OREANDA-NEWS. As do commercial banks, and, to a lesser extent, pension funds. The new approach provides for the establishment of specialized mortgage companies financed through the issuance of covered bonds, which will only be allowed to provide mortgage loans. The proposals specify that HFF will cease lending and its portfolio will be allowed to expire. Meanwhile, the government would establish a new state?owned housing loan company, which would operate on the same terms as other specialized mortgage companies and, unlike HFF, will not benefit from a state guarantee.

Even though our baseline scenario continues to assume broad implementation of the proposals, we note that the government has taken no tangible steps toward enacting the proposals since they were presented in May 2014. During that time, HFF has continued to operate, although its market share in new lending has been low (below 10% of new lending in both 2014 and 2015). The institutionhas maintained a larger presence in certain niches--such as lending to rural areas and to lower income households--whereas other market segments have been increasingly taken over by commercial banks.

Although its role has diminished in recent years, we see HFF as still being important for the government of Iceland. We believe that until the new housingsystem is implemented, HFF will maintain its presence in the rural and lower income segments of the market--which are important for the authorities for social reasons--and in regions in which the banks have little presence.

We also understand there is a proposal in place under which HFF would administer government grants for the construction of social housing; the corresponding bill was passed by the Icelandic Parliament in June 2016. There are also plans to potentially explicitly entrust HFF with the social role in the future, whereby the institution would undertake lending under specified household income?based criteria rather than be completely wound?up. That said, even in that case the entity would likely be several times smaller compared tocurrent levels as the majority of mortgage lending would be gradually taken over by commercial banks.

We also assess HFF’s role for the government as important based on the consequences for the government and the domestic capital market of a default by HFF. HFF's outstanding bonds amounted to about 35% of Iceland's GDP as of end?2015 and close to 80% is held by Icelandic pension funds. A default would therefore entail losses for the pension funds; we do not expect the governmentto view this as politically acceptable. The government also provides an ultimate, but not timely, guarantee on HFF's outstanding debt. In our view, HFF's default could undermine confidence in other companies that benefit from similar guarantees by the government.

In our view, HFF continues to maintain an integral link with the government ofIceland. Based on its 100% government ownership and the consequences of its default, the authorities are highly likely to provide timely extraordinary support should the need arise. As a state agency, HFF is not subject to bankruptcy proceedings and is exempt from taxation. The government has provided support to HFF through capital injections three times during 2010?2014, contributing a total of more than Icelandic krona (ISK)50 billion.

Given positive earnings, improving asset quality, and an orderly downsizing ofthe balance sheet, we now see the need for further injections as less likely over the next few years. We expect the government will only inject sufficient capital to ensure that HFF honors its obligations in a timely manner rather than tie up extra capital within the institution. For example, even though thegovernment planned to capitalize the entity in both 2014 and 2015, this was cancelled once it became apparent that HFF would post net profits.

Our revision of HFF’s SACP to ‘b’ from ‘b?’ reflects its better-than-expected improvements in capital and earnings, which we now think will remain above ourprevious forecast. HFF's capitalization has considerably improved following analmost ISK2 billion (around €15 million) capital increase from net profits in 2015. The largest difference from our previous forecast was the more-than ISK1billion net impairment reversals, as opposed to an expected net loss. In our view, the reversals indicate a stronger-than-anticipated positive impact on HFF from improving economic conditions in Iceland. Although subject to risks, these include robust projected economic growth and an increase in real incomes.

Moreover, the entity has taken initiatives to ease its prepayment problem and bolster capitalization. These include the sale of the subsidiary Leigufelagi? Klettur ehf (Klettur) in May 2016 and the active sales of repossessed properties, supported by favorable real estate market dynamics. Both have an immediate positive impact on capital. In addition, improved interest income and reduced costs have also led us to revise upward our forecast of earnings and capital. The main driver of this is the investments in asset-backed bonds (in December 2015 and in March 2016), as well as cost management initiatives, including organizational changes and a lower headcount, which has already yielded some results.

Overall, we expect positive net earnings of ISK2.75 billion and total adjustedcapital of ISK19.43 billion in 2016, which is a notable improvement from our previous forecast. While our forecast is somewhat more conservative, we note that HFF’s management anticipates regulatory capital ratios reaching 8% by 2020 (from 5.5% at end-2015) and positive earnings over the coming five years.

Our assessment of other factors that contribute to the SACP, such as moderate business position and moderate risk position, remain unchanged. Even though wenow expect HFF to benefit from the improving economic conditions in Iceland more so than we thought previously, the impact will still be smaller than thaton Iceland's commercial banks. In particular, the continuing prepayments and only marginal new lending activity undertaken by HFF preclude it from attaining a stronger market position or growth in core business.

We consider HFF's funding profile to be below average, based on its reliance on the capital markets without any central bank access. Although HFF has not issued bonds since 2012 due to high prepayments and low new lending, we consider that its ability to access the domestic bond market remains stable. In our view, this is mainly due to HFF's close link with the government and the outstanding government guarantee and does not signify a stand?alone strength. We assess HFF's liquidity position as adequate, taking into account the expected contractual cash flows from prepayments and amortizing loans, andthe cash liquidity buffer, which is heavily invested in long?dated covered bonds issued by Arion Bank to reduce the maturity mismatch. We expect that HFFwould receive state support to meet any liquidity needs, although we do not currently anticipate that it will need such support in the next few years.

The stable outlook reflects our expectation that HFF's SACP will remain unchanged, and that the likelihood of the government of Iceland providing timely extraordinary support to HFF in the event of financial distress will remain high over the next 12 months. We do not expect to take a rating action on HFF if we raise or lower our long-term local currency sovereign credit rating on Iceland by one notch, all else being equal.

We could lower the ratings if we concluded that the effects of a potential HFFdefault for the government and the capital markets had reduced, which would reduce the incentive for the government to provide timely extraordinary support to the institution.

We could raise the ratings if we believed that the risks inherent in unwindingthe mortgage portfolio had reduced substantially, for instance based on materially improved asset quality and resilient pre-provision earnings generation.