Evidence of global
contagion surfaced in August as a string of German
banks ran into trouble with their leveraged bets
on collateralized debt obligation (CDO)
instruments and the even more toxic "'synthetic"
CDO derivatives: securities that contain
top-rated tranches of US
unbundled subprime mortgage pools. A series of
emergency actions by the European Central Bank
(ECB) injecting a further US$85 billion in
liquidity through various mechanisms in the third
week of August highlighted the seriousness of the
crisis.
Germany A
Dusseldorf-based bank that focuses on small and
medium-sized companies, IKB Deutsche Industriebank
AG, invested in structured credit portfolios and
was the first German bank to crumble early in
August, requiring an 8.1 billion euro (US$12
billion) state rescue just days after it denied
any significant exposure to subprime debt. Fallout
from the subprime mortgage rout was roiling
markets around the world as rising risk premiums
caused companies to face higher interest on their
borrowings.
Contracts on 10 million euros
of debt included in the iTraxx Crossover Series 7
Index of 50 European companies increased as much
as 60,000 euros to 504,000 euros. Investor
confidence in high-risk, high-yield loans fell to
the lowest in nine months as the iTraxx LevX Index
of credit-default swaps on loans to 35 European
companies dropped 0.25 to 94.50. Credit-default
swap contracts based on 10 million euros of IKB
debt, which traded at 15,000 euros in early July,
were at 120,000 euros on July 27.
The
state-owned bank Sachsen LB in former East
Germany, founded in 1992 after the fall of the
Berlin Wall, reportedly accumulated $80 billion of
exposure to risky assets through a set of Irish
funds kept off balance sheet. Sachsen LB was
rescued in August in a state-orchestrated bail-out
by a consortium of banks agreeing to provide a
17.3 billion euro credit lifeline, but only on the
understanding that it agreed to be sold to a
stronger player.
The regional government
of Saxony then agreed to sell the state-owned bank
- the biggest victim up to that time in the
worldwide credit rout - for a token 300 million
euro to the Landesbank Baden-Wurttemberg in
Stuttgart (LBBW), ending a three-week saga that
revealed the extent of German involvement in
treacherous US subprime debt. LBBW has the right
to cancel the sale if further significant
exposures to subprime risk are found at Sachsen LB
or in any of its off-balance sheet units.
Suddeutsche Zeitung reported that Irish
"conduits"(off-balance sheet vehicles) were used
by Sachsen LB to fund 65 billion euros for
investing in CDOs and other high-risk structured
investment vehicles (SIVs), which involve using
short-term credit to buy longer-term assets,
creating mismatches in maturities that were highly
vulnerable in a volatile market.
Rhinebridge Plc, a fund managed by
Dusseldorf-based IKB Deutsche Industriebank, sold
$176 million of assets after it couldn't find
buyers for its short-term debt.
Ireland-Britain News of the
unwinding of Dublin-based Cheyne Finance flashed
around the globe in late August. Cheyne Finance,
an SIV managed by British hedge fund Cheyne
Capital Management Ltd, was forced to begin
selling its $6.6 billion portfolio after a
downgrade by Standard & Poor's, the ratings
agency.
Cheyne Finance went into
receivership (known as bankruptcy in the US) in
September after exhausting bank liquidity credit
lines to help repay maturing debt. The receivers
had to arrange with the Royal Bank of Scotland
(RBS) to restructure the finances of Cheyne
Finance after the SIV stopped making payments on
its debt in early October. S&P said the Cheyne
Finance portfolio was made up of 56% of
residential mortgage-backed securities (RMBS), 6%
of collateralized debt obligations of asset-backed
securities (CDOs of ABS, consumer credit) and 38%
of other debt, such as corporate CDOs and
commercial mortgage-backed securities. Some 52% of
the portfolio was rated AAA before S&P cut the
ratings on Cheyne Finance eventually to D, or
default, after it stopped payments.
Cheyne
Capital Management, whose Queen's Walk Investment
Ltd mortgage bond fund in June reported a loss of
67.7 million euros in the year ended March 31, was
forced to sell assets backing a $6 billion
commercial paper program amid the global credit
market rout. The Cheyne Finance fund had been
selling assets and had enough cash to repay
commercial paper due through November. But then
S&P cut Cheyne Finance ratings, citing the
deteriorating market value of its assets. S&P
initially lowered the credit rating on the
commercial paper issued by Cheyne Finance by two
levels to A-2 from the highest level of A-1+. The
rating on senior debt was cut six levels to A-
from AAA.
The average yield on the
highest-rated asset-backed commercial paper with
one-day maturity has risen 0.71 percentage point
to 6.04% as investors have fled funding linked to
subprime mortgages. Cheyne Finance had drawn on
all three of its emergency funding facilities and
would continue to sell assets to meet its
liabilities. Cheyne is working on recapitalizing
or restructuring the company and extending its
debt maturities.
As contagion from the
subprime slump drove up the cost of borrowing,
HBOS Plc, the largest mortgage lender in the UK,
in late August repaid about $35 billion of
commercial paper owed by its Grampian Funding LLC
unit.
RBS agreed to set up a new
investment vehicle that would buy Cheyne's failed
SIVs $7 billion portfolio, financed by new and
existing investors. The new company set up by RBS
would attempt to liquidate the portfolio in an
orderly manner over time, with the existing senior
creditors buying the senior part and new investors
for the junior part. The bulk of the risk is taken
by the junior investors with compensatory returns.
Mezzanine investors could get back some of
their investment in the event of a sale above a
certain level. Similar to the Goldman Sachs rescue
of its Global Equity Opportunities fund, it is a
strategy to maximize the post-restructured value
of the senior tranches at the expense of the
junior tranches by creating a new level of
investors with increased risk appetite. It is
essentially a vulture solution.
Barclays
Plc was left with an exposure of hundreds of
million of dollars to failed debt vehicles created
by its investment banking arm amid growing
scrutiny over its links to Sachsen LB, the failed
German public sector bank. The UK bank provided
back-up financing to one of four structured
investment vehicles set up by its asset management
unit, Barclays Capital, leaving it with a credit
exposure. Ironically, news of Barclays' exposure
eased concerns among investors about potential
losses arising from the vehicles, known as
SIV-lites, the Financial Times reported.
However, the bank's relationship with
Sachsen faced scrutiny after it emerged that
Barclays had set up a SIV-lite on the German
bank's behalf less than three months before it
collapsed, the
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