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Opinion

German banks: Desperate times call for desperate measures

Germany’s banking system is in dire straits, and the answer could be a radical one.

Germany’s much-vaunted economic recovery could well be over, as the country recently emerged as the US sub-prime market’s biggest foreign victim. Investor confidence is lower than at any time since 2002, and is declining further as more and more financial institutions reveal large exposures to sub-prime US mortgages. The bailouts of Deutsche Industriebank (IKB) and Sachsen LB have made foreign banks far less willing to extend credit to even the healthiest of German banks. Unlike the troubles of five years ago, however, this time around there might be no cure.

In 2002, the traditional reliance on bank debt was no longer acceptable as senior unsecured financing disappeared. As the troubles grew, securitization was seen as the panacea, and the true-sale initiative was born. Tax and legal constraints were removed, and German banks were free to participate in this rapidly expanding market. IKB, for instance, became known as one of "the usual suspects", because it always seemed willing to buy securitized assets.

For many years, IKB concentrated on loans to small and medium-sized enterprises but began partaking of the securitization market as early as 2001. The bank made decent profits, and continued to expand this part of its business aggressively even as the sub-prime difficulties became apparent. It was buying a lot of questionable CDOs as late as June this year. Thanks to a reported £12 billion exposure to the US sub-prime market, Germany’s self-proclaimed leader in securitization failed, and was bailed out by KfW, the government-owned development bank. Similarly, Sachsen LB was bailed out by the association of German savings banks to the tune of a €17.3 billion credit facility extended to its troubled investment conduit, Ormond Quay. (This despite reassurances to investors given a few weeks previously.)

There are others. WestLB is said to have its head on the block, with 6,000 jobs in danger. Deutsche Postbank has up to €800 million of exposure to the US sub-prime market, with €600 million through credit lines linked to investment vehicles run by IKB.

So what’s the cure this time around? One possibility might be to shore up the troubled banks through massive mergers. Landesbank Baden-Württemberg (LBBW) has already snapped up Sachsen LB, and is on the verge of taking over WestLB as well.

Separately, Jürgen Rüttgers, prime minister of Nordrhein-Westfalen, is touting the merits of two huge merger operations that would link all of the Landesbanken in Germany into two large groups: one for the northern regions and one for those in the south. This could mean fewer job losses in the region. It would also ensure that Dusseldorf remains a financial hotspot, whereas the LBBW deal would leave the city financially crippled, as LBBW is southern-based.

Although many consider the mass-merger idea to be impracticable, it does suggest that large-scale M&A activity could be the way to get back on track for the troubled German banking sector. This is especially true of the Landesbanken, many of which have been struggling to compete ever since the European Commission’s ruling to abolish state credit guarantees came into effect in 2005.

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