Debt, Exposure and Off-Balance-Sheet Loans Banks in Germany Wobble

Just last week, German banks reassured the world that they weren't overly exposed to the American sub-prime crisis. The weekend bailout of Sachsen LB, though, brings Germany's Achilles' heel into the spotlight.

Nice sign -- should be red.

Nice sign -- should be red.

As recently as last week, German banks sought to convince investors that they were not overly exposed to the suddenly wobbly US mortgage market. But as the weekend bailout of Sachsen LB demonstrates -- coming just two weeks after a similar bailout of IKB Deutsche Industriebank AG -- the reassurance wasn't completely accurate.

On Friday evening, Sachsen LB announced that the German association of savings banks was making €17.3 billion ($23.3 billion) available to the Saxony state bank to cover an affiliate that was suddenly unable to provide the credit it had pledged. The bank denied a weekend SPIEGEL report that losses of €500 million loomed due to direct involvement in sub-prime mortgages. But the bailout is raising new questions about the health of Germany's banking system and its ability to weather the kind of precipitous drop in investor confidence kicked off by the collapse of the sub-prime market in the US.

The problem, analysts say, stems from the tendency of some German banks to issue lots of short-term debt -- exactly the kind of debt investors are currently keeping at arm's length. The quick-turnaround loans, known in the industry as "commercial paper," are often used to buy securities, which, in the case of Sachsen LB, were backed by US mortgages.

Even worse, those asset-backed commercial papers (ABCPs) are often issued by affiliates which make no appearance on the mother ship's balance sheet. It was just such an affiliate, known as a "conduit," which sent Sachsen LB to the brink. Called Ormond Quay and based in Dublin, Ireland, the conduit ran into liquidity problems as investors began shying away from ABCPs, leaving Sachsen LB in a bind.

"The ongoing market disruption in selling asset-backed commercial papers resulted in there being doubt on securing funding for the Ormond Quay conduit supported by Sachsen LB," the bank said on Friday. "As a result, the credit standing of Sachsen LB has been called into question."

It is a problem that may not be limited to the Saxony state bank. According to a report in Monday's online version of the Wall Street Journal, German banks issue a lot of ABCP debt -- a business model that can quickly run into difficulties if investors no longer trust the securities the conduits are investing in. It was the same story with IKB Deutsche Industriebank AG at the beginning of the month. According to Moody's Investors Service, German banks have ABCP conduits worth more than $110 billion, with publicly-owned state banks making up half that. Furthermore, many smaller banks are highly exposed through large conduits, the Wall Street Journal reports.

Conduits are often invisible from the outside, but they have become increasingly important, having increased 500 percent from a decade ago and now valued at $983 billion, according to Standard & Poor's Register of Corporations. Indeed, German Chancellor Angela Merkel over the weekend used Sachsen LB's problems to once again call for more transparency, particularly with hedge funds.

"In the case of hedge funds, we need to know where the capital comes from and how high the credit risks are," Merkel told the mass circulation weekly Bild am Sonntag. She said that recent market developments show "how urgent it is that we have greater transparency on international financial markets."

Just what's ahead for Germany's banks, though, is difficult to say. There remain signs that banks are having difficulty raising credit, with European three-month interbank rates at 4.65 percent, much higher than the European Central Bank's 4 percent. Many are concerned that Sachsen LB won't be the last German bank to hit the headlines.



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