How Subprime Mess
Ensnared German Bank;
IKB Gets a Bailout
By CARRICK MOLLENKAMP, EDWARD TAYLOR and IAN MCDONALD
August 10, 2007; Page A1
DÜSSELDORF, Germany -- Five years ago, a little-known bank that lent to small and midsize German companies decided it wanted to broaden its business. An affiliate of the bank started buying complex bonds invented in the U.S.
The strategy brought a sharply higher industry profile for IKB Deutsche Industriebank AG. Moody's Investors Service endorsed its move, crediting the bank last year with "successfully diversifying."
Today, IKB is on the receiving end of a bailout, organized over a weekend of emergency meetings by Germany's financial regulator, with contributions from major German banks. To rally the banks, the lead regulator warned that they needed to head off the risk of what could become the country's worst financial crisis since the 1930s. The safety net for IKB consists of about €3.5 billion, or $4.789 billion, available now to cover possible losses, plus a further financial backstop of €14.6 billion to keep afloat IKB and the affiliate that invested in fixed-income securities.
The case shows how quickly global investors' abrupt new appreciation of credit risk can ricochet around the world. As some strapped homeowners in the U.S. fail to make their monthly mortgage payments, among those touched by their defaults are institutions in Europe that borrowed to buy bonds backed by the mortgages. Their troubles, in turn, affected others in the market and injected worry into markets for even some safe securities.
IKB is housed in a seven-story stone-clad building a short distance from the Rhine. Since its founding 83 years ago, its main business has been to provide long-term financing to the smaller German companies called the Mittelstand -- companies like Trumpf Group, a maker of machine tools.
The affiliate IKB set up for bond investing five years ago is Rhineland Funding Capital Corp. The purchases included bonds backed by subprime mortgages, those issued to home buyers with weak credit. It was a global circuit: Rhineland partly funded its bond purchases through short-term debt issued to U.S. investors, such as a suburban Minneapolis school district and the city of Oakland, Calif.
But Rhineland's short-term borrowings had to be renewed frequently. And when investors realized that their collateral for the borrowings included U.S. subprime mortgages, they shut off the spigot. Suddenly, Rhineland couldn't repay other debt that was coming due. If other German banks hadn't agreed to bail it out a week and a half ago, Fitch Ratings believes IKB "would have defaulted," says a Fitch credit analyst in Frankfurt, Sabine Bauer. IKB is using bailout funds to repay the short-term borrowings, which are known as commercial paper.
This wasn't the only U.S.-related credit problem to surface in Europe yesterday. The big French bank BNP Paribas SA suspended withdrawals from three investment funds, citing volatility in the U.S. asset-backed-securities market. That led to a scramble for cash. Short-term money-market interest rates spiked above their target levels in both Europe and the U.S. In response, the European Central Bank, in an extraordinary step, injected €94.8 billion in short-term funds into the system to get rates back down. The U.S. Federal Reserve injected $24 billion through its Open Market operations.
The crisis at IKB unfolded quickly. As recently as July 20, the German bank told investors it was fine. But days later, it began having trouble selling commercial paper.
That instrument is a staple of money-market funds and other risk-averse investors, regarded as one of the safest investments apart from U.S. Treasurys. It's often issued by big companies that use the proceeds for day-to-day expenses. But even the haven of commercial paper has been rattled in recent weeks, as investors began to worry about securities that might be tied in some way to subprime mortgages.
Rhineland's difficulty in issuing new commercial paper didn't go unnoticed by Deutsche Bank AG, one of several banks that helped Rhineland sell the paper. Deutsche Bank tipped off Germany's financial watchdog, called BaFin. Within 48 hours, the banks and regulators had structured a bailout package.
Three of IKB's top executives, including Chief Executive Stefan Ortseifen, departed. The bank formed a task force to sort out its problems. Its stock is down 33% since the crisis began to develop about two weeks ago. Mr. Ortseifen declined to comment.
IKB dreamed up Rhineland in 2002 as a way to move beyond its German client base of smaller companies. IKB set up Rhineland in Delaware and Jersey, a tiny tax haven in the English Channel, so it could borrow from investors in the U.S. and Europe.
Rhineland poured the proceeds into a highly rated portfolio of bonds. Seeking high yields, it often invested in bonds or bundles of bonds backed by other securities, including subprime mortgages. According to people familiar with IKB, it was courted by banks such as Lehman Brothers Holdings Inc., J.P. Morgan Chase & Co. and Deutsche Bank AG, which sought to sell it securities including collateralized debt obligations. Known as CDOs, these are pools of debt broken into tranches, or slices, that offer investors various levels of yield and risk.
IKB was such a good customer that banks would adjust which assets they bundled together in CDOs on IKB's wishes. For example, IKB's risk team didn't like airplane loans, so banks would often remove them. The banks declined to comment.
Rhineland's profit was the difference between what it had to pay for its commercial-paper borrowings and the return on the bonds it bought with the proceeds. On its commercial paper, Rhineland had to pay approximately the London interbank offered rate, or Libor, a common benchmark. The bonds it bought returned about a full percentage point above Libor. IKB is just one of many banks that set up companies to use this strategy. They're usually off-balance-sheet so that banks don't have to set aside capital to cover the liabilities.
To sell its paper, Rhineland often looked to U.S. investors. Robbinsdale Area Schools district in a northwestern suburb of Minneapolis bought some last year, thus lending money to Rhineland. It did so on the advice of a Citigroup Inc. broker in St. Paul, says Gary Hauan, director of finance. Citigroup declined to comment.
'We Don't Take Risks'
Oakland, Calif., also bought some of the paper, figuring that the collateral-backed debt was safe. "We don't take risks," says Katano Kasaine, the city's treasury manager. Also buying Rhineland commercial paper was the Montana Board of Investments, which manages a $13.2 billion fund.
All three say they won't be buying any more of this issuer's commercial paper. They shouldn't have to worry about what they did buy, despite IKB's troubles, because its affiliate can repay the paper with proceeds of the IKB bailout. The Montana board, however, is looking through the rest of its commercial-paper holdings to see if any others are tied to CDOs, says its executive director, Carroll South.
IKB, started in 1924, helped Germany rebound from the decimation of World War II by lending to companies rebuilding. But in 2002, when German bank profits were hurt by an economic slowdown, ratings agencies pressured the country's banks to diversify away from lending to companies.
A trio of IKB officials came up with the idea for Rhineland, led by a banker and lawyer named Dirk Röthig. He joined IKB in 2001, bringing with him experience working with bonds in Europe for the U.S. bank State Street Corp. Alongside him was a longtime IKB official, Winfried Reinke.
The venture was a success. IKB's fledgling asset-management arm earned fees for selecting Rhineland's investments. IKB bought similar bonds for Rhineland and its own portfolios, according to IKB's annual report.
In the fiscal year ended March 31, IKB earned just under €180 million, with €108 million of that coming from fees and commissions. Rhineland paid roughly half of the commissions, according to IKB's annual report.
The bank and other banks established a line of credit -- to be tapped only in the most drastic of situations -- promising to cover liabilities if Rhineland couldn't pay off the commercial paper.
Rhineland grew quickly. In September 2003, it held €4.8 billion of debt. By January 2006, it had €9 billion.
Its commercial-paper program, led by Deutsche Bank, won an award in 2003 from Banker Magazine. In 2004, Mr. Röthig told industry publication Risk magazine, "This adventurous portfolio building was the outcome of a carefully planned strategy. We wanted to diversify in asset classes as well as geographically because we were pretty much dependent on the German economy." The next year, at an investment conference in Barcelona, Spain, Mr. Röthig sat alongside executives from banking heavyweights -- France's Société Générale SA and Dresdner Bank AG -- on a panel on how to pick investments in U.S. asset-backed and mortgage backed-securities.
But executives at Rhineland disagreed about how fast to expand. In January 2006, Mr. Röthig left after others overruled his objection to growing so quickly, he said. "I made several proposals for a more sophisticated portfolio management to address expected negative market developments," which weren't accepted by IKB, he said in a statement. IBK declined to comment.
Growth accelerated after he left. Between then and this July, Rhineland boosted its assets -- that is, the bonds and other debt it had purchased -- to €14 billion from €9 billion. That was a large investment in view of IKB's stock-market value, which was just a bit over €2.6 billion at the end of this March.
A December 2006 report by Moody's credited IKB for its success and noted, "IKB has over the last few years been successfully diversifying its business activities by expanding outside Germany." Earlier this year, IKB founded another Rhineland-type vehicle, called Rhinebridge, to invest in bonds backed by U.S. home-equity loans.
By February, though, U.S. subprime mortgages written in 2005 and 2006 were showing increasing delinquencies, as home prices weakened and some borrowers' mortgage rates adjusted higher. As defaults rose, the value of securities backed by those mortgages began to tumble.
In a financial update July 20, IKB said it wasn't incurring problems. It acknowledged that both Moody's and Standard & Poor's had downgraded some debt securities but said, "It is worth noticing that the bulk of our investments are in portfolios of corporate loans."
But Rhineland's commercial-paper investors were getting jittery, as they saw erosion in the value of the bonds backing their investments. Even if the company wanted to sell bonds to pay off creditors, it would have a tough time finding buyers, some worried. About a week after IKB's financial report, the bank started having difficulty finding buyers for additional commercial paper. At SEI Investments Co. in Oaks, Pa., Sean Simko, head of fixed-income asset management, says his firm stopped buying Rhineland paper last month because of growing volatility.
By Friday, July 27, IKB was in trouble. Some of the commercial paper was maturing, and investors needed to be repaid. But buyers for new commercial paper had vanished. It couldn't sell CDO assets to raise funds, because the market for CDOs had dried up.
Rhineland was going to turn to IKB, Deutsche Bank AG and others that had promised a credit line to pay its bills in an emergency. That strategy had its own pitfalls. If they provided Rhineland with the money, Rhineland's bills would move to IKB's modest balance sheet, a scenario that could topple the bank.
Even worse, the banks, including Deutsche Bank, that had standing agreements to lend IKB money backed out. Deutsche Bank declined to comment.
Instead, Deutsche Bank, Germany's biggest bank, phoned BaFin, the German financial supervisory agency, to tell it there was a problem with IKB, people familiar with the matter say.
That same day, according to a person familiar with the matter, IKB's management board reported the problems to the bank's biggest shareholder: KfW Group, which is state-owned.
BaFin called for a special probe of IKB's books. Over the last weekend in July, it convened a crisis meeting at IKB's Düsseldorf headquarters near the Rhine River. Representatives from KfW, BaFin and IKB met in the large auditorium of IKB's headquarters.
On Sunday, July 29, executives from Germany's banks as well as regulators began meeting at IKB as well. BaFin repeated that it wanted to prevent panic selling of IKB shares when the markets opened the next morning. Joining Jochen Sanio, the BaFin chief, were Joerg Asmussen, a department head at the German finance ministry, and Ingrid Matthaeus-Maier, head of KfW. From his office at Deutsche Bank's headquarters in Frankfurt, CEO Josef Ackermann participated by phone, along with Klaus-Peter Mueller, chief of German bank Commerzbank AG.
One CEO was missing. IKB's Mr. Ortseifen had agreed to resign.
KfW's Ms. Matthaeus-Maier said the extent of the assets at risk was unclear. Other executives disagreed over the structure and size of the rescue deal. Negotiations dragged on late Sunday night, as BaFin's Mr. Sanio grew impatient.
They finally settled on a plan for KfW, the state-owned institution, to shoulder most of the rescue package. The rest would come from other German banks, the Association of German banks, and other associations. IKB got a new chief executive: Günther Bräunig, an executive of KfW.
The next day, stock markets reopened, and IKB's shares tumbled 20%.
IKB hasn't yet decided what to do with the Rhineland portfolio of bonds and CDOs. An IKB spokesman, asked about the bank's statement July 20 that it didn't face any trouble, said it was an "attempt to calm fears. Nobody anticipated that the market for commercial paper would develop in such a way."
Moody's analysts, meanwhile, are monitoring small and midsize European banks, looking for other subprime stress, according to a report the firm published after the IKB bailout. Like IKB, Moody's analysts wrote, some of these smaller banks in Europe have boosted profits in recent years the way IKB did, by creating off-balance-sheet affiliates.
Write to Carrick Mollenkamp at firstname.lastname@example.org, Edward Taylor at email@example.com and Ian McDonald at firstname.lastname@example.org