Moody’s bets Germany will support Deutsche Bank derivatives above all else — ANALYSIS

12 October 2016

by Bill Harrington

 

* The rating agency’s generous assumption allows the second-largest global financial institution to postpone remedial actions for innumerable structured finance transactions with inflated ratings.

 

Is Deutsche Bank the next Lehman Brothers or merely another Bear Stearns?

 

Given the size of Deutsche Bank, does the distinction between a possible insolvency or liquidity crunch matter? In either event, taxpayers in Germany and potentially elsewhere are already expected to bail out all or parts of the bank.

 

Moody’s has been upping the ante for a full bailout of at least the bank’s counterparty obligations since March 2015. Moody’s assigns Deutsche Bank AG a long-term counterparty risk assessment of A3, which is two notches above the senior unsecured rating of Baa2, as previously reported (see article, 30 September). Moody’s also assigns the bank a short-term counterparty risk assessment of P-2.

 

The rationale? Moody’s credits German regulators with a singular willingness and ability to prop up the counterparty obligations of Deutsche Bank AG, including the London, New York, Paris, Singapore and Sydney branches.

 

Along the same lines, DBRS assigns Critical Obligations Ratings of A (high) / R-1 (middle) to Deutsche Bank AG and Fitch may begin notching the bank’s counterparty obligations under derivative contracts above the long-term issuer default rating this quarter.

 

Why does this matter? The counterparty assessments and ratings allow banks such as Deutsche Bank AG to enter into financial contracts — such as derivative trades — while postponing any penalties which may come along with the lower senior unsecured credit rating. This is already the case in the structured finance and covered bond sectors. How long before these sectors’ bad practices seep into the wider financial system, again?

 

Moody’s has doubled-down on derivative counterparty assessments for a while

 

Moody’s rates Deutsche Bank AG as being in a league of its own with respect to precarious finances. The two-notch upgrade for the Deutsche Bank AG counterparties relative to unsecured debt holders is the largest of 12 global investment banks that Moody’s rates.

 

Moody’s assigns a counterparty risk assessment that is one notch above the senior unsecured rating for eight banks and equal to the senior unsecured rating for the remaining three banks. Moreover, one of these three banks — the Royal Bank of Scotland plc — is the only one of the 11 with short-term and long-term counterparty risk assessments that are as low as those of Deutsche Bank AG.

 

However, Moody’s also assigns the Royal Bank of Scotland plc a senior unsecured rating of A3, i.e., two notches above that of Deutsche Bank AG. In other words, the rating agency clearly expects that counterparties of the German bank will be protected even if debtholders are not.

 

Recent protestations by senior German lawmakers that taxpayers will not bail out Deutsche Bank AG haven’t changed Moody’s assessment, as reported.

 

Bailing out only the counterparty obligations under derivative contracts is an expensive proposition. Deutsche Bank AG and its affiliates had gross notional derivative exposure of EUR 46trn as of 30 June 2016, according to an investor relations presentation published in September. After netting and collateral, reported derivative trading assets fell to EUR 41bn.

 

The aggregate derivative exposures were not broken out by units but the vast majority are likely to be in the books of either Deutsche Bank AG or one of its overseas branches and thus covered by Moody’s counterparty risk assessment. Moreover, the counterparty risk assessment covers many contract types in addition to derivative contracts, according to the Moody’s bank methodology.

 

“Obligations and commitments that CR Assessments typically take into account include payment obligations associated with covered bonds (and certain other secured transactions), derivatives, letters of credit, third party guarantees, servicing and trustee obligations and other similar operational obligations that arise from a bank in performing its essential customer-serving operating functions.”

 

Even so, Moody’s doesn’t obligate itself to price just how expensive the proposition may be or even differentiate the types of counterparty obligations. Recent announcements and reports on Deutsche Bank AG, other European banks and the European banking system, including one dated 11 October, provide few if any measurements of the obligations covered by the counterparty risk assessment.

 

Instead, the rating agency notches up all of these obligations based on a self-described ability to read the minds of regulators and perceive the moods of their respective bodies politic, as previously reported (see article, 1 July).

 

“Our approach to government support is similar to that for determining support from an affiliate. Our assessment is designed to be qualitative and flexible in nature, enabling us to incorporate the often subtle real-world shifts that define attitudes to support for bank creditors.”

 

The counterparty risk assessment has enabled Deutsche Bank AG to book new counterparty business in some structured sectors and avoid performing remedial actions in others despite Moody’s having downgraded the bank’s senior unsecured rating twice this year. Prior to introducing the counterparty risk assessment, both Moody’s and structured issuers tied the eligibility and remedial actions of a bank to the senior unsecured rating, as reported.

 

The Deutsche Bank AG counterparty risk assessment of A3 may also provide comfort to non-structured counterparties that might otherwise be wary of the bank’s senior unsecured rating of Baa2. The bank certainly features the counterparty risk assessment prominently in the September presentation and other materials on its website.

 

Presumably, Moody’s is fine with this, given the assessment’s broad scope.

 

Moody’s announced upgrade plans for structured finance early and often

 

Moody’s simultaneously introduced the counterparty risk assessment in an updated bank methodology and incorporated the assessment into the methodologies for asset-backed, structured and municipal debt around the world on 16 March 2015.

 

partial list of Moody’s methodology updates on 16 March 2015 set the stage:

 

- “Moody’s updates approach for rating covered bonds, after introduction of counterparty risk assessment”;

 

- “Moody’s updates several structured finance rating methodologies in light of its new counterparty risk assessment for banks”;

 

- “Application of Bank Counterparty Risk Ratings to Letter of Credit and Liquidity Facility Supported Transactions”; and

 

- “Approach to Assessing Swap Counterparties in Structured Finance Cashflow Transactions”.

 

Within a day, Moody’s started placing impacted debt on review for possible upgrade:

 

- “Moody’s reviews for upgrade 69 European covered bond ratings”;

 

- “Moody’s places under review ratings on 36 Repack deals”;

 

- “Moody’s places 1,721 letter of credit and liquidity supported municipal ratings under review”; and

 

- “Moody’s has placed on review for upgrade the ratings of 95 tranches in 53 structured finance deals”.

 

A slew of upgrades and affirmations in a slew of sectors in a slew of countries followed. In each case, a bank and issuer were party to a contract that Moody’s assesses in rating the issuer’s debt.

 

Within three months, Moody’s had upgraded and affirmed ratings in global structured sectors such as: ABCP; ABS where an issuer is party to a derivative contract; auction-rate securities; covered bonds; and re-packagings of all types.

 

Moody’s also upgraded and affirmed ratings in a slew of national sectors, including: Australian CMBS; Brazilian future receivables; Canadian credit cards; Chinese financing bonds; EU derivative product companies; Irish, Italian, UK and US RMBS; and Italian consumer receivable and SME ABS. In the US municipal sector, Moody’s upgraded and affirmed variable rate demand bonds issued by financing entities and municipal tax credit-linked structured notes.

 

To be clear, the upgrades and affirmations reflected few if any banks adding resources either to their own balance sheets or their counterparties’ deals, based on extensive review of the respective rating announcements and bank methodology that describes the counterparty risk assessment.

 

In fact, upgrades and affirmations were likely to have had the opposite effect. By swapping out lower, senior unsecured ratings for the generally higher counterparty risk assessment, Moody’s and the banks reduced the latter’s obligations to post collateral or take other remedial actions that are tripped by rating downgrades. This impact will be felt down the road should a bank with an inflated counterparty risk assessment become impaired.

 

Counterparty risk assessments help Deutsche Bank AG & harm counterparties

 

Debt from structured issuers that are counterparties to Deutsche Bank AG or rely on it for liquidity facilities or other services wasn’t left out of the initial upgrades and affirmations. At that time, Moody’s assigned Deutsche Bank AG a long-term counterparty risk assessment of A2, a short-term counterparty risk assessment of P-1 and a senior unsecured rating of A3.

 

Subsequently, many of these structured ratings remained intact when Moody’s downgraded the bank’s senior unsecured rating to Baa1 on 25 Jan 2016 and to Baa2 on 23 May. On this latter date, Moody’s also downgraded the long-term and short-term counterparty risk assessments to A3 and P-2, respectively.

 

In fact, Deutsche Bank AG itself is just such a structured finance issuer under its covered bond program. The approximately EUR 6.5bn of covered bonds in this program continue to be rated Aaa, according to the Moody’s website.

 

The securities affiliate of Deutsche Bank AG jumpstarted a program of issuing custodial receipts in which the bank provides credit default swaps on US municipal entities. Moody’s has assigned ratings to at least USD 2bn of these custodial receipts since 16 March 2015, based on the announcements for 60 series of custodial receipts.

 

Moody’s rates the receipts under a “joint default analysis” that primarily credits both the counterparty risk assessment of the swap provider and the rating of the municipal entity being referenced. In this way, Moody’s rates the custodial receipts higher than either of the two inputs. Subsequent changes to the ratings of individual custodial receipts have generally been driven by changes in the rating of the municipal entity rather than the counterparty risk assessment.

 

In many instances, Moody’s also rated tender option bond trusts that were associated with the custodial receipts. Deutsche Bank AG is the liquidity facility provider for these trusts.

 

ABS ratings around the world where issuers are counterparties to Deutsche Bank AG under derivative contracts have also been propped up, including in these sectors: Australian trusts; UK CMBS, hospitality, re-packs and RMBS; and US RMBS and SLABS.

 

The counterparty risk assessment could not completely stave off downgrades where Moody’s used the short-term assessment as a rating input. For instance, Moody’s downgraded a USD 3bn commercial paper program to P-2 on 8 June owing to the downgrade of the short-term counterparty risk assessment of Deutsche Bank AG to P-2 on 23 May. The bank is the paying agent for the program, which is also linked to the ratings of the Export and Import Bank of China.

 

A Moody’s spokesperson declined to comment.

 

Fitch treads a narrower derivative path…

 

Fitch has been more cautious in defining the derivative counterparty rating that company introduced in a bank methodology dated 15 July, as previously reported (see article, 12 August).

 

The Fitch rating covers only derivative contracts and not the remaining laundry list of payment obligations that Moody’s lumps together in a counterparty risk assessment. Moreover, the Fitch rating addresses the performance of a bank’s non-collateralized derivative contracts and thereby sets a lower boundary for other derivative contracts that are collateralized or centrally cleared.

 

Moreover, Fitch will cap a derivative counterparty rating at one notch above a bank’s long-term issuer default rating in most instances, based on review of the bank methodology and supporting documents.

 

Fitch has also been much, much more cautious in assigning a derivative counterparty rating to any bank, let alone Deutsche Bank AG. So far, Fitch has assigned no such ratings although the company expects to do so sometime this quarter, according to earlier announcements.

 

However, like Moody’s, Fitch doesn’t obligate itself to evaluate a bank’s portfolio of derivative contracts before notching a derivative counterparty rating above a long-term issuer default rating. Nor will Fitch limit this notching to only those banks that set aside additional reserves or capital against a derivative portfolio, as reported.

 

Fitch also seems to share the Moody’s goal of helping banks book new business and avoid taking remedial actions in the structured finance and covered bond sectors, judging by the methodologies that the rating agency updated to incorporate the derivative counterparty rating.

 

But Fitch also rates Deutsche Bank AG more generously

 

However, Fitch is more easygoing in its overall ratings for Deutsche Bank AG. The long-term issuer default rating and senior debt ratings are A-, in part because “senior creditors can no longer rely on receivingfull extraordinary support from the sovereign in the event that Deutsche Bank becomes non-viable,” according to a Fitch announcement of 14 June.

 

By implication, Fitch may assign Deutsche Bank AG a derivative counterparty rating of A based in part on an expectation of at least some extraordinary support from the sovereign in the event that the bank becomes non-viable.

 

A Fitch spokesperson declined to comment.

 

Bill Harrington has been conducting research on the obligations and risks of derivative contracts in the structured finance sector for 15 years, most recently at Debtwire ABS and previously at Moody’s Investors Service. He has filed evaluations of rating processes and derivative methodologies with US and European regulators and with credit rating agencies. Bill has also worked as a derivative structurer at Merrill Lynch and a currency analyst at Wharton Econometrics. Bill has an MBA from The Wharton School.