Der Nächste Schuh (The Next Shoe)?

The German financial system is teetering on the brink. But you could hear a pin drop amid the silence from Der Spiegel or Frankfurter Allgemeine. The mantra is that Germans were far more responsible in their lending and their borrowing, there were no housing bubbles there, and the regulatory framework was much more stringent than in the US. Therefore, goes the common opinion, Germany will sail through the crisis relatively unscathed.

Instead, the German media (and Germans who listen to it as unquestioningly as Americans do CNN) prefers to focus on the fate of Opel amid GM's impending bankruptcy. This is indeed a problem for the heart of German industry, the Rheinland, where a majority of their auto industry is concentrated. And for Germany, if I remember correctly, the auto industry is a larger percentage of their total GDP than it is for the US. So they have reason to be concerned.

But the size of the problem pales in comparison with the struggling Landesbanks (state owned regional banks). And perhaps this is precisely why the auto problems are garnering so much attention: they are far more manageable. And proving to be able to solve problems is an issue of high importance for the German coalition government, who are hoping to be reelected on Sept 27. It appears they are trying to sweep everything under the rug until after the election. For their sake, one would hope that they do a better job than Paulson/Bush did in '08.

For North Americans, trying to understand the German banking system is a difficult exercise (I'm still working on it). It is tempting to solely focus on the large banks like Deutsche Bank (NYSE: DB) to assess the country's financial health. But that would be misleading due to the large role that state owned banks play.

To get a better handle on what is happening in Germany, I would highly recommend reading the following interview with Hans-Joachim ("Achim") Dübel. Below are some excerpts. The entire interview can be read here.

Dübel: I pursued the housing field as a private consultant economist to agencies such as the World Bank and the EU Commission. My role here in Germany is somewhat that of the critic. Since I have worked outside of Germany and have relative freedom, I decided to use my perspective to provide an independent voice here. The sad fact is that there is virtually no discussion in the policy community in Germany regarding the financial crisis. Most of the professors in the universities in Germany that work in finance have their chairs co-sponsored by banks, so they are effectively gagged in many cases. It is easy to become a critic in Germany because there are so few independent voices. The political parties are deeply involved in finance through the state sector banks, (Landesbanken and Sparkassen) and the private financial community takes its lead from Deutsche Bank (NYSE:DB), which has decided not to make a public issue out of the problems in the state sector institutions.

The IRA: Wait a minute! Was it not DB that sold most of the toxic waste to the Landesbanks? Our recollection is that it was DB, Merrill Lynch and Lehman who were the key perpetrators in stuffing the Landesbanks with toxic waste. No wonder the DB does not want to talk about it! We have the same problem in the US, namely that the larger banks have taken control over the federal government, leaving the real economy and the population at the mercy of Wall Street. Our colleagues who work in the financial world are mostly employees and thus are cowed into silence. The lack of critical debate in the US financial community regarding the crisis is stunning.

Dübel: I am familiar with the problem in the US from colleagues who ran into problems with the GSEs, particularly Fannie Mae. Funnily enough, we have the same problem in Germany with most bank lobby groups, and public banks are not different from private in that respect. They are very aggressive in going after independent economists to attack their reputations if they have the temerity to criticize them. I think both countries have a serious oversupply of bank lobbying groups, which mostly are staffed with aggressive lawyers.

The IRA: We used to get a lot of flak from Fannie and Freddie, but this is not a problem now. In fact, after we published a brief comment about the role of Peer Steinbrück in creating Germany's financial crisis, we started getting calls from the German press before we even ran this interview. One reporter from the German edition of the Financial Times called last week demanding to know the identity of our sources. We gave our usual reply: "Foxtrot Oscar."

Dübel: What Fannie Mae did in her worst days, which I think are behind us, was to put indirect pressure on people who were critical, usually to try to get them fired. German banks play the same games, some as direct as Fannie, but most are more subtle, working behind the scenes to undermine critics. The fact is that everything in Germany is public; all of the data that I use in my work is freely available, yet nobody looks at it or uses it in the public debates. The Brussels declaration of 2001 that allowed the Landesbanken to issue dozens of billions of state-guaranteed bonds without any other purpose than regulatory arbitrage clearly names the German politicians who were the negotiators. Each of these men are also the key figures in creating the problems within the Landesbanks in each state, but still there is virtually no debate in Germany regarding these issues.

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The IRA: So the German Landesbanks started to issue debt and buy toxic assets from DB, Merrill and Lehman? Great. Was there any legitimate purpose for this debt? How much are we talking about?

Dübel: The direct extra issuance by the banks following the EU transition period decision was already massive and totaled probably €100 billion. However, if you consider guarantees given by Landesbanken you might well end up at €200, perhaps €300 billion in total exposure. Those guarantees were called upon when the banks and investors funding ABCP and SIV called in their capital during 2007. Moreover, there was a considerable balance sheet shift inside Landesbanken in particular from interbank market exposures to securities holdings. All in all, the data leaking out of various sources suggest that Landesbanken today sit on problem assets of €300-500 billion, much of them funded effectively with German government debt. Individual banks, such as WestLB, LBBW, BayernLB, HSH Nordbank sit on high double-digit € billion exposure positions. Compare these pictures to peak outstandings of US high-risk markets in €, e.g. Subprime RMBS of € 575 billion in 2007, and you get an idea about to what extent the Landesbanken funded Wall Street. Take all high-risk securities markets at peak levels together - from leveraged loan CLOs to Alt-A RMBS, and I think we are looking at some 15% of the Buy Side demand.

The IRA: Do you think that the Landesbank management just abused the political system?

Dübel: Politicians were always broadly in the picture regarding strategy; remember that they staff the boards (Verwaltungsrat) of the Landesbanken against good remuneration. They knew that the typical loan portfolio for a Landesbank was only 20-25% of total assets, so the rest of the structure was typically securities. Before 2001, the pressure set by the EU had lead to all types of strategies to spur loan growth. For example, the HSH Nordbank based in Hamburg and Kiel focused on ship finance, WestLB had an aircraft engine finance business. There were also regional expansion strategies, with HSH investing in Scandinavia, WestLB in Britain, BayernLB in South-Eastern Europe. Some have entered retail banking by acquiring other banks (e.g. BayernLB), so the business models were not homogeneous. But these markets were already overcrowded, and nobody in the political system dared to put pressure on the Sparkassen to accept the transfer of retail business to the Landesbanken to stabilize their business models. The Brussels agreement reached by German politicians against a reluctant EU was just the final nail in the coffin: it is like a parent who gets a child to finally focus on studies, only to have a rich uncle show up, give the child $1,000 in cash and says "do what you want" with the money. A political decision completely destroyed market discipline.

The IRA: Well, we know that story. Citigroup (NYSE:C) was doing precisely the same thing in the US during that timeframe under the direction of board members like Robert Rubin. The US banks also expanded their leverage via the issuance of non-guaranteed structures such as SIVs. At the end of this year, assuming that the FASB does not get rolled again a la fair value accounting, all US banks must repatriate hundreds of billions of dollars in off-balance sheet ("OBS") assets, which will drive down capital levels dramatically. The notion of banks repaying their TARP equity this year is ridiculous if you include OBS assets in the analysis. Yet isn't it remarkable that C and the German banks were essentially all doing the same stupid things? The common denominator must the global sales push from the large Sell Side dealers like DB, Merrill and Lehman, among others.

Dübel: The dealers in Germany, DB included, are certainly co-responsible. The dealers always looked at the Landesbanken with their distorted incentives as easy prey. C surely fell into the same trap after Glass-Steagall was repealed; to me the important Citi analogy there is rather the Garn-St.Germain Act of 1982 that allowed the US S&Ls to expand into commercial lending. To me it looks as if C and Landesbanken are not very far apart in their clout on their domestic political system, just the flavors of the favors differ.

The IRA: There are no coincidences on Wall Street. Whatever toxic waste the dealers are feeding to Buy Side firms in the US is also being offered around the world. The Sell Side firms are not clever enough to have a different sell message for each market. We can recall the first adventures of Solomon Brothers in Europe selling CMOs to Belgian dentists in the 1980s. It was a slaughter, but none of the regulators in EU or US ever said a word.

Dübel: In the US and particularly with C, the problems in the asset-backed commercial paper or ABCP market was very similar to what was happening in Germany. This was very typical of the Landesbanken, who basically have no set business model. They saw the yield curve and played the markets. They demanded "AAA" ratings with a juicy spread pickup, which means squaring the circle. If you put together all of the factors, the lack of limits on state guarantees, the lack of controls on the activities of the Landesbanks, and the sales pressure from the global securities dealers, you have a real toxic mix.

The IRA: What we find startling about your tale is the EU here is the more conservative, fiscally responsible party, while the German bankers, who are reputed to be so conservative, seem instead to be completely reckless cowboys. It's as though the entire German financial system was run like Fannie Mae, with the Barney Frank (D-MA) and other American politicians making financial decisions from Capitol Hill and carving out special slush funds for their own personal use. Is this a fair comparison?

Dübel: Yes, absolutely. And it is a complete conflict of interest. The typical German savings or state bank has 25-30 board members. This becomes a harbor for politicians, who are given sinecures on these boards when they retire. The campaign finance system in Germany is under continuous scrutiny, but meanwhile practices like packing the boards of banks with retired politicians continues. But we see some change: there is a big uproar currently as BAFIN has started calling for minimum banking qualifications of supervisory board members, which typically excludes your local mayor.

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The IRA: So it sounds like the situation in Germany was not about a bubble in the housing market but instead failed financial engineering motivated by the wrong incentives set by politicians.

Dübel: Yes, you must forget the word "mortgage" when you are looking at Germany. I am a housing expert, but this problem comes down to a lack of basic prudential and political controls in German banks. The state banks have entered and exited the mortgage market several times in the past few decades. Most recently, there has been a proliferation of direct banks providing mortgages, ING from the Netherlands and even the Postal Bank is involved. The irony of the Landesbanks is that they did not lose a penny on investments and loans Germany. All of the losses were caused by investments in foreign assets, primarily from the US. The overhang of assets was caused by the failure of the EU Commission to limit debt issuance by the German banks. Thus the question came: where to put the money raised via the issuance of debt? The US was the choice. Had there been a capital markets boom in China, the Germans would have invested there instead. The choice of asset selection was completely opportunistic and engineered by Wall Street. Don't forget that many other nations in Asia and the Middle East were given the same treatment by the American banks.

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Dübel: Another one of the German stories that connect with the global crisis and nobody here wants to tell is de-facto collapse of local financial centers such as Düsseldorf or Munich. The entire European leg of the crisis is the story of the ambition of smaller banking centers, backed ultimately by local taxpayers. You have Reykjiavik, Dublin, Edinburg with Royal Bank of Scotland (NYSE:RBS), Dusseldorf, Leipzig, Stockholm with Swedbank, Budapest with OTP, you have Lisbon with Millennium Bank losing money in Poland, Belgium with both Fortis and KBC and so on - the axis of the insolvent is longer than most people imagine. So the smaller European banks went on a speculative spree where, the believed, they were becoming regional and even international players. The results are very serious for smaller European jurisdictions, such as Belgium which has 25% of GDP in loan exposure in Central and Eastern Europe. And there was lots of local contagion. Everybody knows the Iceland story, but few know that, for example, basically all of the banks in Düsseldorf went bankrupt in the crisis. My suspicion is that they all talked to the same investment bankers on road shows.

The IRA: Of course.

Dübel: Long story short, the total back of the envelope figure for Germany in terms of rescues so far is already safely in the 10% of GDP range. SoFFin, the federal rescue fund, has provided alone about €190 billion or roughly 7.5% of GDP; add to this the state rescue programs, which are basically SoFFin cofinancing shares, for the Landesbanken. Are some €250-300 billion in protection enough to address a problem calibrated semi-officially in the €800-€900 billion range? Probably not, especially considering the high toxic asset shares at the Landesbanken .

Dübel shows that the rescue programs have already consumed 10% of German GDP, yet the problem assets have hardly even begun to be uncovered. This is going to become increasingly problematic for the world's second largest economy. I find it utterly amazing that Germany's problems have gone almost totally unnoticed in the American press (not to mention Germany's own) and high level politicians are able to get away with statements like the following, which are just simply not consistent with reality:

"The United States is solely to be blamed for the financial crisis. They are the cause for the crisis, and it is not Europe and it is not the Federal Republic of Germany." - Peer Steinbrück, German Finance Minister, September 25, 2008

Sadly, that kind of attitude was very prevalent among Germans during my six month stay there this winter. The Germans are very proud of what they thought was a far more prudent way of living and running business. People did not buy homes they could not afford (down payments of 30% are the norm). There was a trade surplus. The bubble wasn't visible to the average German, so the idea of a collapse sounded absurd. But the bubble was there. Just as big and bloated as elsewhere. It was just buried amid bank balance sheets. Not being used to fund domestic excesses mind you, but as part of an international finance ring that was all caught up equally in funding asset bubbles elsewhere.

So not only are German banks now saddled with garbage, but their export industry is being crippled by falling demand from the same people they were buying debt from. This is the same type of debtor financing that I believe will eventually sink the Chinese economy as well. The major difference being, of course, that the Chinese export surplus was derived from an artificially weak currency. Whereas, the German export surplus appears to be as a result of their willingness to import financial WMD, rather than government treasuries. (Only time will tell who was wiser).

Suffice to say, German purchases of mortgage toxic waste have subsided, and the manufacturing industry is taking a hit. Plant and machinery orders fell at an annualized rate of 58% in April. Exports fell 9.7% in the first quarter. GDP is off 6.9% year on year. Ed Hugh has some nice charts highlighting all of this here.

In summary, there is nothing that leads me to believe that Germany (or Europe in general) are in better shape than the US and will be able to lead the way to recovery. To the contrary. The same cataclysms that hit the US financial system are lurking on the balance sheets of European banks. Should the talk of "green shoots" in the US become a self-fulfilling prophecy (which they won't), there is enough evidence to contend that the crisis baton will be passed to the eurozone.

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