State support for German Pfandbrief issuers is likely to remain strong for now under most “reasonable” scenarios, according to Fitch, but implementation of restructuring frameworks at the national and EU level could eventually lead to changes in levels of external support.

In a special report published on Tuesday the rating agency said that state support for German Pfandbrief issuers drives their ratings, noting that out of 24 German banks that had Viability Ratings (VRs) from Fitch as at the end of July, 19 had issuer default ratings (IDRs) based on state or institutional support and not on their VRs, which represent the rating agency’s view as to the intrinsic creditworthiness of an issuer.

It drew attention to four banks for their strong or expressed focus on commercial real estate (CRE) lending, predominantly wholesale funding profile including Pfandbrief issuance, and their independence (not owned by another bank or group of banks), and noted that the IDRs of these banks – Aareal Bank (A-/F1/bb), Deutsche Pfandbriefbank (A-/F1/bb), Corealcredit Bank (BBB-/F3/bb), and Düsseldorfer Hypothekenbank (BBB-/F3/c) – are at their Support Rating Floors.

Fitch said that if its expectation of strong state support for medium-sized and small Pfandbrief issuers weakened, most of these banks would be downgraded to speculative grade.

The rating agency noted that German Pfandbriefe have an “impeccable” track record, with investors benefitting from the protection enshrined in the Pfandbrief Act and from state support for German banks in general and Pfandbrief issuers in particular.

“The importance of broad systemic support for banks in Germany is compounded by the fact that the long term viability of some specialised commercial real estate and public-sector lenders is still far from certain,” said Fitch. “Some banks’ business models now centre on leveraging the Pfandbrief product while closing the unsecured funding gap with deposits from retail and institutional investors backed by the Deposit Protection Fund.”

However, Fitch flagged the possibility of changes to the level of broad state support for banks as a result of Germany’s bank restructuring act and European Commission legislation on bank resolution. These are important steps towards a workable alternative to ongoing external support, it said, namely predictable and operational bank restructuring.

Michael Dawson-Kropf, senior director in Fitch’s financial institutions group, said that the German authorities, in some cases in co-operation with the Deposit Protection Fund of German Banks (DPF), have provided support in times of stress to specific Pfandbrief issuers to ensure that the robustness of the product has not had to be put to the test.

“However, the medium- to long term consequences of the financial crisis and the resulting changes to the regulatory environment may eventually alter the authorities’ assumption that support for the Pfandbrief always needs extend to their issuers,” he added.

In the report Fitch analysts said that the any alternation of such assumptions are a matter of timing, with detailed living wills, ring-fencing and other operational measures needed to ensure that winding up banks becomes a workable alternative to ongoing external support.

“Until these measures are in place, Fitch doubts that the German authorities would apply the Restructuring Act, given the risk to financial stability,” said the rating agency. “In the meantime, for some German banks, the incentive to apply the Act is diluted by the DPF being the only – or at least the largest – unsecured creditor.”

Deposits backed by the DPF, mainly in the form of Schuldscheine, have become the only access to senior unsecured funding for some German banks, including troubled Pfandbrief issuers, said Fitch, which creates a moral hazard if a bank is exclusively funded by Pfandbriefe and insured deposits and goes into insolvency. This is because all losses above the equity buffer would need to be absorbed by the DPF, with no group of uninsured investors to share the losses with.

UniCredit analysts said it accepted Fitch’s criticism of issuers’ standalone credit quality lagging improvements of the Pfandbrief product and reliance on Schuldscheine backed by the DPF, but took issue with some aspects.

“We do not necessarily consider the heavy reliability on protected funding to be a weakness,” they said. “The protection mechanisms are certainly older than the current crisis.”The conclusions Fitch has drawn from the financial status of the four independent banks (Aareal, Deutsche Pfandbriefbank, Corealcredit and Düsseldorfer Hyp) are too general, they added.

“Particularly regarding Aareal, which is the only institution in the list above that had to be saved, one has to accept that the utilisation of protected funding is not necessarily a sign of weakness,” they said. “’If there is a wall right next to you, you might be tempted to lean on to it when you are tired’.

“In other words, there might be other ways for banks to find unsecured funding, but why choose the hard way?”