SOVEREIGN AND SUPRANATIONAL

SECTOR IN-DEPTH27 OCTOBER 2015

ANALYST CONTACTS

Kathrin Muehlbronner 4420-7772-1383Senior Vice Presidentkathrin.muehlbronner@moodys.com

Yves Lemay 4420-7772-5512MD-Banking & Sovereignyves.lemay@moodys.com

Sovereigns – Euro Area

'Bad Banks' in Ireland, Spain andGermany: Diverging FortunesDuring the course of the financial crisis, several EU countries established so-called “badbanks” to insulate their banking systems from impaired assets that threatened individualbank solvency and wider confidence in the respective banking systems. We have comparedand contrasted the three largest European “bad banks” – Ireland's NAMA (Baa1 positive),Spain's Sareb (unrated) and Germany's FMS Wertmanagement (FMS-WM, Aaa stable) – andconclude that they diverge significantly in terms of financial performance and success indivesting their impaired assets.

All three entities were originally established with a life span of 10-15 years, with the objectiveof selling the impaired assets they acquired from the financial institutions without incurringfurther costs for the country’s taxpayers. We rate FMS-WM and NAMA in line with theirrespective governments, given the explicit government guarantee on their debt. Given thediverging performance and the relative size of their balance sheet, we only consider Sareb tostill be a constraining factor on the debt rating of its sovereign, Spain.

» NAMA (National Asset Management Agency), the largest of the “bad banks” in relationto the size of the economy, is the most advanced in selling its assets. It has redeemed70% of its senior obligations and is on course to repay them in full by 2018 – two yearsahead of the original schedule. The entity is also likely to realize a profit for the Irish statewhen it is wound down. We no longer consider NAMA’s debt as a material contingentliability for the Irish government.

» Sareb (Management Company For Assets Arising From the Restructuring of the BankingSector) is in the early stages of reducing its portfolio, having been established only at theend of 2012. It is likely to post the third consecutive year of losses in 2015, after nearlydepleting its capital in the first two years of operations. The continued write-down ofasset values also raises some concerns over the overall asset quality of its portfolio. It willlikely remain a contingent liability for the Spanish government for several years.

» FMS-WM (FMS Wertmanagement) has been reasonably successful thus far in reducingits assets. However, given the complexity, illiquidity and long maturity profile of itsportfolio, the speed of asset disposal will likely be slower in the coming years. In addition,in 2014, FMS-WM was tasked with winding down another portfolio and no longer has a

set date for the end of its operations.1 FMS-WM has large debt refinancing needs giventhe short maturity of its liabilities. But its debt is part of Germany’s government debt and

any potential future losses can be easily absorbed by the government.2

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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

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Real-estate portfolios of NAMA and Sareb contrast with FMS-WM’s more diversified and complexportfolioNAMA and Sareb are both entities that were set up to house the real-estate related assets and loans of several banks – five in the caseof Ireland, nine in Spain – while FMS-WM is the “bad bank” for the impaired assets of only one institution, Hypo Real Estate. Also, only15.5% of its assets were linked to real estate at the start of its operations. It also has a far more geographically dispersed and morecomplex portfolio than the others (see Exhibit 1). NAMA was by far the largest “bad bank” in relative terms: its original balance sheet

amounted to 19.6% of GDP, compared to less than 5% and 7% of GDP for Sareb and FMS-WM, respectively.3

Exhibit 1

Key characteristics

NAMA Sareb FMS-WMDate of establishment Dec-09 Jul-12 Jul-10Assets Transferred Real estate loans and

property assets of 5 financialinstitutions

Real estate loans and assets of9 financial institutions

Assets of Hypo Real Estate group (HRE),incorporating real estate (15.5%),infrastructure (10.2%), public sector (49.3%),structured products (25%)

Total assets transferred from banks, € billion 74 50.8 175.7Average discount on asset values at transfer 57.0% 63% 0%Life of entity as envisaged at inception Repayment of all senior bonds

by 202015 years 2020

Geographical composition of assets atinception

54% in Ireland, 38% in UK 100% in Spain Wide dispersion with 28% of public-sectorsegment in Italy and 58% of structuredproducts portfolio in the US

Source: Companies' annual accounts

NAMA most advanced in selling down assetsNAMA, the first of the bad banks to be created in late 2009, is also the most advanced of the three entities in selling the assets on itsbalance sheet. It reduced the size of its portfolio of loans and other receivables by close to 60% between its inception and June thisyear. Germany’s FMS-WM, established seven months later, has managed to reduce the size of its winding-up portfolio by close to 42%by June 2015, while Spain’s Sareb reduced its portfolio by 15.6% in the first two years of its operations, a slightly slower pace than theother two entities managed to achieve over the same time period.

Exhibit 2

NAMA most successful in reducing portfolioReduction in portfolio size, indexed to 100 at size and year of establishment

Source: Companies' annual accounts

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NAMA has been able to significantly accelerate asset disposals since early 2014. This is mainly due to the recovery in Irish house prices,which have started to increase from Q2 2013 onwards, albeit from a depressed base. Up to 2013, NAMA mainly focused on selling itsUK assets, which accounted for around 38% of the portfolio at the outset, and where real estate prices held up better than in Ireland(see Exhibit 2).

In contrast, Sareb’s assets are exclusively located in Spain, where house prices have yet to recover in a meaningful manner. Aroundtwo thirds of Sareb’s portfolio is located in the autonomous regions of Madrid (22% as of end-2014), Catalonia (18%), Valencia (17%)and Andalucia (9%), which have seen only a moderate increase in house prices over the course of 2014 and 2015. Absent a strongeracceleration in real estate prices, the speed of asset disposals will probably remain slower than it has been for its two peers.

Exhibit 3

Positive house price development in UK helped NAMA’s asset salesIndex 2009 Q1=100, % year-over-year

Source: Eurostat, Moody's Investors Service

FMS-WM has so far been reasonably successful in reducing the size of its portfolio, which is by far the largest of the three entities'portfolios in absolute terms. However, 62% of the assets that remain on its balance sheet (as of October 2015) have a maturity ofmore than ten years and many are complex and illiquid securities. Going forward, we therefore expect a slower pace of asset disposalsthan in past years. This has already been evident since 2014, with only €12.8 billion being divested and a further €3.9 billion in the firsthalf of this year, compared to €17.8 billion and €23.8 billion in 2013 and 2012, respectively. So far, around 73% of FMS-WM’s portfolioreduction came via contractual and extraordinary redemptions, rather than active sales.

NAMA no longer a material contingent liability for Irish governmentAll three entities benefit from explicit guarantees on their bonds by their respective governments. FMS-WM is fully incorporated into

the general government sector, hence its liabilities are already recognized as obligations of the German government.4 In contrast,both NAMA and Sareb have been structured to ensure that their debt obligations would not add to the government’s debt burden, by

having private-sector entities as the majority shareholders.5 We have therefore considered the entities as contingent liabilities to theirgovernments since their inception.

However, NAMA has managed to reduce its debt load significantly, especially since last year. It has repaid €21.1 billion, or nearly 70%of the original €30.2 billion in senior bonds that were due by October 2015, and is now targeting the full redemption of all senior debtby 2018 – two years ahead of the original schedule. Given NAMA’s strong financial and divesting performance to date, we no longerconsider it to be a material contingent liability for the Irish government. Instead, it is more likely that it will produce a profit for the Irish

state, with the company itself expecting a cumulative profit of €1.75 billion.6

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Exhibit 4

NAMA’s strong cash flows allow for accelerated debt reduction€ billion

Source: NAMA

Sareb’s financial performance and asset quality remain under pressureIn terms of the speed of asset disposals, Sareb’s performance has not been materially different from that of NAMA, although it hasmanaged to reduce its debt burden at a somewhat faster pace than NAMA did at the same point in time (-9.5% in the first two yearsof operations, NAMA: -6.8%).

But Sareb’s financial performance continues to be negatively affected by write-downs on its assets. Its original capital of €1.2 billionhas already been nearly depleted, standing at only €354 million at the end of 2014, after having absorbed losses over the prior threeyears. Following new accounting requirements that were recently introduced by the Bank of Spain – Sareb’s supervisory authority –

Sareb expects further write-downs in 2015 and 2016.7 While the size is unclear at this point in time, Sareb assumes that it will have toconvert part of its subordinated bonds (€3.6 billion, subscribed by broadly the same group of investors as in the capital) into capital.It seems unlikely that private shareholders would be prepared to inject further capital into Sareb beyond what they have alreadycontributed. Therefore, any further capital requirements beyond the remaining subordinated bond cushion would most likely have tocome from the government.

Besides the possible need for further capital injections, the continued write-down on the asset values raises concerns over Sareb’soverall asset quality, also because the economic environment has, if anything, turned out more positive than expected at the timeof the original asset transfers in late 2012 and early 2013. Back then, the assets were transferred from the banks’ balance sheets withsignificant sector-specific haircuts on their face value, which on average amounted to 63%. The transfer also followed an extensiveand detailed asset quality review by international firms and under the auspices of the ECB, the EC and the IMF. Overall, we expectthat Sareb will remain a contingent liability for the Spanish government for several years to come. However, its debt burden is atmanageable levels, standing at €46 billion at the end of 2014 (approximately 4% of GDP).

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Exhibit 5

Sareb’s debt load is still high€ billion

Source: Sareb

FMS-WM’s debt load is included in Germany’s government debtA profitable exit is also less certain for FMS-WM, given the weak credit quality, long maturity and illiquid nature of many of itsremaining assets. Moreover, while the entity has posted small net profits since 2012, losses in coming years cannot be excluded.However, FMS-WM differs from the other two entities in that any loss will be compensated directly by SoFFin (through a losscompensation agreement) and ultimately by the German government, as was the case in 2010 and 2011, when FMS-WM accumulated(combined) losses of €13 billion. While large in nominal terms, there is little risk that Germany’s public finances would be materiallyaffected, even in adverse scenarios. FMS-WM’s debt load remains high in nominal terms at around €130 billion and its refinancingneeds are substantial, with an average maturity of its liabilities of around three years. But its debt is already fully incorporated into theGerman government’s debt burden. On a relative basis, FMS-WM’s debt level amounts to just over 4% of German GDP.

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Moody's Related Research

Credit Opinions:

» Government of Germany

» Government of Ireland

» Government of Spain

» FMS Wertmanagement

Analyses:

» Government of Spain, May 2015

» Government of Germany, March 2015

» Government of Ireland, February 2015

Issuer Comments:

» Government of Ireland: 2016 budget loosens fiscal policy but keeps deficit reduction on track, a credit positive, October 2015

» Generalitat de Catalunya & Government of Spain: Credit negative tensions between Catalunya and Spanish government likely topersist post-election, September 2015

» Government of Germany: Stability Programme Points to Declining Debt-to-GDP Ratio Despite Slightly Expansionary Fiscal Stance,April 2015

Issuer In-depth:

» Government of Ireland: Key Drivers of Moody’s Decision to Change the Rating Outlook to Positive, September 2015

Sector Comment:

» Progress Toward Italy's Bad Bank Is Credit Positive, May 2015

Rating Methodologies:

» How Sovereign Credit Quality Can Affect Other Ratings, February 2015

» Sovereign Bond Ratings, September 2013

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

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Endnotes1 The additional portfolio (of €30.4 billion) originates from DEPFA Bank plc, a HRE subsidiary.

2 NAMA and Sareb were explicitly set up with a structure that ensures that their debt would not be included in general government debt, given the difficultsituation of the two sovereigns at the time. We have considered the liabilities of both entities as contingent liabilities for their sovereigns. The Germangovernment as the ultimate guarantor had to such concerns, reflecting its strong government finance position.

3 FMS-WM’s figures only include the wind-down portfolio of €175.5 billion, whereas total assets stood at €333 billion or 12.8% of GDP at end-2010.

4 The guarantee and loss compensation are provided indirectly via the government-owned Financial Market Stabilisation Fund – FMS (SoFFin).

5 NAMA holds 49% in its investment holding company, with three private investors holding the remaining 51%. NAMA has a veto right over decisions takenby the company. In Sareb’s case the government ultimately holds 45% of Sareb’s equity, with the remainder held by mostly Spanish financial institutionsand insurance companies.

6 In addition to the senior bonds NAMA has close to €1.6 billion in subordinated debt outstanding, on which it started to pay interest in 2014. The bonds arecallable annually from March 2020 onwards.

7 See https://www.sareb.es/en-en/press-office/news/Pages/Sareb-to-appraise-250,000-assets-this-year-to-meet-new-accounting-framework-requirements-.aspx

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AUTHORKathrin Muehlbronner