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Depfa demise could have been Ireland's biggest headache

Nineteen months ago, a small group of no more than 30 people gathered in a room in a Dublin hotel to vote on the biggest deal in Irish corporate history.

But, by any standard, the rubber-stamping of the €5bn takeover of IFSC-based specialist lender Depfa Bank by Munich group Hypo Real Estate (HRE) was remarkably low key.

A specialist lender to governments and municipalities, Depfa had barely raised an eyebrow outside Dublin financial circles since it transferred its headquarters from Germany to Ireland in 2002 -- to tap the local educated workforce, "favourable" regulatory environment and, of course, the 12.5pc corporate tax rate.

The shareholder vote was a perfunctory event, where one ageing member of the Depfa board on the podium kept lethargy at bay by leafing through his copy of the Financial Times.

The results of the poll -- passed, in the event by over 98pc of investors, most of whom voted by proxy -- attracted little attention at the time. It managed to get over the line eight weeks after the subprime-induced financial crisis first erupted.

The takeover deal, which transferred ultimate responsibility for Depfa from Dublin to Munich, must surely go down as one of the narrowest escapes since the foundation of the Irish State.


Less than a year later, Hypo was engulfed by the crisis, with its Depfa operations in Dublin at the centre of the chaos as it failed to find short-term funding as the financial crisis spiralled out of control.

Since then, Hypo has had to rely on €102bn in debt guarantees and credit lines from Germany's government and financial institutions. To put it in context, it amounts to almost two-thirds of the size of the Irish economy, which has been struggling enough under measures to shore up the six domestic banks.

This week, Hypo shareholders had to reluctantly agree to the first nationalisation of a German bank since the 1930s, as the government increased its stake from 47.3pc to 90pc by pumping €5.6bn of fresh capital into the stricken lender.

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Even all-powerful US buyout firm JC Flowers, which bought a 25pc stake a year ago, appears powerless to prevent Berlin now taking full control by invoking a so-called "squeeze-out" process to force minority shareholders to sell their shares.

But the extraordinary general meeting in Munich on Tuesday was mainly thronged by close to 2,000 small investors, who were intent on venting their anger. They were not allowed bring fruit or bottles into the meeting, for fear they could be hurled at the board. Burly security guards were on standby to ensure order.


Ulrike Struzek, a housewife from near Stuttgart, told of how she had invested €160,000 in Hypo a year ago on behalf of her disabled teenage daughter. Wiping away tears, she asked: "If we weren't allowed to remain shareholders, then what will be left of the money for my daughter in five or 10 years' time?"

The presence of Ireland at the epicentre of the drama has left a bad taste in the mouths of many in Germany.

It follows the near-collapse two years ago of state bank Sachsen LB after its Dublin-based special purpose vehicles -- which fell between the stools of two regulatory regimes -- was found to be stuffed with speculative investments in US subprime mortgages.

Michael Somers, head of the National Treasury Management Agency, recently recalled taking "quite a lot of flak" from the German delegates at the IMF World Bank meetings last autumn.

Aside from Ireland's rejection of the Lisbon Treaty, he said: "They also complained about the fact that we guaranteed the six Irish institutions and forgot about everybody else, and they were very annoyed about Depfa."

At the time of the takeover, ratings agencies agreed that Depfa, in the business of bankrolling safe, public sector infrastructure projects, would bring some balance to the party. Hypo, after all, was in real estate finance and subject to higher levels of credit risks and market swings.

Matthias Mosler, Depfa's outgoing deputy chief executive, told journalists in Dublin at the time that the transaction was cushioned from the global credit crunch. "The deal went through all the kinds of asset tests you can imagine. Depfa is a public sector bank. We're lucky that our own portfolio is involved in safe assets."

But on the morning of September 29 last -- just 24 hours before the Government here unveiled its blanket guarantee of Irish lenders -- German Finance Minister Peer Steinbrueck announced that Hypo had received a €35m credit line from a consortium of other banks to keep it afloat.

Depfa's problems lay in the fact that it uses the short-term funding markets to bankroll long-term infrastructure projects. More worryingly, the bank relied on the unsecured money markets for about 22pc of its funding. Unsecured lending was worst hit as wholesale funding markets dried up in the weeks following the collapse of US investment bank Lehman Brothers on September 14.

"While Depfa's credit risk was low by virtue of who its borrowers were, its market risk would have been high," said one observer. "Hypo, on the other hand, had high credit risk, but low market risk."

A tentative attempt by Steinbrueck to get Ireland to shoulder some of the burden, along the lines of multi-government bailouts of European financial groups Fortis and Dexia, was rebuffed.


Depfa also sought to join the Irish guarantee scheme, but was turned down on the basis that the Government was looking to safeguard domestic retail banks.

"You hear people talking about banks being too big to fail. Depfa was too big to bail out," said one government source. "Just as AIB is responsible for its Polish unit, the buck for Depfa stops in Munich." The roles of "consolidating" and "host" supervisors are enshrined in the Capital Requirements Directive.

With Germany in the midst of a Superwahljahr (super election year, with polls at local, European and federal level, along with some state votes), the collapse of HRE has become a massive political football.

In April, a German parliamentary committee launched an inquiry into the collapse of one of the country's largest lenders, following a request by opposition parties.

Manfred Eder, a senior official at the Bundesbank, the country's central bank, told the committee last week that Depfa's business model "was like driving a car from Munich to Berlin with just a few gallons of gasoline in the tank".

"You'd expect that there are enough gas stations on the autobahn," he said. "No one would predict that all of them suddenly stopped selling gas."

Mr Eder led a team of 19 auditors who carried out a root-and-branch review of Hypo from in the spring of last year -- including two weeks in Dublin. Their report highlighted 49 breaches of "proper business conduct and the functional capability of risk management", 12 of which were considered "severe".

Their report suggested Hypo address any shortcomings in the second half of 2009. But Mr Eder said that Depfa would have remained risky even if the bank acted immediately on all the recommendations.

"The refinancing structure at Depfa wouldn't have changed," he said. "Eliminating the shortcomings we discovered would have changed nothing in its business model."

It is understood that officials in the Financial Regulator's office in Dublin were concerned in recent years about Depfa's increased reliance on the unsecured wholesale market for funding.

This was highlighted as a risk as it and German financial watchdog BaFin kept in close contact as the merger was going through, but concerns were mitigated somewhat by Depfa's relatively low-risk lending model.

The German and Irish authorities also ran stress tests for the group with what was seen at the time as the highly unlikely event of the wholesale funding markets closing for up to 10 days. "The tests had to be realistic and demonstrable," said one source. "Nobody foresaw a Lehmans situation and the inter-bank market completing drying up."

There were other points of concern, such as Depfa's rapid growth in recent years, particularly with its expansion into America. On the other side of the Atlantic, it focused on advising on the sale and structuring of municipal bonds -- and, for a fee, effectively guaranteeing a liquid market for them.

Depfa's global markets unit, a risky business where the bank traded its own money, is also understood to have cropped up as an issue during Hypo's due diligence on the merger. It quickly moved to discontinue the operation after the deal, as it did "not fit with the strategic focus and risk policy of the new group."

Hypo was quick to point the finger at its new partner's liquidity problems as the root of all its ills. But the parent had problems of its own. Back in January 2008, Hypo unexpectedly revealed it took a €390m writedown on troubled US subprime-linked securities, prompting Standard & Poor's put its ratings on the group to "outlook negative".

S&P subsequently called on Hypo to raise additional capital to shore up its capital defences. "The problem with Hypo is the portfolio of structured credit (an asset class at the heart of the subprime crisis) and the generally difficult market situation," it said in March last year.

Last year, the group's €4.3bn structured credit portfolio was battered by almost €1.7bn of impairments, which, together with a €2.5bn goodwill writedown on the Depfa deal, helped send Hypo plunging to a pre-tax loss of €5.3bn. (Goodwill writedowns do not affect a bank's regulatory capital base.)

After pouring over the BaFin-commissioned Bundesbank report, German news magazine Der Spiegel concluded that the management had been overstretched with the integration of Depfa and that internal structures didn't meet official guidelines.

The report also found that a requirement that high-risk investments be identified early enough "had not been fulfilled" by Hypo and that its daily liquidity report didn't show "all the relevant inflows and outflows".

Then there's the question of who knew what and when. The German finance ministry has said that when it got hold of the final report in July, the addressee was on holiday and it was duly filed away without the relevant senior official or minister getting to see it.

In addition, BaFin's own rules meant it couldn't properly intervene as Hypo, as a holding company, and Ireland-based Depfa were both outside the regulator's remit.

In the face of intense questioning from German journalists in Frankfurt recently, Finance Minister Brian Lenihan said: "There were clearly regulatory failings on the part of both sets of regulators and clearly that points to the need for a joined-up system of regulation at European (level)."

Lenihan is all too aware that Depfa would very much have been Ireland's headache had it not been taken over. It partly explains why the Government has gone against the UK, its traditional ally on regulatory matters, to row in behind Germany in fully supporting the EU Commission's plan to set up two pan-EU bodies to strengthen banking supervision in the financial crisis.

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