios of 35%-70% for CRE and 60%-80% for residential rental property and cooperative housing. On June 30, 2016, the aggregate value of these guarantees was DKK14.4 billion on a portfolio of about DKK34.1 billion. In addition, for the entire pre-2015 loan portfolio, DLR Kredit has the right to set off commission payments against incurred losses and may do so for four years. We recognize that our RAC framework overstates the risk of the loan portfolio because it cannot fully account for the joint guarantee on the agriculture portfolio, nor DLR Kredit's ability to withhold unpaid commissions to distributing banks to cover losses, nor the double-default nature of the guarantee mechanisms. As such, the adequate risk position assessment includes that the guarantees offset the sector concentrations in the portfolio. SEPTEMBER 23,

8 Table 5 DLR Kredit A/S Risk Position --Year ended Dec (%) 2016* Growth in customer loans 5.8 (0.1) (0.4) (1.2) 1.8 Total diversification adjustment / S&P Global Ratings' RWA before diversification Total managed assets/adjusted common equity (x) New loan loss provisions/average customer loans Net charge-offs/average customer loans Gross nonperforming assets/customer loans + other real estate owned N/A Loan loss reserves/gross nonperforming assets N/A *Data as of June 30. N/A--Not applicable. Funding and liquidity: Wholesale funding model and low liquidity buffers due to the Danish balance principle In our view, DLR Kredit's funding is adequate and its liquidity is average, reflecting the proven liquidity of the Danish covered bond market over the past several years, along with measures by the industry to reduce the reliance on short-term interest rate fixings. DLR Kredit's funding and liquidity ratios have continued their significant improvements over the last months, though they still compare negatively with those of international peers, due in large part to smaller liquidity buffers. DLR Kredit remains relatively more reliant on short-term funding and has a larger maturity mismatch between assets and liabilities than international peers owing to the balance principle for Danish mortgage lending, which has historically meant that DLR Kredit's bond maturities match interest rate fixings, rather than loan maturities. As of June 30, 2016, DLR Kredit's broad liquid assets represented only 0.42x of its short-term wholesale funding (compared with 0.14x at end 2013), and the stable funding ratio was 85.5% (compared with 41% at year-end We anticipate that the ratios will continue to improve over the next two years, thanks to the introduction of new funding structures with longer maturities and incentives for borrowers to choose longer-term interest fixing periods. DLR Kredit, like other Danish mortgage companies, is working to reduce the asset-liability mismatch by issuing bonds within the Danish regulatory framework that provide both a short-term interest rate for customers and a longer-term maturity profile of issued debt, while still adhering to the balance principle. One such product is "RT-Kort," an adjustable-rate mortgage that, at present, extends funding terms to four years while offering customers rates based on the six-month Copenhagen Interbank Tomorrow/Next Average or the Copenhagen Interbank Offered Rate. In addition, DLR Kredit has raised lending fees on shorter-term mortgages to encourage more customers to switch to longer-term interest rate fixings and, thereby, extended its funding maturity profile. As DLR Kredit reduces its structural mismatch of asset and liability maturities, we expect a very direct positive impact on our core measures of funding and liquidity. We also anticipate that the Danish Financial Services Authority's benchmarks to indicate banking activities which initially should be regarded as having a higher risk profile for mortgage institutions--the "Supervisory Diamond"--and the future regulatory funding and liquidity requirements will encourage DLR Kredit to develop more longer-term funding structures. SEPTEMBER 23,

9 DLR Kredit's funding and liquidity ratios mainly reflect the Danish mortgage market, which has been characterized by a widespread preference for one-year fixed-rate refinancing of 30-year loan commitments. This is further exacerbated by the "balance principle" regulation in Denmark, which requires domestic mortgage banks to refinance loans and bonds simultaneously, resulting in minimal balance-sheet liquidity due to a lack of unsecured debt issues or customer deposits supporting liquidity positions. Therefore, it is equity and subordinated debt issuance which supports mortgage banks' liquid securities. However, we note that the refinancing risk on DLR Kredit and other Danish mortgage issuers was passed to investors as a result of law changes in 2014 and consequently, we see DLR Kredit's liquidity position as neutral to the ratings. Although Denmark has implemented the Bank Recovery and Resolution Directive (BRRD), it has introduced an exemption from the bail-in tool for mortgage banks. Instead, DLR Kredit and other mortgage banks will be required to build up a bail-in-able buffer equivalent to 2% of unweighted loans, in addition to all applicable capital requirements. The 2% buffer will be phased in over the four years started June 1, 2016, and can comprise a broad variety of instruments, including equity, hybrids, and nondeferrable subordinated debt. It can also contain senior unsecured debt, which at the Danish regulator's discretion may be required to have contractual write-down features. As such, we anticipate DLR Kredit will add about DKK2.7 billion of eligible instruments, which will further increase the size of its liquidity buffers and improve its liquidity metrics. Table 5 DLR Kredit A/S Funding And Liquidity --Year ended Dec (%) 2016* Long-term funding ratio Stable funding ratio Short-term wholesale funding/funding base Broad liquid assets/short-term wholesale funding (x) Short-term wholesale funding/total wholesale funding Narrow liquid assets/3-month wholesale funding (x) *Data as of June 30. Support: The implementation of the BRRD's bail-in provision makes the likelihood of extraordinary government support uncertain We consider that DLR Kredit has moderate systemic importance in Denmark, given the importance of the agricultural sector to the Danish economy. However, following the implementation of the BRRD bail-in provisions in June 2015, we view this support as uncertain for senior unsecured creditors. While BRRD's bail-in provision will not be used for Danish mortgage banks, all other tools to resolve a bank under the BRRD, such as establishing a bridge bank or an asset-separation exercise, will be available to the authorities to resolve a Danish mortgage bank. As such, we no longer add any notches to the issuer credit rating for government support for DLR Kredit. Additional rating factors: None No additional factors affect the ratings. SEPTEMBER 23,

10 Related Criteria And Research Related Criteria Bank Hybrid Capital And Nondeferrable Subordinated Debt Methodology And Assumptions, Jan. 29, 2015 Group Rating Methodology, Nov 19, 2013 Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Bank Capital Methodology And Assumptions, Dec. 6, 2010 Related research Denmark's Proposed Regulatory Changes Could Lower Covered Bonds' Credit Risk, Sept. 16, 2014 Credit FAQ: The Danish Covered Bond Market Explained, July 15, 2014 Credit FAQ: Why Denmark's Proposed Covered Bond Law Doesn't Fully Eradicate Refinancing Risks, Feb. 4, 2014 Banking Industry Country Risk Assessment: Denmark, Dec 10, 2014 Commercial Paper I: Banks - March 23, 2004 Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity - April 27, 2015 Methodology For Mapping Short- And Long-Term Issuer Credit Ratings For Banks - May 04, 2010 Quantitative Metrics For Rating Banks Globally: Methodology And Assumptions - July 17, 2013 Revised Market Risk Charges For Banks In Our Risk-Adjusted Capital Framework - June 22, 2012 Related Research Nordic Banks' Capital Growth Tapers Off, Aug. 2, 2016 Future of Banking: Nordic Banks Looking Svelte In The Fintech Race, June 14, 2016 Nordic Banks Stay Resilient To Negative Rate Noir, Mar. 24, 2016 Banking Industry Country Risk Assessment: Denmark, Jan 28, 2016 Anchor Matrix Industry Risk Economic Risk a a a- bbb+ bbb+ bbb a a- a- bbb+ bbb bbb bbb a- a- bbb+ bbb+ bbb bbb- bbb- bb bbb+ bbb+ bbb+ bbb bbb bbb- bb+ bb bb - 5 bbb+ bbb bbb bbb bbb- bbb- bb+ bb bb- b+ 6 bbb bbb bbb- bbb- bbb- bb+ bb bb bb- b+ 7 - bbb- bbb- bb+ bb+ bb bb bb- b+ b bb+ bb bb bb bb- bb- b+ b bb bb- bb- b+ b+ b+ b b+ b+ b+ b b b- Ratings Detail (As Of September 23, 2016) DLR Kredit A/S Counterparty Credit Rating Senior Secured BBB+/Stable/A-2 A SEPTEMBER 23,

11 Ratings Detail (As Of September 23, 2016) (cont.) Senior Secured Senior Secured Senior Secured Short-Term Secured Debt Counterparty Credit Ratings History 13-Jul May Jul Sep Jun May-2012 Sovereign Rating Denmark (Kingdom of) A/Stable AAA AAA/Stable A-1+ BBB+/Stable/A-2 BBB+/Watch Neg/A-2 BBB+/Stable/A-2 BBB+/Positive/A-2 BBB+/Watch Pos/A-2 BBB+/Stable/A-2 AAA/Stable/A-1+ *Unless otherwise noted, all ratings in this report are global scale ratings. S&P Global Ratings credit ratings on the global scale are comparable across countries. S&P Global Ratings credit ratings on a national scale are relative to obligors or obligations within that specific country. Issue and debt ratings could include debt guaranteed by another entity, and rated debt that an entity guarantees. Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@spglobal.com SEPTEMBER 23,

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