Karl Nolle, MdL

Irish link proved fatal to Sachsen

 
Behind the forced sale of German state-owned bank SachsenLB, announced yesterday, is an Irish affiliate of the bank that aggressively invested in an array of risky securities, including some backed by U.S. subprime loans, whose downturn hobbled the bank.

In the past several weeks, a substantial part of those investments, which totaled about €27 billion (.9 billion), quickly soured, forcing Sachsen into a cash crisis and the decision yesterday to sell itself to another state-owned bank, Landesbank Baden-Württemberg, for a provisional €300 million in a stock swap.

Sachsen's woes have put the spotlight on bank affiliates called conduits -- off-balance-sheet structures that rarely fall under public scrutiny. Sachsen's Irish arm oversaw one conduit holding €3.2 billion of securities exposed to U.S. subprime loans, or mortgages to borrowers with spotty credit records. Some bank conduits in recent weeks became cash-needy as investors balked at buying conduit IOUs.

Sachsen is the second German bank hit by U.S. subprime exposure. IKB Deutsche Industriebank AG required a financial safety net from German regulators and banks in late July. Both banks operated affiliates that sold short-term IOUs to buy mortgage securities.

The reach and risk of Sachsen's operations appears to have exceeded that of IKB's one affiliate, Rhineland Funding. Sachsen's Irish office, SachsenLB Europe PLC, oversaw investments in two hedge funds, one of which recently ran into financial trouble, an investment vehicle called an "SIV-lite," and two conduits called Ormond Quay Funding PLC and Georges Quay Funding Ltd., according to documents filed with the German state government of Saxony and people familiar with the situation. An SIV-lite relies on short-term commercial paper to buy portfolios of securities, typically residential mortgage-backed issues, with longer-term returns.

Sachsen had no comment.

The conduits issue commercial paper, a type of debt with a term of less than a year, and buy longer-term bonds that pay higher interest rates. The bonds include securities such as residential mortgage-backed securities or collateralized debt obligations and are underpinned by mortgages or credit cards.

In the past several weeks, the conduit model broke down. Bank conduits as well as SIV-lites operated by banks and hedge funds ran into difficulties because investors quit buying the paper, concerned the loans had been used to buy securities backed by U.S. subprime loans. That forced conduit sponsors such as Sachsen to quickly come up with funds to pay off the loans.

"SachsenLB Europe is a black box," said Karl Nolle, member of a German parliamentary committee that has been monitoring Sachsen amid concern about its investments. "Its auditors were unable to monitor its deals."

Talks to sell Sachsen began this month after its Ormond Quay affiliate faced difficulties selling commercial paper. A group of local banks agreed to provide a €17 billion credit line to cover Ormond Quay's obligations. Talks sped up Friday.

The buyer, known as LBBW, can pull the plug on the deal by the end of 2008 if more Sachsen risk is uncovered. LBBW also agreed to an emergency cash infusion of €250 million for Sachsen.

Ormond Quay isn't included in the sale. It lists assets of €17 billion, including €3.2 billion of exposure to U.S. subprime. In Germany, the Saxony government and local banks are in talks over who absorbs liabilities of the conduit. Despite Sachsen's small size -- shareholder equity is €1.4 billion -- Ormond Quay in May was the 10th-largest asset-backed commercial-paper conduit in Europe.

London bank Barclays PLC, according to the documents and interviews, helped arrange or finance several SachsenLB Europe structures, including an investment vehicle called Sachsen Funding I Ltd., an SIV-lite vehicle that invested heavily in subprime-backed securities.

In recent years, SachsenLB Europe became a profit generator for its parent bank, which was incurring losses. For 2005, SachsenLB Europe had a profit of €41 million, enough to help Sachsen report a profit of €17 million.

Sachsen's investments extended to hedge funds operated by London firm Synapse Investment Management, which specialized in credit investments and was started by former Barclays Capital executives.

The Barclays Capital executive responsible for helping develop SIV-lite structures, Edward Cahill, resigned this month from the capital-markets unit of Barclays PLC. A Barclays spokeswoman declined to comment.

In the past week, Sachsen's investment in Synapse began to struggle. Barclays asked the hedge-fund firm and at least one of its funds to meet a margin call. When Synapse said it couldn't meet that margin-call request, Barclays entered discussions with Sachsen to assess whether the German bank would provide money to Synapse to preserve its investment. When Sachsen said it couldn't provide support, Barclays seized collateral.

Write to David Crawford at david.crawford@wsj.com and Carrick Mollenkamp at carrick.mollenkamp@wsj.com