GERMANY/BANKING CRISIS: RESCUE OF HYPO REAL BANK CONSIDERED

UNCLAS MUNICH 000331 SIPDIS E.O. 12958: N/A TAGS: ECON GM SUBJECT: GERMANY/BANKING CRISIS: RESCUE OF HYPO REAL BANK CONSIDERED NECESSARY EVIL REF: BERLIN 1366 ¶1. Summary: Representatives of the Bavarian financial community believe the rescue of Hypo Real Estate (HRE) is not comparable to recent interventions in the U.S., due to participation by the private sector, and because the German government is not buying assets but giving guarantees. The German government is particularly concerned about HRE because it issues a special type of bond, known as the "Pfandbrief," which is the principal funding instrument of the mortgage banks and represents the largest segment of the German bond market. Large and small investors rely on this instrument to secure pensions and income. German contacts believe the financial situation in Germany is not as dire as in the U.S., but remains serious and that a response is necessary to prevent a chain reaction. End Summary. ¶2. Almost two-thirds of all Pfandbriefs are issued by mortgage banks such as HRE. Even though Bavarian officials deplore the HRE bailout, they agree it is unavoidable. Since the Mortgage Bank Act came into existence in 1900, no Pfandbrief holder has ever suffered any loss on Pfandbrief investments, and the German government is determined to keep it that way. HRE is the main issuer of these tradable debts secured against mortgages and official-sector loans. The Pfandbrief industry, valued at over 1.5 trillion euros, considers itself a highly secure, core investment for institutional fixed-income investor portfolios, combining liquidity and government-like credit quality. The bonds fund loans secured by mortgages or loans to the public sector. ¶3. Officials at the Bavarian Economics Ministry noted that HRE's situation was unlike that of U.S. banks. Through its subsidiary Depfa PLC, based in Ireland, HRE financed creditworthy government institutions, such as states and municipalities. Depfa's problem was that its balance sheet consisted of short-term liabilities offset by longer-term assets, though the short-term loan market is now frozen. Depfa's underlying assets remain conservative and valuable, according to Bavarian officials. Bavarian officials also pointed to the participation of German private banks as another key difference with the U.S. rescue package; private banks could not afford to let HRE go bankrupt because of its importance as an issuer of Pfandbriefs. Another major difference with the U.S. package is the government's extension of guarantees rather than the purchase of non-performing assets. The guarantees will be exercised only if HRE's debtors default. Regarding spillover into the broader German banking sector, Bavarian officials noted that Germany's banking system seems relatively stable because it rests on three pillars: public banks, cooperative banks, and private banks, and does not depend on capital markets to a great degree. Our contact wondered about the regulatory consequences of ongoing discussions in the U.S. He was sure that the U.S. would legislate new financial market controls that could prove to be as far-reaching as Sarbanes-Oxley. ¶4. Guenther Picker, President of the Association of Bavarian Banks (Bayerischer Bankenverband) was confident that new loans by private banks and the Bundesbank, as well as state guarantees, would secure HRE's survival. He also underscored that private commercial banks had participated in the bailout, while in the U.S. the government had acted single-handedly. He conceded that HRE would find it hard to conclude any new business in the future. It is therefore likely HRE would continue to operate, but on a smaller scale. Picker called for a comprehensive solution, whereby the government establishes a fund for non-performing assets: a so-called "Bad Bank." Picker was confident that HRE's senior management would be dismissed, "because a sacrifice was needed"; subsequently, the head of HRE left his job. ¶5. Our contact at the Bavarian Stock Exchange (Bayerische Boerse) also highlighted HRE's role as an issuer of Pfandbriefs. Were it not for the government intervention, the assets of savers and mortgages of home owners would have been on the line. HRE's status as one of the country's top financial institutions qualified it as too big to fail. He blamed the acquisition of Depfa in fall 2007 for HRE's problems today. (Note: HRE first shocked the market in January 2008 when the bank made the surprise announcement of 390 million euros in U.S. sub prime related write-downs. Since then, HRE lost more than half of its market value.) He remarked that current troubles extended beyond HRE, as the push for ever-higher profits had been industry-wide. In order to enhance return on equity, banks had increased borrowing to an irresponsible degree. ¶6. There is consensus that financial turbulence in Germany is not as grave as in the U.S., but that it is nevertheless serious. Our contacts all agreed that the rescue was necessary to prevent a chain reaction. ¶7. Find previous reporting from Munich on our SIPRNET website at www.state.sgov.gov/p/eur/munich/. NELSON