Cablegate: Second Wave of Financial Market Crisis Hits

Published: Mon 17 Dec 2007 06:30 AM
DE RUEHRL #2208/01 3510630
P 170630Z DEC 07
E.O. 12356: N/A
1. SUMMARY: The "second wave" of the U.S. sub-prime
mortgage crisis has hit the German banking sector,
striking hardest those banks that were already
affected at the beginning of the crisis in July and
August. IKB (Industrie Kreditbank) and Saxony state
bank (Sachsen LB) announced their need for further
liquidity and extended credit lines. The news
surprised the German banking sector and further eroded
confidence. Positive business figures in October and
relief over the seemingly moderate impact of the sub-
prime mortgage crisis had lured German banks into a
false sense of security that the crisis was largely
over. Now there is far greater caution over the
destabilizing impact of the IKB and Sachsen LB crises.
This leads to what an analyst described to us as a
"bunker mentality" in which liquidity is held back and
M activities are suspended. End Summary.
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Setback on Confidence - "Credit Crunch" Continues
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2. Just as German banks had read October figures as
an easing of the U.S. sub-prime crisis -- at least as
far as the German banking system was concerned --
November and early December figures renewed concerns
over the real exposure of some German banks. "The
fears and suspicions of early September are back" an
HSBC analyst told Embassy. "Nobody knows exactly what
some of the papers are really worth," he said. As a
result banks are holding back liquidity. This is
reflected by the rise of the ECB's "Euribor," a three-
month tender that reached its highest point since the
beginning of the crisis at 4.93 percent (93 basis
points above the ECB benchmark rate) this week.
Overnight lending shows a comparable trend.
"Liquidity is expensive and one has to pay a 'risk
premium'" an analyst of the Association of German
Savings Banks told the Embassy. Many banks are trying
to "window-dress" statistics before the end of year
reports, he added.
3. The fact that banks have withheld credit, however,
also have strategic motivations. An analyst of the
Association of Private German Banks told Embassy that
he believes banks are keeping their "war chest" filled
to be in a position to buy up those banks that are
weakened once the crisis is over. None of the
analysts believe that the "credit crunch" will be over
before the end of the year.
IKB and Sachsen LB as Destabilizing Elements
4. The crises at IKB and Sachsen LB are having ripple
effects on other German banks. Following the creation
of an IKB rescue fund of 3.5 billion euros in July,
IKB's biggest owner, KfW (state-owned Kreditanstalt
fuer Wiederaufbau), had to step in again at the end of
November and expand the fund to 4.8 billion euros.
This time private banks refused to assist in the
operation, leaving it up to the 80-percent state owned
KfW to keep its subsidiary IKB afloat. With the full
extent of IKB's sub-prime mortgage involvement still
unknown, analysts have speculated IKB losses may be as
high as 9 billion euros. This would more than deplete
KfW's (general) emergency fund of about 6 billion
euros and would force the bank to draw upon its
equity. Such a scenario triggered reactions from
federal Finance Minister Peer Steinbrueck and
Economics Minister Michael Glos, both of whom called
for structural changes in the management of KfW. The
KfW board has already exercised its decision to sell
IKB once the bank is stabilized again. Despite its
current losses, IKB's ties to German SMEs make the
bank an attractive partner and several private banks
are expected to bid.
5. In the case of Sachsen LB, the lingering crisis
was merely covered up by the early willingness of
Germany's biggest state bank, Landesbank Baden-
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Wuertemberg (LBBW) to step in and take-over Sachsen
LB. Many overlooked the fact that the LBBW only
stepped in as a trustee with an option to purchase
Sachsen LB, provided the bank's liabilities were
manageable. This week LBBW announced that its review
of Sachsen LB records revealed a sub-prime mortgage
exposure of approximately 43 billion euros. In light
of these new figures, LBBW declared it would honor its
merger agreement only if the state of Saxony would
cover ten percent of the exposure as potential losses.
The Saxony state government instantly rejected LBBW's
6. The stalemate between Saxony and LBBW caused the
German banking supervisory authority "Bafin" to step
in. Its president, Jochen Sanio, allegedly threatened
to withdraw Sachsen LB's operating license if no
acceptable solution was found. Following Bafin's
intervention, the Saxony state government and LBBW
(assisted by the Federal Finance Ministry, the
Chancellery and the Association of German Savings
Banks) hammered out an agreement under which Saxony
agreed to cover 2.75 billion euros of potential
losses. In return, LBBW will purchase Sachsen LB for
328 million euros and take over any additional
liabilities from the bank's sub-prime mortgage
involvement. Saxony Minister-President Milbradt
justified the assumption of 2.75 billion euros in
potential liabilities (equal to about 20 percent of
the state's annual budget) with the overall interest
in preserving the deal with LBBW. Milbradt claimed
that without it, the state would have had to cover up
to 35 billion euros in potential losses. (Note: A
closure of Sachsen LB would have sent even greater
shock waves through the German banking system. All
rescue operations (including that by LBBW) were
designed to avert such a case, keeping the financial
market in Germany stable and maintaining confidence in
the German banks. End Note.)
Consolidation Efforts Suspended
7. The impact of the U.S. sub-prime mortgage crisis
on Germany is most noticeable in the public banking
sector. While the top three German private banks also
reported significant losses ranging from 2.2 billion
euros at Deutsche Bank, 591 million euros at Dresdner
Bank, to 291 million euros at Commerzbank, most
observers believe they have managed to weather the
most severe part of the crisis. Practically all
disturbances stem from Germany's public banks and
specifically from state banks. Contrary to earlier
expectations, however, the crisis has not led to a
consolidation process among the eleven state banks.
8. Heavy losses due to sub-prime engagement by
Sachsen LB, West LB, the Bavarian state bank, and
Rhineland-Palatinate state bank (subsidiary of LBBW)
have triggered even stronger political backing than
these state banks enjoyed before, postponing
consolidation. The new Bavarian Minister President
Guenther Beckstein reversed the position of his
predecessor Edmund Stoiber of a few months ago by
declaring the Bavarian LB would not merge with LBBW.
Beckstein stressed the importance of an independent
Bayern LB for the state of Bavaria and declared the
bank strong enough to survive independently.
Likewise, his North-Rhine Westphalia counterpart,
Juergen Ruettgers, refused calls by the co-owner of
WestLB, the state's savings banks, to merge the West
LB with LBBW and now prefers a merger with the Hessen-
Thuringia Helaba Bank instead. The Association of
German Savings Banks views this trend with great
concern since they favor the creation of one to two
major state banks (which would mean relative autonomy
of the savings banks) and resist the tendency by state
politicians to force the savings banks under the roof
of the state banks.
Who is to Blame for the Financial Crisis?
9. At a December 5 luncheon of the Association of
Private German Banks, analysts offered a first "stock-
taking" of the U.S. sub-prime mortgage crisis by
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German bank analysts. The financial experts
contrasted the way banks and brokers handled the
mortgage business at the beginning of the decade with
that of recent years. They concluded that what had
worked at the beginning of the housing boom --
especially proper underwriting for loans -- had fallen
by the wayside. While loans were increasingly granted
to customers who did not qualify, rating agencies and
banks did not adjust to the rising default risk.
Rating agencies applied the same mathematical models
to SIVs (Structured Investment Vehicles) that they
applied to bonds, despite their different nature and
10. The banks on the other hand were all too willing
to accept the ratings as long as they themselves would
not have to do the risk assessment or assume
responsibility for the risk. The false feeling of
security combined with prospects of high returns
especially attracted German state banks -- which
otherwise generated only very modest profits from
their core business -- to join the sub-prime market.
The fact that German state banks do not have to
publish quarterly reports delayed recognition of the
problem. The introduction of Basel II rules, which
will oblige originating banks to keep more of their
loans on their balance sheets, will help in making
such transactions more transparent.
11. On the regional level, our Consulates General
have encountered considerable criticism this fall
along the lines of "yet another crisis from the United
States affects Germany" and critics attempted to
attribute responsibility to American banks lending to
"unworthy customers." In recent weeks, however, some
senior financial contacts in NRW have walked this
message back, conceding to Dusseldorf CG that affected
German banks had often not done their homework and had
become involved in businesses they did not understand,
that management had often not followed their units'
activities closely, and that they received a rude
awakening when they experienced the downside of risky
investments. One very senior Deutsche Bank official
agreed with Dusseldorf CG that the broad media
criticism focusing on the U.S. origins of the crisis
was "unfair and inappropriate."
12. Most analysts here believe that the current
crisis stemmed from a lack of trust among banks but
will, entirely independent of government intervention,
likely lead those institutions themselves to adopt
greater transparency in banking operations. Observers
also believe that among priate banks there was also
agreement that the Germn state banks will in the
future stay away from IVs because of their high risk.
In order to avoi financial failures again, the
supervisory authorties of the state banks (heretofore
politicized)would try to manage "their" banks more
prudently This, however, would again put into
question te state banks' business model and their
very reaon for existence.
Timken Jr
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