Before I get stuck in, I want to make it clear. it is not my intent to paint Depfa as angels and HRE as devils. Depfa did stupid things. Their funding problems were not so dissimilar to Northern Rock’s. But Depfa had far better assets. And therein is part of the story.
So what went wrong? And why did HRE buy Depfa when it was already going wrong?
The fact is HRE bought Depfa and did so after the debt wave had already curled and started to break. But then again why shouldn’t the Germans be as thick as the Brits at RBS who at almost the same time bought ABN Ambro?
The question that always circles however, is did Depfa knowingly lie to HRE about their problems? Did they somehow withhold ugly problems? Well according to one of the very senior bankers, who was there and had full and complete access to the deal, and who agreed to talk to me on condition of anonymity, it would have been very hard for Depfa to hide anything. Inside the bank there was a secure room where ALL the bank’s data, all its books and accounts were available to the two boards of Directors during the months the deal was being negotiated. This room was run and controlled by a senior German employee. According to my source the HRE people looked VERY carefully at EVERYTHING.
This still leaves the possibility that there was a board within the board at Depfa and this inner circle was somehow concealing things even from the rest of the bank and board. The stuff of conspiracy stories which I am not much given to. Could there have been a board within the board? I have evidence there was; first hand testimony from someone who was there.
Interestingly this person does not believe the purpose of an inner group was to hoodwink HRE. If anything it was to keep some of Depfa’s own board slightly out of the loop.
All in all it does not seem as if Depfa lied to HRE or concealed any hidden debts. So if HRE didn’t buy Depfa because they were sold a pup, why did they? And particularly why did they pay 2 billion over its book value!
Depfa’s collapse was due to being unable to find funding. In other words the same idiocy as killed Northern Rock. But it’s the differences from Northern Rock that are important. Let’s look at the time line. Northern Rock collapsed in September of 2007. It did so because it could not get the short term funding it relied upon to keep its loans rolling over. The wholesale funding market locked it out. Why? Because the lenders in the market, other banks, were worried that Northern Rock’s assets were so dodgy that their ability to repay became highly doubtful.
Note that at the time the HRE/Depfa deal was being signed Depfa was NOT locked out of the markets; it was a whole year later that Depfa found itself unable to get funding. This document by the huge law firm Herbert Smith (see p. 8), written just after the bail out in 08, makes it clear Depfa was having problems. They had about 35 billion euros of debt that needed funding in the markets and those markets were seizing up. Both Depfa and HRE knew about this funding need before the merger. But crucially Depfa was NOT locked out. It did not collapse in 2007 but was a going concern for another year. Why was that? What made them different from Norther Rock and others who did collapse in 2007?
The reason is simple, its funding worries were off-set by the fact that Depfa had some of the best, most solid gold assets of any bank. As noted in part one as many as 80% of their assets were rated higher than the bank itself or the banks lending to it. THAT is why HRE were so interested in Depfa and were even willing to buy it for 2 billion over book value.
HRE knew exactly how Depfa funded itself. There is NO WAY those details could have been hidden. We know that both banks were aware of funding problems. Let’s just note in passing that advising Depfa on the merger/sale was Goldman Sachs. So Goldman too would have known all there was to know about Depfa’s funding problems. Hang on to this.
It is worth pausing for a moment to understand how Depfa funded itself. It becomes important later. Depfa’s business was making large loans to cities and states for public works. 100% pure gold assets. Government backed all the way. It funded them by selling Pfandbrief and later ACS (the Irish version of the Pfandbrief called an Asset Covered Security) which the Landesbanks and others bit their hand off to get hold of. The Pfandbrief typically is a bond for 5-7 years. But Depfa, like Northern Rock and ALL the big banks, swapped this long dated debt funding for shorter debt/funding. The idea seems foolish now, and I think it is foolish, but the risk managers I have spoken to still adhere to the holy writ of relying on short term market funding. I’ll explore this piece of banking some other time. But what is important is that Depfa’s reliance on short term wholesale funding was nothing unusual. It was the norm rather than the exception.
Back to the story.
Unlike Depfa, HRE had a legacy of poor quality assets, which I wrote about in Dominoes falling from the East. HRE had also been aggressively expanding its business in Real Estate and we know from the subsequent bails of HRE’s own collapsed debts that, as this article written in 2009 makes clear,
In reality, HRE was a ticking time bomb and this is the reason it had run into liquidity problems (By the way, this is much the way I see Northern Rock – which was also nationalized by the UK government). The company has massive commercial property (CRE) exposure and the CRE market is imploding in financial centers like Frankfurt, London and Dublin and elsewhere. HRE is highly leveraged to these places.
So it’s not just me who is saying that Depfa may have triggered events but the main blast was from within HRE. HRE was a ticking bomb and HRE’s board thought buying Depfa was the way to diffuse it. HRE also relied on wholesale funding, but unlike Depfa, didn’t have great assets. It was therefore more like Northern Rock than Depfa. HRE’s poor assets would have also, and this is my speculation, have meant HRE would have started to have problems on the Repo market. Remember repo is the oxygen of overnight funding. It is also what destroyed Lehmans. Lehman’s assets became distrusted and eventually other banks would not accept them as collateral for repo funding.
I think this is what HRE were worried about and why they were so desperate to buy Depfa. Depfa had what HRE didn’t – assets for the all important repo market. That is what they were trying to buy. Remember, funding problems are a threat to survival like starvation. But being unable to repo is not being able to get just one more breath.
My source tells me that HRE thought that by buying Depfa’s absolutely top quality assets, HRE would be upgraded by the ratings agencies and be able to breath again on the repo market. But instead, as my source said, “The minute HRE bought Depfa, the rating agencies downgraded Depfa.”
The merger ended with the worst of both worlds. Where each bank had exposure to one kind of risk HRE to credit risk, Depfa to funding (though I think HRE actually had both) by coming together they united the nitro with the glycerin. Sheer banking genius. Depfa brought funding worries to the marriage, HRE brought credit rating downgrades. I love you too darling.
So why did the whole thing wait a year until Oct ’08 to collapse? And what finally brought it all down?
So now we come to the nub of it. We have created the bomb with equal parts funding crisis and credit risk but even so nothing exploded for a year. During that year other banks went down. So what was it that jolted the container and set it off?
Well we know that Depfa’s funding was the trigger. So what happened to it? Turns out, while other banks like Northern Rock collapsed Depfa didn’t, because it had a sugar daddy funder. A big funder who was always happy to take Depfa’s Pfandbrief long term debt and fund it with shorter term money. Depfa’s sugar daddy was AIG’s Paris subsidiary, Banque AIG.
That should give you a bad feeling. AIG’s problems started as far back as ’06. Certainly by the 1st quarter of ’07 AIG had had to write down a 20 billion dollar loss. But the Dow was still going up. So there was still plenty of money around. By the time HRE and Depfa had kissed and exchanged vows, AIG had been downgraded and faced the first of what would turn out to be many Collateral calls. This first one was for $14 billion. Oops.
It was at this point that Northern Rock found there was no more funding. But HRE/Depfa survived.
Banque AIG in Paris was still in business, still funding Depfa’s needs. Banque AIG was not a small affair. It was systemically important for many banking clients in Europe for swapping one short of funding for another, for hedging and for derivatives. But it was also getting itself into a bit of a funding pickle. In part this was just its share of the over all implosion AIG was undergoing world wide. In part, I think, it was Paris’s own problem.
Banque AIG in Paris was an essential part of AIG’s funding mechanism. It was part of what was called AIG Financial Products (AIG-FP) whose notorious central office was AIG in London. This is where all the ‘losses were made’ and where the obligatory ‘rogue’ trader-type villain, Mr Joseph “Iron Hand” Cassano was in charge. What is a little less well known is that most of, if not all of London’s deals were routed through Banque AIG in Paris, where the deals were all supposed to be ‘reviewed’. And we know that as far as Depfa was concerned their funding was from Banque AIG.
So why tell you this? Well, on 31st of August 2007 a new branch of AIG-FP was set up in Ireland, AIG-FP Matched Funding (Ireland) Plc. Why? And why then and not before? I can’t know of course. But this is how it smells to me.
Why did any of the banks in our story end up going to Ireland? For access to money that liked the lax and laid back, ‘we have neither teeth nor balls’ regulatory atmosphere. AIG had been getting funds just fine for years. Suddenly, when AIG is in all sorts of trouble and its own funding is starting to get dicey it suddenly opens a brand new branch – in Ireland.
In under a month, on 25th September 2007 to be precise, AIG-FP Ireland issued a funding prospectus for $20 billion. AIG was already beginning to feel the heat by now and wholesale funding had already locked out Northern Rock precipitating a bank run 11 days earlier.
To me, the fact that AIG-FP opened a branch in Ireland is a hint that its normal funding was, at the very least, in need of reinforcing, if not replacing with ‘other’ sources which could be best found in Dublin. So now Depfa’s sugar daddy funder was alongside it in Ireland looking for the SAME money as everyone else, such as HRE, for example. This situation does not fill me with confidence.
But would Depfa or HRE have known of this development at the time it was doing the deal with HRE? I doubt it. AIG would not share any plans with customers. Even ones to whom it was a sugar daddy. So did anyone know? Well it’s just a little footnote but it turns out that none other than Goldman Sachs was arranging and advising AIG-FP Ireland on its funding adventure.
No way would Goldman have told one client (Depfa) what another (AIG) was doing. So Depfa did not know from Goldman about any troubles at Banque AIG. But Goldman knew. Goldman was advising Depfa on merging/selling itself to HRE for 2 billion over its book value while it also knew that Depfa’s main funder was probably in more trouble than the rest of the market suspected.
I would love to know, but never will, if Goldman had any short position on the new HRE/Depfa bank it had helped broker?
In short what I hope to have shown is that Depfa did not ‘bring down’ HRE. HRE was going to collapse anyway. And buying Depfa was an ruinously ill-thought out attempt to solve HRE’s credit crisis. The plan back-fired and made every one’s position worse than it had been.
The entity which actually brought down HRE was AIG. It was their implosion along with the general shock of Lehmans which cut off Depfa from funding which had kept it alive for a year after other banks collapsed. So it was the Americans who brought down HRE not the Irish if you really want a scape goat.
And the only people who perhaps knew the whole HRE/Depfa deal was destined to end in disaster and bankruptcy, were Goldman. Goldman knew both how Depfa was funded an WHO was their lynch pin funder, while also knowing the true state of that funder (AIG-FP).
SO to circle back to where I started. It is NOT as simple case of a dodgy Irish bank bringing down a solid German one. If anything the opposite is just as true. And therefore it is NOT the case that Ireland has some moral debt it owes to ANYONE to bail them out.
The threats are already coming thick and fast. The Irish people MUST defend themselves, their children and their country. Their leaders haven’t and won’t.
AN ARTICLE WELL WORTH A READ
by Golem XIV on JANUARY 24, 2011 in LATEST
Now that Mr Cowen has lost control of his party, coalition and country, the Irish can expect to be bullied and hectored from all sides. It is more important than ever for Ireland to defend herself against the claims that she owes the rest of us. She doesn’t.
Every European bank exposed to Irish loans, every bond holder holding Irish debt – both bank and sovereign, and every foreign central bank concerned for the solvency of its own banks will start to crank up a barrage of propaganda and threats. It will be top of everyone’s propaganda agenda to make sure the Irish election offers no choices that could destabilize the unexploded ordinance of European bank insolvency.
The European financial class will be desperate to ensure that the Irish have an election that is carefully constrained so as not to offer anything that might actually help them. As far as the banks, the ECB and all the leaders of nations whose banks would suffer losses if Ireland were to default or restructure, the Irish people are NOT to be exposed to ideas of default.
All parties must be told, and if that fails to convince, made to feel directly via the bond market, the consequences of any alteration of the course followed so far. And, of course, it has already started. Here is what senior ECB banker, Lorenzo Bini-Smaghi, said on January 15th regarding Ireland’s electoral choices.
“It would be dramatic for Ireland if just by changing government you renege on the promises that Ireland as a sovereign has made.”
Not that he would dream of making veiled threats to try to frighten Irish public opinion into choosing what would be best for the banks over what would be best for the Irish people.
“Look at those countries which defaulted, like Argentina, Pakistan, Ukraine, Zimbabwe, Cote d’Ivoire. Do the Irish people want to go through the same experience?”
No mention of Iceland there. Funny that.
The foreign press will run story after story about the dangers of ‘contagion’, of the need for responsibility and resolve. The Irish Central bank will step in to make grave pronouncements if the political parties seem not to be holding the line.
Foreign leaders such as , Merkel, Olli Rehn, Barosso, Trichet and our British clowns, all with their own national interest, will give talks and be quoted in their papers about the need for steady fiscal responsibility and the unthinkable consequences of any waivering.
If there is any rumbling of popular discontent, then scape goats will be found – people upon whom some anger can be harmlessly vented. But if that does not work then the rhetoric will get more pointed. Ireland will be reminded that ‘it’s their fault’ and they ‘have no one to blame but themselves’. In the German press any hint that Ireland may be thinking of restructuring will be met with dark reminders of how ‘Ireland’ in the form of Depfa had to be bailed out by Germany.
In short I don’t think the Financial class is pleased that the politically unreliable (when it comes to European questions) Irish are going to have an election at this delicate time. I think the run up to the elections will involve a lot of propaganda designed to shout down any opposition to bail outs and debt payments.
So I thought this might be a good moment to get a few things on record regarding Depfa, HRE (Hypo Real Estate) and the banking crisis blame-game.
For those who aren’t already familiar with the Depfa and HRE story, here it is in a very small nut shell. Hypo Real Estate was the huge German bank which we were all suddenly told, back in 2008, had to be bailed out by the German State at vast cost. But, they said, they had no choice, because Hypo (HRE) was so large and its debts so huge that if it collapsed it would, at the very least, bring down German banking. It was Europe’s AIG – to big to be allowed to fail. Then the back story emerged. HRE had bought ‘Irish’ bank Depfa at the top of the market at almost the same time as RBS bought ABN Ambro. Both purchases were insane and both killed the purchasing bank.
It was then put about that the collapse of HRE was in fact due to a huge funding crisis at Depfa always referred to as ‘its Irish subsidiary’. From that came the notion that Depfa must have hidden its true state from HRE. Why else would HRE have bought a bank which couldn’t fund itself?
And that is how the story firmed up. Irish Depfa must have lied about its true state in an effort to sell itself to Hypo, so that when Depfa’s hidden financial problems surfaced, the cost of them killed Hypo and then fell upon the German rather than the Irish tax payer.
It is sometimes easy to forget with all the sordid and ruinous business of Anglo Irish, that the beginning of the whole crisis in Ireland and in Europe was intimately tied to Depfa and HRE. Thus I think it is worth reminding ourselves of some of the misinformation and perhaps offering a few less well known facts. Facts which might help the Irish defend themselves.
It was often said, particularly in the German press, that Depfa ‘brought down HRE’. Had HRE not bought Depfa when it did in 2007, then it would have been the Irish, who had incubated the problem, who would have had to pay for it, not the Germans. There is always this undertone that somehow Depfa must have lied to or misled HRE.
Was DEPFA really an Irish Bank which the Irish should have bailed out?
Less than 1% of Depfa’s business was Irish. Virtually no Irish Banking money flowed into Depfa or its deals. Depfa was not a major employer in Ireland. A couple of hundred jobs at most. Few of its senior positions were held by Irish people. Thus in purely bloodless financial terms there was virtually no reason for Ireland to bail out Depfa. Depfa was not systemically important to Ireland or the rest of its banking sector. Depfa was, however, vital to the continued health of the German banking sector. Add to this that the size of any bail out of Depfa was quite beyond what Ireland as a nation could have done. Ireland’s total IMF bailout stands at €85 billion. All on its own the HRE/Depfa bail out has already cost Merkel well over €100billion. Depfa, like one or two other banks in Ireland, was simply too big for its host. It was a financial cuckoo in the nest.
The German’s, however, would have bailed out Depfa even if it had not been bought by HRE because Depfa’s failure would have crippled something essential to the entire German banking sector – the Pfandbrief business. The Pfandbrief is a German ‘covered bond’. A covered bond is simply a super safe kind of bond. It is considered as safe as Sovereign bonds but gives a higher return. Germany invented the Pfandbrief and its banks relied on it.
The Pfandbrief/covered bond is considered super safe because, unlike other bonds, the Pfandbrief is backed by a ring-fenced set of assets which cover the total value of the Pfandbrief/bond. So even if the bank issuing the Pfandbrief were to go under, the Pfandbriefs themselves would never default. And it has been the bed-rock of the Pfandbrief’s reputation that in 250 years no Pfandbrief has ever defaulted.
At the time of the Depfa bail out there were €806 Billion in Pfandbrief outstanding. The third largest chunk of the German bond market and the section that had been growing rapidly and which everyone wanted to be a part of. The German banking sector wanted to grow and compete with the British and the Americans on the international stage. They saw the Pfandbrief as an important part of their strategy. This article from 1999 gives a great feel for how the markets were then, as they stood on the cusp bubble years.
If Depfa had gone down, it would have taken the AAA rated dependability of the Pfandbrief with it. Ireland could let that happen, Germany could not. That is why, I think, Germany would have bailed out Depfa no matter who owned it.
Why did Depfa move to Ireland if it was still a ‘German’ bank?
Depfa was always a German bank, that had simply chosen to locate itself in Ireland for funding and regulatory reasons. Does this mean that Ireland was stealing Germany’s banking sector? No. The best way to think of Ireland is as German’s off-shore tax haven banking centre with one significant feature – it was within the Euro zone. Every country has one. The UK has many. Germany needed one and Ireland was happy to oblige. Thus it suited Germany as much as it did Ireland. It was a partnership.
Of course Ireland made itself everyone’s honey. But I think it is fair to say that of her many customers she had a special relationship with Germany. Think about it. Depfa, HRE and HVB (Now UniCredit), Deutsche Bank, LBBW, DZ bank, Commerzbank, Bankgesellschaft Berlin, Landesbank Sachsen, WestLB all gravitated to Dublin.
The fact that this arrangement/partnership has fallen apart in acrimony doesn’t alter the fact that when the money was flowing the Germany banks, German bankers and all their politicians were every happy with what was going on in their Irish subsidiary. Ireland does not owe Germany an apology.
In fact I think Ireland should be asking Germany some hard questions over the sometimes abusive relationship German banks have had, and some still have, with Ireland. See here for how WestLB after it collapsed created an SPV called Phoenix, as a means for parking/dumping €23 billion of toxic ‘assets’ in Ireland. This, it seems to me, is the Toxic Debt Wasteland I wrote about, becoming real.
How did the Irish Funding work?
Depfa had always raised its cash through its own Pfandbrief bank. It’s source of funding were the Landesbanks who in turn got the cash from the bottom of Germany’s banking system the Kasse, deposit banks. They had all the cash.
But there were limiting factors. German money was the spur to Depfa’s early growth but the bank, according to a former board member I have spoken to, wanted more. They wanted better access to international funding and international customers. Neither, as more than one German banker has told me, was readily available in Germany.
Ireland made itself a meeting place for those with money in need of investing and those looking for loans. For Depfa in particular it was an attractive place. Depfa had decided to target Russian and East European public investments (investing in publicly funded works) and Ireland had made itself attractive to Russian and Eastern money. Money in various shades of shadiness flowed to Ireland. The timeline of German banks and for that matter all European banks (thinking of UniCredit here) going to Ireland runs parallel to East European and later Russian money beginning to flood out of the former soviet states looking for a new home in the West. Ireland met that need. Ireland become THE favourite investment destination for Russian money.
Money was placed in the East. There were and are plenty of subsidiaries there who could pass it along to be funneled westward through Austria (Bank Austria) or Cyprus onward to Ireland where it could find its way to the heart of European banking in Ireland.
Depfa set up a brand new bank Depfa ACS bank, specifically to tap into all this new money. It even got the Irish parliament, in agreement with the European authorities and German banking sector, to write a new law making it possible. Ireland created its own version of the Pfandbrief – the Asset Backed Security. This allowed lots of new money to join with the steady flow of Germany money from the Landesbanks to unite in Ireland to the benefit of Ireland AND Germany.
Of course Europe has access to all sorts of Off Shore Banking so what made Ireland special? Ireland was physically close, was already a corporate centre, was English speaking (good for the Americans), was low tax, used English Law (good for London) and had the same ‘we can do if for you’ attitude of Luxembourg. What gave Ireland the edge over Luxembourg was it offered faster turn arounds on setting up deals and far more lax regulation. Ireland was perfect.
Ireland and Luxembourg are banking competitors. But Luxembourg is not English speaking, is slower and worst of all has a regulator who occasionally regulates. The Luxembourg regulator has all his own teeth. Ireland’s had his removed along with his balls a long time ago.
As long ago as 2005, Charlie McCreevy, Ireland’s former Minister of Finance, (another Fianna Fáil man who was at the Ministry of Finance before Brian Cowen took over that job and showed everyone how it should really be done!) who then became European Commissioner for Internal Market and Services (nothing like failing at one job in order to get a better job…) addressed an esteemed EU/UN gathering in New York in 2005 in which he famously stated
“As Finance Minister in Ireland I saw what great entrepreneurial energies that a “light touch” regulatory system can unleash. 25 years ago we were the sick man of Europe. Today we are among the richest countries in Europe. Ireland is indeed testimony to the fact that you don’t need to be rich in natural resources to generate real wealth.”
That was shortly before someone shouted ICEBERG!
For those of you whose German is better than mine you will enjoy this German television (ZDF) expose of German Banking in Ireland and Depfa/HRE in particular*. Apart for revealing interviews with senior people in the German banking world, it also contains a brief interview with David McWilliams who famously referred to the fact that the German bankers behaved in Ireland “like men in a brothel” – with the blind eye of the Irish Financial Regulator seeing no evil. WhistleblowerIRL’s roller coaster experience as UniCredit Ireland’s risk manager illustrates the extent of the Irish regulator’s incompetence and/or criminality, and refusal to actually enforce regulations.
You can find more on Ireland’s regulatory cess pit and WhistleblowerIRL’s story in Why Bank Regulation is a Joke, and Who Bankrupted Ireland. For more the details of WhistleblowerIRL’s very much ongoing story see his blog here.
Of course if you want no regulation why not just go to the Caribbean? The answer comes back to the German banks again.
Much of the money flowing into Europe looking to be invested would end up in Special Purpose Entities/Vehicles (SPE, SPV) or Structured Investment Vehicles (SIVs). These are the legal containers which house and run the securities in a Collateralized Debt Obligation. You securitize debts, you put them in a CDO you house the CDO in an SPE/V or SIV and you need somewhere to set up and domicile the SPE/SIV. What Germany wanted was to have the dubious advantages of off shore combined with the above board respectability of Europe. German investors, the Landesbanks, wanted their money inside the OECD cordon of respectability while getting all the perks of off-shore. Ireland provided both.
A former, very senior banker from Depfa told me the Landesbanks could not buy Depfa’s debt/Asset Backed Securities fast enough. Any issue Depfa made would be pre-sold to and wolfed down by the landesbanks before the ink was dry. This was a partnership.
Now before I wrap this first part up, I would just like to note that,
Another banker, based in Germany, has recently pointed out to me that in all of the discussion about the Greek-Ireland-Spain/Portugal bailouts, the debate over the tax-payers’ money that was, and still is, being poured into the now-nationalised HRE/Depfa has mysteriously been silenced. I wonder why? The banker referred me to this documentary which raises some interesting questions about why and how HRE was bailed-out. It makes the importatnt link to Akerman at Deutsche Bank and how he appears to have told, not advised, but told, Merkel what to do. Merkel might be more of a tin wind-up model of an Iron lady rather than the real thing.
As I have very basic German-language skills, I would welcome any comments readers might have about these documentaries. This would help me to learn more about the HRE/Depfa saga.
On that note I am going to break the story here to stop this becoming too large. I will continue in the next part with the question:
So what went wrong? And why did HRE buy Depfa when it was already going wrong?
In which we will meet once again our old adversaries AIG and Goldman Sachs.
* I think no longer available
Part Two Tomorrow