Cablegate: Bayernlb - Subprime Crisis Hits Bavaria

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TAGS: ECON ETRD GM PGOV PREL
SUBJECT: BAYERNLB - SUBPRIME CRISIS HITS BAVARIA

MUNICH 00000130 001.2 OF 002

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SUMMARY
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1. A BayernLB official told ConGen Munich that the bank,s
subprime losses would exceed the embarrassing 1.9 billion
euros already declared in February. Both Moody,s and
Bavarian Minister-President Beckstein share this view, saying
as much as 4 billion euros may be at risk. While the losses
don,t appear to threaten the solvency of the bank, they have
raised questions about the lack of oversight by bank and
state officials, and may potentially provide the catalyst for
a merger with Landesbank Baden-Wuerttemberg at some point
after Bavaria,s fall elections, creating Germany,s second
largest bank.

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BAVARIA,S STATE BANK
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2. ConGen Munich met with Peter Kulmburg, BayernLB,s head
of communications, March 27 to discuss the impact of the
financial crisis in the U.S. on BayernLB and the prospects of
a merger with its counterpart Landesbank Baden-Wuerttemberg
(LBBW). BayernLB is a semi-public bank, owned jointly by the
state of Bavaria and the regional savings bank association
(Sparkassen). The bank serves as a &house bank8 to the
state of Bavaria and as a clearing house for the Sparkassen
located in the state.

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SUBPRIME LOSSES BUILD
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3. As with most of the German banking sector, BayernLB has
not been immune to the effects of the U.S. subprime crisis.
In February, the bank admitted losses of approximately 1.9
billion euros (USD 3 billion) because of a number of
non-performing loans backed by U.S. mortgage securities. The
losses were particularly embarrassing given that BayernLB
officials had previously maintained that their exposure to
the subprime crisis was minor. As a result, CEO Werner
Schmidt was forced to step-down and was replaced by Michael
Klemmer. The affair also embarrassed Bavarian Finance
Minister and Christian Social Union (CSU) chief Erwin Huber,
a member of the bank,s supervisory board.

4. Kulmburg explained that BayernLB owned a portfolio of
asset-backed securities previously valued at 30 billion euros
(USD 46.8 billion). For a significant part of the package it
was not possible to determine current market prices, he said,
as there were currently no buyers. As result, a valuations
model had to be accepted by the bank,s auditors to determine
the value of the package. The &loss8 of 1.9 billion euros
BayernLB reported in February was composed of a write-down of
600 million euros (USD 936.3 million) of subprime related
investments and a revaluation of assets resulting in the
reduction of their book value by 1.3 billion euros (USD 2
billion).

5. Kulmburg pointed out that BayernLB was determined to keep
these assets because it expected that a good part of them
would perform nonetheless. He explained, however, that the
losses would likely exceed the 1.9 billion euros, as problems
with U.S. mortgage-backed securities had deepened during the
first quarter. This view is shared by ratings agency Moody's
Investors Service, which announced March 25 that it had put
BayernLB's &C-8 bank financial strength rating on review
for possible downgrade. "Moody's decision ... reflects the
bank's significant 32 billion euro (USD 49.9 billion)
exposure to structured credit products, of which more than 4
billion euros (USD 6.2 billion) is subprime related," said
Peter Burbank, lead analyst for BayernLB at Moody's.
Kulmburg,s and Moody,s comments appear to also be shared by
Bavarian Minister-President Beckstein, who told the press on
March 31 that he also expected the bank,s losses could
ultimately mount to as much as 4 billion euros.

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NOT ALL BAD NEWS
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6. Kulmburg explained that even though the crisis was
clearly bad news for the bank, it posed no threat to
BayernLB,s survival. He added that the bad news related to
subprime losses overshadowed the bank,s successes, such as
its well-run business loan program which had almost no
insolvencies. Another strength was the bank,s growing
business in southeastern Europe, which BayernLB was pursuing
through its Austrian subsidiary, Hypo Alpe Adria Group.
Kulmburg said BayernLB,s overall strategy included a

MUNICH 00000130 002.2 OF 002

stronger focus on retail banking, especially in southeastern
Europe, loans to small and medium sized firms, and a
reduction of its securities trading activities.

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MERGER ACTIVIITY?
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7. Kulmburg said despite rumors, a merger with another
German Landesbank was not immediately forthcoming, especially
not before Bavarian state elections in September. He
nevertheless expressed the view that a merger of BayernLB
with another Landesbank, preferably Landesbank
Baden-Wuerttemberg (LBBW), might be in the cards at some
point in the future. Kulmburg noted that there had already
been merger negotiations last fall, which the Bavarian state
government had stalled, arguing that it wanted to maintain
BayernLB as an independent entity in order to preserve
Bavaria,s importance as a financial center. Despite the
Bavarian government,s desire to keep BayernLB independent,
the savings banks in Bavaria and Baden-Wuerttemberg, which
each own 50 percent of their respective state banks, would
have welcomed the merger, arguing that a merged bank would
result in better and cheaper services.

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COMMENT
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8. At this point, BayernLB,s losses represent more of an
embarrassment for the bank and the Bavarian government than a
threat to the viability of the institution. However, it is
an example of the questionable business model of state banks.
Even BayernLB's successful operations in southeastern Europe
barely conceal the fact that the actual role of state banks
-- to provide higher financial volume than regional savings
banks could provide -- has vanished. Together with
North-Rhine Westphalia's WestLB, BayernLB is a prime case of
how (parochial) state government policymaking prevents
desirable banking consolidation in Germany.

9. It is not yet clear whether frustration on the part of
the savings banks and the public (which ultimately will pay
for losses with tax money) with the bank,s leadership and
apparent lack of government oversight could be the catalyst
for a merger between BayernLB and LBBW, the two largest
German state banks. A merged institution would become
Germany,s second biggest bank after Deutsche Bank, with its
business focused on Germany,s most economically dynamic
region. However, despite economies of scale, a combined bank
would face the challenge of needing to report to two separate
state governments interested in securing the greatest number
of jobs and other benefits for their states.

10. This report has been coordinated with Embassy Berlin.

11. Previous reporting from Munich is available on our
SIPRNET website at www.state.sgov.gov/p/eur/munich/ .

NELSON

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