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Fire brigade called to IKB but losses hidden in smoke

The credit crisis caused by overheating in the US subprime mortgage market claimed its biggest victim this week, as the German government had to marshal the country’s banks into a consortium to rescue IKB Deutsche Industriebank.

Banks from every sector of the German market have coughed up Eu3.5bn to cover potential losses of up to 20% on IKB’s Eu17.5bn of investments in asset backed securities, both on and off balance sheet.

KfW, the German state development bank — which owns 38% of IKB — is bearing the brunt. It is contributing Eu2.5bn of that rescue package, on top of an Eu8.1bn commitment to cover IKB’s liquidity loan to its asset backed commercial paper conduit, where some Eu10bn of the ABS are held.

The episode is a frightening indicator of how quickly a fully regulated and supervised bank can founder, despite capital adequacy rules and risk management procedures.

Talk by Jochen Sanio, head of financial regulator BaFin, that Germany was facing its "worst banking crisis since 1931" was greatly exaggerated, and later repudiated by the head of the Federal Association of German Banks.

But the emergency services have had to be called out, for a full scale, state-backed rescue operation. If the guesstimate of a 20% loss on the ABS is right, that would indeed wipe out IKB’s equity, which is now languishing at Eu1.12bn after catastrophic share price falls this week.

Yet so far, the losses causing the hullabaloo are nearly all potential, rather than actual. That makes the episode very different from the collapses of Barings Bank or Long-Term Capital Management, when regulators also had to orchestrate rescues.

IKB still claims to have Eu12bn of liquid reserves, enough to cover its outgoings for a year; it is still rated Aa3/A+ by Moody’s and Fitch for long term debt, P1/F1 for short term debt and A1 and A2 for its subordinated capital.

None of these ratings has been lowered, though Moody’s placed its long term senior and subordinated ratings on review for possible downgrade on Tuesday, while affirming the short term rating.

Both agencies have lowered their individual or bank financial strength ratings: Fitch from B/C to C and Moody’s from C+ to C.

Top heads roll

IKB’s management has paid for the debacle. Stefan Ortseifen, speaker of the board of managing directors, retired this week. Günther Bräunig, member of the board of managing directors at KfW, has taken over as chief executive of IKB.

Bräunig, who joined KfW as head of international capital markets in 1989, will also be responsible for corporate development and communications and group audit.

Dieter Glüder, head of securitisation at KfW, has joined IKB’s board of managing directors.

And yesterday (Thursday) IKB said that Winfried Reinke, managing director of IKB Credit Asset Management, which managed the conduit, had been "relieved of his duties".

There were unconfirmed reports that the asset management arm had appointed a new chairman.

Eggs in one basket

IKB is known in the structured credit market as one of the bigger accounts — one banker estimated that it was one of the five or six largest investors in central Europe.

But it has never before attracted attention as unduly cavalier about risk. At first sight, the problem would appear to be a very basic one: IKB had too many eggs in the same basket.

Remarkably, as recently as July 20 IKB released a confident statement announcing its preliminary first quarter results. The bank noted the extreme market volatility, especially in the US mortgage market, but predicted annual profits of Eu280m.

"In this context," the report stated, "Moody’s has put quite a number of tranches ‘on watch’ for possible downgrade, whereof IKB is only affected by a single digit million figure.

"Furthermore, IKB is in no respect affected by the most recent analysis carried out by Standard & Poor’s with regard to the CDO market. It is worth noticing that the bulk of our investments are in portfolios of corporate loans."

How management could have made this statement so soon before the bank needed rescuing, and the role of IKB’s auditors, KPMG, are likely to be carefully scrutinised in the months to come as politicians and shareholders demand to know who to blame.

Deutsche says no

IKB’s problems appear to have come to the surface only last week, when Rhineland Funding had difficulty issuing ABCP.

Rumours were circulating among investors that the conduit’s exposure to US subprime mortgages amounted to between 40% and 50% of its assets.

Last week, Rhineland placed only $350m of paper in the ECP market.

German media have reported that the next stage came last Friday (July 27), when Deutsche Bank refused to extend credit to IKB.

Royal Bank of Scotland, ABN Amro and Wachovia are also reported to have declined to lend to IKB.

It is not known why Deutsche refused, or why IKB had asked for the advance, but the conjunction of events suggests that IKB could have needed money because it was facing a draw on the liquidity facility it provides to Rhineland.

All asset backed commercial paper conduits are covered by liquidity facilities from highly rated banks, usually to 100% of the value of their outstanding CP.

Rhineland has Eu19bn of CP outstanding and IKB provides 52% of the programme’s liquidity, with the rest syndicated to other banks.

The liquidity facility is there to make sure the conduit can redeem all maturing CP, in case for some reason, such as a market disruption, it cannot issue fresh CP.

Liquidity lines are not intended to cover the credit risk of the assets in the conduit, and may not be drawn against defaulted assets, which usually includes any rated triple-C or below.

If Rhineland could not roll over all the CP it needed to last week, it would have had to call on liquidity facilities.

Weekend emergency
Whether or not this was what led to banks refusing credit, it is clear that the banks’ refusal led directly to the rescue plan organised over the weekend by finance minister Peer Steinbrück; Jochen Sanio at BaFin; KfW; and the Federal Association of German Banks (BdB).

The first part of the rescue package to be announced — on Monday — was KfW’s commitment to guarantee Eu8.1bn of obligations for IKB. Specifically, that meant KfW took over IKB’s liquidity obligation to Rhineland. So far, that measure appears to have worked. This week — following the KfW guarantee — ECP dealers were able to place $1.549bn of paper for Rhineland.

Considering that the conduit only had $474m of paper maturing this week, this implies that Rhineland had a funding deficit from the previous week of over $1bn. However, it is not known whether the paper sold this week went to genuine, third party commercial investors.

Meanwhile in the stockmarket, IKB’s problems were just beginning. The bank’s shares plunged more than 13% to below Eu19 on Monday’s open. They then hovered within a Eu3 range before plummeting again on Thursday by almost 24% to Eu12.76.

The trigger was more news emerging about the extent of the trouble facing IKB, and the shape of the Eu3.5bn rescue package that was additional to KfW’s Eu8.1bn liquidity commitment.

"The joint package of measures put together at the weekend to cover potential risks at IKB is a viable solution which will stabilise the bank and prevent market disruption," said Manfred Weber, chief executive of the BdB, in a statement.

"My association has agreed to take a stake of up to Eu500m in an overall risk-covering package worth Eu3.5bn."

The BdB portion is thought to have been paid for by a consortium of German banks including Deutsche, Dresdner Kleinwort, Commerzbank and DZ Bank.

KfW is providing Eu2.5bn of the package, while the other Eu500m is split between Landesbanks, cooperative banks and savings banks.

The package will cover a potential 20% loss of the Eu17.5bn of asset backed securities IKB holds, on and off its balance sheet.

Yesterday (Thursday), WGZ Bank reinstated a Eu300m liquidity line that had been temporarily suspended.

Also on Thursday, IKB issued an ad hoc announcement that KfW would assume Eu1bn of the bank’s possible losses.

EuroWeek was unable to confirm whether this would be part of the Eu2.5bn the state bank was contributing to the Eu3.5bn bail-out fund.

IKB then announced that it was postponing its annual general meeting from the end of August to the fourth quarter, and had asked PricewaterhouseCoopers to do a "comprehensive audit, especially concerning Rhineland Funding".

Exposure still hidden

There is so far very little public information on the nature of IKB’s exposure. Fitch and the BdB have said IKB has Eu7bn of ABS on its balance sheet, of which two thirds, according to Fitch, are US deals.

If the Eu17.5bn overall figure is right, that suggests about Eu10bn of ABS are in Rhineland.

However, at the end of June Moody’s published a performance review on the conduit, which stated that 95.5% of its portfolio consisted of CDOs and CLOs. The rest was trade receivable securitisations.

If Rhineland has Eu19bn of CP — and therefore of assets — it could hold Eu18bn of CDOs.

About a fifth of these, according to Moody’s, represented US exposure; some 15% was rated below Aa3.

If these figures are correct, it is hard to see how the market rumours about Rhineland having 40%-50% exposure to subprime could be right.

It is not thought that any of the assets in Rhineland’s portfolio have defaulted, although some have been downgraded.

On Tuesday, KfW filed an amendment to its annual report with the US Securities and Exchange Commission, declaring its assumption of the Eu8.1bn liquidity facility.

KfW said that, while it had assumed some credit risk, it considered the portfolios of the conduit to be "satisfactory" and added that even if the credit quality of the portfolio did deteriorate, it would not affect KfW’s financial or liquidity position.

This may simply mean KfW is confident Rhineland will behave as an ABCP conduit is intended to, with liquidity providers covering disruptions to CP issuance but not assuming credit risk.

"If something defaults then, firstly, there is programme-wide credit enhancement [PWCE]," said Peter Winning, associate director of European structured credit at Fitch Ratings.

"So for an investor to take a loss the default would have to be bigger than the PWCE. Assuming there was no more credit enhancement left, then all losses would be distributed equally among all outstanding CP."

Neither KfW nor IKB provides credit enhancement for the vehicle. "The main part of the conduit — over 90% — is a securities portfolio," said Winning. "The credit enhancement for that — at a minimum of 4.5% — is provided by credit default swaps from an F1+ rated bank. KfW hasn’t taken over any of the credit enhancement."

Curiously, Fitch Ratings actually placed Rhineland’s F1 rating on positive Rating Watch after the confirmation that KfW would be the liquidity provider, since all its liquidity providers are now rated F1+. Moody’s affirmed its P1 rating on Rhineland.

Bank strength ratings cut

However, on Tuesday, Fitch downgraded the individual rating of IKB from B/C to C, while affirming its debt ratings.

"This rating tries to capture the standalone strength of the bank without any external support," said Sabine Bauer, financial institutions analyst at Fitch in Frankfurt. "Even though KfW has removed the risks imminent on the liquidity line IKB had outstanding for Rhineland funding, we feel IKB’s profile has weakened."

Bauer said she still expected IKB to come out with profit. The risk, she argued, was not losses but less profit than predicted in the preliminary results announced two weeks ago.

It has not been confirmed how much of IKB’s ABS portfolio is exposed to US subprime mortgages.

Bauer said Fitch expected credit impairments and mark-to-market losses from the ABS book to be significant, but added that she viewed it as a positive that KFW intended to provide support for certain portfolio investments on IKB’s balance sheet.

"We placed the [already lowered] individual rating on Rating Watch negative today [Thursday]," Bauer said, "as we are currently reviewing whether it would have been likely or not that IKB had defaulted without support. If we come to the conclusion that IKB would have failed, we would need to downgrade IKB’s individual rating to ‘F’. This is reflected in the profit warning that has been announced."

However, since its losses are as yet unrealised, and hence very hard to quantify, it may be a long time before market participants know exactly how bad the trouble at IKB is. That uncertainty is only likely to worsen the effect on investors’ and dealers’ already anaemic confidence.

Matthew Thomas, Chris Dammers, Hélène Durand

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