VZCZCXRO3171
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHRL #2208/01 3510630
ZNR UUUUU ZZH
P 170630Z DEC 07
FM AMEMBASSY BERLIN
TO RUEHC/SECSTATE WASHDC PRIORITY 0031
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCNMEM/EU MEMBER STATES
RUCNFRG/FRG COLLECTIVE

UNCLAS SECTION 01 OF 03 BERLIN 002208 
 
SIPDIS 
 
SIPDIS 
 
TREASURY PASS TO FEDERAL RESERVE 
 
E.O. 12356:  N/A 
TAGS: EFIN PREL PGOV GM
SUBJECT:  SECOND WAVE OF FINANCIAL MARKET CRISIS HITS 
GERMAN BANKS 
 
 
THIS CABLE HAS BEEN COORDINATED WITH CONSULATES 
GENERAL FRANKFURT, DUSSELDORF, AND LEIPZIG 
 
 
¶1. SUMMARY:  The "second wave" of the U.S. sub-prime 
mortgage crisis has hit the German banking sector, 
striking hardest those banks that were already 
affected at the beginning of the crisis in July and 
August.  IKB (Industrie Kreditbank) and Saxony state 
bank (Sachsen LB) announced their need for further 
liquidity and extended credit lines.  The news 
surprised the German banking sector and further eroded 
confidence.  Positive business figures in October and 
relief over the seemingly moderate impact of the sub- 
prime mortgage crisis had lured German banks into a 
false sense of security that the crisis was largely 
over.  Now there is far greater caution over the 
destabilizing impact of the IKB and Sachsen LB crises. 
This leads to what an analyst described to us as a 
"bunker mentality" in which liquidity is held back and 
M&A activities are suspended. End Summary. 
 
--------------------------------------------- ---- 
Setback on Confidence - "Credit Crunch" Continues 
--------------------------------------------- ---- 
 
¶2.  Just as German banks had read October figures as 
an easing of the U.S. sub-prime crisis -- at least as 
far as the German banking system was concerned -- 
November and early December figures renewed concerns 
over the real exposure of some German banks.  "The 
fears and suspicions of early September are back" an 
HSBC analyst told Embassy.  "Nobody knows exactly what 
some of the papers are really worth," he said.  As a 
result banks are holding back liquidity.  This is 
reflected by the rise of the ECB's "Euribor," a three- 
month tender that reached its highest point since the 
beginning of the crisis at 4.93 percent (93 basis 
points above the ECB benchmark rate) this week. 
Overnight lending shows a comparable trend. 
"Liquidity is expensive and one has to pay a 'risk 
premium'" an analyst of the Association of German 
Savings Banks told the Embassy.  Many banks are trying 
to "window-dress" statistics before the end of year 
reports, he added. 
 
¶3.  The fact that banks have withheld credit, however, 
may 
also have strategic motivations.  An analyst of the 
Association of Private German Banks told Embassy that 
he believes banks are keeping their "war chest" filled 
to be in a position to buy up those banks that are 
weakened once the crisis is over.  None of the 
analysts believe that the "credit crunch" will be over 
before the end of the year. 
 
-------------------------------------------- 
IKB and Sachsen LB as Destabilizing Elements 
-------------------------------------------- 
 
¶4.  The crises at IKB and Sachsen LB are having ripple 
effects on other German banks.  Following the creation 
of an IKB rescue fund of 3.5 billion euros in July, 
IKB's biggest owner, KfW (state-owned Kreditanstalt 
fuer Wiederaufbau), had to step in again at the end of 
November and expand the fund to 4.8 billion euros. 
This time  private banks refused to assist in the 
operation, leaving it up to the 80-percent state owned 
KfW to keep its subsidiary IKB afloat. With the full 
extent of IKB's sub-prime mortgage involvement still 
unknown, analysts have speculated IKB losses may be as 
high as 9 billion euros.  This would more than deplete 
KfW's (general) emergency fund of about 6 billion 
euros and would force the bank to draw upon its 
equity.  Such a scenario triggered reactions from 
federal Finance Minister Peer Steinbrueck and 
Economics Minister Michael Glos, both of whom called 
for structural changes in the management of KfW.  The 
KfW board has already exercised its decision to sell 
IKB once the bank is stabilized again.  Despite its 
current losses, IKB's ties to German SMEs make the 
bank an attractive partner and several private banks 
are expected to bid. 
 
 
¶5.  In the case of Sachsen LB, the lingering crisis 
was merely covered up by the early willingness of 
Germany's biggest state bank, Landesbank Baden- 
 
BERLIN 00002208  002 OF 003 
 
 
Wuertemberg (LBBW) to step in and take-over Sachsen 
LB.  Many overlooked the fact that the LBBW only 
stepped in as a trustee with an option to purchase 
Sachsen LB, provided the bank's liabilities were 
manageable.  This week LBBW announced that its review 
of Sachsen LB records revealed a sub-prime mortgage 
exposure of approximately 43 billion euros.  In light 
of these new figures, LBBW declared it would honor its 
merger agreement only if the state of Saxony would 
cover ten percent of the exposure as potential losses. 
The Saxony state government instantly rejected LBBW's 
demand. 
 
¶6.   The stalemate between Saxony and LBBW caused the 
German banking supervisory authority "Bafin" to step 
in.  Its president, Jochen Sanio, allegedly threatened 
to withdraw Sachsen LB's operating license if no 
acceptable solution was found.  Following Bafin's 
intervention, the Saxony state government and LBBW 
(assisted by the Federal Finance Ministry, the 
Chancellery and the Association of German Savings 
Banks) hammered out an agreement under which Saxony 
agreed to cover 2.75 billion euros of potential 
losses.  In return, LBBW will purchase Sachsen LB for 
328 million euros and take over any additional 
liabilities from the bank's sub-prime mortgage 
involvement.  Saxony Minister-President Milbradt 
justified the assumption of 2.75 billion euros in 
potential liabilities (equal to about 20 percent of 
the state's annual budget) with the overall interest 
in preserving the deal with LBBW.  Milbradt claimed 
that without it, the state would have had to cover up 
to 35 billion euros in potential losses. (Note: A 
closure of Sachsen LB would have sent even greater 
shock waves through the German banking system.  All 
rescue operations (including that by LBBW) were 
designed to avert such a case, keeping the financial 
market in Germany stable and maintaining confidence in 
the German banks.  End Note.) 
 
------------------------------- 
Consolidation Efforts Suspended 
------------------------------- 
 
¶7.  The impact of the U.S. sub-prime mortgage crisis 
on Germany is most noticeable in the public banking 
sector.  While the top three German private banks also 
reported significant losses ranging from 2.2 billion 
euros at Deutsche Bank, 591 million euros at Dresdner 
Bank, to 291 million euros at Commerzbank, most 
observers believe they have managed to weather the 
most severe part of the crisis.  Practically all 
disturbances stem from Germany's public banks and 
specifically from state banks. Contrary to earlier 
expectations, however, the crisis has not led to a 
consolidation process among the eleven state banks. 
 
¶8.  Heavy losses due to sub-prime engagement by 
Sachsen LB, West LB, the Bavarian state bank, and 
Rhineland-Palatinate state bank (subsidiary of LBBW) 
have triggered even stronger political backing than 
these state banks enjoyed before, postponing 
consolidation.  The new Bavarian Minister President 
Guenther Beckstein reversed the position of his 
predecessor Edmund Stoiber of a few months ago by 
declaring the Bavarian LB would not merge with LBBW. 
Beckstein stressed the importance of an independent 
Bayern LB for the state of Bavaria and declared the 
bank strong enough to survive independently. 
Likewise, his North-Rhine Westphalia counterpart, 
Juergen Ruettgers, refused calls by the co-owner of 
WestLB, the state's savings banks, to merge the West 
LB with LBBW and now prefers a merger with the Hessen- 
Thuringia Helaba Bank instead.  The Association of 
German Savings Banks views this trend with great 
concern since they favor the creation of one to two 
major state banks (which would mean relative autonomy 
of the savings banks) and resist the tendency by state 
politicians to force the savings banks under the roof 
of the state banks. 
 
----------------------------------------- 
Who is to Blame for the Financial Crisis? 
----------------------------------------- 
 
¶9. At a December 5 luncheon of the Association of 
Private German Banks, analysts offered a first "stock- 
taking" of the U.S. sub-prime mortgage crisis by 
 
BERLIN 00002208  003 OF 003 
 
 
German bank analysts.  The financial experts 
contrasted the way banks and brokers handled the 
mortgage business at the beginning of the decade with 
that of recent years.  They concluded that what had 
worked at the beginning of the housing boom -- 
especially proper underwriting for loans -- had fallen 
by the wayside.  While loans were increasingly granted 
to customers who did not qualify, rating agencies and 
banks did not adjust to the rising default risk. 
Rating agencies applied the same mathematical models 
to SIVs (Structured Investment Vehicles) that they 
applied to bonds, despite their different nature and 
volatility. 
 
¶10.  The banks on the other hand were all too willing 
to accept the ratings as long as they themselves would 
not have to do the risk assessment or assume 
responsibility for the risk.  The false feeling of 
security combined with prospects of high returns 
especially attracted German state banks -- which 
otherwise generated only very modest profits from 
their core business -- to join the sub-prime market. 
The fact that German state banks do not have to 
publish quarterly reports delayed recognition of the 
problem.  The introduction of Basel II rules, which 
will oblige originating banks to keep more of their 
loans on their balance sheets, will help in making 
such transactions more transparent. 
 
¶11.  On the regional level, our Consulates General 
have encountered considerable criticism this fall 
along the lines of "yet another crisis from the United 
States affects Germany" and critics attempted to 
attribute responsibility to American banks lending to 
"unworthy customers."  In recent weeks, however, some 
senior financial contacts in NRW have walked this 
message back, conceding to Dusseldorf CG that affected 
German banks had often not done their homework and had 
become involved in businesses they did not understand, 
that management had often not followed their units' 
activities closely, and that they received a rude 
awakening when they experienced the downside of risky 
investments.  One very senior Deutsche Bank official 
agreed with Dusseldorf CG that the broad media 
criticism focusing on the U.S. origins of the crisis 
was "unfair and inappropriate." 
 
------------- 
Consequences 
------------- 
 
¶12.  Most analysts here believe that the current 
crisis stemmed from a lack of trust among banks but 
will, entirely independent of government intervention, 
likely lead those institutions themselves to adopt 
greater transparency in banking operations.  Observers 
also believe that among priate banks there was also 
agreement that the Germn state banks will in the 
future stay away from IVs because of their high risk. 
In order to avoi financial failures again, the 
supervisory authorties of the state banks (heretofore 
politicized)would try to manage "their" banks more 
prudently  This, however, would again put into 
question te state banks' business model and their 
very reaon for existence. 
 
Timken Jr