Standard & Poor's revisited the Landesbank credit issue in late November, stating that it will be publishing its stand-alone ratings for the Landesbanks one year ahead of the 2005 deadline. At that point, the German banks will officially lose their public- sector support mechanisms - state guarantees that had granted them optimal credit ratings (see ASR 7/29/2002).

The European Commission decision to remove the Anstalslast and Gewahrtagerhaftung guarantees in 2001 has forced the Landesbanks to rethink their strategies. The EC regulations now dictate that these state support instruments will be replaced by normal owner relationships, but past issues will be grandfathered and a transitional period will exist until July 2005.

According to analysts at ABN AMRO, funding for these banks currently depends on the capital markets. As a result of the public-support guarantee, the banks have been able to tap the wholesale markets cheaply.

"Performance at most Landesbanks has been fairly anemic in recent years," reported analysts. "Rigid, oversized and uncompromising cost structures, low margin lending, high provisioning and lack of critical mass in the trading arena are all contributing to struggling profitability."

As a result, on a stand-alone basis, ratings could plummet as low as double-B, said market sources; however it's likely the rating agencies will acknowledge an implicit state ownership structure. Both S&P and Fitch Ratings have noted that this support will be factored into the banks' stand-alone rating. S&P stated that up to three notches of support could be applied. It's speculated that eight out of the 11 Landesbanks might only reach the triple-B level, in current form.

Whether spread widening takes effect once the new ratings are released will depend on the banks' business models and capital structures. An increase in capital is an essential prerequisite for the development and expansion of profitable businesses. Initial reactions from the rating agencies show that improvements have been slow, so far.

According to S&P, balance sheet restructuring efforts and adapting future cost structures to counter future loss in earnings, along with the improvement of risk management systems, are still needed.

"The strengthening of ties with the Landesbanks natural business partners, the savings banks (Sparkassen), has proven difficult until now," explained analysts at Commerzbank. "S&P considers that Landesbanks and savings banks have strong economic incentives to jointly tackle these challenges, which could lead to closer, mutually beneficial cooperation and integration."

It's expected that S&P will rate HSH Nordbank at A', based on this natural relationship between the Landesbank and savings bank. According to market reports, HSH Nordbank plans to increase its commission-based income through capital market services for local Sparkassens and will address its risk management system through an active securitization program going forward.

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