OREANDA-NEWS. Fitch Ratings has revised HSH Nordbank's (HSH) Outlook to Negative from Stable and the Rating Watch on the Viability Rating 'b' to Positive from Evolving. Its ratings have been affirmed at Long-term Issuer Default Rating (IDR) 'BBB-', Short-term IDR 'F3', and Support '2'. Its guaranteed debt has also been affirmed at Long-term 'AAA'. A full list of rating actions is at the end of this rating action commentary.

The rating action follows the announcement that the European Commission (EC) has reached an agreement in principle with the German authorities to conclude state aid proceedings on HSH that commenced in 2009. The agreement is subject to parliamentary approval by the bank's owners, the federal states of Schleswig Holstein (AAA/Stable) and the City of Hamburg (AAA/Stable).

The Outlook revision to Negative reflects Fitch's expectation that institutional support from HSH's current owners would no longer be forthcoming if HSH is privatised in accordance with the EC agreement. However, if privatisation is not possible, the agreement envisages the bank will be wound down.

The Rating Watch Positive (RWP) on HSH's VR reflects Fitch's expectation that the bank's asset quality and earnings will improve. Under the agreement, HSH will be able to transfer a material part of its non-performing assets to its owners and sell further assets in the market, and fees paid on the state guarantee provided by the owners, which have weighed heavily on the bank's earnings, will be reduced substantially. Fitch expects the bank's company profile to improve as a result of this restructuring, which should help to restore its long-term sustainability.

KEY RATING DRIVERS

IDRS, SENIOR DEBT AND SUPPORT RATING
The IDRs, senior debt and Support Ratings are driven by support from the bank's owners, the federal states of Schleswig-Holstein and Hamburg, the regional savings banks and ultimately the Sparkassen-Finanzgruppe (SFG, A+/Stable). HSH's Long-term IDR is five notches below the SFG's Long-term IDR because the bank's intrinsic weaknesses make support less likely given the private investor test under EU legislation.

If HSH's owners are unable to privatise the bank through a sale or an initial public offering, the bank will have to cease new business activities and manage the assets with a view of winding them down. We expect that in such a scenario there are financial and reputational incentives for HSH's current owners to ensure that a wind-down is managed in a way that avoids imposing losses on senior unsecured creditors, which supports the bank's 'BBB-' IDR.

The Negative Outlook reflects the EC agreement that privatisation of HSH should be targeted within 24 months after the formal EC decision, which we expect in 1H16. Our base case is that any new owners of HSH are unlikely to have the ability and propensity to provide any necessary support at a 'BBB-' level.
VR
The VR primarily reflects the bank's weak company profile and legacy asset quality, as well as its weak earnings and profitability that have been weighed down by fees paid to the state for the asset guarantee. The RWP reflects Fitch's expectation that asset quality and earnings will improve, albeit from weak levels, as a result of the agreement with the EC.

Fitch expects HSH's asset quality to improve substantially as non-performing loans with a book value of EUR15.4bn at end-1H15 are expected to decline by EUR8.2bn. The bank plans to transfer EUR6.2bn non-performing loans to its state owners and to sell a further EUR2bn of non-performing assets. Both transactions will be at market prices. We expect the transfer to the state owners to result in material losses to the bank, which will be covered by the guarantee.

We expect HSH's asset quality to remain weak even after the transaction as it impaired loan/gross loan ratio is likely to remain above 10%. However, as we estimate that these impaired assets will continue to benefit from the guarantee but at declining levels, their potential impact on capital is limited.

Fitch expects HSH's earnings to benefit materially from the agreement, as it envisages a substantial decrease in the fees paid for the guarantee. Once the agreement has been implemented, HSH will only be required to pay a base fee of 220 basis points of the unutilised portion of the guarantee, whereas to date fees amount to 400 basis points of EUR10bn. HSH will also no longer have to pay any additional fees that are part of the guarantee scheme.

However, HSH's funding costs could start to increase in the run-up to planned privatisation, as financing currently benefits from its ownership structure and access to the savings banks' funding.

SUBORDINATED DEBT
HSH's subordinated debt is rated one notch below the VR to reflect the higher loss severity of the notes versus senior unsecured obligations. The rating was placed on RWP to reflect the RWP on the bank's VR.

STATE-GUARANTEED/GRANDFATHERED SECURITIES
The 'AAA' rating of HSH's state-guaranteed/grandfathered senior debt, subordinated debt and market linked securities reflect the credit strength of the guarantor, the federal state of Schleswig Holstein and the City of Hamburg and our view that they will honour their guarantees.

RATING SENSITIVITIES
IDRS, SENIOR DEBT AND SUPPORT RATING
HSH's IDRs, senior debt rating and SR are primarily sensitive to the likelihood of a successful privatisation. A sale of HSH or a successful public offering would result in the bank's IDRs being driven either by HSH's VR, in the absence of a sufficiently strong new institutional owner, or by institutional support from new owner, if the owner is rated higher than HSH's VR at the time and shows a sufficient propensity to provide support.

HSH's IDRs and Support Rating would be downgraded if Fitch concludes that the probability of a privatisation becomes more likely and that institutional support from a new owner would not be sufficiently strong to warrant an IDR of at least 'BBB-'.

If HSH is acquired by a strategic investor with a strong ability and propensity to provide support, the bank's IDRs and Support Rating could be affirmed or even upgraded, but this is currently not our base case. Strategic buyers for HSH could include other Landesbanken, which could result in an upgrade of HSH's IDR. However, this is not our base case given HSH's company profile, with its focus on asset-based lending which other Landesbanken could grow organically on their own balance sheets, and given the need for the other Landesbanken to focus on restructuring their own legacy assets and strengthen their earnings.

If HSH's privatisation is not successful, HSH will be wound down under its current ownership structure. We believe that in this case HSH will likely remain a member of the protection scheme of the Landesbanken (Sicherungseinrichtung), and that it could continue to receive support from its owners in combination with the SFG to protect senior unsecured bondholders. This would likely result in us affirming its IDR if we conclude that the likelihood of imposing losses on senior creditors during the run down of assets will remain low.

VR
Fitch expects to resolve the RWP on HSH's VR when the measures under the EC agreement, including the transfer and sale of non-performing assets, have been implemented. The resolution of the RWP may take longer than six months as we expect the final EC agreement no earlier than in 1H16.

Improvement in asset quality and stronger earnings capacity after the reduction of the fee payments for the guarantee will likely be the main drivers for an upgrade. If improvements in asset quality and profitability are sufficiently material, we could upgrade the VR by more than one notch. However, we believe that although the company profile is likely to improve, HSH's limited franchise and large remaining legacy portfolio make it unlikely that the VR could reach investment-grade in the next two years.

SUBORDINATED DEBT
As the ratings are notched off HSH's VR, the subordinated debt ratings are broadly sensitive to the same factors that might affect HSH's VR.

STATE-GUARANTEED/ GRANDFATHERED SECURITIES
The ratings of HSH's state-guaranteed/grandfathered senior debt, subordinated debt and market linked securities are primarily sensitive to changes in Fitch's view of the creditworthiness of the guarantors.

The rating actions are as follows:

HSH Nordbank AG
Long-term IDR: affirmed at 'BBB-', Outlook Revised to Negative from Stable
Short-term IDR: affirmed at 'F3'
Support Rating: affirmed at '2'
Viability Rating: 'b' Rating Watch revised to Positive from Evolving
Long-term senior debt, including programme ratings: affirmed at 'BBB-'
Short-term senior debt: affirmed at 'F3'
State-guaranteed/grandfathered senior and subordinated debt: affirmed at 'AAA'
State-guaranteed/grandfathered market-linked securities: affirmed at 'AAAemr'
Senior market-linked securities: affirmed at 'BBB-emr'
Subordinated debt: 'B-'; Rating Watch revised to Positive from Evolving