Tuesday, October 28, 2008

Lehman Toxic Debt Advice Led Leipzig Bank to Ruin Via Dublin

(Bloomberg) -- Teachers at the Clara Zetkin Middle School in Freiberg, Germany, were counting on a budget surplus to ease staff shortages across the state of Saxony.

Those hopes have faded as a result of bets made by state- owned Landesbank Sachsen Girozentrale on structured investments backed by mortgages in the U.S. The German lender loaded up on asset-backed securities and derivatives manufactured and sold by Wall Street amounting to more than 27 times the bank's equity. Now Saxony, which pledged taxpayer money as a guarantee against losses, is on the hook for 2.8 billion euros ($3.5 billion).

``They gambled away money needed for Saxony's teachers,'' said Wolfgang Renner, 55, who teaches math and physics at the 106-year-old yellow-brick school in Freiberg, named for a former Communist Party leader.

It doesn't take a degree in mathematics to calculate the potential damage in nearby Leipzig, where Sachsen is based and where Gottfried Wilhelm von Leibniz, the 17th-century polymath who invented calculus, was born. Plans to replace thousands of retiring teachers and build new roads are now in jeopardy.

``As Saxony politicians, we pray every day that the guarantee won't be used,'' said Mario Pecher, a lawmaker in Dresden, the state capital flattened by Allied bombing in World War II. ``There's a Damocles sword hanging over our heads.''

`Irresponsible' Loans

The bank's near collapse in August 2007 was proof of how far and wide U.S. investment banks had peddled toxic repackaged mortgages. It was also a harbinger of worse to come -- a global credit contagion that led to bailout packages from Germany to Iceland to the U.S. aimed at shoring up bank capital by partially nationalizing firms and guaranteeing lending until the storm passes.

Two days after a 50 billion-euro Oct. 5 rescue of Munich- based Hypo Real Estate Holding AG, Germany's second-largest commercial-property lender, German Chancellor Angela Merkel told an emergency session of parliament that ``irresponsible'' loans in the U.S. had helped destroy faith in the global financial system.

Germany's Landesbanken, whose state ownership, high credit ratings and low borrowing fees whetted their appetite for asset- backed securities earlier this decade, accounted for $22 billion of the more than $650 billion in writedowns and credit losses linked to the U.S. subprime-mortgage market. The Sept. 15 bankruptcy of Lehman Brothers Holdings Inc., the New York-based securities firm that helped set up Sachsen's biggest offshore conduit, may cost the Landesbanken half a billion euros more.

`Gambled Away Billions'

The demise of Sachsen is a story of overreaching and of how Wall Street banks exported financial technology and products whose risks were not fully understood, according to interviews with two dozen bankers, board members, credit analysts and politicians. In the end, the citizens of Saxony will probably be left holding the bag.

``They made huge bets with taxpayers' money, they gambled away billions and nobody has been held responsible,'' said Andreas Schmalfuss, a member of the parliamentary committee probing Sachsen's collapse.

Schmalfuss and local prosecutors are looking at whether former top executives at the bank misrepresented risks in annual reports, improperly used funds and put Sachsen in danger by setting up an off-balance-sheet conduit in Ireland to buy more asset-backed securities than it should have.

German Raids

On the morning of Aug. 12, German authorities raided the homes and offices of five former Sachsen board members. Prosecutors, police and Germany's equivalent of the FBI carted off computers and documents from 28 venues. Police in Ireland also raided Sachsen's Dublin headquarters. No criminal charges have been filed.

The searches came almost a year after a series of credit rating cuts and margin calls pushed the bank to the brink of insolvency despite a 17 billion-euro lifeline extended by other banks. Under pressure from Germany's financial authority, BaFin, which had threatened to shutter Sachsen, an emergency sale was arranged to Landesbank Baden-Wuerttemberg, the country's biggest state-owned bank, for 328 million euros.

One of the targets of the raids, according to people familiar with the investigation, is Stefan Leusder, 53, who as head of the bank's capital markets business was responsible for its principal investment vehicle, Dublin-based Ormond Quay Funding Plc, when things began to unravel.

Targeting Big League

Under Leusder's watch, investments in asset-backed securities more than doubled to almost 18 billion euros in the two years he ran the unit. Leusder, a member of Sachsen's management board, resigned on Aug. 23, 2007, three days before the bank's fire sale.

Also under investigation, the people say, are Herbert Suess, 69, the former chief executive officer of Sachsen who recruited Leusder in 2005, and former board members Yvette Bellavite-Hoevermann, Werner Eckert and Gerrit Raupach. Leusder and Suess declined to comment. Raupach didn't respond to a message left at his home, and the others couldn't be reached.

Created by regional politicians and small-town bankers in 1992 to promote economic growth in Saxony in the wake of German reunification, Sachsen was the newest and smallest of Germany's then 13 Landesbanken. That put pressure on executives to prove the bank could compete.

``The main mistake was Sachsen tried to play in a league it was way too small for,'' said Sebastian Scheel, a member of the committee investigating the bank's collapse.

Prague Meeting

Being small didn't stop Sachsen from thinking big. In 1999, under the direction of Claus-Harald Wilsing, a banker from Wiesbaden hired the previous year, Sachsen set up a subsidiary in Dublin to push into capital markets. The decision was made during a meeting in Prague that lasted less than 30 minutes, according to testimony Wilsing gave in January. Wilsing, who became managing director of the Dublin operation, Sachsen LB Europe Plc, declined to be interviewed.

The unit planned to take advantage of Ireland's 12.5 percent corporate tax rate -- compared with about 30 percent in Germany at the time -- as well as Dublin's proximity to Anglo- Saxon investors. Its offices were in the city's second-tallest building, in George's Quay Plaza on the Liffey River, which also housed a unit of UBS AG, the European bank that has taken the most subprime-related writedowns.

McKinsey's Proposal

At first, the Dublin unit focused on risk-averse, low- margin investments, such as European corporate and government bonds. Then, in 2000, Sachsen hired New York-based management consulting firm McKinsey & Co. to help it solve a problem. The bank was worried about what would happen after state guarantees for Landesbanken expired in July 2005 under a European Union- imposed plan designed to remove their competitive advantage. Without government backing, borrowing costs would rise, making it harder to profit in capital markets.

The McKinsey team recommended that Sachsen scale back its traditional, low-margin lending to regional firms and expand into niche businesses such as leasing, according to an October 2007 speech by Georg Milbradt, a former Saxony premier who oversaw the creation of Sachsen. McKinsey warned against an aggressive push into capital markets, however, saying the strategy wouldn't work because the bank was going to lose its state guarantees, according to two people with direct knowledge of the situation.

`Not Sustainable'

Despite the warnings, Sachsen management pushed ahead with plans to expand its Dublin operation, raising money by selling short-term debt so it could invest in assets backed by mortgages, credit cards and student loans. At least one board member objected, saying the bank should stay focused on loans to small and mid-size German companies. The board member, Eckhard Laible, left at the end of 2001 when his proposal was vetoed.

``I left because the strategy wasn't sustainable,'' said Laible, now retired and tending a farm near Stuttgart, Germany.

In 2001, Wilsing recruited Adrian Fitzgibbon, an Irishman with capital markets expertise garnered from stints at JPMorgan Chase & Co. and Lehman Brothers. There he had specialized in credit and structured products, according to the Web site of AC Capital Partners Ltd., the Dublin fund management firm he and Wilsing created with backing from the Leipzig bank.

By 2002, according to the bank's annual report, the Dublin unit was managing 11 billion euros of synthetic assets -- those in which risk is taken in the form of a derivative -- an amount 77 times the value of its shareholder equity. The Dublin unit was a boon for Sachsen: Profits nearly doubled in 2003 to 29 million euros, accounting for more than two-thirds of the bank's net income of 42 million euros that year.

`The Green Isle'

Executives in Leipzig characterized the Dublin operations as being ``in the black on the green isle,'' Schmalfuss said.

Then Sachsen overreached. The bank's owners, including state and local governments and regional savings banks, laid out plans in the 2003 annual report to generate a 15 percent pretax return on equity by 2007. Bigger, better-capitalized banks at the time, such as Frankfurt-based Deutsche Bank AG, Germany's largest lender, had returns of about 13 percent.

``We had the problem that the pressure from the management board side, in other words from Leipzig, was very, very strong that we generate more earnings,'' Wilsing, now a management board member at Dusseldorf-based Deutsche Apotheker-und Aerztebank eG, a niche bank for the medical industry, testified on Jan. 21. Sachsen turned to Lehman Brothers for help. Together they created Ormond Quay Funding in early 2004, a move that would ultimately lead to the bank's demise.

Ormond Quay

Named after a wharf on the Liffey River, Ormond Quay's raison d'etre was raising money by selling commercial paper to cities, companies, money market funds and bank treasuries. The off-balance-sheet entity then bought asset-backed securities with a minimum rating of AA- from major investment banks. Among the sellers were Lehman, once the biggest U.S. underwriter of mortgage-backed bonds, Deutsche Bank and London-based Barclays Plc.

Sachsen worked with Lehman on a plan for locking in Ormond Quay's top credit ratings before the July 2005 EU deadline, people familiar with the bank's operations say. Without that government backing, Sachsen would have had the weakest rating of any Landesbank, in turn hurting Ormond Quay's rating, according to a May 2005 report by Standard & Poor's.

The solution was an agreement for Sachsen to cover all of Ormond Quay's risks until 2015, in effect extending the state's guarantee for another decade. Ormond Quay got a line of liquidity of about 4 percent of the financing from Sachsen, which would have amounted to at least 200 million euros. The remaining 96 percent was covered by Dublin unit Sachsen LB Europe, which, as a wholly owned subsidiary of Sachsen, benefited from its state backing.

`Bankruptcy-Remote'

That meant buyers of the vehicle's commercial paper got paid if Ormond Quay's assets declined in value or funding ran out. The guarantee covered sales made after 2005, since Ormond Quay was launched prior to the deadline. The agreement also kept Sachsen from having to set aside equity capital to cover Ormond Quay's risks. A spokesman for Lehman in New York declined to comment.

S&P gave Ormond Quay an A-1+ rating in a June 2004 report, its highest for short-term debt, pointing to support for the fund from the state of Saxony. It called the conduit a ``bankruptcy-remote entity'' and a ``novel structure.''

The table was set for Ormond Quay to feast. It grew to 8.3 billion euros of investments in asset-backed debt securities by the end of 2005 from 1 billion euros in June 2004, government documents show. That year, the Dublin unit was the bank's best performer, reporting a profit of 44.2 million euros, offsetting losses in Leipzig and enabling Sachsen to report a net income of 17 million euros, according to the annual report.

`Cash Cow'

``Dublin was the cash cow, and they thought it could be milked for profit,'' said Karl Nolle, a Dresden lawmaker on the investigative committee. ``It was like a gambling addiction.''

As the EU deadline approached, Sachsen's credit committee, composed of Leipzig executives and politicians, stepped up its push into capital markets. In June 2005, it voted to boost Ormond Quay's 4 percent liquidity line to allow for a maximum investment of 43 billion euros by 2010, about the size of Croatia's annual gross domestic product.

The jump in profits at the Irish arm caught the attention of financial services regulator BaFin, which asked the accounting firm KPMG LLP to review the situation in 2004. KPMG found, according to testimony given to the committee, that Sachsen's administrative board was unaware of the level of investments made at the subsidiary or the potential losses they posed.

Barclays Capital

By the end of 2005, the key architects of the Irish operation were gone. Michael Weiss, the bank's CEO, and board member Rainer Fuchs, who joined the bank in 1993 and backed Wilsing's push into Dublin, both resigned in connection with an unrelated fraud investigation at a leasing unit. No charges were filed in that case. Weiss was not available for comment.

Then Wilsing left, frustrated, he told investigators, that the board wouldn't let him sell the unit to a larger, better- capitalized partner.

The KPMG report led Sachsen to review its risk management system. Yet over the next two years, under the direction of Suess, a former savings bank executive, and Leusder, a bearded chain smoker who replaced Fuchs, the bank accelerated its investments.

Warning Signs

In the spring of 2007, Leusder turned to Barclays Capital, Barclays's investment banking arm, to set up a new type of structured-investment vehicle called a SIV-Lite, dedicated to residential mortgages. SIVs make money by selling commercial paper in order to invest in longer-term bonds, usually asset- backed securities and bank debt. SIV-Lites differ because they invest more heavily in mortgage-backed securities.

The timing couldn't have been worse. In February, Sachsen's Dublin unit boasted in a press release that it was one of Ireland's most profitable banks, just weeks before data emerged showing that U.S. subprime-mortgage defaults had risen to a seven-year high, forcing more than two dozen lenders to close or sell operations. The warning signs prompted Germany's central bank, the Bundesbank, which helps regulate financial firms, to ask Sachsen and others about their investments in mortgages to American homeowners with dubious credit histories.

Still, Sachsen pressed ahead.

``The bank at first initiated no noticeable measures to limit the volume or risk,'' an Ernst & Young LLP report concluded a year later. ``Quite the opposite: The businesses were expanded.''

`Successful Axis'

The Dublin-based SIV-Lite, called Sachsen Funding I, garnered a P-1 rating from Moody's Investors Service in May 2007, the highest grade for short-term debt. It invested all of the $2.5 billion it raised in mortgage-backed securities, including subprime assets, according to government documents as well as Moody's and Ernst & Young reports.

Sachsen was so gung-ho it featured a two-page color photo in its 2006 annual report, published in May 2007, featuring Jane Privett, then a Barclays Capital director, sitting in a London cab above a caption praising the bank's ``successful Dublin- London-Leipzig axis.'' Privett, who recently left Cheyne Capital Management Ltd., a London hedge fund firm, declined to comment.

In July 2007, two Bear Stearns Cos. hedge funds heavily invested in subprime assets collapsed, triggering a global credit crisis. As fears about collateral damage spread abroad, Sachsen said on Aug. 10, 2007, that it had ``sufficient liquidity'' and didn't expect Ormond Quay's asset-backed securities to default.

``The mistrust of the market cut off our liquidity,'' Sven Petersen, who replaced Wilsing as head of the Dublin unit, told a parliamentary hearing.

Time Runs Out

On Aug. 16, Fitch put Sachsen's credit rating on ``watch negative,'' citing concerns about cash commitments to Ormond Quay. The next day, the bank obtained a 17 billion-euro credit line from other state-owned banks to repay debt sold by its Dublin unit.

Still, on Aug. 20, S&P cut its assessment of Sachsen debt to BBB+ from A-, saying the bank ``needs to restore investor confidence.''

It had no time to do so. A few days later, Barclays warned it would make a margin call on two funds that Sachsen had invested in, according to Ernst & Young and four people with direct knowledge of the matter. Sachsen realized on Aug. 22 that the Leipzig bank could incur 250 million euros in losses from a sale of those assets. When politicians balked at a fresh bailout, the bank sought a buyer.

`So Dangerous'

``An insolvency of Sachsen would have had far-reaching consequences for the entire banking landscape in Europe,'' Milbradt said in what has since become a common refrain around the world.

Emergency talks were held, and at 2:30 a.m. on Sunday, Aug. 26, the bank agreed to sell itself to Stuttgart-based LBBW. Siegfried Jaschinski, LBBW's chief executive officer, stunned Sachsen employees when he said the Irish funds accounted for about half of the bank's income.

``It's not that they didn't know the business was there, but that it was so dangerous,'' Jaschinski said in a telephone interview in May.

When LBBW got cold feet four months later, Saxony agreed to provide guarantees of up to 2.8 billion euros to cover losses on a new fund, into which 16 billion euros of assets from Ormond Quay and Sachsen Funding were placed. Jaschinski signaled at a Sept. 10 banking conference that he would be interested in merging LBBW and what is now its Sachsen Bank unit with Bayerische Landesbank in Munich in a further consolidation of the seven remaining state-owned banks.

How Much?

Whether Saxony's taxpayers can avoid covering losses and afford to hire new teachers next year depends on whether the homeowners backing the securities default and at what price those assets can be disposed of. Saxony's Finance Ministry said on Sept. 19 that the guarantee hadn't been tapped and that it had set aside about 825 million euros for possible defaults.

``We expect defaults, but how much and when we can't say,'' Finance Ministry spokesman Stephan Goessl said.

In July, Saxony and LBBW hired an outside bank to help them clean up the mess. The firm they selected was the asset management arm of Lehman Brothers, the bank that advised Sachsen on setting up Ormond Quay in 2004.

Now, with Lehman in bankruptcy, LBBW and Saxony may need to find a new adviser. And Germany will need to find a way to stop the contagion from spreading.

Following an agreement to bail out Hypo Real Estate, which came after its Dublin-based Depfa Bank Plc unit failed to get short-term funding, Germany announced plans to provide up to 500 billion euros in loan guarantees and capital to bolster the banking system, the government's biggest intervention since the Berlin Wall came down in 1989.

`Poison' Debt

The rescue, which will amount to about 20 percent of the GDP of Europe's largest economy, faced opposition from some state governments unhappy at the share of the bailout they are expected to bear. Saxony's Finance Ministry said in a statement on Oct. 14 that the state had already made a ``substantial contribution'' to overcoming the financial crisis with its 2.8 billion-euro guarantee for Sachsen.

Only now are European regulators getting around to addressing the lax oversight of banking activities. On Oct. 1, the European Commission published a proposal to enhance the authority of national regulators to police banks' foreign subsidiaries. The Basel, Switzerland-based Financial Stability Forum, an international group of regulators and finance officials, has put forward measures requiring banks to report off-balance-sheet exposure and raising capital requirements for liquidity facilities such as Sachsen's Dublin conduit.

That won't help the citizens of Saxony. In Leipzig, where Johann Sebastian Bach composed some of his most beautiful music, there is no shortage of discordant voices.

``The poison was the off-balance-sheet vehicles that far outweighed the amount of risk the bank could shoulder,'' former board member Laible said. ``The bank might have survived had it invested within the scope of its own capital.''

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