SECOND WAVE OF FINANCIAL MARKET CRISIS HITS

UNCLAS SECTION 01 OF 03 BERLIN 002208 SIPDIS SIPDIS TREASURY PASS TO FEDERAL RESERVE E.O. 12356: N/A TAGS: EFIN PREL PGOV GM SUBJECT: SECOND WAVE OF FINANCIAL MARKET CRISIS HITS GERMAN BANKS THIS CABLE HAS BEEN COORDINATED WITH CONSULATES GENERAL FRANKFURT, DUSSELDORF, AND LEIPZIG ¶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&A activities are suspended. End Summary. -------------- -------------- Setback on Confidence - "Credit Crunch" Continues -------------- -------------- ¶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, may 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- BERLIN 00002208 002 OF 003 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 demand. ¶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 BERLIN 00002208 003 OF 003 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 volatility. ¶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." -------------- Consequences -------------- ¶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