The first German bank has died from Austrian contagion.
Duesseldorfer Hypothekenbank AG (“Duesselhyp”), a tiny mortgage lender,
has been seized by the Bundesverband Deutsche Banken (BDB), Germany’s
association of private banks. According to Reuters,
The BDB had hammered out a deal over the weekend with financial
market watchdog Bafin, the Bundesbank and resolution authority FMSA to
provide a guarantee for DuesselHyp’s holdings of around 350 million
euros ($370 million) in Heta bonds that are subject to a debt moratorium
imposed by Austrian financial regulators.
Duesselhyp’s core tier1 (CT1) capital of 233m euros was
not enough to allow it to continue trading after the expected 50%
haircut on its holdings of senior unsecured HAA/Heta bonds. Under German
law, Lone Star, the private equity group that owned Duesselhyp, was not
obliged to contribute more capital, and the planned sale
of Duesselhyp to Attestor Capital could not proceed. The BDB’s seizure
of Duesselhyp is therefore understandable: the alternative was
disorderly collapse.
But it is not immediately clear why the BDB opted to bail out
Duesselhyp rather than forcing bail-in of its creditors. After all,
Germany has already adopted the European Bank Resolution & Recovery Directive
(EBRRD). True, Duesselhyp is tiny: bailing it out could be done
entirely from existing funding without recourse to taxpayers. But
bailing out a tiny, over-leveraged and under-capitalized bank seems
contrary to the spirit if not the law of the EBRRD. So why did the BDB
do it?
The
reason is the nature of Duesselhyp’s liabilities. Duesselhyp is an
issuer of Pfandbriefe, the super-safe covered bonds that are the bedrock
of the German financial system. A look at Duesselhyp’s 2014 interim balance sheet
shows that Pfandbriefe backed by public sector loans are by far the
largest proportion of Duesselhyp’s liabilities: it has issued a rather
smaller number of mortgage Pfandbriefe too. The remainder of
Duesselhyp’s liabilities are institutional deposits (it has no retail
deposits), which are covered by unlimited guarantees from the German
deposit fund. In short, almost all of Duesselhyp’s liabilities are
covered by explicit or implicit German government guarantees.
Unfortunately its asset base is not nearly so gold-plated. It has a
large legacy portfolio of US mortgages and MBS, which it is gradually
reducing. More than half of its real estate loan assets are
cross-border, and over two-thirds are backed by commercial property. On
the capital markets side, the portfolio is dominated by public sector
loans, including Spanish, Portuguese and Italian sovereign debt. In
short, Duesselhyp’s balance sheet is riskier than it should be. And it
is also encumbered and illiquid. There is no easy way of recapitalizing
it. Because all its deposits are guaranteed and all its bonds are
covered, bailing in creditors to close the capital gap left by the
HAA/Heta bond haircut would have been extremely expensive, involving
claims on the German bank deposit insurance fund and calls on the
Pfandbriefe cover pools. No wonder the BDB opted to bail it out rather
than attempt to bail in creditors.
But this is not the first time Duesselhyp has been bailed out. It was
previously seized by the BDB when it collapsed in the financial crisis.
BDB sold it to Lone Star in 2010, but has now been forced to
expropriate it again. To my mind this raises serious questions about the
quality of Duesselhyp’s management: to misquote Oscar Wilde, one
bailout could be considered unfortunate, but two looks very much like
negligence.
There is some support for the negligence theory in Duesselhyp’s 2014
interim report and accounts (cited above). As might be expected after
its previous bailout, Duesselhyp is progressively shrinking its balance
sheet, divesting riskier assets (including public sector assets from
distressed parts of the EU) and rebalancing away from public-sector
lending towards (mainly) commercial real estate. In early 2014 it
divested its Hungarian assets on grounds of political risk: but it
failed even to consider the possibility of losses on its 348m euros
worth of HAA/Heta bonds, despite the fact that Austria had already attempted to bail in 2.35bn
euros worth of loans from the German Landesbank BayernLB. Despite an
apparently robust CT1 capital ratio, a simple leverage calculation gives
2.1%, which suggests that the CT1 capital ratio was achieved by gaming
risk weights, probably by taking into account explicit and implicit
guarantees of its assets – including, presumably, the Carinthian guarantees on HAA/Heta bonds.
But it is hard to see how
Duesselhyp could have protected itself from HAA/Heta bond losses anyway.
It has been making losses for years and is seriously short of money. It
lacks sufficient capital to provision against losses on its legacy
portfolios. Presumably it just tries to divest them as quickly as
possible and prays that nothing will go wrong in the meantime. This is
hardly a prudent way to run a bank, though there seems to be little else
it could do.
The truth is that Duesselhyp is a zombie.
Its balance sheet is stuffed with risky legacy loans, it lacks the
capital to expand new lending significantly and it is unable to protect
itself from negative shocks. Surely it is time to convert it into a “bad
bank” – an asset manager whose sole purpose is to eat itself?
Apparently not. The underlying issue is the supposedly risk-free
nature of the Pfandbriefe. It is inconceivable that Pfandbriefe could
ever default. Back in 2010, Tracy Alloway of FT Alphaville sarcastically observed
that the gold-plated nature of the Pfandbriefe meant that their ratings
could remain AAA even when their issuers were being systematically
downgraded. The ratings agencies Moody’s and S&P attempted to link
Pfandbriefe ratings to the ratings of their issuers, and received a
dusty response from the German authorities.
To this day, the fiction remains. Suddeutsche Zeitung reports the real reason for the bailout of Duesselhyp
(my emphasis):
Düsselhyp funded primarily through Pfandbriefe – these are secured
bonds, which are regarded as virtually risk free and are acquired with
the insurers and pension funds. The financial industry wants to avoid casting doubt on the soundness of the mortgage bond market under any circumstances.
(translation by Google – original in German)
So we pretend that Pfandbriefe are backed by dedicated pools of
assets, when in reality they are backed by unlimited guarantees from the
German banking system as a whole and, as a last resort, from the German
government. And similarly, we pretend that the issuers of Pfandbriefe
are private sector banks bearing private sector risks, when in reality
they would never be allowed to fail, as Hans-Joachim Duebel of the
German financial consultancy Finpolconsult explains:
Recent test cases confirm our
expectation of strong support for European covered bonds. During the
financial crisis, 19 European issuers defaulted on their senior
unsecured or sub-debt, but covered bondholders never needed to rely
exclusively on the cover pool. Instead,
key operations were transferred to another existing bank, the bank
continued to operate after resolution and toxic assets were either
transferred to a bad bank or another solution was found. As a result, we
think European authorities are very likely to take steps to ensure the
continuity of covered bond payments when the bank supporting the covered
bonds is in resolution, and we reflect this in our assessment of
European covered bonds issued under special covered bond laws.
This creates a simply massive moral
hazard problem. There is a clear incentive for market participants to
overstate the risk to the financial system of allowing either
Pfandbriefe or their issuers to default, thereby ensuring bailout if it
all goes wrong. And consequently there is also clear incentive for
Pfandbriefe issuers to stuff cover pools with higher-yielding,
poorer-quality assets in the near-certain knowledge that they will never
be called. Subprime Pfandbriefe, in fact. Of course this couldn’t
possibly ever go wrong, now could it?
So tiny Duesselhyp must be bailed out to preserve the fiction that Pfandbriefe are risk-free, even though the degraded nature of their cover pools
as a result of German bank adventures in exotic lending products and
risky sovereign debt means that they manifestly are not. Both
individually and collectively, Pfandbriefe issuers are “too important to
fail”. Preserving the Pfandbriefe’s stainless character means keeping
zombies alive.
