The saviors of the German financial sector came together early this month in a sterile conference room at the Düsseldorf headquarters of the IKB commercial bank. The head of Germanys state development bank KfW, Ingrid Matthäus-Maier, looked anxious. Jörg Asmussen, a departmental head at the Finance Ministry, wrung his hands. His boss, Finance Minister Peer Steinbrück, called from his home in Bonn; other top leaders of German banks were also listening in.
Germany had been hit by a version of the crisis that surprised French investors on Thursday, sending stock markets from New York to Tokyo into unexpected dives. Debts arising from America's so-called subprime mortgage sector had just caused IKB to falter.
The most thankless job fell to Matthäus-Maier. She had to tell those in attendance that KfWs stake in IKB was in an unforeseen predicament. The niche bank specializes in the rather dull sector of financing mid-sized companies; but recently it had taken on risky investments in the United States. The banks management made some bad bets, and lost. Now it was teetering on the edge of insolvency, unless other German financial institutions chipped in with emergency funding.
Jochen Sanio, president of Germanys banking supervisory agency BaFin, was pessimistic: If IKB folded, the failure might spread to other institutions, and maybe set off the biggest bank crisis since the Great Depression in the 1930s. Bundesbank President Axel Weber was less bleak, but made another troubling prediction: A chain reaction could endanger Germanys banking reputation. The gathering of bankers and government officials decided to undertake the biggest rescue operation for a single bank that Germany has ever seen.
American Dreams Gone Sour
The epicenter of this financial quake is the United States. Hardly a day passes now when an American mortgage lender or hedge fund doesnt go belly-up. The worlds equity markets first plunged in response to the crisis in mid-July. Germanys leading stock index, the Dax, lost over ten percent in a matter of days, and Americas Dow Jones dropped six percent.
Another round of panic hit world markets this week after a French bank, BNP Paribas, had to freeze three investment funds worth €2.76 billion ($3.79 billion) because of American mortgage debts. The Down Jones fell three percent on Thursday, and central banks in the US, Europe and Japan have injected money markets with billions of dollars to ease credit jitters.
The crisis has even started to frighten US consumers, whose joy in spending has until recently the bedrock of the world economy. Theyre not just victims in this story, but also the cause of the mess. Theyve built and bought big new houses on easy credit without thinking about potential consequences. This was not a problem as long as real estate values climbed, allowing them to take out ever-larger housing equity loans. But the overheated US housing market started to crash this year, putting an end to the carefree days of American homeownership.
Rising house prices in America started a craze for "subprime" mortgages, or housing loans offered to homebuyers below the prime lending rate. Typically these loans involve a low-rate grace period before a higher rate comes into effect. And as long as housing prices boomed, debts associated with these mortgages could be packaged as attractive investment vehicles for big institutions. But now the market has stalled and abundant credit for such risky investments has dried up -- and anyone, apparently, can run into trouble.
One Bank's Quick Decline
In mid-February, the leadership of the Düsseldorf-based IKB was still boasting of noticeable successes in the department for real estate customers. But IKB had jumped into the real-estate business long after many market players had cashed in and jumped out.
At the banks last supervisory board meeting before the crisis went public, two supervisors asked the board whether IKB was properly covered for bad housing loans in the United States. How big were the potential risks? Participants at the meeting remember IKB Chairman Stefan Ortseifen saying: There is no risk. Two special audits by the Auditing Association of German Banks -- the last one in spring -- also found nothing unusual.
But the house of cards was brought down two weeks ago by Deutsche Bank, which ended the line of credit for Rhineland Funding, an innocent-sounding investment vehicle based in the American state of Delaware. IKB had securities holdings there and in another fund worth more than €20 billion ($27.6 billion).
Deutsche Bank had handled Rhinelands payment transactions and some of its financing. After canceling the line of credit, the bank alerted regulators at BaFin, the German supervisory agency. It became clear during subsequent crisis meetings examining IKBs credit liabilities that the humble bank had losses totaling between €2.3 billion to €2.5 billion at current market conditions. They were broke on Monday, says a board member.
Expecting further liabilities to surface, regulatory boss Sanio went around the summit meeting in Düsseldorf with his proverbial hat in his hand. In the end, the state-backed development bank KfW, as principal shareholder in IKB, would have to cover the €2.5 billion in potential losses. Germanys private banks offered €500 million. The nation's credit unions and public savings banks are expected to pony up another €500 million.
The bad news coming from the United States -- where mortgage lenders had been outdoing each other doling out easy credit -- isnt 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 doesnt 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 isnt 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, its 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 Moodys and Standard & Poors -- 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 its already clear that the next insolvent bank wont get off so easily.
Besides IKB, some of Germanys 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 banks Brightwater fund. The fund has $35 billion in structured debt spread across several special-purpose vehicles. A spokesman from WestLB denies this, though: We dont 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 IKBs 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.
Theres no way to sugarcoat the situation, said David Rosenberg, Merrill Lynchs 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, theyve 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.