The European Commission's decision to eradicate state-supported financial guarantees will force the German Landesbanks to rethink their strategy going forward, which will depend largely on what restructuring techniques are implemented in the future.

According to a Commerzbank report, future ratings of non-guaranteed obligations under the new agreement will depend on future business and financial profiles, legal and ownership structures, and other factors. This will be the key assessment of the banks' ratings in the absence of the explicit support of Anstalslast and Gewahrtagerhaftung. The EC regulations now dictate that these state support instruments will be replaced by normal owner relationship, but issues will be grandfathered and a transitional period will exist until July 2005.

An increase in capital will be an essential prerequisite for the development and expansion of profitable businesses, said the report. In their present state, the financial profiles of these entities are defined by low profitability and weak capitalization, but the banks have not been under pressure to maximize returns in the past. The Landesbanks' business expansion was heavily dependent on their ability to raise low cash funding based on the state guarantee. With the removal of these guarantees, however, the cost of funding will rise and will further pressure the banks' earning performances and capital bases.

This need to manage regulatory capital would lead to higher risks, and essentially means that banks will have to address the need for more risk capital. "The trend of low profitability has been exacerbated recently by the economic slowdown in Germany, which put further pressure on the sector's already weak financial fundamentals, as declining revenues and higher credit costs combined to put pressure on profitability indicators," said Commerzbank.

Pfandbriefe financing is the predominant financing tool for the Landesbanks' public sector assets. The implications of the new regulation on future public sector Pfandbriefe instruments issued by Landesbanks may include ratings deterioration should the underlying collateral change. Because rating agencies such as Moody's link the pfandbriefe rating to the issuer's creditworthiness, the market could experience lower standalone ratings for unguaranteed obligations in the future, which could lead to lower pfandbriefe ratings, concluded the Commerzbank report.

At its core the pfandbriefe instrument functions much like a securitization, except that it is on-balance-sheet financing. While it's likely that Landesbanks will continue to employ pfandbriefe financing going forward, the need for regulatory capital and risk management might make off-balance-sheet securitization more likely. "In essence, if people choose to move more into securitization it would signal a big restructuring effort," said one market participant.

German mortgage and universal banks have already been using securitization as a complement to their pfandbriefe in order to achieve risk transfer and to transform the traditionally higher-risk elements of the mortgage loans into qualifying public sector assets. On the other hand, Landesbanks have typically used securitization in the public sector for residential and commercial mortgage portfolios and for commercial loan portfolios, but it's possible that they may choose this structure as a method to address risk capital as well.

"In a pfandbriefe issue there is a need for senior funding," said one market analyst. "There is a minimum loan-to-value and the remainder has to be funded elsewhere - which is sensitive to regulatory capital growth." Securitization would enable the Landesbank to transfer the credit risk associated with risky assets, and at the same time permit the bank to hold a lower level of regulatory capital relative to their overall level of risky assets.

"By leveraging their balance sheet, the Landesbanks have the ability to lock into the origination and servicing revenues associated with the relevant loans and to minimize the credit costs," reported Commerzbank. "This enables returns on capital to be optimized to a greater extent, as capital can potentially be employed to support the origination of more significant pools of assets."

There are six Landesbanks that have used state support gurantees: Bayern LB, Landesbank Berlin, Hamburgische Landesbank, Norddeutsche Landesbank, Landesbank Schleswig-Holstein and Westdeutsche Landesbank. All are currently reviewing restructuring plans in preparation for the July 2005 deadline.

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