KommuneKredit Copenhagen, Denmark

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1 AUGUST 2, 2010 SUB-SOVEREIGN CREDIT ANALYSIS KommuneKredit Copenhagen, Denmark Table of Contents: SUMMARY RATING RATIONALE 1 INTERNATIONAL PEER COMPARISONS 1 RATING OUTLOOK 2 ISSUER OVERVIEW 2 KEY RATING CONSIDERATIONS 2 Institutional Framework 2 Financial Position and Performance 3 Capital Adequacy 4 Liquidity 5 Asset Quality 5 Risk Positioning 7 RATING HISTORY 9 ANNUAL STATISTICS 10 MOODY S RELATED RESEARCH 14 Analyst Contacts: LONDON Magnus Thuren Analyst Magnus.Thuren@moodys.com Thomas Amenta Senior Vice President Thomas.Amenta@moodys.com David Rubinoff Team Managing Director David.Rubinoff@moodys.com Summary Rating Rationale The Aaa issuer and debt ratings of KommuneKredit, with stable outlook, reflect its extremely strong franchise, which has been built over a century and now benefits from a very high market share of long-term loans to local governments in Denmark. The rating also reflects:» Strong asset quality and highly risk-adverse asset/liability management, which has functioned well throughout the global financial crisis» The joint and several guarantee of its members, which comprise all of Denmark s municipalities and regions» Strong financial fundamentals, including a strong equity position to absorb unanticipated risks» Strong integration within national governmental funding policies, as it reports directly to the Ministry of the Interior and Health, which is responsible for approving any changes to the organisation s bylaws and overseeing its activities. International Peer Comparisons KommuneKredit s Aaa rating reflects its stable and dominant franchise, the security of its lending, its prudent asset/liability management, its high level of capital and the strength provided by the joint-and-several guarantee of its members. Its capital position is higher than its Nordic peers and has not been challenged by an increase in demand for its lending. KommuneKredit s rating is the same as other specialised lenders in Nordic countries and in the Netherlands. This Credit Analysis provides an in-depth discussion of credit rating(s) for KommuneKredit and should be read in conjunction with Moody s most recent Credit Opinion and rating information available on Moody's website.

2 Rating Outlook The outlook is stable, reflecting KommuneKredit s strong market share, the strength of the joint-andseveral guarantee of its members, its solid capitalisation as well as its conservative asset/management and liquidity practices. Issuer Overview Established in 1898 by a special law that was recently updated in 2006, KommuneKredit is the oldest specialised local government lender in the Nordic region. Membership is voluntary and is currently made up of all municipalities and regions in Denmark. KommuneKredit reports directly to the Ministry of the Interior and Health, which oversees the local government sector as well. Key Rating Considerations Institutional Framework KommuneKredit s government-related footprint is considered significant, considering its establishment through special legislation, as its clients and members are restricted to the public sector and given the strict oversight of the Ministry of Interior and Health, which must approve changes to its risk guidelines. Membership includes all Danish regional and local governments Lending is restricted to Danish local authorities and any semi-municipal institutions benefiting from the 100% guarantee of a local authority. 1 Members include all of Denmark s municipalities and regions; any member or regional authority that obtains a loan from KommuneKredit or enters into a leasing contract with it automatically becomes a member of the institution. Joint and several liability underpins KommuneKredit s creditworthiness Members are directly, severally and jointly liable for all commitments entered into on their behalf by KommuneKredit. However, there have been no claims under the pledge to date and the process by which notifying and securing funding from its members in the case of a call on the pledge have never been tested. A member can only be released from this responsibility when all of its debt has been repaid and when it has fulfilled its liabilities according to the rules of membership. The pricing and security conditions of KommuneKredit s loans are offered equally to all members, regardless of the loan s size or the financial conditions of the member. Whilst it is not required to bid on all loans, in practice, KommuneKredit acts as a lender of last resort, which helps to reinforce the collective nature of the firm s activities and support within wider government financial policy. KommuneKredit is not subject to Danish banking law or regulation by the Financial Supervisory Authority (Finanstilsynet or FSA). The Ministry of the Interior and Health is the institution s supervisory authority. 1 Lending also includes previous lending to Faroe municipalities that have the guarantee of the Landsting and are guaranteed by the Kingdom of Denmark at 75% of interest and remaining debt 2 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

3 Long-standing market dominance KommuneKredit holds a very high market share of local government financing. Competition remains limited as low lending rates and the smaller size of requested borrowings remain unattractive to commercial banks. New covered bond legislation, which would allow the pooling of local government assets, could give rise to future competition, although this has not yet developed. It remains possible that the broader privatisation of local government-owned electricity, heating, and power companies could reduce KommuneKredit s total lending market, as these entities would no longer qualify as borrowers. Other activities within core market KommuneLeasing A/S, a wholly owned subsidiary of KommuneKredit, has leasing agreements with 94 of 98 municipalities and with all regions. KommuneLeasing is most active in IT and office equipment, vehicles and hospital equipment. Financial Position and Performance Profits down, due to planned reductions in margins Like other specialised lenders, KommuneKredit s profitability depends primarily on the spread between its lending rates and funding costs. Continuing flight to quality has improved its margins, despite the fact that it continued to offer competitive lending rates. KommuneKredit s board of directors decided to pass some benefits on to borrowers via an extraordinary interest rate reduction on loans that had been entered into under specific conditions. 2 This resulted in good returns, albeit intentionally below the record results of the prior year.» Net interest income was set at DKK350 million, despite being on track to achieve DKK492 million for the year (DKK378 million recorded in 2008)» As a result of the adjustment to interest rates and value adjustments on lending, funding and derivative financial instruments of DKK39 million (DKK24 million in 2008), after-tax profit for 2009 was recorded at DKK192 million (DKK254 million in 2008)» As shown in Exhibit 1, net interest margins declined to 29bps as of year-end 2009 from 33bps in It is unclear whether this still generally high level of margins will be sustainable over the long term, although over the near-to-middle term strong competition from other funders appears unlikely KommuneKredit receives fees for administrative expenses associated with its loans and the returns on its investment portfolios. 3 In 2009, strong financial results allowed KommuneKredit to reduce this fee to zero on the bulk of its loans. 2 The interest adjustment amount was paid in March 2010 and distributed on the accrued interest expenses on loans excluding bondloans loans from KommuneKredit in proportion to the borrowers accrued interest expenses on loans excluding bondloans (92% of gross lending) granted by KommuneKredit for KommuneKredit s bylaws allow for a management charge to cover administrative expenses. The charge is currently 0 bps of outstanding loans and limited to a maximum of 8 bps. 3 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

4 EXHIBIT 1 Net interest margin from 1999 to 2009 KommuneKredit (%) Source: KommuneKredit Leasing gains continue KommuneLeasing A/S saw its inflow of new lease assets grow by DKK892 million in 2009 from DKK738 million in The company realised a pre-tax profit of DKK22 million in 2009, compared to DKK21 million in KommuneLeasing anticipates that its pricing will allow it to maintain its high market share going forward. Efficient cost structure KommuneKredit s high lending volumes offer economies of scale, which are reflected in its cost structure. Its operating expenses-to-total assets ratio was 6bps in 2009, unchanged from 2008 and It has stayed within a steady range of 6bps to 10bps since As KommuneKredit has no branches, its cost base is considerably lower than that of Danish commercial banks. At the end of 2009, KommuneKredit had 57 employees, up from 44 in 2007 mainly due to higher risk-management costs as a result of the global financial crisis. In addition, KommuneLeasing has increased their staff to support the administrative demands related to administration of leasing contracts. Capital Adequacy Capital levels strongly support stand-alone credit KommuneKredit has relatively high capital levels compared to its peers and is well placed for the risks to its business as a standalone entity. Despite the robustness of current ratios they may continue to decline given the current balance sheet structure and anticipated lending margins going forward.» KommuneKredit is required by law and within its articles of association to maintain total equity capital of no less than 1.0% of its total obligations, which is substantially lower than the internal target of 3.0%. Equity falling below the 1.0% level would trigger a capital call to its members, at a time that is likely to be well in advance of a capital crisis. This explicit mechanism offers a useful margin not enjoyed by other specialised lenders.» At year-end 2009, KommuneKredit maintained an equity position of 3.1% of assets (DKK4.375 billion), down from 3.25% in 2008, but remaining substantially over the 1% requirement. 4 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

5 Whilst KommuneKredit is not formally subject to Basel II and does not calculate a Tier 1 ratio, Moody s estimates that if such a calculation was undertaken, the results would comparable to the high Tier 1 ratios of Dutch specialised lenders. Liquidity KommuneKredit s liquidity management is strong KommuneKredit has maintained ample liquidity throughout the financial crisis, allowing it to act as lender of last resort for Danish local governments. In practice, KommuneKredit analyses its total net cash flow position based on its lending and investment activities as well as prudent working estimats of potential new lending requirements. The firm aims to maintain sufficient liquidity to meet approximately 12 months of ongoing business activities without access to financial markets. In its worst-case analysis, which takes into account the full implementation of adverse calls in both financing and lending portfolios, KommuneKredit anticipates that cash outflows can be met with existing cash inflows for about six months, before liquidity investments must begin to be sold. In order to limit liquidity demands in its operations, KommuneKredit s total liquidity deficits, assuming no new loans are made or funding is raised, may not exceed the equity capital as reported in the previous quarterly financial statements from the Ministry of the Interior and Health. Although KommuneKredit s internal liquidity has grown substantially over the past five years, the firm continues to have a smaller liquidity pool and less investment exposure than other Nordic specialised lenders.» In 2007, the Ministry of the Interior and Health permitted KommuneKredit to raise up to 25% of total lending without commitments from local authorities to take up the funding. Under this higher threshold, the securities and cash portfolio has grown to approximately DKK21.5 billion or 15% of total assets as of December 2009 from DKK15.3 billion or 12% of total assets in These amounts may vary substantially over the course of the year with the pace of lending and cash influx from large benchmark issues.» The equity capital investments is split between a strategic portfolio which is required under the firm s bylaws to be held for first-line liquidity needs, and a performance portfolio, which aims for higher returns but which is also highly liquid.» If required, KommuneKredit could preserve cash by cutting back on its lending. Given its strong market position, Moody s believes that KommuneKredit could ration funding to the sector without seriously eroding its franchise, although the current levels of pre-funding make this less of an immediate possibility. Asset Quality As KommuneKredit may only lend to local governments, regions or entities that they guarantee, its loan portfolio is of high quality and is secure. Moody s views the credit quality of the local government sector in Denmark to be very high, with KommuneKredit never having incurred a loss on any of its loans in its 112-year history. 5 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

6 » Large share of governmental services. The local government sector currently makes up approximately 50% of governmental spending and 20% of GDP; Moody s anticipates that this high level of integration into the social fabric of the country, combined with effective controls by the central government to ensure prudence and to balance funding where necessary will lead to very high support from the sovereign to individual local governments in highly unlikely cases of financial distress.» Reliable and flexible revenues. Local governments have an unlimited right to levy taxes on income and property. Ongoing finances for the sector and broader reforms have been well-managed through consultation and there is consensus between central and local governments on total spending. A recent example of effective reform was the consolidation and elimination of approximately two-thirds of local governments, which required only limited intervention by the central government to assist or direct mergers despite maintaining consistent funding for services.» Equalisation payments effective. The equalisation of resources within the local government sector in order to meet the overall costs of government services is strongly managed at the national level. Accounting standards are high and government oversight has historically been thorough.» Strict oversight and intervention when necessary. Prudential regulations imposed by the central government provide strict controls and effectively limit debt accumulation beyond agreed levels for the sector. Denmark is very highly ranked internationally in terms of transparency and absence of corruption. Effective powers of intervention by the central government to ensure prudence and to balance funding have been used in the highly infrequent cases of financial distress.» No provision for bankruptcy. Danish local governments are prevented from declaring bankruptcy. 4 EXHIBIT 2 Growth in gross lending and total equity KommuneKredit DKK million 120, ,000 80,000 60,000 40,000 20,000 0 Gross Loans Total Equity ,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, DKK million Source: KommuneKredit Loan exposures are generally balanced but are inevitably concentrated given the limitations on KommuneKredit s business lines. Its ten largest exposures accounted for approximately 28% of the loan portfolio as of 31 May 2010, with the largest borrower accounting for 4.6% of total loans. 4 KommuneKredit Publications Summary AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

7 Sustained growth, although pace is slowing. As of December 2009, KommuneKredit s loan portfolio had grown by 6.0% to DKK111.5 billion from DKK105.2 billion at year-end Gross new lending in 2009 fell to DKK30.8 billion from DKK40.5 billion in 2008, driven by a decrease in the number of loans granted to regions; it is now at a level that is more historically consistent with KommuneKredit s business and the sector s demand. Risk Positioning Solid corporate governance supported by a well-diversified board The Ministry of the Interior and Health is the supervisory authority for KommuneKredit and is responsible for approving any changes to the organisation s bylaws and overseeing its activities. The ministry sets limits for liquidity and pre-financing and must approve KommuneKredit s rules for the management of financial risks and the use of financial instruments. Its board of management and its auditors have a legal obligation to inform the ministry of any material information that may prevent it from meeting its obligations. The board of directors consists of 10 members, with two members representing the regional authorities and eight representing the municipalities. The board of directors appoints the board of management, which itself consists of two managing directors. The managing directors are responsible for the decision-making related to everyday business. However, the board of directors has to approve all major decisions taken by the management. Comprehensive asset-liability management KommuneKredit s policies for hedging and managing counterparty risks in the liquidity portfolio and hedge providers have held up very well to global financial volatility. KommuneKredit s guidelines, as approved by the board of directors, require the institution to closely match its funding and lending activities in terms of currency, maturity and interest. Interest rate risk is calculated as the capital loss incurred by a 1% parallel increase in rates, with the impact felt largely in the investment portfolio. The maximum exposure is 4.5% of equity capital as stated in the latest adopted financial statement (DKK4.375billion at year-end 2009) or DKK188 million for At year-end 2009, the calculated exposure of DKK87 million was well within limits. Currency exposure is essentially zero, with the group s bond portfolio related to equity capital placed in Danish kroner. Counterparty risks limited to high-quality credits. New exposures must be Aa3 or better or to those rated A1 if special security is provided. 5 Financial counterparties must be in the EU, full members of the OECD or have special agreements with the International Monetary Union.» Total liquidity funding is highly rated. KommuneKredit s pre-funding must be invested in highly liquid and highly rated bonds in a hedged currency or placed on short term deposit. Investments are only made in bonds rated at least Aa3 or equivalent. As of May 2010, 45.4% of the total portfolio was Aaa to Aa3 Government, Danish Mortgage Backed and Financial Bonds; 17.1% of the total portfolio was invested in highly rated short-term papers, with the balance in deposits. KommuneKredit reports that it has no exposure to US sub-prime related securities and no structured bonds are permitted. 5 In addition, minor lines may be assigned to banks in Denmark that are under the supervision of the Danish Financial Supervisory Authority and to Danish branches of foreign credit institutions that are under the supervision of the Danish Financial Supervisory Authority. 7 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

8 » Frequent monitoring. Derivative counterparties are monitored daily and are assessed along with investments on a total credit-line exposure per counterparty.» Additional counterparty support when needed. KommuneKredit began to extend the use of credit support annexes (CSAs) to all of its derivative counterparties, with 20 agreed as at year-end These agreements currently cover most of the firm s largest counterparties. Market funding from diversified sources KommuneKredit issues bonds internationally (57%) and in Denmark (43%) in order to minimise its dependence on specific markets and instruments. 6 As can be seen in Exhibit 1, exposures may vary over time. Total funding increased to DKK57 billion in 2009 from DKK54 billion in 2008, demonstrating a strong continuity of funding. KommuneKredit has particularly benefitted from a flight to quality and lower yields, particularly for its short-term debt, which has helped maintain strong net interest margins over the last two years. Like other specialised lenders, KommuneKredit may target specific markets, sometimes with particular concentration over brief periods. EXHIBIT 3 Funding distribution by currency 2009 CHF 9% Other 7% 2008 CHF 8% Other 7% EUR 16% DKK 43% EUR 15% DKK 49% JPY 10% JPY 11% Source: KommuneKredit USD 15% USD 10% We regard KommuneKredit s global recognition as a borrower as its major strength and therefore believe that it must protect its reputational standing in the market. Like most other specialised lenders, KommuneKredit can issue notes with more variable payments and widely changing market values, which may only be appropriate for sophisticated investors. Operational risk is low KommuneKredit has reviewed all significant business procedures in order to ensure that they are fully updated and comply with what constitutes adequate controls. Written business procedures and reconciliation and control procedures in relevant areas ensure the continual monitoring and limitation of operating risks. Risk management is separate from the finance department and reports directly to the CEO. 6 In its domestic market, KommuneKredit mostly issues bonds with fixed coupons on the NASDAQ OMX Copenhagen A/S. In the international market, it uses its EMTN and ECP programmes. 8 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

9 KommuneLeasing is not exposed to business risk related to depreciation in the value of leased assets. All losses associated with early cancellation or from lower-than-expected resale values are covered by the local authority to which the leasing contract is assigned. KommuneKredit prepares its financial statements in accordance with the International Financial Reporting Standards (IFRS), as adopted by the EU Commission. Rating History KommuneKredit 23 AUG 1999 Aaa RATING RAISED 19 JUN 1995 Aa1 RATING ASSIGNED 9 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

10 Annual Statistics KommuneKredit Summary Balance Sheet (DKK million) 12/31/09 12/31/08 12/31/07 12/31/06 12/31/05 31/12/04 31/12/03 Due from banks 11,001 10,219 8,811 6,367 9,070 3,805 6,071 Cash & central bank Securities 12,350 5,067 12,077 3,084 3,413 3,381 3,257 Gross loans 111, ,213 90,703 86,159 80,408 75,178 70,449 Loan loss reserves (LLR) Derivative Financial instruments 8,055 8,121 5,900 6, Fixed assets Other assets Total assets 143, , , ,757 93,409 82,868 80,216 Total assets (USD million) [1] 27,579 24,369 23,205 18,155 14,802 15,202 13,528 Demand deposits Savings deposits [2] Due to banks Market funds 133, , ,403 92,167 83,348 77,053 73,107 Insurance liabilities Other liabilities 4,906 7,351 8,440 6,853 6,425 2,311 3,695 Total liabilities 138, , ,843 99,020 89,772 79,363 76,803 Subordinated debt Shareholders' equity 4,375 4,183 3,929 3,738 3,637 3,505 3,413 Total capital funds 4,375 4,183 3,929 3,738 3,637 3,505 3,413 Total liabilities & capital funds 143, , , ,758 93,409 82,868 80,216 Derivatives - notional amount ,719 96,459 86,142 80,284 Derivatives - replacement value ,515 4,469 2,829 2,493 Contigent liabilities ,000 5,800 6,300 Risk weighted assets (RWA) ,703 4,726 4,840 3,048 4,122 Assets under management (DKK million) [3] Number of employees Summary Income Statement +Interest income 4,361 5,224 4,128 3,118 2,771 2,683 2,785 -Interest expense 4,019 4,868 3,873 2,922 2,569 2,503 2,657 =Net interest income AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

11 KommuneKredit 12/31/09 12/31/08 12/31/07 12/31/06 12/31/05 31/12/04 31/12/03 +Trading income Fees & commissions Insurance income (net) Other operating income =Operating income Personnel expenses Other operating expenses = Operating funds flow Amortisation/depreciation (Total operating expenses) =Preprovision income (PPI) Loan loss provisions (LLP) Other non operating adjustments [4] Extraordinary profit / loss =Pretax income Taxes =Net income Minority interests =Net income (group share) Growth Rates (%) Gross loans Total assets Customer deposits (demand and savings) Net interest income Fee and commission income Operating expenses Preprovision income Net Income Income Statement in % Average Risk Weighted Assets Net interest income Trading income Fee and commission income Insurance income Operating income Operating expenses Preprovision income Loan loss provisions AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

12 KommuneKredit 12/31/09 12/31/08 12/31/07 12/31/06 12/31/05 31/12/04 31/12/03 Extraordinary profit Net income Liquidity, Funding & Balance Sheet Composition Avg. liquid assets % avg. total assets Avg. gross loans % avg. total assets Avg. customer deposits % avg. total funding Avg. interbank funds % avg. total funding Avg. market funds (excl. interbank) % avg. total funding Avg. sub debt % total funding Avg. liquid assets % avg. customer deposits Avg. gross loans % avg. customer deposits Avg. market funds reliance [5] Avg. RWA % avg. total assets Breakdown of Operating Income in % Net interest income % operating income Trading income % operating income Fees & commissions % operating income Insurance income % operating income Other operating income % operating income Profitability Annualising by multiplying by 2 Yield on avg. earning assets (%) Cost of interest bearing liabilities (%) Net interest margin (%) Recurring earning power (PPI % avg. assets) Risk-weighted recurring earning power (PPI % avg. RWA) Return on average assets (%) Return on avg. RWA (%) Return on equity (period end) (%) Net interest income coverage of loan loss provisions Loan loss provisions % preprovision income Internal capital growth (%) Dividend payout ratio (%) Efficiency 12 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

13 KommuneKredit 12/31/09 12/31/08 12/31/07 12/31/06 12/31/05 31/12/04 31/12/03 Cost/total assets Cost/income ratio (operating expenses % operating income) Operating expenses % average assets Operating income / employee (DKK thousand) 6,175 7,600 6,414 4,791 4,772 4,331 4,809 Operating expenses / employee (DKK thousand) 1,632 1,600 1,616 1,613 1,534 1,308 1,771 PPI / employee (DKK thousand) 4,544 6,000 4,798 3,178 3,238 3,023 3,038 Total assets / employee (DKK million) 2,512 2,576 2,677 2,283 2,031 1,842 1,823 Asset Quality Problem loans % gross loans LLR % problem loans LLR % gross loans Loan loss provisions % gross loans Problem loans % (shareholders' equity + LLR) Replacement value % shareholder's equity Capital Adequacy (Period End) Tier 1 ratio (%) Total capital BIS ratio (%) Shareholders' equity % total assets Equity participations % shareholders' equity [1] USD figure uses historical exchange rate against the DKK. [2] Full disclosure may not be available for all years. The amount is then included in "demand deposits". [3] As reported by the bank [4] This may include value adjustments of securities. [5] Avg. [(market funds-liquid assets) % (earning assets-liquid assets)] 13 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

14 Moody s Related Research Analysis:» Denmark, April 2008 (108753) Banking System Outlook:» Denmark, July 2009 (118576) Banking Statistical Supplement:» Denmark, June 2009 (117615) Statistical Handbook:» Non-U.S. Regional and Local Governments, June 2009 (117472) Special Comments:» Specialised Lenders to Nordic Local Governments, August 2006 (98800)» Government Related Issuers: May 2007 Update, March 2005 (102945)» Rating Impact of GRI Methodology for Non Depository Financial Institutions in the EMEA Region, June 2005 (93349) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 14 AUGUST 2, 2010 CREDIT ANALYSIS: KOMMUNEKREDIT

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