Subprime infection spreads to Germany

It seems like just yesterday, but it has been five months since the first signs of credit woes began in the global debt markets. As we have incessantly predicted, to the point of boring even ourselves, the U.S. subprime cancer has finally found its way into the central nervous system of the banking system.

But no one seems to be asking the right questions.

The high yield market has closed up shop, and not a result of warm summer weather. And if that wasn’t enough, banks are watching each other with a careful eye (as discussed in our posts “‘Panic’ sets in to the debt markets“, July 29-07 and “The end of cheap debt has arrived“, July 20-07).

According to Reuters, via The New York Times, Germany’s “financial watchdog” oversaw a rescue of IKB earlier today. This is just the latest shoe to drop:

German Lender Hit by U.S. Subprime Woes

By REUTERS
FRANKFURT, July 30 (Reuters) — The American subprime mortgage crisis claimed the lender IKB as a first victim in Germany today, setting off sharp falls in other German bank shares on fears that they, too, could face sudden problems.

IKB, a small-company lender, surprised markets with a profit warning linked to problems in the American subprime market and announced that its chief executive had stepped down, sending its share price down more than one fifth.

IKB’s biggest shareholder, the state bank KfW, stepped in to prop up the bank’s creditworthiness in the wake of the difficulties.

But IKB’s exposure to complicated American mortgage investments was the first time the subprime specter had loomed in Europe’s biggest economy. It scared investors, fuelling worries that other German banks could be affected in the same way.

Shares in Deutsche Postbank were down 1.2 percent at 55.06 euros by mid-afternoon here, having fallen as low as 52.60 earlier in the session, despite assurances from the company that it would not suffer from the subprime market.

An international property financier, Hypo Real Estate, dropped 3.5 percent to 44.71 euros, while Commerzbank was down 2.7 percent at 30.84 euros.

Deutsche Bank , which had declined to tell investors about its exact exposure to subprime markets, was down 0.7 percent at 97.25 euros, off a day’s low of 95.85.

It will unveil its second-quarter results on Wednesday, and the shares had already tumbled last week on fears of a profit warning.

Simon Adamson, an analyst at the credit research firm CreditSights, said that banks had generally failed to explain their obligations stemming from such structured finance deals.

“This announcement from IKB will confirm the fears of a lot of investors that we don’t really know what the scale of the problem is,” he said. “If you look through banks’ annual reports you will not find information to tell you what this potential liability is and that is one of the main reasons that the market has been so worried recently.”

Mr. Adamson also said that the IKB case showed how quickly subprime problems could get out of control. Just 10 days ago IKB had confirmed its profit goal for the year.

But credit rating agencies played down the prospect of ripples from the United States endangering the country’s top-tier banks.

“We don’t see any significant impact on the big German banks directly from U.S. sub-prime mortgage problems,” said Stefan Best, an analyst with the rating agency Standard & Poor’s, which recently surveyed big German banks about their exposure.

Thomas von Luepke, chief German banks analyst at the ratings agency Fitch, said much depended on whether the American problems spread to the country’s real estate market generally and the United States and European economies.

“Most German banks are well-positioned to digest any shock of a limited size,” Mr. von Luepke said.

The German financial watchdog BaFin, which oversaw the IKB rescue, said the deal ensured there would be no fallout for the country’s banking system.

It is worth repeating that IKB is a lender to smaller companies, much like ourselves. Somehow, despite not being in the mortgage or housing industry, they got themselves exposed to the U.S. subprime real estate market. Indirectly, one can only assume. My bet is that in the search for some premium yield on their idle cash, they went headlong into a CDO for some of that delicious “alpha” everyone is always yakking about.

You can hear the money market salesman selling IKB’s Treasurer on this S&P (or Moody’s) A-rated CDO paper on the basis that it pays several basis points more than the corporate debt issued by an A-rated Life Insurance Co. of a similar tenor. Turns out the equity in the CDO has now been wiped out, and the rating has been pulled. Or something like that.

And it was just 10 days ago that IKB confirmed their profit forecast for the year.

If IKB wasn’t able to ascertain their disaster a mere ten days ago, why is ever other holder of CDO paper backed by subprime mortgages (and we are talking billions on $) so sure about their “exposure”. Perhaps they are sure about the exposure to the sector, it just that everyone is asking them the wrong question. Exposure just explains how large the position is. It doesn’t speak to the value of that position.

My friends and the cribbers in the DTM should try these questions, instead:

“Is there a liquid market for the subprime paper that you are holding today? And if so, are you holding that paper at the bid side of the market as would be required under GAAP Fair Value Accounting? In addition, has your prime broker offered you a quote based on what they’d actually pay for that position, or just what they believe it might trade at? If there is not a liquid market for your paper, or if you are the sole owner of that series of issuance (hello CIBC?), how can you possibly value it at all?”

MRM