Moody’s is reviewing for downgrade Deutsche Pfandbriefbank (pbb) because it has concerns about the bank’s wholesale funded business model and the level of support from the German government.

The rating agency today (Tuesday) said that it has placed on review for downgrade pbb’s standalone bank financial strength rating (BFSR), at E+, and A3 senior debt and deposit ratings. As a result, the bank’s subordinated debt (B2) and Prime-1 short term ratings have also been placed on review for downgrade.

Pbb’s senior debt and deposit ratings are likely to remain investment grade, said Moody’s.

It rates mortgage and public sector Pfandbriefe issued by pbb, at Aa1 and Aaa, respectively, with a Timely Payment Indicator (TPI) of “probable-high”. Under Moody’s TPI methodology the public sector covered bonds are faced with zero TPI leeway, meaning that a downgrade of the issuer rating would, all else being equal, automatically lead to a downgrade of the Pfandbriefe, while the mortgage covered bonds’ rating could withstand a downgrade of the issuer of one notch.

Moody’s said its review of pbb’s ratings reflects the rating agency’s concerns regarding the bank’s wholesale funded business model together with “increased asset-side vulnerabilities”, also as result of a deteriorating operating environment in Europe.

It said that pbb has made progress in stabilising and rebuilding its business following an asset transfer to FMS Wertmanagement in October 2010, and that it has remained profitable in the last seven quarters and successfully re-entered the capital markets, including issuing benchmark covered bonds. In addition, pbb’s liquidity levels remain satisfactory and its asset quality compares positively with its peer group as a result of the previous asset transfer, said Moody’s.

However, the rating agency said that several factors are putting pressure on the long term viability of pbb’s franchise, noting that the bank is constrained in its ability to obtain senior unsecured funds maturing beyond 2015, which is the date by which the German government, the bank’s sole owner, must sell its majority stake according to a state aid ruling of the European Commission (EC).

Moody’s also flagged high leverage at pbb and sizeable exposures to sectors and regions such as the euro-zone periphery, including Spain (Eu5.1bn) and Italy (Eu4.2bn), which could expose the bank to potentially material losses over the medium term. Commercial real estate is particularly vulnerable to impairments in the weakening European operating environment, added the rating agency.

The longer term viability of pbb’s business model is coming under increasing pressure, said Moody’s, because of low core profitability, which partly reflects the bank’s low yielding public finance legacy portfolio.

“Challenges for the bank to build up more profitable businesses (including commercial real estate) have increased as market conditions and the operating environment have deteriorated as a result of the euro area debt crisis,” it said.

As a result, Moody’s review will focus on pbb’s ability: (i) to raise funding in the debt capital markets at conditions that allow for a suitable margin; (ii) to bear potential losses in the context of its exposures to euro area peripheral countries; (iii) to write new business to replace the existing – partly low yielding – asset base; and (iv) to adjust its business profile to the changing regulatory and market environment, as a precondition for the bank to be privatised by 2015.

Moody’s will also reassess its very high assumptions for support from the German government in the light of the pending privatisation and shifting policy towards support in Europe. Current assumptions result in seven notches of rating uplift from pbb’s b1 standalone credit assessment, more than the level of support assumed for pbb’s peers, according to Moody’s.

The rating agency said this reflects the strong support that has been evolving since pbb’s parent Hypo Real Estate (HRE) first experienced distress and needed financial assistance in late September 2008, and the role the government has played in restoring pbb’s capital and liquidity position.

“However, there remain uncertainties regarding the level of support creditors could expect over the rating horizon that arise from the government’s need and desire to privatise the bank, and the challenges it will face in doing so given the weak market outlook and pbb’s size and profile,” said Moody’s.

It also noted that implementation of the bank resolution regime as part of the German Bank Restructuring Act in January 2011 allows for more flexibility to impose losses on certain debt classes and has made government support less predictable.