The prelude to the Irish crisis began at 10am on August 24th, 2007, at a closed-door meeting of German bankers in the Bundesbank in Frankfurt.
Jochen Sanio, then head of banking regulator BaFin, launched a scathing attack on bank executives present from SachsenLB bank, based in the eastern German state of Saxony. The bank faced ruin, Sanio said, because of a “shatteringly large discrepancy” between its equity and the value of assets managed by its Dublin subsidiary, SachsenLB Europe.
The Dublin operation controlled off-balance sheet operations, called special-purpose vehicles, with names such as Ormond Quay and Georges Quay and with a portfolio worth about €40 billion. Their business was interest rate arbitrage: refinancing long-term asset-backed securities such as credit card debt or mortgages with short-term commercial papers and pocketing the interest-rate difference between the two.
But, by August 2007, the subprime toxin had spread from the United States to Europe. Nervous banks began hoarding cash, drying out the short-term commercial paper market.
“[That] market is dead and for you it is particularly dead,” said Sanio to the SachsenLB representatives. “[You] are still clinging to the hope that the markets will spring back to life and there will be a happy end . . . [but] if we don’t act today, I don’t see how you will survive Monday.”
When the meeting finally broke up on August 26th at 2.15am, German bankers threw SachsenLB a €17 billion lifeline. It survived – just – and was later sold off but Saxon taxpayers were stuck with the rescue bill of €429 million and counting.
Next year, five former SachsenLB directors face trial, accused of breach of trust and exposing the bank to irresponsible levels of risk. The trial will recast the narrative established with SachsenLB, and developed further by the near-collapse of Depfa, that pre-crisis Dublin was Europe’s financial “wild west”.
This narrative, well worn in Germany, presents Ireland’s subsequent banking and economic meltdown as the self-inflicted, logical consequence of attracting too many banks to Dublin with low tax and light-touch regulation.
Risky activities
But a study commissioned by the state prosecution in Leipzig, written by a leading international law firm and seen by The Irish Times, paints another picture. Over 556 pages, it vilifies the institutional incompetence by German managers who encouraged profitable, risky activities in Ireland that would eventually bring down a politicised German bank that had no commercial reason to exist.
“Not only did the [SachsenLB board in Leipzig] not find fault with the [Dublin] capital market business,” the audit for the prosecution concludes, “on the contrary it encouraged and placed demands on it.”
The Dublin conduits – green-lighted by and ostensibly overseen by German executives in Leipzig – were an “unusually creative solution, without capital limits, to use the minimum of a capital burden to maximise off-balance revenue using interest arbitrage business”.
Leipzig mangers let the Dublin subsidiary operate under a “very unusual contract structure” which laid down “far-reaching obligations to meet liabilities” of the subsidiary “yet took no appropriate measures to steer and limit these”.
A guarantor’s letter (Patronatserklärung) extended “unqualified obligation” from Leipzig to cover Dublin’s liquidity needs – and its liabilities.
“Such a guarantee was essential for a credit rating,” the report notes. “In addition, it would allow SLBE [SachsenLB Europe] obtain favourable refinancing conditions.”
These favourable refinancing conditions arose thanks to SachsenLB’s own public guarantee obligation (Gewährträgerhaftung). This allowed all landesbanken to borrow at similarly low rates to their sovereign owners, undercutting private rivals.
The European Commission ruled this an illegal market distortion in 2001, but allowed the landesbanken a five-year transition phase to a level financial playing field.
“It was during this period that landesbanks rushed to borrow cheap money one last time. They didn’t know what to do with it all,” said one senior Saxon official familiar with the SachsenLB case. The hunt for new sources of business began, he said, and “word got around that you could do great business in Dublin, particularly with American property investments”.
SachsenLB began a relationship of mutual, if shifting, dependence with its subsidiary. Initially the Dublin operation needed Leipzig for its top credit rating. As time passed, Leipzig needed Dublin as a cash-cow.
In 2002, SachsenLB’s board backed a new strategic plan to expand the Dublin operations. A former SachsenLB Europe executive told prosecutors there was a recognition “at all levels at the bank . . . of [Dublin] as a good possibility to generate revenue”.
SachsenLB Europe’s off-balance sheet structure, the audit says, helped the German bank “avoid accounting and consolidation obligations which would have triggered equity capital obligations and large credit limits that possibly would have worsened SachsenLB’s own credit rating”.
By the end of 2006, SachsenLB’s final year as a standalone entity, the Dublin off-balance sheet activities had a portfolio value of €41 billion – 60 per cent of the bank’s total value that year.
In the four years to the end of 2006, the Dublin operation contributed about 82 per cent of total group profits.
Germany’s smallest landesbank was now, the audit asserts, a “capital markets-dominated bank for whom the domestic business [in Germany] was nothing more than a revenue-reducing millstone around its neck”.
Prosecution’s case
The prosecution’s case is that no one in Leipzig was interested in risk control because the Dublin goose continued to lay golden eggs to keep the German farm afloat.
Capital markets director Stefan Leusder told prosecutors he thought Leipzig was responsible for providing emergency liquidity to Dublin, not full liability.
“It is not possible to decide here,” the audit notes, “whether cluelessness or aimlessness was responsible for Mr Leusder’s behaviour and manner.”
By spring of 2007, while the rest of the finance world was “at first creeping, then galloping” out of the market, the Leipzig board backed further Irish investments like a “fair-weather pilot racing towards a storm front at full speed”.
Though some 82 per cent of its Irish investments were in mortgages, the Saxon bank said in March 2007 that it saw “no sign of increased risk exposure”.
Then Bear Stearns collapsed and Germany’s IKB was rescued, liquidity markets dried up and SachsenLB was left holding billions in loans it could not refinance. The rescue meeting was called.
So what of Ireland’s role in all this?
“It’s easy to reduce the story to ‘Ireland as casino’ because of supposed weak banking regulation, but neither the opportunities in the IFSC nor what the Irish regulator did or didn’t do were the cause for the SachsenLB case,” said Sven Petersen, managing director of SachsenLB Europe in Dublin in 2006 and 2007.
He insists the Dublin operation bought only top-rated assets which, right to the end, enjoyed top risk ratings.
Even leaving aside the benefit of hindsight over these faulty ratings, however, German prosecutors say risk warnings were disregarded. In 2005, auditor KPMG noted that SachsenLB Europe’s “shortcomings meant the internal control and risk early-warning system were inadequate”.
Blame game
Does responsibility for what followed lie with the financial regulator in Ireland, the executives in the bank’s Dublin subsidiary or its Leipzig board of directors? Opinion remains divided.
“It was the German landesbanks that consciously sought out the weak Irish regulation to exploit the business possibilities this offered,” said one Saxon state official, who asked not to be named. “We’re not going to blame Ireland for that.”
But those involved closely in the SachsenLB criminal case in Germany say their lack of focus on Ireland is because it lies beyond its legal remit. “We are not at all convinced that the Irish regulator carried out its role professionally or conscientiously,” said one high-level source. “We get the impression that, in Ireland, looking into this isn’t a high priority.”
Pat Farrell, chief executive of the Irish Banking Federation, insists the Irish regulatory system functioned at all times.
“There is no issue that emerged in IFSC specifically that can be used to stack up the, as far as I know unattributed, ‘wild west’ assertion,” he said.
The Central Bank says no settlement was reached with SachsenLB Europe but declines to comment on whether any investigation took place or is planned into the bank’s special-purpose vehicles under its regulatory mandate.
The question remains open as to whether there was anything of concern in the bank’s Irish-regulated operations or, unlike in Germany, nothing been found because no one has gone looking.
Profit and loss: SachsenLB’s Dublin story
Established in 1992, SachsenLB, the state-owned “Landesbank” of the eastern state of Saxony, was one-third owned directly by the state and two-thirds by eight public savings banks.
SachsenLB Europe was set up in Dublin in 1999. The benefits of setting up shop in Ireland were explained at a June 1999 board meeting thus:
“Proximity to the Anglo-Saxon finance world, low overheads in comparison to London, availability of well-educated and internationally oriented employees, modern infrastructure, no commercial taxes and a corporate tax burden of just 12.5 per cent”.
In 15 years of independence, SachsenLB generated about €250 million in tax and profits for its state owners.
Sold in 2007 to another landesbank, LBBW, the Saxon state has since paid €400 million to cover losses arising from the bank’s activities.
It still manages a fund to cover total losses which, under a worst-case scenario, will reach €2.75 billion.
