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