Rather than following Japan's banks into the NPL black hole, Germany's financial institutions have experienced a renaissance in terms of investor sentiment and spread performance this year. And although it may be not be fashionable to praise some areas of the German banking system, the truth is that the panic that was rampaging through the sector at the end of last year was heavily over-played.
Remember last October, when, if you believed the hype, the German banking industry was staring into a Japanese-style abyss? At about that time, Hermann Watzinger was settling into his new position as head of financial markets at ABN Amro in Frankfurt. He says that the progress made by the German banking sector over the last 12 months has been dramatic. "I have never seen so many banks managing their portfolios so actively," he says. "The banks' commitment to asset liability management makes me very confident that the German financial services industry is well on the way to resolving its problems."
Those challenges remain formidable. At HSBC in London, director of financial institutions Tobias Grün believes that while Germany's banking sector has shared a number of characteristics with Japan's, there are also important differences. One of those, he says, is that Germany's banks are not sitting on anything like the kind of unrealised losses that have held back the Japanese banking industry.
Another important difference between Japan and Germany, says Grün, is that although German banks are saddled with an uncomfortable burden of non-performing loans (NPLs), these remain far lower than the pile of NPLs in the Japanese system. He says that according to calculations made by equity analysts at HSBC based on numbers reported in accordance with US GAAP, NPLs in the US banking system equate to between 2% and 4% of GDP, compared with 8% or 9% in Japan. Germany, says Grün, sits roughly half way between these two.
Not that Germany's banks are out of the woods quite yet. "The real problem in the German banking system is still the chronic lack of recurring earnings power measured by pre-provision profits over risk-weighted assets. By this measure German banks still aren't doing very well, with the ratio among the large German banks hovering at or around 1%," says Grün.
Although the indications are that this figure is now rising, it still stacks up very poorly in comparison with other banking systems. Grün says that he believes the European average is in the region of 2.4%, while among the top 10 banks and former building societies in the UK the figure is just over 3%. At the large US money-centre banks, meanwhile, it rises to a little over 4%.
Nevertheless, in 2003 the investor community appears to have given German financial issuers in the capital market the benefit of the doubt about their recovery prospects. "It's been a tremendous year for the German banks," says David Soanes, managing director and head of European financial institution origination at UBS in London.
"There has been a renaissance in terms of investor sentiment and spread performance, and the same goes for the insurance sector. It may be not be fashionable these days to praise some aspects of the German banking system but the reality is that the panic that was affecting the market last October was grossly overdone."
Soanes says that the turning point came in April when Munich Re launched its successful Eu3bn 20 year non-call 10 hybrid deal via Deutsche Bank and UBS, which was the largest ever subordinated debt transaction denominated in euros.
That debut euro bond attracted an order book worth Eu6.5bn and was priced well below guidance, which was an astonishingly positive response to an issuer in an uncertain sector that had just been downgraded by Standard & Poor's from AA+ to AA-.
"The fact that a company like Munich Re could attract such a vast order book and price such a large deal resonated very positively with a number of investor groups," says Soanes.
To Martin Keutner, executive director of debt origination at UBS, deals such as the Munich Re blockbuster and the LB Kiel tier one issue that followed soon afterwards made an important statement about German financial issuers in the international capital market. "One of the most striking developments in Germany from a capital market perspective is that in the expansion of the market for European capital securities German issuers have adopted a lead role," he says.
Keutner's reference to LB Kiel as a borrower that has been in the vanguard of issuance innovation is telling, because bankers hope that its pioneering spirit has established a precedent for Germany's other Landesbanks to contemplate.
For the 11 Landesbanks, the key date in the diary is July 2005, when the twin state guarantee mechanisms of Anstaltslast and Gewährträgerhaftung will eventually be consigned to the dustbin of history, removing the prop that for decades allowed the Landesbanks to retain triple-A ratings, borrow at razor thin terms and re-lend the proceeds at ludicrously low rates.
Thereafter, the Landesbanks will have to live with sharply lower credit ratings, which analysts think will settle at anywhere between double-A for strong players such as Landesbank Baden-Württemberg through to triple-B for the weaker operators.
KfW and Rentenbank show how it's done
He does, however, concede that getting the message across about KfW's overall funding volume may have been more challenging over the last 12 months than in previous years. "We announced that we would be raising between Eu45bn and Eu50bn this year, and by the end of September we had raised about Eu41bn, so the total will be in line with our expectations and announcements," he says. "But we constantly need to convey the message to the market that every new project that KfW launches on the lending side does not necessarily translate into new borrowing on a one-to-one basis.
"When we announced a new infrastructure lending programme some people immediately suspected that that would feed through into larger borrowing requirements and we had to explain to them that the programme had already been factored into our total projected borrowing for the year."
On balance, however, Czichowksi says that he feels that KfW's global investor relations programme has paid off in that it has helped the bank to build an international investor base that will be there for KfW in lean times as well as good years. That was most conspicuous, he says, in the bank's recent $3bn transaction.
"The market was volatile after July and we had some feedback suggesting that some people were uneasy about a $3bn transaction," says Czichowski. "But it was very positive to see that even in a difficult environment KfW was able to execute such a large transaction successfully. One reason for that is that because we are established as an international borrower throughout the world, even though there was muted interest in the US for the dollar deal we were able to rely on Asian demand to take up the slack. And that works both ways. For example, in our 10 year euro deal there was very little take-up from Asia but a huge level of demand in Europe."
In between its benchmark offerings in euros and dollars, KfW tapped a new source of investor demand this year when it issued its record breaking equity-linked bond exchangeable into Deutsche Telekom shares, which Czichowski said sold "like hotcakes". That transaction served a number of important purposes. Aside from allowing the government to proceed with its privatisation programme in spite of the weak climate for IPOs, it also allowed KfW to diversify its investor base. "One of the beauties of the deal from our point of view is that we were able to place a large amount of the bond outside our traditional investor base," says Czichowski.
Perhaps most important, the use of the equity-linked structure continues in the recent KfW tradition of exploring new financing solutions for other issuers in much the same way as its synthetic securitisation platforms, Promise and Provide, have done in the ABS world. "The exchangeable has also opened up a market for other governments, such as Austria's, looking at the possibility of using this structure as a means of promoting privatisation programmes," says Czichowski.
Rentenbank wins plaudits
Like KfW, Rentenbank is well regarded for having done a commendable job in terms of exploiting all geographical regions in diversifying its investor base, with its dollar globals generating substantial support from US accounts. "In our first two dollar globals we had a very strong showing from US investors, who bought more than 40% of the bonds," says Horst Reinhardt, Rentenbank's treasurer. "In the third and fourth dollar globals US demand was slower, but in our most recent deal US institutions were the driving force again, buying about 37% of the bookrunners' allocation."
Rentenbank's penetration of the global investor base, says Reinhardt, has been strongly supported since it secured a schedule B registration with the SEC in 2001, underpinning its status as a quasi-sovereign borrower.
Rentenbank has made a virtue of a relatively small borrowing requirement, which in an especially strong year for triple-A borrowers has allowed it to focus more on diversifying its funding base than on ensuring that it was able to raise a comparatively modest total.
Nevertheless, there are obvious drawbacks associated with a borrowing requirement that inevitably puts a cap on the size of Rentenbank's benchmarks - such as the ineligibility of these issues for trading on EuroMTS. "That probably makes it more difficult for us to track the secondary trading of out transactions, and it means that there are some investors like prop traders who don't participate in our issues," says Reinhardt. "But traditionally we have placed much of our paper with institutional investors which have a medium term investment horizon. For them the quality of the bookrunners and their commitment to support a secondary market is important, so I don't believe the liquidity of our benchmarks is adversely impacted by their not trading on EuroMTS."
Rentenbank's borrowing requirement and strategy for 2004 will not be substantially different from this year's, although Reinhardt says that the yen market may play a more prominent role.
In September, Rentenbank tapped the Euroyen market for the first time since April 2001 with a ¥50bn five year transaction via Morgan Stanley and Nomura. Reinhardt says that this transaction was very well received by an investor base that had been starved of top quality Euroyen issuance throughout the summer, and that if the market continues to look attractive in 2004 it could pave the way for a larger yen issue. Given that Rentenbank aims to retain a 50/50 split between strategic and arbitrage-driven funding, a benchmark yen deal next year would need to come at the expense of a dollar or euro benchmark.
Away from the triple-A public sector banks, an increasing flow of quasi-sovereign benchmark German issuance continues to emanate from the Länder (state) borrowers, an increasing number of which have been turning towards internationally oriented, strategic transactions. That group has been led by the State of Nordrhein Westfalen and Sachsen-Anhalt, with others such as Berlin, Hesse and Brandenburg increasingly active over the last year or so in building up liquid yield curves.
That club may soon to be joined by Niedersachsen, which in February launched a benchmark size Eu1.5bn, which as an unrated bond was placed principally with Landesbanks. "I think a Land like Niedersachsen is in a transitional stage," says one banker, "and that we can expect it to secure a rating within the next few months that will allow it to launch internationally-targeted benchmarks next year."
Others agree that they expect to see more benchmark issuance from the Länder next year. Marco Bales, head of debt capital markets at HVB in Munich, says that there has been less strategic issuance from the Länder in 2003 than many expected, chiefly because these borrowers have been able to exploit the availability of very competitive funding in the domestic Schuldschein market.
With opportunities in that sector probably diminishing in 2003, more Länder will need to look at alternative funding options, says Bales. One of those options is likely to be an increasing recourse to issuance off MTN programmes in currencies other than euros. That process gathered momentum in 2003, with Nordrhein Westfalen building upon its reputation as one of the most innovative of the Länder when it launched the first ever public dollar deal from a German state in the form of a $500m three year issue led by BNP Paribas and Merrill Lynch.
July 2005, say bankers, is starting to loom. "The Landesbanks have precious little time, and if they want to be ready for the changeover in July 2005 they will need a year or so to show the market that they have made the necessary preparations," says Lucas Gnehm, co-head of FIG German debt capital markets at BNP Paribas in London.
"For those that are unable to do so, the danger is that investors will refuse to buy unguaranteed paper after July 2005 until they are confident that the issuers have established viable future business strategies."
The imperative is two-fold. On the one hand, the Landesbanks need to demonstrate that they have formulated credible and durable business plans that will safeguard their future in the post-2005 environment; on the other, they need to communicate those plans articulately to the investor base that they will be accessing as borrowers no longer cushioned by state guarantees.
HSH in the lead
Galloping ahead on both fronts, say bankers, is HSH Nordbank, the product of the merger between Hamburgische Landesbank and Landesbank Schleswig-Holstein (LB Kiel), which became effective at the start of June. That represented the first cross-border merger within the Landesbank sector and created an entity with total assets of about Eu180bn.
It has also paved the way for synergies which the bank believes will lead to annual cost savings of Eu150m starting in 2006.
Whether others will step down the HSH Nordbank route and accelerate change in the Landesbank sector via consolidation is open to question. Bankers say that M&A advisers are working around the clock on counselling Landesbanks about potential mergers and tie-ups, and the hope expressed by many is that political opposition to consolidation will give way to an acceptance of economic reality.
"What is absolutely obvious is that some of the Landesbanks will be too small to survive," says one capital market chief. "What happens next is largely up to political negotiations, but I believe that by 2010 there will be between three and five Landesbanks."
Perhaps. But in the meantime there is plenty that the Landesbanks have been doing - and can still do - to prepare themselves for the more competitive environment awaiting them in July 2005.
Towards the top of their priority list has been reappraising their lending policies to ensure that loans are advanced and priced at market-based terms, with exposure to individual borrowers restricted to more prudent levels than in the past.
The consensus is that this process is already well advanced, with politically-influenced, uneconomic lending a thing of the past in the Landesbank sector. "The Landesbanks recognise that is no longer the way to do business," says Bridget Gandy, managing director in the financial institutions group at Fitch Ratings in London.
Fair enough. But until very recently too many of the Landesbanks appeared to be shuffling towards 2005 with all the insouciance of turkeys gathering outside the pre-Christmas slaughterhouse. As Fitch's Gandy says, as recently as this time last year many were still recruiting new personnel in areas such as investment banking. Gandy believes that that process has now been arrested, although she is concerned that many of the Landesbanks are still not grasping the nettle of their inflated cost bases aggressively enough.
Many are making all the right noises about cost-cutting. Probably the most troubled of all the Landesbanks, WestLB, is pledging that it will cut an additional Eu500m from its costs between now and the end of 2005, reducing its workforce from 8,000 to 6,200 over the same period.
But reducing costs goes only part of the way towards addressing the weaknesses of the Landesbank sector.
Equally important is the need to address the issue of abysmally low profitability, with HSBC's Grün saying that of all the banks within the sector, WestLB has the most shockingly low pre-provision profits to risk-weighted assets ratio.
By his calculations, this ratio stands at between 24bp and 25bp at WestLB, compared with 104bp for LBKiel and 116bp for Hamburgische Landesbank (before the merger) and 111bp at Bayerische Landesbank.
Moving swiftly to cut costs and increase profitability is a key priority for Landesbanks if they are to optimise their credit ratings in the post-2005 world. So, argue bankers, should be positioning themselves in the capital market and establishing a dialogue with investors. Again, HSH Nordbank is held up as a prototype in this respect.
Allied to the clarity of and apparent durability of its business plan, HSH Nordbank has demonstrated impressive credentials in the capital market.
Setting alight bank capital
Those credentials were underscored in the borrowing strategy of LB Kiel, which was the first Landesbank to secure a standalone subordinated rating, and began to act as a pioneer among Landesbanks in February 2002 with the first of its Silent Participation Assimilated Regulatory Capital Securities (Sparcs) tier one deals.
That was followed in December 2002 with a Resparcs Asian-targeted structure, and again in May 2003 with Resparcs II.
At Lehman Brothers, which has structured, developed and led each of the Sparcs transactions, director of debt capital markets Richard Zirps describes Resparcs II as a "revolutionary" deal which was the first euro denominated retail targeted transaction of its kind. "Resparcs is the purest form of hybrid capital banks can raise because it qualifies for the most equity credit from the ratings agencies," says Zirps, adding that May's transaction met with phenomenal investor demand. He reports that a book worth well in excess of Eu2bn was the decisive factor in allowing for an increase in the transaction from Eu300m to Eu500m with the coupon tightened from an initial price talk of 8% to 7.5%.
With the Sparcs and Resparcs transactions carrying A3 ratings at launch, LBKiel has been able through its hybrid capital programme to establish a bridgehead into a number of the investor bases it will need to tap for its debt as an unguaranteed borrower starting in July 2005. That strategy is in stark contrast with those too many other Landesbanks, which, says BNP's Gnehm, remain preoccupied with cultivating their relations only with agency-type investors.
A more forward-looking strategy, he believes, would be for the Landesbanks to build a dialogue with the credit-based investors which will be their prime targets when they are in the single-A or even the triple-B bracket.
That is easier said than done, with the borrowing options available to Landesbanks positioning themselves as non-guaranteed borrowers limited. One of these would be for more Landesbanks to follow in the footsteps of LB Kiel by issuing subordinated paper not covered by guarantees - although to date other Landesbanks have been reluctant to take this path.
Another alternative for Landesbanks is to issue in the Pfandbrief market, although opportunities there are limited to refinancing associated with the banks' public sector and mortgage lending.
As Fitch Ratings observed in a report published in March, "some Landesbanks have already made extensive use of Pfandbriefe, largely exhausting available collateral, and are therefore more reliant on unsecured senior bond issues. Their focus now, therefore, is on benchmark issues to minimise funding costs and widen the international investor base."