Germany is feeling sub-prime fallout

When the Berlin Wall fell and start-up businesses began sprouting across eastern Germany, former communists who saw themselves as budding entrepreneurs were many, but banks ready to lend them money at affordable rates were few.

Enter Germany’s state banks, locally run institutions whose board members were often mayors, local finance ministers and small-town bankers who cared as much about what a business brought to the community as its bottom line. Because these banks’ assets were guaranteed by the state, their loans came cheaper than private banks could offer.

Here in the eastern state of Saxony, loans from community savings banks and the regional government bank, SachsenLB, helped fuel the region’s dynamic biotech industry, new Porsche and BMW plants and the expansion of the airport at Leipzig. Such projects helped Saxony achieve the highest economic growth rates in depressed eastern Germany.

But when the state banks were forced by the European Union to compete on even terms with their commercial counterparts, several over the last few years turned to the U.S. sub-prime market for quick profits. Now, SachsenLB has become one of the European banks with the greatest exposure to sub-prime losses, as a fraction of total assets.

In a sobering tale of old-fashioned community banking’s clash with the complexities of modern international finance, the bank’s financial woes led to the resignation last month of Saxony Gov. Georg Milbradt. Saxon taxpayers, meanwhile, have been left holding the bag for potential losses of as much as $4.2 billion -- 17% of the state budget.

SachsenLB is among several state-owned German banks that have foundered in a meltdown that Germany’s top industry regulator said fell just short of “the worst financial crisis since 1931.”

Most other analysts hurried to say it wasn’t that bad. But estimates of the potential losses have reached as high as $69 billion, with taxpayers liable for nearly half that amount, under some scenarios.

Private banks haven’t been immune. Deutsche Bank announced in April a pretax first-quarter loss of $391 million after write-downs of $4.16 billion.

The first bank to take a hit in Germany’s sub-prime banking crisis, IKB Deutsche Industriebank, a Dusseldorf-based commercial lender specializing in loans to small and medium-size businesses and in real estate finance, has so far received a bailout package exceeding $13 billion, including more than $3 billion from the public purse.

“Everyone has talked about the banking losses, but it could be even more interesting to look at the social consequences of the crisis,” said Jorg Rocholl, associate professor at Berlin’s European School of Management and Technology. “In Saxony you are talking about a guarantee of almost 3 billion euros to bail out a bank -- money which could have been used in financing schools, hospitals.”

Germany’s second-biggest state-owned bank, Munich-based BayernLB, revealed in April that fallout from the U.S. housing market crisis had cost it $6.6 billion. BayernLB, like most of the regional state banks known as landesbanken, is owned jointly by the state of Bavaria and the state’s association of savings banks.

WestLB, the third-biggest state-owned bank, in the state of North Rhine-Westphalia, in April reported 2007 losses of $2.5 billion, nearly $925 million more than the bank was predicting a few months earlier. Bank executives said they would lay off nearly a quarter of the workforce and its CEO stepped down.

Yet the tempest in the banking industry so far has not hit the wider economy. Germany posted its highest quarter-on-quarter growth rate in 12 years in the first quarter of this year, with a gross domestic product boost of 1.5%.

Germany’s banking industry has always been more diffuse than its European peers, in part because of the presence of so many state banks. These take the form of about 400 community savings banks -- down from nearly 2,000 a few years ago -- and bigger regional landesbanken that originally were fixed in many of Germany’s 16 states as the equivalent of state central banks.

Thus, although institutions such as Deutsche Bank may come to mind when people think of German banks, the market share of big commercial banks is low -- barely 20% for Germany’s five biggest banks.

State banks have been especially prevalent in eastern Germany, where citizens in the communist era used them as a repository for their savings and turned naturally to them for loans when it came time to set up private businesses.

The state banks also offered a local ear: Saxony’s finance minister chairs SachsenLB’s board, which also includes four county politicians, the mayors of Dresden and Leipzig, the state economics minister, four union representatives, two state lawmakers and representatives of three state-owned community banks.

SachsenLB acted as banker for the state of Saxony and handled financing of big infrastructure projects. It also could offer financing for larger-scale commercial transactions, historically at rates lower than those offered by commercial banks. That’s because the imprimatur of the Saxon state guaranteed an attractive rating from international ratings agencies and thus enabled the bank itself to borrow money more cheaply and pass those savings on to clients.

That all changed in 2005, when the EU heeded the complaints of commercial banks and phased out state guarantees. Shorn of their competitive edge and limited from expanding investment in Germany, banks like SachsenLB began looking further afield for moneymaking opportunities.

And a Dublin investment company operated by SachsenLB invested more than $5 billion in risky sub-prime securities, investigators believe.

The bank and its European investment arm plowed money into a variety of other ventures: residential and retail projects in India, solar energy projects, office buildings in New York, Australia, Austria, the Czech Republic and Poland, nearly a dozen passenger jets and even Hollywood movies such as “How to Lose a Guy in 10 Days” and “The Perfect Score.”

As soon as the sub-prime losses became apparent, senior bank executives insisted not only that they were unaware of the high-risk nature of the investments but also that they did not know that Saxony taxpayers would be liable for the losses.

Saxony’s former finance minister, who headed SachsenLB’s board, resigned in September. Milbradt, an economist who helped set up the bank, stepped down in April amid allegations that he had personal financial dealings with the bank.

In hindsight, government officials say a bank as small as SachsenLB perhaps should not have taken such grand risks.

“Seen through the political glass, the relationship between a bank the size of SachsenLB and the amount of business they did in Ireland has to be seen as wrong. It was not the right relationship,” said Burkhard Beyer, spokesman for the ministry of finance.

SachsenLB, meanwhile, was saved from ruin when it was purchased by one of the bigger, healthier regional state banks, Stuttgart-based Landesbank Baden-Wurttemberg, for $505 billion.

Analysts say the move is part of a trend that should have started long ago -- revamping regional banks into more efficient business models through consolidation or specialization.

“In politics, the feeling is ‘now or never.’ If ever we can crack the impasse in which the savings and landesbanken have been sitting for so long, it is now, under the headline of the crisis,” said Jan Peter Krahnen, director of the Center for Financial Studies at Goethe University.

It’s unclear how much of the potential $4.2 billion in state liability will have to be paid.

Saxony enjoyed a boom in tax revenue last year and had set aside $1.3 billion to fund state employee pensions. State officials have erased “pensions” from the fund and relabeled it “bank bailout.”

“We are very hopeful,” Beyer said, “that it will be enough.”

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kim.murphy@latimes.com