Why the WestLB is in Trouble

I am fascinated by the current meltdown in the credit industry, which is currently smashing a hole in WestLB’s bottom line (G) and will hit other German financial institutions before it’s over.

The cause of the crisis is hard for outsiders to understand, but don’t feel stupid.  The crisis itself was caused, as far as I can tell, by the fact that the financial instruments now going bust were hard even for insiders to understand.  Steven Pearlstein of the Washington Post does a good job here of initiating us into the mysteries and explaining why the current crisis is "way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001."  Fasten your seat belts and read on:

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches — those with the lowest credit ratings — were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used — in buying the original mortgages, buying the tranches for the CDOs [collateralized debt obligations] and then in buying the tranches of the CDOs — the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

8 thoughts on “Why the WestLB is in Trouble

  1. Martin, I’m kinda curious: Doesn’t being a greedy sucker just about epitomize the model of the free and independent American-style entrepeneur as opposed to “sucking up to authorities” the way the Germans do?

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  2. One of the major problems in Germany was the ability of regional / provincial banks like IKB or the Landesbanken to buy into these things without possessing proper internal oversight. For decades, these banks have been prevented from merging or getting bigger, although their mandates for investment have been consistently loosened. This means that essentially mid-sized local banks are allowed to invest in more and more diverse sets of complicated financial instruments and fields – without having the wherewithal to properly analyse these assets. As long as the banks were churning out good returns, this was fine. Now, however, the costs of prohibiting them from achieving critical mass in diversification and internal oversight have come due. The government treats the banks as though they still make loans covered by property and commercial assets, prevents them from banding together and being able to afford analytical and research departments, tells them ‘and then wonders when a number of these banks collapse. Little wonder, when the guy who used to oversee family business transition financing is now speculating on US s/p mortgages.

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  3. @Junger Gott,I wouldn’t know that it does, but I’m sure that in the parallel universe that is the German Sphere of Imagination and All Things Detached from Reality there is plenty of room for such delusions.

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  4. @Koch,your attempt at a defense by portraying Landesbanken as wide-eyed little children and blaming it all on the bad, bad regulators is also really cute. Like, WestLB with 285 billion Euros in assets doesn’t have someone around to ask what the risk is in an investment.

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  5. @ Martin

    Unfortunately, M., that’s pretty much exactly what I’m saying. Take a look at the breakdown of how the WestLB’s assets are held. What percentage of that are co-sponsored by numerous other provincial banks? That often means that Bank B is trusting Bank A’s judgement (just as troubled). In particular, look at the co-sponsored loans held with the KfW. To be fair, the Danes and the Swedes operate the same way. Only the Dutch and the French have cme out clean on this one.

    Do you trust a German regional bank with a management board that was trained in property management and SME loans, and made it to the board based on that portfolio up until 2000?

    I can’t post these numbers, but trust me – the numbers and brains behind the people selling these assets – and the German banks buying them – call to mind county fairs where people breeze into Springfield with the loaded roulette wheel. The point I’m making is that you don’t give the smart bank trainee from Buxtehude or Nürtingen your cash and then send him off to Wall Street to invest in penny stocks. For that, you take your best people from Frankfurt and Düsseldorf, allow them to collaborate and hire a serious team of analysts, and then send them off.

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  6. Oh, and Matin – I’m in favor of deregulation. Let these banks grow and sort themselves out organically by merging. Let them compete viably with the Deutsche Bank and the Commerz and anyone else out there. Otherwise, they’re just wide eyed children with too much cash in hand to be safe in the global markets.

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  7. I recently came across your blog and have been reading along. I thought I would leave my first comment. I don’t know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

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