HRE: defusing the German financial time bomb

The first bank nationalization in German history is about to take place. At issue is Hypo Real Estate (HRE), a troubled Munich-based company that lends to commercial property developers and to build offices, hotels, roads, airports, you name it.

This issue has been building for nearly 7 months. Back in late September, just after Lehman went under, the Germany government was forced to bail HRE out as it ran into funding problems at its Irish subsidiary, Depfa. Since then, the situation at HRE has got considerably worse. Cognizant that it had a Lehman situation on its hands, the German government went so far as to change the laws to allow it to nationalize HRE. This is about to happen.

The Financial Times writes:

The government has given HRE shareholders until May 4 to accept the offer. As of Thursday more than 7.5 per cent of HRE shares had been tendered, giving the government control of 16.2 per cent of the company. It already held a stake of more than 8.6 per cent after a small capital increase last month.

At the end of the offer period the government hopes it will control enough HRE votes to force through a much larger capital increase at a shareholder meeting. It could eventually use “squeeze-out” rules to force out JC Flowers and other remaining minority shareholders.

If this does not work – as it may not, if enough shareholders reject the tender offer – a recently passed law will allow expropriation of HRE shares. It would be the first nationalisation of a German bank since the 1930s.

Expropriation would be compensated but the government has warned this is likely to be at a lower price than that proposed in the tender offer.

The US firm hinted at a legal challenge to try to stave off expropriation, pointing to expert opinions that “indicated considerable reservations” about the expropriation law and another piece of legislation approved last month. “JC Flowers is reviewing, in the interest of its investors, all options,” the firm said.

Some JC Flowers investors, holding less than 1 per cent of HRE shares, will accept the government’s offer.

I have written a number of posts about the situation at HRE:

I have been following this story closely because I used to work for the predecessor bank of HRE. In the mid-1990s, I worked at a consulting company in Munich under the now head of HVB Group in a project to re-engineer HRE predecessor Bayerische Vereinsbank’s credit processes. My boss, an extremely decent man, later moved on to Goldman Sachs and then over to HVB as their CEO.

I mention this because I see HRE’s problems as linked to its predecessor organizations and the culture of risk that developed after the Berlin Wall fell. Obviously, this is just my view given that I in no way have worked for HRE.

Here’s my understanding of the matter. Bayerische Vereinsbank and Bayerische Hypothekenbank both ran into trouble due to ‘Verspekulierungen (bad speculation)’ in the period immediately after German re-unification. Vereinsbank and Hypobank were front and center in the speculative property bubble that developed in the former East Germany after the Wall fell. This was one reason my consulting firm was working at Vereinsbank.

In 1996, Hypobank revealed huge losses in eastern Germany even though the Board of Directors had been aware of the problem since early 1994 (does this sound familiar).  In fact, fraud was a factor at Hypobank.

Vereinsbank had their own problems.  So, subsequently, in 1998, those two organizations came together as Hypo Vereinsbank (later HVB Group) in a merger of necessity despite being bitter crosstown rivals. They are the largest banks in Bavaria with a long crosstown rivalry and history dating back to 1780 at Hypobank and 1869 at Vereinsbank.  The deal was touted as a Munich counterweight to the big three German banks Deutsche Bank, Dresdner Bank and Commerzbank, all based in Frankfurt.

Unfortunately, they were forced to write off 3.5 billion that same year because of Hypo’s eastern German speculation. (Later in 2005, 7 years later, bad bets on the Vereinsbank side were uncovered as well costing the bank 2.5 billion).

Fast forward to 2003 and HVB spins off HRE before HVB itself gets taken over by Unicredito two years later. Now, I haven’t been integrally involved with HVB or HRE since, but again the history of risk taking is there.  And I should mention that HVB and Unicredito are problem children with huge exposure to Eastern Europe.

By 2007, HRE was a force to be reckoned with and they looked to increase in size. They bought Depfa at the top of the market in a deal not unlike the Golden West Financial deal that Wachovia did in 2006.

Now Depfa, which caused HRE’s near collapse in October, is not an Irish company at all. It is in Ireland merely as a tax dodge (another example of how the Irish are massively and unwisely leveraged to the financial services industry). In reality, Depfa is a German institution, the Deutsche Pfandbrief  Bank. (As an aside, back in 2008, Hank Paulson talked a lot about Pfandbriefs as a panacea for the U.S. mortgage market.  I have two posts on that from last summer here and here).

So Depfa was lending long and borrowing short. When Lehman collapsed it ran into liquidity problems, so a consortium of German bank creditors struck a deal to bail out HRE and its subsidiary.  But, this deal collapsed and the German government was forced to step in.

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.

HRE is also systemically important because it has a huge loan book in commercial property in Germany, Ireland and in Europe more generally. It also has a lot of off-balance sheet exposure a la Citigroup. Its failure would cause great distress to the market it operates in.

Moreover, it has counterparties and lenders. So, its demise would adversely impact those institutions. I don’t have a list of those lenders in front of me but the consortium banks which failed to bail it out in October are the biggest ones. I’m sure it’s a list of who’s who in German finance.

What has the press left out in all of this? Dunno. I would say the bailout is similar to what we are seeing with systemically important institutions in every single Western country (Fortis in the Benelux, RBS in the UK, Citigroup in the US).  In short, a property bubble and massive bust has meant that the most imprudent lenders now face ruin. Unfortunately, the web of actors in our financial system is so intricate and the imprudent lenders so large that governments are loathe to allow them to simply collapse. The demise of Lehman Brothers has sent a signal that this raises a very real spectre of Financial Armageddon.

Come May 5th, a large part of this problem will be solved for the Germans.  The only German non-state bank left with massive exposure is Commerzbank, and its day is coming too.

JC Flowers rejects Berlin’s offer for HRE –
HRE: Die erste Enteignung in Deutschland – Handelsblatt
HypoVereinsbank – Wikipedia (German)
HypoVereinsbank – Gourt (German)
Depfa Bank – Wikipedia (German)

  1. Thomas says

    Quote Edward: “In reality, HRE was a ticking time bomb ”

    Isn’t it funny that Chris Flowers considered HRE to be a good investment as recently as June 2008, and valued HRE at more than 5 bn € back then… Kind of makes you wonder what he was thinking back then.

    1. Edward Harrison says

      You know, every country seems to have its problem child: Citi in the U.S., Fortis in the Benelux, Natixis in France and so on. These institutions were the most aggressive and took on the most risk prior to the bursting bubble. It was not a systemic problem in Germany or anywhere else. It was a case of imprudence.

      Why Flowers did not see this is beyond me. But, even TPG put up billions for WaMu only to see it disintegrate weeks later

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