Fitch has downgraded covered bonds issued by DZ Bank from AAA to AA after increasing their Discontinuity Factor to 100% because of high correlation between DZ and its cover pool and the wider co-operative banking group of which it is a member.

DZ Bank, Frankfurt

DZ Bank Briefe, as Deutsche Zentralgenossenschaftsbank’s (DZ Bank’s) covered bonds are called, are like Pfandbriefe but issued according to legislation specific to the German bank, the DG Bank Transformation Act, rather than the Pfandbrief Act.

Downgrading the covered bonds on Monday, Fitch said that it has revised the covered bonds’ D-Factor from 27.9% to 100%, reflecting the “considerable” exposure of DZ Bank’s cover pool to Genossenschaftliche FinanzGruppe (GFG), a German co-operative banking group of which it is a member and the central institution, and whose members own DZ.

“The agency deems the whole sector as highly correlated, especially in a scenario in which DZ Bank defaulted,” said Fitch. “The strong mutual support mechanism and the writedowns of the cooperative banks’ equity in DZ Bank in the case of a default of DZ Bank, would lead to a deterioration of the overall credit quality within the sector.

“Together with the expected decreasing liquidity of cooperative assets, in Fitch’s view this would reduce the alternative manager’s ability to meet payments in time following an issuer’s default.”

DZ Bank, like GFG and its other members, is rated A+ by Fitch and the rating agency said that the possibility of payment interruptions cannot be excluded with the certainty necessary for ratings above A+, meaning that the covered bonds’ rating on a probability of default basis is the same as that of DZ.

In a AA stress scenario Fitch expects significant recoveries on defaulted covered bonds due to restructuring events in the co-operative sector following DZ Bank’s default and a break-up of GFG, said the rating agency.

“According to Fitch’s covered bond criteria the covered bonds can be rated up to two notches above the rating on a probability of default basis due to recoveries on defaulted covered bonds,” it said. “Fitch has calculated a level of overcollateralisation (OC) of 25% to support a two notch recovery uplift to a ‘AA’ covered bond rating.

“During the last 12 months OC has always been above 30%, which is the level taken into account by the agency according to its covered bonds criteria.”