There was standing room only in the River Room at the Savoy hotel in London. Issuer press conferences usually attract a slim and often reluctant group of clients. But Landesbank Rheinland-Pfalz (LRP), without anything to sell, had managed to draw a noisy crowd. The bank was in London to persuade everyone that Standard & Poor's had made a mistake in downgrading it. LRP had hired Michael Gruson of Shearman & Sterling, who had flown in by Concorde from New York, to present the bank's legal case. And the audience members were not going to let him finish until he answered all their questions. Dealers frequently interrupted him and Ian Bell of Standard & Poor's (S&P) was on his feet every other minute, determined that all present understood why his agency had downgraded the bank. And then came the killer question: "Are you here representing the entire landesbank sector or are you here to improve the performance of your bonds in the secondary market?" asked a dealer at the back. LRP failed to answer the question convincingly. For though all the landesbanks are affected by the guarantee controversy, LRP is the only one to have been downgraded. December 1999 saw all landesbanks placed on outlook negative by S&P - a situation that has not changed. But many landesbanks play down any effects on their funding costs. Andreas Strate, head of international funding at Westdeutsche Landesbank (WestLB) says: "Our funding levels in Libor terms are more expensive these days than a few years ago, but they have moved in line with the whole market." He is only prepared to admit that they have widened by just a few basis points more than other double-As. Jeffrey Spencer, public sector research at Merrill Lynch, says: "Issuing spreads for landesbanks have been wider. But it is difficult to attribute that just to news flow. As long as this controversy remains unresolved, there will be pressure on spreads." At the moment all the landesbanks benefit from both an anstaltslast (maintenance obligation) and a gewahrtragerhaftung (guarantee obligation) from their state owners. These are explicit guarantees that have given great comfort to investors. However the European Commission announced in July this year that it would be formally investigating the guarantees to see whether they contravened Europe's competition laws. All triple-As and double-As have had a bad time since investors started moving down the credit curve. But it is the investigation by the Commission into the guarantee system that has really hit the issuers. One landesbank funding manager, who did not want to be named, says: "We are being penalised twice and it's unfair." However some of the landesbanks have discovered that they can find refuge in the private Euro-MTN market. Though the private market is not immune from spread widening, structured Euro-MTNs offer some of the best value for these beleaguered German issuers. Achim Walter, funding team at Landesbank Baden Wurttemburg (LBBW), says: "The structured market has not been affected much. The plain vanilla private market has seen some knock-on from the public markets where spreads have widened. But we do not issue many plain vanilla private notes." Of the 62 notes sold off its Euro-MTN facility this year only two have been syndicated. The rest have mainly been structured yen trades, many linked to Sony shares or to the yen-dollar exchange rate. And most have found it difficult to get any long-term funding done. This year only 14.34% of landesbank private Euro-MTNs had maturities of more than 10 years. This compares to 42.15% for the same period last year. Manfred Steyer, head of new issues and syndicate at LRP, says: "Our maturities have gone down but the whole financial industry has seen this effect. In due course, if this situation continues, we will have to pay up for long-dated debt." And over half the private notes issued by LRP this year have been in yen. WestLB has also found comfort in the yen market. This year it has raised less than a third of the volume of yen it raised in the same period last year. But Strate, at the bank, says: "WestLB¦s specific advantage in the yen market in comparison to some other issuers is our presence in Tokyo and Osaka. WestLB has been in Japan for more than 30 years." But some dealers are quick to point out that landesbanks cannot become too reliant on yen. Peter Jackson, head of Euro-MTNs at Salomon Smith Barney, says: "Many Japanese investors are limited to buying sovereign paper. Sovereign is of course open to interpretation. Some say that notes issued by an entity that is 50% state-owned fit this criterion. So landesbanks, with their state guarantees, have slipped into the sovereign category. Many Japanese investors are worried that if the guarantees are removed they will have to sell their landesbank paper." And it seems increasingly likely that the Commission will scrap the landesbanks' state guarantees. A complaint was filed on July 26 by the European Banking Federation, saying that the guarantees constitute illegal state aid. With the Commission receiving an official complaint it has no option but to press on with its investigation. But Tobias Grun, senior credit officer at Moody's, points out: "The European Commission is primarily interested in creating a level playing field rather than exactly how such a level playing field should actually come about." Most market players agree that there are two possible options. Merrill Lynch's Spencer outlines them both: "The banks could compensate their owners by paying for their guarantees with a fee. Or it is theoretically possible that the banks could split, separating their public and commercial activities. But this would be practically very difficult to do. The landesbanks tend to have very complex internal structures which would make such a split very difficult." And many landesbank treasurers, in private, admit that paying their owners for their guarantees is the most likely option, saying that it makes no sense for the owners of the landesbanks to destroy value in the banks by cutting themselves off. But when and how this might happen is unclear. Until that moment most landesbanks have to reassure their investors that their paper is as credit-worthy as the day they bought it. And this mainly consists of persuading investors that landesbank paper will be grandfathered. This means even if the landesbank sector was to lose its guarantees and be downgraded, existing paper would keep all the guarantees and ratings that it carried when the investor bought it. Salomon's Jackson says: "It's my personal opinion that grandfathering must happen. There is a tradition in the bond markets that once you buy a bond the conditions under which you bought that bond will apply for the life of the deal." And many issuers go further in stressing grandfathering as a certainty. Walter, at LBBW, says: "There is no need for the German government to confirm that grandfathering will take place if the guarantee system should change. As far as I am informed, grandfathering is derived from the constitution." But despite many believing there is no need for this to be clarified, LRP has sought clarification. On August 31 LRP received a letter from Gernot Mittler, the state of Rhineland-Pfalz's finance minister, saying that at grandfathering would happen and that LRP's grandfathered paper would be fully guaranteed. Getting political backing is the latest tactic in LRP's fight against S&P's downgrading. LRP's Steyer says: "If the guarantees were eventually to be taken away it is possible our new debt could be downgraded to single-A. But our existing debt would remain unchanged. This is why the negative outlook by S&P is based on a misunderstanding. An outlook should only refer to outstanding debt, not any future new debt. Their action is unjustified." He believes that the rating agency knows it has made a mistake but cannot risk its reputation by admitting so. He goes on to say that its presentation at the Savoy was a successful move. He says: "The rating agencies did not oppose the legal opinions that we brought along. On the contrary, Ian Bell of S&P said that he agreed with the legal opinion of Shearman & Sterling and that we can rely on the guarantees." Bell is not wholly convinced however. He believes that LRP's ownership structure means that, in an insolvency situation, investors with grandfathered paper have less chance of having prompt recourse to the guarantors. He says: "In the case of LRP, the supporting states - North Rhine Westphalia, Rhineland-Pfalz and Baden-Wurttemberg - are all multiple steps removed and not direct guarantors. The connection between the bank and a better rating via these states is more tenuous and distant than in other landesbanks." Steyer is quick to rubbish this: "The idea that we are "multiple steps removed" from our guarantor is completely wrong. Each and every owner of LRP is obliged to guarantee 100%, without any restriction, the debt of LRP on first demand. If WestLB or LBBW didn't pay the investor he has a direct claim against the state. It doesn't cost the investor any time. He can get on the express train and be in Dusseldorf or in Stuttgart in one and a half-hours. If he receives no payment from WestLB or LBBW it only takes five minutes to go to the finance minister of North Rhine Westphalia or Baden-Wurttemburg and demand payment. There is no need for litigation." And Moody's has not downgraded LRP. Tobias Grun, from Moody's, says: "We have rated LRP since late 1993 and the ownership structure was just the same then as it is now." But S&P is unrepentant. And it seems the arguments will rage until the Commission gets its way. But many point out this could take a long time even if the Commission is determined. Steyer says: "The Commission cannot abolish the guarantees themselves. They must first go to Berlin and ask the federal government to ask the states to change the laws." However many insist that the Commission's political will is strong. Bell of S&P says: "The German government doesn't have a choice. Short of walking out of the Treaty of Rome, they are bound by any rulings from the European Commission." This is ultimately a political issue. And most agree the present German government is less supportive of the landesbank sector than Helmut Kohl's administration. Moody's Tobias Grun outlines the one stalling tactic that Germany might employ: "Many of the federal states see the Commission's investigation as a full attack on the entire public sector in Germany. They have publicly threatened to veto - within Germany's upper house - forthcoming EU enlargement plans." And though it may look like it is just the landesbanks which are suffering because of this controversy, others are anxiously awaiting the outcome. Many triple- and double-A issuers enjoy implicit state guarantees that have never been questioned before by investors. But the questioning has started. As Bell of S&P says: "The world has changed. Ten or 15 years ago it was inconceivable that a state would allow a bank or any institution carrying the state's name to go under. But you no longer get laughed at if you suggest the possibility now."
November 17, 2000
