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  Bad Debts: American Mortgage Crisis Rattles German Banking Sector

Bad Debts American Mortgage Crisis Rattles German Banking Sector

By Frank Hornig, Lothar Pauly and Christian Reiermann

Part 2: 'Liar Loans'

The bad news coming from the United States -- where mortgage lenders had been outdoing each other doling out easy credit -- isn’t likely to slow down. People have become accustomed to financing new houses with no money down. Ballooning housing prices encouraged lender GMAC to offer mortgages requiring only a $500 fee: “Thanks to the HomeStrength plan, you can stop saving and start shopping today.”

Often it was enough for a potential homebuyer to dream up an imaginary salary: income, questionable credit history, and proof of a job were just “annoying paperwork” for some mortgage lenders. “Difficult-to-prove income doesn’t have to be hurdle,” says one offer, while another crows: “$2.5 million loan, no credit check necessary!” In the jargon of mortgage lenders, these are "NINA" loans: no income, no assets.

For buyers who inflated their incomes to borrow money for a nicer house, critics coined the term “liar loans.” But as long as US housing prices continued to climb, the risky math paid off. From 2002 to 2006, the US mortgage market grew on average 15 percent annually. American regulators shut their eyes and hoped for the best. Nouriel Roubini, an economics professor at New York University, accused government watchdogs of "falling asleep at the wheel while a reckless credit bubble occurs."

So is the bubble popping? In October, higher interest rates for some $50 billion in housing loans will go into effect. Through September 2008, mortgages totalling around $1 trillion will be hit by higher interest rates. “The worst isn’t over yet,” warns the investment bank J.P. Morgan Chase.

Most of the US housing market, with a few notable exceptions such as New York City, has slid into its deepest funk in decades. Average housing prices are falling across the United States this year for the first time since the 1930s, according to Roubini. Only a few months ago, many hoped the crisis would be limited to the subprime lending sector -- that is, to borrowers with bad or no credit -- but that wishful thinking is gone. Now everyone tied to American homebuyers who wanted lives built on easy credit are facing the consequences.

The first to get hit are hedge funds that hoped to make fast money with the loans. Next in line are the banks -- and not just in America. And in Germany, it’s not just IKB.

But how could a small German bank with only 1,700 employees and a mere €1.4 billion in equity capital make such huge bets in the United States without someone noticing? IKB bought €12.7 billion in special securities via Rhineland Funding that failed to show up on the bank's ledgers. These securities consist of loans bundled together by banks wishing to unload their real estate and corporate debt risks. The various packages were then categorized according to credit ratings by agencies such as Moody’s and Standard & Poor’s -- enabling the mortgage of a welfare recipient in Alabama, say, to be traded on global financial markets.

IKB could at least show that most of its special holdings had higher credit ratings. However, it now seems that during a housing market slump, nobody wants to buy these prettily packaged parcels of debt. “It could be full of rat poison,” says one banker, shrugging his shoulders. Indeed, as the market has gone south, credit agencies have started to become more realistic and ratchet down their ratings.

All That Glitters

Part of the rescue plan for IKB is for the state-backed KfW to keep the bank liquid with €8.1 billion. When the new chairman -- installed by KfW -- has overhauled the bank, it will be sold. The German government, which owns an 80-percent stake in KfW, approved the plan last week. It's a radical solution, and it’s already clear that the next insolvent bank won’t get off so easily.

Besides IKB, some of Germany’s regional state banks have run into trouble with risky US real estate debt. WestLB allegedly has liabilities in the range of €300 million to €400 million, according to a banker familiar with the situation, noting “toxic elements” found at the bank’s Brightwater fund. The fund has $35 billion in structured debt spread across several special-purpose vehicles. A spokesman from WestLB denies this, though: “We don’t have any provisions of that size.” More than half of the funds managed by Brightwater are for foreign clients, he says, and only a small portion is made up of shabby subprime loans.

Nevertheless, regional public banks in Germany have been oddly zealous to jump into the Asset Backed Securities (ABS) markets. Landesbank Sachsen, partially owned by the German state of Saxony, has led the financing for a totally unknown company named Ormond Quay Funding. Outfitted with $16.75 billion at the end of 2006, Ormond Quay is slightly larger than IKB’s Rhineland Funding. The official line from Saxony is that most of the debt held by the fund has excellent credit ratings.

The US housing market's woes have shaken Wall Street, too. The Dow Jones industrial average on Thursday fell more than 380 points, or 3 percent, after the crisis with BNP Paribas in France pointed out a problem with credit in the US: Investors feared that not just individuals but also institutions, investors, and companies might not be able to borrow money when they needed to -- which has motivated central banks around the world to inject money markets with cash.

“There’s no way to sugarcoat the situation,” said David Rosenberg, Merrill Lynch’s chief economist for North America, even before the recent market drops. Investment bank Bear Stearns had been forced to close two hedge funds because of the crisis; a third was in trouble. Private-equity takeover titans were also forced to rethink their business plans. For years, they’ve been able to buy undervalued companies on margin, only to spin them off later for a tidy profit. However, such lucrative deals are now feeling the credit crunch as well. In the past five weeks alone, more than 35 loans to finance takeovers have been rejected or restructured.

The most prominent example is the recent purchase of US carmaker Chrysler by the Cerberus private equity firm. A $12 billion package of debt financing never materialized.

Once fêted financial stars are now being mocked on Wall Street: KKR founder Henry Kravis is one of the pioneers of private equity. But now he's having trouble financing his latest billion-dollar coup, the takeover of the UK drugstore chain Alliance Boots. Kravis was saying only back in May there was “plenty of capital” for such deals. But now the old adage once again holds sway: Not all that glitters is gold.

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