Germany’s state-owned development bank, für Wiederaufbau (KfW), is one of the world’s largest and most respected bond issuers, with lines to most major fund managers worldwide for its near-daily sales, and a track record of superlative execution and innovative deal features. So it is a sign of tough times that the bank’s treasurer, Dr Frank Czichowski, is thinking about the competition KfW faces in the funding markets. He says: “There are more unknowns in this market, we have a large number of government-guaranteed issuers out there, and the issuance of government paper itself will increase. This supply weighs on spreads.”
Germany’s financial market stabilisation fund – Sonderfonds Finanzmarktstabilisierung (SoFFin) – can offer up to €400bn in government guarantees on bond issuance by German banks until 2011. So far, less than €20bn of government-guaranteed paper has been issued, mainly by Commerzbank and IKB Deutsche Industriebank, but other banks are joining the scheme, and the final amount of government-guaranteed issuance is hard to predict.
A Bund auction in January 2009 that was only two-thirds covered prompted jitters in the market (see Drowning in debt). However, Mr Czichowski emphasises that the difficulty had more to do with the Bund’s 10-year tenor than any wider malaise in the appetite for German paper. “Many investors are very defensive on their credit exposure, and on their maturity exposure, so there is clearly a tendency for shorter-dated paper. But the funding conditions for a borrower like KfW are overall very positive. It is clear that the demand for shorter-dated securities is very high, it is a little more muted for longer-term paper, but even so we have managed to issue €3bn in the 10-year section,” he says.
KfW’s participation in the German government’s fiscal stimulus package has added about €15bn to its funding needs for 2009, bringing them to €75bn. The bank is ahead of schedule so far, with more than €21bn issued by mid-February. Mr Czichowski believes that government guarantees on commercial banks should not squeeze KfW unduly, because the SoFFin scheme is limited to three-year maturities, and to the euro as the issuing currency. Only about half of KfW’s own issuance is usually in euros, with the rest in sterling, yen, dollars and a few non-core currencies, including a few exotic currencies.
The bank even launched the first global bond issue with a US filing in Egyptian pounds early this year, settling in dollars for clearing purposes, in response to a reverse enquiry. But deals such as this, with a long lead time, are likely to be the exception rather than the rule for a while. “It will be a potentially choppy year, so you have to be ready to issue in two hours, not two weeks, as sentiment changes very fast,” says Mr Czichowski.
Liquidity returns
As bankers adjust to those market conditions, unguaranteed issuance should become possible. Commerzbank broke the ice with an unguaranteed five-year bond for €1.5bn in February, although the bank benefits from a 25% government stake propping up its capital position.
Even funding for the real estate sector, which is in the eye of the storm in the US and much of Europe, may recover more quickly in Germany as there was less of a market bubble in the boom years. The PricewaterhouseCoopers and Urban Land Institute Emerging Trends report for 2009, published in February, listed four German cities – Munich, Frankfurt, Berlin and Hamburg – among the top 10 most attractive cities in Europe for real estate investment.
Of the two leading German commercial real estate lenders that did not have significant exposure to US subprime assets, Aareal Bank stayed in profit for 2008 and CorealCredit Bank is projected to do so. Dr Karsten von Köller, chairman of the Lone Star Germany fund that purchased the distressed Allgemeine Hypothekenbank Rheinboden at the end of 2005 and transformed it into the far more focused CorealCredit, believes the bank can continue recording good results in 2009. “What still awaits is the exit, which may be by strategic sale, listing or merger with another bank. But we are not under any time pressure, and all this should be possible in the future, when markets function better,” says Mr von Köller, who was previously the CEO of Germany’s largest dedicated real estate lender, Eurohypo.
Aareal tapped SoFFin for a capital injection of €525m in perpetual bonds in February, together with issuance guarantees for up to €4bn. Coreal has not tapped state funding or guarantees, and Mr von Köller is heartened by signs of life on the pfandbrief (German covered bond) market. Landesbank Baden-Württemberg (LBBW) and Deutsche Postbank both issued €1bn five-year
pfandbrief in February, which were the first jumbo pfandbriefe since August 2008. “The pfandbrief market was nearly closed for some time but it is coming back, we have seen a number of private placements and two jumbo public issues. That is an important funding instrument also for Coreal, and it could be the first sign of a turn in the capital markets,” says Mr von Köller.
Turning on the taps
The next step is to ensure that the gradually returning liquidity in capital markets translates into lending for the real economy. In contrast with other governments that are struggling to find ways to channel government funds into the real economy, KfW provides the German government with a ready-made manager for its fiscal stimulus package. The development bank is providing an extra €27.5bn in special financing over the next two years, or three years in the case of €3bn in funds to municipal governments to improve local infrastructure (see chart below).
With the exception of the municipal funds, the money will be onlent via commercial banks but with different terms from the usual conditions that normally require the loans to be repaid by the onlending bank in full, even if the end-borrower defaults. “These loans will include risk relief of 90% in the case of funds for investment, and 50% in the case of working capital,” says Dr Norbert Irsch, KfW’s chief economist. “This means that for investment lending, if the end-borrower cannot repay, the commercial bank would only need to repay KfW 10% of the loan,” adds Mr Irsch. Losses to KfW will be covered by the government, and commercial banks would only need to keep regulatory capital against the unguaranteed portion of the loan, to provide a strong incentive for banks to continue financing investment in Germany. As at February 2009, KfW had received applications for €800m in loans, most of which would receive the highest risk relief.
Understandably, there are concerns that this risk relief could create moral hazard, if commercial banks use KfW funds for making loans to clients whose means to repay are in doubt, while keeping high-quality risk on their own books. However, the government has over-ruled these anxieties given difficult market conditions and a sharp rise in credit standards and risk premia.
Similarly, there is some flexibility in the definition of small and medium-sized enterprises (SMEs) for the purpose of the programme. “In general, turnover should not be more than E500m, but we can make exceptions where an enterprise is broadly defined as of economic importance, for instance because of employment or a strategic role in the supply chain,” says Mr Irsch. A second package under discussion in the Bundesrat (senate) at the time of going to press would, if passed in its original form, create an additional KfW facility for larger enterprises. KfW could offer maximum loans of up to €300m per company on condition that it is not able to access capital markets. The proposed risk relief for loans to these companies would be 70% for investment and 50% for working capital.
Banking on the Mittelstand
So far, credit conditions in the German real economy are less severe than in the US or UK, but Germany cannot escape the situation in those countries. Exports accounted for 47% of gross domestic product (GDP) in 2008, and the five largest export destinations – France, the US, the UK, Netherlands and Italy – have some of the worst growth prospects for 2009. Including a fiscal stimulus of 1% of GDP, the German government is forecasting GDP growth of 2.25% for 2009, with an economic turnaround beginning in mid-year. KfW is rather less confident, forecasting a contraction of 1.5% to 2.5% for the year.
Even so, German companies start from a better position than many peers, says Mr Irsch, as debt servicing costs have fallen relative to other developed countries. SMEs – Germany’s distinctive Mittelstand backbone – have increased equity during the past five years, making them more soundly financed to avoid bankruptcy. And these companies benefit from Germany’s three-tier banking system. “The private sector banking share in financing these companies is relatively small. About 40% of their funding comes from the sparkassen [savings banks], or 60% if you include the co-operative banks,” says Mr Irsch. “The deposit share in the financing of these banks is about 60% to 70%, compared to 30% for the private banks, so their funding is less affected by the problems in capital markets.”
Even so, there are signs of stress showing through, with three insolvencies in the Mittelstand sector in recent weeks – porcelain manufacturer Rosenthal, lingerie company Schiesser, and toymaker Märklin, which had been considered a model turnaround story after its takeover by a UK private equity firm in 2006.
One man watching the sector especially closely is Mr von Köller of Lone Star
Germany. The Texas-based fund has raised €7.5bn to begin investing opportunistically in distressed assets in Germany for two to three years starting in 2008. Its most high-profile deal so far was the purchase of IKB Deutsche Industriebank from KfW for an undisclosed sum (thought to be about €130m, plus a fresh equity injection of €225m) in August 2008.
With previous distressed financial asset purchases, Lone Star has tended to retain only 20% of the business, but with IKB the ratio is reversed. “About 80% of the portfolio is the healthy Mittelstand business,” says Mr von Köller. The bank has a compact network of seven business centres, which he toured in the final quarter of 2008. He was pleased to find “long-standing customer relations, and a Mittelstand base that is very diversified and economically viable. There are hidden champions in the provinces that lead in certain products, even internationally,” he says.
It is a new experience for IKB’s staff, clients and partners to be working with a private equity owner – one that is known for non-performing loan acquisitions and associated debt collection activity. Mr von Köller is especially focused on reassuring all three groups that Lone Star intends to retain the core of the bank’s business. As IKB is a leading conduit for onlending KfW Mittelstandbank funds, he says the relationship that Lone Star built with KfW during the purchase process has given it a head start with one of their key state sector partners.
IKB’s next strategic aim is to alter the balance of its income streams, because interest income historically accounted for almost all of the bank’s revenues. This balance provided steady profitability for the Mittelstand component of the bank, but at low margins. “This is still under development, but we hope to offer advisory, M&A [merger and acquisition] and other services. The bank has also begun taking customer deposits which IKB had not done before,” says Mr von Köller.
The approximately 20% of the business that Lone Star plans to wind down largely coincides with the divestments required by the European Commission to meet state aid rules. KfW retained about €1.3bn of IKB’s structured credit exposure (the Rhineland vehicle) on its own balance sheet, as well as injecting capital into a special purpose vehicle of €3.3bn to hold other IKB structured assets. KfW’s accounts for the 2008/09 financial year will show the performance of its Rhineland portfolio, but it is thought that valuations have been written down by about 90%.
“The Commission has asked us to dispose of commercial real estate financing and leasing, non-core asset portfolios, and activities in New York, Amsterdam and Luxembourg. This fits into our concept to focus on Mittelstand financing, and also helps to solve the funding and liquidity challenge,” says Mr von Köller. The bank has until September 2011 to complete this divestment, or it can return to the European Commission to explain if market conditions make it impossible to meet that deadline.
Helping the worst offenders
IKB has tapped SoFFin’s bond guarantee scheme with a €2bn three-year bond in January, but other banks may still need more substantial assistance. SoFFin has €80bn in funds to inject capital into troubled banks, or to temporarily buy illiquid structured credit portfolios.
These measures have been approved by the European Commission, at least until 2012. By comparison, WestLB and the government of North-Rhine Westphalia proposed a ‘risk shield’ scheme in February 2008 that would have ring-fenced €23bn in structured investments and given them a government guarantee of €5bn. The European Commission initially rejected this proposal as contrary to state aid rules, but has now given the bank more time to put forward a new plan, by the end of March.
Dr Uwe Eyles, a partner at law firm Latham & Watkins in Frankfurt, who specialises in bank regulation and restructuring, says the Commission’s stance has softened in the meantime. “In good times, competition comes first and politics is redundant. In times like these, if banks are on the surgeon’s table, competition aspects appear to be of less importance to the related decision-makers,” says Mr Eyles, who was on a panel advising KfW on the restructuring of IKB Deutsche Industriebank and who also advises the Deposit Protection Fund of German Banks.
In terms of liquidity measures, the Commission has initially limited its approval for SoFFin-guaranteed bonds to a maturity period of up to 36 months, with a possible extension to 60 months, if certain requirements are met. However, Mr Eyles believes that the SoFFin framework is insufficient. For instance, the off-balance sheet treatment of ‘toxic’ structured securities which can be temporarily purchased by SoFFin is unhelpful, because the exposures which derive from these assets would inevitably remain on the relevant bank’s balance sheet. He believes that SoFFin may therefore need to reconsider the option of guaranteeing certain banks’ receivables portfolios, rather than just their own liabilities. “A government guarantee on a bank’s asset portfolio gives the bank time to work on that portfolio and resolve its liquidity and capital needs, rather than having to make loss provisions on day one,” he says.
Moreover, SoFFin support does not resolve questions over the sustainability of the business model for Landesbanken, the distinctive regional wholesale banks that are some of the worst hit by the crisis as they took excessive risks to boost margins. In addition to WestLB’s unsettled situation, HSH Nordbank and Bayern Landesbank (BayernLB) have also needed to issue government-guaranteed bonds, and BayernLB has used the SoFFin risk assumption mechanism for up to E6bn in asset-backed securities.
Any number of possible mergers have been discussed involving WestLB, BayernLB and LBBW, and also Dekabank, which is the central asset manager for the German savings banks. It is also expected that Landesbanken will need to increase their access to deposit funding. But the importance of German banks to regional stakeholders remains a hurdle for this process. “The problem is the complex ownership structure of many of these banks, which includes, among others, regional governments and giro and savings associations,” says Mr Eyles. Many of the Landesbanken already have more than one head office to accommodate the status of different municipal owners, and staff rationalisation would therefore become extremely complex and political.
