What exactly is wrong with Hypo Real Estate?

According to reports in today's Sueddeutsche and Der Spiegel, HRE will need a capital injection of 10 bn €.

Unfortunately, press reports on German banks don't offer much in-depth analysis. Der Spiegel still traces HRE's problems to liquidity issues caused by short-term financing of long-term liabilities. Yes, that was the official explanation given by the old management when the crisis first started. But is it convincing? Hardly: With more than 100 bn € of guarantees provided to HRE by now, and much lower money-market rates for sovereign debt, any short-term refinancing problem would have been easy to solve. The fact that it wasn't solved strongly indicates that HRE is deeply involved in the sub-prime mess.

Full-year results are not due until late April, so the best an outsider like me can do is dig up the 3rd quarter interim report.

Let' see:

- Q3 loss was 3.1 bn €

- 1-9/08 loss was 2.9 bn € (i.e. Q1/Q2 profit was 0.2 bn €)

- However, equity is down 4.2 bn € since 12/08, i.e. additional valuation losses of 1.3 bn € weren't taken through the p+l

There's 1.9 bn € equity left as of 9/08. Not exactly a reassuringly strong capital-base.

Now for the interesting bit: Why exactly did HRE lose those 4.2 bn €?

- 2.5 bn € is due to write-down of goodwill. They bought DEPFA in 10/07, and they wrote off the entire goodwill in Q3 2008. M&A can be such a wonderful way of destroying value!

- 1.4 bn € were changes in the revaluation reserve. In other words, the market value of some of their assets declined.

- Another 0.6 bn € were due to "valuation result of the CDO portfolio", i.e. yet more market value drops.

- 175 m € were "impairments related to Lehman Brothers".

- A positive effect of 180 m € was related to an "embedded derivative".

- Finally, 40 m € Icelandic impairments are hardly worth mentioning.

All of this adds up to 4.4 bn €. They only lost 4.2 bn €, though. Which means they had an operating profit of 200 m € from the rest of their business.

And they make much of this in their report: "This pre-tax profit underlines that the HRE Group was profitable with its operations despite the financial market crisis".

That's right! They actually have the guts to write that sentence. As in: If we hadn't lost all that money for all sorts of reasons, we would have been profitable.

Now what does all this mean for the Q4 results?

Nothing good. Sure, the 2.5 bn € goodwill write-off is gone. But as various other banks have already shown, Q4 was much worse than Q3 as far as market value adjustments were concerned. HRE took a 2 bn € valuation hit in Q1-3. If the rest of the financial industry is any guide, their Q4 hit is likely to be substantially bigger than this. So it's not about liquidity. It's about their balance-sheet having lots of assets which aren't worth as much as they're supposed to be worth.

Having said that, it is of course misleading to look at the >100bn€ of government guarantees and assume that they will be lost. HRE has a balance-sheet of 400 bn €, and much of it is backed by German real estate and German municipalities. It's pretty much inconceivable that they will lose anything close to 100 bn €.

Let's take a closer look at their balance-sheet:

- 144 bn € loans to public sector. Not too much of a problem, hopefully.

- 61 bn € real estate loans. If they applied proper German lending standards, that shouldn't turn into a major problem either. Again, hopefully.

- 46 bn € are "loans to other banks". If there are no more big bank failures, that should be ok (fingers crossed).

- But there are also 105 bn € in "financial investments", and those are rather troubling: A lot of toxic stuff can be hidden in there.

According to a country break-down, 17 % of the credit portfolio is related to the USA. That's 70 bn €.

Apparently, 45 bn € of this is related to "public sector & infrastructure finance", which doesn't sound like subprime (though American municipalities do default at times).

8 bn € are related to US commercial real-estate. That's more risky.

Finally, 17 bn € of US-exposure are related to "capital markets & asset management".

According to the financial statements, less than 5 bn € are CMBS, RMBS and CDOs (i.e. potentially toxic securitised stuff), of which only 1 bn € related to the US.

Hmmm. Vaguely comforting. Doesn't sound like they will lose 100 bn €. The way they put it, they will lose hardly anything at all.

So why is it that they took a valuation loss of 2 bn € in Q3, and why is it that they need 10 bn € of fresh capital...?

And what about this innocuous little sentence in the "Outlook" section: "Provisions for losses on loans and advances will significantly rise in the future"

So what can we conclude? My guess is: When all is said and done, the overall valuation hole will be in the 5 to 20 bn € ballpark.


Oh, by the way, regarding the cost of the various guarantees:

HRE received a bridge facility from the Bundesbank at 250 bp above the normal lending facility rate. The final contract then provided for a 93 bp spread over 3-month Euribor, plus a Besserungsschein for an additional 90 bp if they return to profitability.

Not exactly prohibitively expensive, especially considering how much money market rates have fallen. If their liabilities are indeed fully recoverable, they should make a decent profit out of it. If they fail to make a profit, it once again proves that the real problem was the quality of their asset side all along. We shall see.


And before we conclude, here's a snippet picked up from "general administrative expenses":

Expenses were materially affected by consultancy fees in connection with the acquisition of HRE shares by Chris Flowers.

No details/amounts are provided, but it was material enough to deserve a mention, and "other general admin expenses" were 176 m € as opposed to 91 m € in the same period last year.

Hmmm. Why did HRE need to incur massive consultancy fees in order to sell a stake to Flowers? Did they mandate an investment banker who charged a huge success fee?