Risky business


FINANCE:Why did one of Germany's smallest banks - Sachsen LB, based in Dublin - go to its financial grave owing several billion euro?

German dramatist Bertolt Brecht once observed that "robbing a bank's no crime compared to founding one". That is a fair summary of the issue at stake in the airless committee room of the Saxon state parliament in Dresden. For weeks, state politicians have met here behind closed glass doors, performing a political postmortem on Sachsen LB.

The state bank was rescued last August after running into multi-billion-euro liquidity problems. As the shock of the near-collapse wears off, the search for answers continues.

How could one of Germany's smallest banks run up debts many times its own value? And what was the bank doing in Dublin?

Six months on, the search for someone to blame continues. Senior bank managers have resigned, some with golden handshakes, but it remains unclear whether they will face criminal charges. Meanwhile, politicians who gave their blessing to the bank's risky business are clinging to office.

Some in Saxony still hold the view from last August that Sachsen LB managers were corrupted by the loose Irish financial regulations. German reporters dispatched to find bogeymen returned with little more than the New York Times remark from 2005 that Dublin was the "Wild West of the European finance sector".

In IFSC bars, managers from other banks gossiped about how Sachsen LB's Dublin managers ran amok with little supervision from Germany. When managers did arrive, the gossip goes, they were more concerned with spending money than inspecting the books. If they arrived at all, that is: it was not unusual for block bookings of suites in top Dublin hotels to be cancelled at the last minute, and at huge cost.

Six months on, a more complex picture is emerging of the greatest bank rescue effort in postwar German history. Many questions are still unanswered, but already the future is looking bleak for Sachsen LB's notorious Dublin subsidiary.

"Sachsen LB was a problem case from the start," says Dr Stephan Rabe, spokesman for the Federation of German Public Banks. "It was always going to be very difficult for this bank to generate profit, given the economy of its regional situation in the east."

A former Sachsen LB manager is more direct: "The bank never had a reason to exist."

Founded in 1992, Sachsen LB was a late addition to the third pillar of Germany's banking sector: regional Landesbanks reflecting the country's federal structure.

Like the Landesbanks West LB or Bayern LB, the publicly-owned Sachsen LB was intended to boost investment in post-unification Saxony and boost the German Mittelstand: small- and medium-sized enterprises. With 54,000 employees and assets worth €1.96 trillion, Germany's Landesbanks would, if they merged, be the second- or third-largest player in the market.

But that is unlikely to happen anytime soon. Critics complain that the banks, owned directly by their respective federal state government and public savings banks, exist largely to boost the influence of regional politicians.

The Landesbanks suffered an existential setback in 2005, after losing a long-running battle with the European Commission over state guarantees for its loans.

The commission argued successfully that this practice boosted the banks' credit ratings and allowed them to borrow money more cheaply than private banks, amounting to illegal subsidies. The Landesbanks, stripped of this privilege, went on a desperate hunt for new, lucrative business.

That goes some way to explaining why the tiny Sachsen LB ended up in the deep end of the sub-prime credit market.

The central figure in the rise and fall of Sachsen LB is Saxon state premier Georg Milbradt. A fatherly figure with sad eyes, the Christian Democrat (CDU) politician pushed for the founding of Sachsen LB's Dublin subsidiary in 1999, during his time as Saxon finance minister.

Documents from the period show Mr Milbradt was anxious to take advantage of the lower capital requirements in Ireland to found a bank. With Sachsen LB Europe established in Dublin, the whole group would benefit from Ireland's low corporate-tax regime. Even when Mr Milbradt left the finance ministry to become Saxon minister-president in 2002, opposition politicians say he continued to take an active role in the bank's affairs.

In 2003, the bank began buying high-risk debts through off-balance sheet "conduits" using money borrowed on the cheap, courtesy of the still-present state guarantee. Under obscure names like "Georges Quay" and "Ormond Quay", the business swelled into a €30 billion opaque operation, apparently with no upper risk limits.

Sachsen LB was not alone in the practice: ratings agency Moody's said last August that at least four other Landesbanks operated Dublin-based conduits worth $9 billion (€5.92 billion).

What made Sachsen LB unique was its appetite for high-risk loans, products later described by Germany's Manager magazine as "toxic rubbish".

The practice was encouraged by a deal between state governments and the Landesbanks. To cushion the blow of the EU ruling, governments extended state guarantees until 2015 for debts taken out between 2001 and 2005. Most of the "toxic rubbish" bought by Sachsen LB Europe falls under this arrangement.

The first concerns about Sachsen LB Europe began to surface in 2005, with a consultant's report that, in hindsight, makes for extraordinary reading.

The authors describe the risk management in Dublin as "out-of-date, incomplete, contradictory and unimplemented". The report claims that Dublin managers had no idea what they were required to control under Sachsen LB's existing risk-assessment regulations. Dublin managers were doing deals too complex to run through the bank's own risk-assessment software.

Sachsen LB Europe would continue to work, the authors concluded, "as long as no market disturbances occur".

That market disturbance hit last August, when the US sub-prime crisis finally rolled into Europe. On August 17th, German savings banks responded to a call for help and provided a guarantee of €17 billion to cover Sachsen LB's dramatic liquidity problems.

In December, the bank was sold off to the Landesbank Baden-Württemberg (LBBW) of Stuttgart. Negotiators for the LBBW drove a hard bargain, buying at a knock-down price on condition that the Saxon state government guarantee the first €2.5 billion of any future debts to emerge.

That guarantee could yet have consequences for the state budget in Saxony. It has also attracted the attention of EC investigators, who have opened an investigation into the legality of the rescue package.

Despite its dramatic end, Sachsen LB still has defenders, like Thomas de Maziere, Mr Milbradt's successor as Saxon finance minister. "I reject the claim that the Dublin business was risky in itself; it was the scale that proved to be the problem," said Mr de Maiziere, now Chancellor Merkel's chief of staff, at the inquiry last month.

The final act of the Sachsen LB tragedy gets under way this month, with a long-overdue report into the bank's activities by consultants from Ernst & Young. Opposition politicians in Saxony say they will be able to prove that ultimate responsibility lies with Mr Milbradt.

"The decision to create companies outside the balance sheet was taken when Mr Milbradt was finance minister," said Antje Hermenau, Green Party parliamentary leader in Saxony and inquiry member. "In 2005, when the first concerns about Dublin were raised, Mr Milbradt promised to wind down foreign activities. But he didn't, and that, I think, will cost him his job."

Meanwhile, Sachsen LB's new owner plans to rebrand and redirect the business into regional private banking in eastern Germany, Poland and the Czech Republic.

Spokesmen for Sachsen LB and LBBW have confirmed independently of each other that, in future, LBBW's entire capital markets business will be run from Stuttgart. That bodes ill for Sachsen LB Europe in Dublin. Managers in the bank's Georges Quay office declined several requests to comment for this article.

The consequences for Germany's Landesbank sector are less clear. After the Sachsen LB shock, analysts forecast a wave of consolidation. Several months of coquettish flirting later, however, and all bets are off - apparently at the behest of state politicians anxious to retain their respective banks.

"At the Landesbanks, vanity still trumps insight," sniffed Der Spiegel magazine.

But that vanity is becoming expensive, as revelations at West LB and Bayern LB reveal multi-billion sub-prime exposure.

At the end, the only party likely to come out of this business with its reputation halfway intact is Dublin. "The responsibility clearly lies with German managers and politicians," says Ms Hermenau.

"The Irish are not guilty," she jokes. "There will be no attack."