OREANDA-NEWS. The costs of transferring non-performing loans from HSH Nordbank to a vehicle set up by Hamburg and Schleswig-Holstein may not be covered by the realisation of these assets, and the expected proceeds from the planned privatisation of the bank may not fill this gap, Fitch Ratings says. This will add to the two Laenders' high debt burden, but we do not think it will increase liquidity risk.

The European Commission said last week that an agreement in principal had been reached to resolve HSH's state aid case. The bank, 85% directly and indirectly owned by the two Laender, will sell a portfolio of non-performing loans (NPLs) with a value of EUR6.2bn expected at default at market prices to a vehicle set up by owners. An additional EUR2bn of NPLs will be sold in the market.

Potential losses from these sales will be covered by the EUR10bn guarantee provided to the bank by HSH Finanzfonds AoeR, jointly owned by Hamburg and Schleswig-Holstein. HSH Nordbank will be split into a holding company and an operating subsidiary. The operating subsidiary will carry on the bank's current operations before being privatised within two years from the date of the final state aid decision of the European Commission.

Proceeds from a successful privatisation would be used initially to pay the Laender's claims relating to their guarantee fees (a large portion of the fee obligations will be transferred to the holding company to initially relieve the operating subsidiary from its payment obligations). If it cannot be sold, the bank will cease new business and wind down its assets. We think there is a risk that privatisation proceeds will be insufficient to cover the Laender funding costs and potential losses on the NPL portfolio.

So the NPL transfer will crystallise a contingent liability for both Laender but the full financial impact is uncertain. It will depend chiefly on the subsequent losses or gains incurred on the NPLs, and whether the operating subsidiary can be privatised.

According to the Laender, the purchase of the portfolio will most likely be funded via a vehicle set up by Hamburg and Schleswig-Holstein. This will either directly or indirectly add to their already high capital market debt of EUR22.9bn in 2Q15 in the case of Hamburg and EUR26.2bn for Schleswig-Holstein. Prior to this week's agreement, unrealised costs on HSH guarantees have not been factored into our debt calculations, which assume that Laender will ultimately be liable for state-owned entities in which they hold more than a 50% stake.

However, Fitch views the risk stemming from an increase in debt as limited. The absolute amount is high for a sub-sovereign by international standards, but Hamburg and Schleswig-Holstein have good access to capital market funding (as do all German Laender).

Their maturity profiles show no concentration risk and correspondingly limited refinancing risk. Their interest burden is moderate, reflecting low interest rates and experience in debt management. At end-2014, the ratio of interest paid to operating revenue was 5.8% for Hamburg and 8.3% for Schleswig-Holstein.

Additional borrowing will increase the interest burden, adding to the challenge of achieving a balanced budget, but both Hamburg and Schleswig-Holstein are implementing well-developed plans to reduce their structural deficits to zero by 2020 to comply with the debt brake rule. At end-2014, Hamburg had achieved a surplus before debt variation of 3.9% of total revenue, while Schleswig-Holstein faced a small deficit of 1.9%.

Liquidity risk is mitigated by the constitutional solidarity system whereby all member states of the federal republic are jointly responsible for supporting a Land in financial distress. If a Land experiences "extreme budgetary hardship", it is entitled to financial assistance from all other Laender and the federal government. Hamburg and Schleswig-Holstein's 'AAA'/Stable ratings, affirmed in May, are in line with Germany's sovereign rating, reflecting this strong institutional framework.