Fitch Affirms 3 UK Building Societies
A full list of rating actions is available at the end of this rating action commentary.
The rating actions follow a periodic review of these three UK building societies. Fitch concludes that although the UK building society sector posted robust performance for 2014, evidenced by high margins and strong balance sheet fundamentals (including healthy asset quality, reinforced capital and sound funding and liquidity), the societies' performance is likely to peak in 2015, if not in 2014. Increasing competitive pressure on mortgage rates, stabilising funding costs and higher loan impairment charges when base rates rise are expected to bring increasing challenges from 2016.
KEY RATING DRIVERS - IDRs, VRs AND SENIOR DEBT
COVENTRY BUILDING SOCIETY
Coventry's ratings reflect Fitch's view of the society's low risk appetite, focussing on low risk, low loan-to-value, prime residential mortgage loans and buy-to-let mortgage loans. This has resulted in healthy, strongly performing asset quality. Its business model is based on maintaining consistent profitability through a low margin, low cost, low impairment charges business model. This low risk appetite has a high influence on the society's IDRs and VR.
Coventry's loan book is performing strongly, with lower impairment levels than its peers and low loan impairment charges (LICs). Although the society has a small portfolio of legacy commercial and specialist residential loans, which are the result of an acquisition of a small building society, these are in wind-down and are in our opinion not a material risk to asset quality.
Reserve coverage of impaired loans is low by sector standards but reflects the low average LTV of its loan book, and write-offs have been minimal.
Although the society operates in the most competitive part of the mortgage sector, where mortgage yields are particularly tight, profitability has remained resilient, supported by the society's strong focus on cost efficiency and low LICs. Profitability improved strongly in 2014 on the back of a strong widening of its net interest margin (NIM), driven by a market-wide reduction in funding costs. Nonetheless, profitability remains modest.
Revenues are undiversified as a result of Coventry's building society business model, as well as recently introduced customer-protecting restrictions on fee-generating advisory business.
Coventry reports strong regulatory capital ratios due to the low-risk nature of its loan book and sound internal capital generation. While low risk weights assigned to its loan book do not, in our view, underestimate the risk profile of its loans, it has resulted in high leverage, which has recently come under tighter scrutiny from the regulators. Following the issue of additional Tier 1 (AT1) notes in 2014, the society was able to report an improved leverage ratio of 3.9% by year-end. While we believe that this level is likely to be just within future regulatory minima the society should be able to meet medium-term capital requirements through earnings retention.
Unreserved non-performing loans-to-Fitch Core Capital (FCC) declined considerably and, at end-2014 was an adequate 16%.
Coventry's 'F1' Short-term IDR, the higher of the two that map to an 'A-' Long-term IDR, reflects the society's strong liquidity position and its ability to use residential mortgage loans to access Bank of England liquidity facilities should the need arise.
LEEDS BUILDING SOCIETY
Leeds' ratings reflect the society's sound profitability and strong capacity for internal capital generation. The society's strong profitability is derived from the composition of its loan book, which includes an element of higher yielding niche exposure, and from its high cost efficiency. Although costs rose in 2014 due to investment in digital services and refreshing the brand, the society delivered record profits in light of exceptionally favourable funding conditions and strong loan growth.
The society has a fairly large proportion of its loan book extended to specialist sectors, particularly mortgages extended on shared ownership properties, which represented 12% of its loan book at end-2014. The society has also increased its exposure to buy-to-let lending, which comprised 16% of the portfolio at end-2014.
Exposure to legacy, closed books (2.4% of loans were extended in Spain and Ireland, a further 3% consisted of loans backed by commercial real estate) has resulted in a higher-than-average impaired loans/gross loans ratio (2014: 2.36%; 2013: 3.22%), although buy-to-let and shared ownership loans have performed well in recent years.
A strong funding profile also has a high influence on Leeds' ratings, with most funds obtained from a loyal customer base. Although its loan-to-deposit ratio has been increasing, as a result of a wish to diversify and extend the maturity profile of its funding, it remained low at 112% at end-2014. The society maintains an active profile in the wholesale markets, with covered bonds, residential RMBS and senior unsecured debt outstanding.
The society pre-funded a large covered bond maturing in 2015 with new covered bonds and also issued senior unsecured bonds in 2015. This had the result of increasing the society's liquidity temporarily in 2015, although liquidity is generally very strong, with a liquidity coverage ratio comfortably above end-point regulatory requirements.
Capital is strong with a CET 1 ratio at end-2014, calculated under the standardised basis, of 15.6% and a leverage ratio of 5.6%.
The society's 'F1' Short-term IDR, the higher of the two that map to an 'A-' Long-term IDR, reflects its strong liquidity position and its ability to use residential mortgage loans to access Bank of England liquidity facilities should the need arise.
NEWCASTLE BUILDING SOCIETY
Newcastle's ratings reflect the gradual return to profitability of the society's member business, reducing tail risk in its legacy loans' asset quality, and a strongly performing prime residential loan book. The ratings also reflect the society's still weak internal capital generation and the resulting vulnerability to unexpected losses.
Profitability has been weak since the financial crisis, driven by high LICs related to the society's legacy commercial loans, and by its large stock of low-risk but low yielding housing association loans. As a result, the society's member business (including housing association and commercial loans) remains loss-making although operating losses have narrowed due to a pick-up in gross mortgage lending, lower LICs and lower funding costs. Fitch expects that the society's member business is now well placed to return to profitability over the medium-term.
Fitch has revised its assessment of Newcastle's asset quality upwards due to the ongoing reduction in its commercial loans, which has accelerated over the past 12 months, and the strong performance of its core prime residential book. Impaired prime residential loans (defined as three months plus in arrears and assets in possession) fell to a low 0.5% at end-2014 (2013: 0.7%), driven by a benign operating environment and sound underwriting standards.
While the society retains a strong appetite for higher LTV lending, where spreads are higher, Fitch considers this risk as well managed as evidenced by low levels of impairments. Although Fitch expects residential impairments to increase as base rates begin to rise, the effect on asset quality is likely to be mitigated by current low arrears and the likely gradual nature of any rise.
Reserve coverage of impaired loans has increased in recent years and is higher than generally seen at peers (end-2014: 37.5%). As a result, tail risk from unreserved impaired loans has fallen to more acceptable levels, and is an important development given the society's still weak capital generation.
Despite the improvement in asset quality and earnings, current metrics should be viewed in the context of the society's still low profitability, small capital base in absolute terms and lumpy commercial real estate portfolio which makes the society vulnerable to a weakening of asset quality.
Newcastle's Strategic Solutions savings management business is performing well and continues to add an element of diversification to the core member business. Although revenues were negatively affected in 2014 by lower demand for retail funding due to the availability of the funding for lending scheme, this is considered cyclical and revenues are expected to pick up in 2015 due to a strong pipeline of new business.
Capitalisation is adequate but weaker than most peers' given the society's small absolute capital base and significant risks inherent in its CRE portfolio. Capital ratios have been maintained through strong deleveraging, with a CET 1 ratio of 12.7% at end-2014 and a CRD IV end point leverage ratio of 4.5%. Fitch expects the society's capital flexibility to improve in the medium-term, driven by a return to profitability in the core member business and further disposals of legacy assets.
KEY RATING DRIVERS - SUPPORT RATING AND SUPPORT RATING FLOOR
ALL SOCIETIES
The SRs and SRFs of all three building societies have been affirmed at '5' and 'No Floor', indicating that Fitch believes senior creditors cannot rely on receiving full extraordinary support from the UK in the event that these societies fail. In Fitch's view, legislation and regulation in the UK are sufficiently progressed to provide a framework for resolving building societies without requiring extraordinary support from the authorities. While such support is still possible, we do not rely upon it in our ratings.
KEY RATING DRIVERS - SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
ALL SOCIETIES
The ratings of Coventry's and Newcastle's subordinated debt are notched once down from their respective VRs, reflecting Fitch's assessment of loss severity. We do not believe that these suffer from incremental non-performance risk relative to their VRs.
Coventry's and Leeds' permanent interest bearing securities (PIBS) are rated four notches below these societies' respective VRs, comprising two notches for their deep subordination and two notches for incremental non-performance risk.
Coventry's AT1 securities are rated five notches below the society's VR, comprising two notches for loss severity to reflect the conversion into core capital deferred shares (CCDS) on breach of a 7% CRD IV common equity Tier 1 (CET1) ratio, and three notches for non-performance risk, reflecting the instruments' fully discretionary interest payment.
RATING SENSITIVITIES- IDRs, VRs AND SENIOR DEBT
COVENTRY BUILDING SOCIETY
Coventry's ratings are primarily sensitive to an increase in its risk appetite, which could give rise to higher LICs, or through an increase in its cost base, either of which could challenge its low profitability. The society's ratings could also come under pressure if higher regulatory capital requirements, which could include a higher minimum leverage ratio, puts pressure on its low-risk business model.
Fitch sees limited upside for Coventry's VR and IDRs given the society's undiversified business model, the high indebtedness of UK households and its fairly small franchise.
LEEDS BUILDING SOCIETY
Given the lack of diversity in the building society's business model, the fairly small size of Leeds's franchise and the risks inherent in its loan book, an upgrade of Leeds's ratings is unlikely in the medium-term. The ratings could come under pressure if profitability weakens, which could result from a material increase in LICs on its higher yielding loan portfolio, or a permanent reduction in cost efficiency, for example, from higher costs of regulation or from higher funding costs. The ratings are also sensitive to a material deterioration in the funding profile. The short-term IDR is sensitive to a reduction in the liquidity position.
NEWCASTLE BUILDING SOCIETY
The society's ratings could be upgraded should its member business return to profitability. However, given the society's limited franchise and its appetite for high LTV lending, the extent of any upgrade is likely to be moderate. Ratings could come under pressure if Newcastle increases its risk appetite to achieve improved profitability or if capitalisation weakens, for example, due to a notable deterioration of asset quality.
SUPPORT RATING AND SUPPORT RATING FLOOR
ALL SOCIETIES
An upgrade to the building societies' SRs and upward revisions of their SRF would be contingent on a positive change in the sovereign's propensity to support its building societies. This is highly unlikely in Fitch's view.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
ALL SOCIETIES
As the ratings are notched off the VR, they are sensitive to the same considerations that might affect their VRs. In addition, the rating of Coventry's AT1 securities is also sensitive to a change in notching, which could be the result of changes in capital management or financial flexibility or an unexpected shift in regulatory buffers, for example.
The rating actions are as follows:
Coventry Building Society:
Long-term IDR affirmed at 'A'; Outlook Stable
Short-term IDR affirmed at 'F1'
Viability Rating affirmed at 'a'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Senior long- and short-term unsecured EMTN programme and notes affirmed at 'A'/'F1'
Subordinated perpetual notes: affirmed at 'BBB-'
Additional tier 1 securities: affirmed at 'BB+'
Leeds Building Society:
Long-term IDR: affirmed at 'A-'; Outlook Stable
Short-term IDR: affirmed at 'F1'
Viability Rating: affirmed at 'a-'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Senior long- and short-term unsecured EMTN programme and notes: affirmed at 'A-'/ 'F1'
Subordinated perpetual notes: affirmed at 'BB+'
Newcastle Building Society:
Long-term IDR affirmed at 'BB+'; Outlook Stable
Short-term IDR affirmed at 'B'
Viability Rating affirmed at 'bb+'
Support Rating affirmed at '5'
Support Rating Floor affirmed at 'No Floor'
Senior long- and short-term unsecured EMTN programme and notes affirmed at 'BB+'/'B'
Subordinated notes: affirmed at 'BB'
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