HRE group is understood to have started the search for a buyer for Depfa Bank and, with private equity firms as potential buyers, a covered bond analyst has suggested that the likely strategy of the acquirer could have negative implications for the covered bonds.

Hypo Real Estate Group is said to have mandated Citi to find a buyer for Depfa Bank plc, its Irish subsidiary and parent of Depfa ACS Bank, which was a leading covered bond issuer before the German group had to be bailed out in 2008. News of the move to sell the Irish unit emerged in mid-May, and is in keeping with the terms of a bail-out agreed with the European Commission, under which Depfa must be reprivatised by 2014. Private equity buyers have been identified as the most likely potential buyers, with Lone Star, JC Flowers and Apollo mentioned in the same Reuters article that reported the Citi hire.

Florian Eichert, senior covered bond analyst at Crédit Agricole, says that other banks are more or less out of the picture as potential buyers given that the sector is faced with higher capital requirements and sluggish economic growth, and are trying to reduce risk-weighted assets.

And because private equity funds in most cases have a different approach to running a bank than that of a more traditional buyer, he says, it makes sense to consider the possible implications of a sale of Depfa to such an entity as they could apply more generally to rescued covered bond issuers that have to be sold as a condition of state aid.

There is a precedent for a covered bond issuer being sold to a private equity firm and the new owner re-establishing the bank as an active lender – as happened with the takeover of Allgemeine HypothekenBank Rheinboden (AHBR), now Corealcredit, by Lone Star in 2005 – but Eichert says this is not representative of what would happen to a public sector lender sold in the prevailing environment.

“You’re talking public sector versus mortgage assets, and five years ago versus now,” he told The Covered Bond Report. “And if anyone wanted to run a public sector business as a going concern they could have already done so, for example by buying West Immo, which has a more cost-efficient funding base via the Pfandbrief compared with Irish ACS.”

Depfa Bank ACS had some Eu25.1bn asset covered securities (ACS) outstanding as at 28 March. The cover pool amounted to Eu27.4bn.

Eichert says it is hard to imagine any potential buyer of Depfa Bank intending to resume active lending. This was stopped as a condition of the European Commission’s approval of the German government’s rescue of HRE. Deutsche Pfandbriefbank (pbb), another covered bond issuer in the HRE group, was allowed to continue operations as a specialised real estate and public finance bank.

Instead, a private equity investor stepping in to buy Depfa would probably be focussed on selling assets at a premium to their book value, says Eichert, which for the covered bonds means that overcollateralisation would probably be managed near the legal minimum.

Ratings pressure without buyback reprieve

This, together with pressure on the issuer or sponsor ratings, would ultimately lead to downgrades of the ACS, which could fall to sub-investment grade at at least one rating agency, he says.

Depfa ACS are rated BBB by Standard & Poor’s, A3 by Moody’s, and A by Fitch.

Moody’s rating of the ACS is capped by a sovereign ceiling of A3 for Irish securities, notes Eichert, but it could conceivably fall to below sub-investment grade given that the rating agency, like others, would probably reduce the uplift it gives for sovereign support and could also change the Timely Payment Indicator (TPI) assigned to the covered bonds. Moody’s rates Depfa Bank Baa3, which includes an eight notch uplift for sovereign support from Germany. A lower rating and worse TPI could together make a junk rating of the ACS by Moody’s at least a possibility, says Eichert.

A junk rating from S&P would also be possible, he adds. Fitch rates the ACS three notches below their theoretical maximum under its Discontinuity Cap (D-Cap) framework due to insufficient overcollateralisation, and any downgrade of the issuer would lead to a cut of the covered bonds, notes Eichert.

“We also do not think that a private equity investor would continue to operate with three ratings for cost reasons,” he adds. “So a combination of rating downgrades with subsequent withdrawals of the lowest ratings is probably the most realistic scenario.”

Investors should not hold out hope for attractive tender offers, though, according to Eichert.

“In the first place, rating agencies would probably act well before any tender operations could help investors out of their positions,” he said. “We could therefore rather imagine that a private equity owner would simply wait for ratings to drop before offering investors a way out.”

In addition, the analyst notes that any private equity owner wanting to quickly reduce the stock of outstanding bonds would be better off turning investors into forced sellers via rating downgrades or even rating withdrawals rather than paying significant tender premiums.

“The main hope that Depfa ACS investors can have is that, similar to 2012, no one can agree on the actual price for the bank this time either and that it will remain with HRE and thus ultimately Germany,” says Eichert.

Reuters reported that a consortium of hedge funds approached HRE in February 2012 to try to buy Depfa Bank but no deal was agreed.