EUROPEAN COMMISSION. Brussels, C (2009) 5260 final. C/17/2009 (ex N265/2009) Germany Aid measures provided to LBBW. Sir, I.

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1 EUROPEAN COMMISSION Brussels, C (2009) 5260 final In the published version of this decision, some information has been omitted, pursuant to articles 24 and 25 of Council Regulation (EC) No 659/1999 of 22 March 1999 laying down detailed rules for the application of Article 93 of the EC Treaty, concerning non-disclosure of information covered by professional secrecy. The omissions are shown thus [ ]. PUBLIC VERSION WORKING LANGUAGE This document is made available for information purposes only. Subject: C/17/2009 (ex N265/2009) Germany Aid measures provided to LBBW Sir, I. PROCEDURE (1) On 30 April 2009, Germany notified to the Commission the intention to provide a recapitalisation of the Landesbank Baden-Württemberg (LBBW) and an asset relief measure for two portfolios. Already on 15 December 2008 Germany had an informal meeting with the Commission where a preliminary plan for injecting capital into the bank was presented and at that time the possibility of an asset guarantee was mentioned. Seiner Exzellenz Herrn Frank-Walter STEINMEIER Bundesminister des Auswärtigen Werderscher Markt 1 D Berlin Commission européenne, B-1049 Bruxelles Belgique Europese Commissie, B-1049 Brussel België Telefon: (0)

2 (2) In May and June 2009 the German authorities and the Commission services held several meetings. Germany provided additional information via and phone. (3) With regard to issues pertaining to the asset valuation methodologies employed in the context of the asset relief scheme, the Commission has drawn on technical assistance provided by external experts under contract with the Commission and from the ECB. Several telephone conferences at the level of the technical experts took place for evaluating the portfolio. The assessment was based on information provided by Germany and the methodological approach was explained in detail. (4) By of 2 June the Commission learned that LBBW has been operating below the regulatory capital requirements since the end of the first quarter (5) Following discussions with the Commission, on 22 June 2009, Germany provided several commitments which modified the already assessed asset relief structure. II. DESCRIPTION OF THE MEASURE 1. THE BENEFICIARY (6) Landesbank Baden-Württemberg (LBBW) is an internationally operating commercial bank which focuses on Baden-Württemberg, Rhineland Palatinate and Saxony. It has more than 200 branches, which are mostly located in those regions, but also in other parts of Germany. In addition, the bank has 26 international business representations. The bank has about employees. Its business model is mainly focussed on SMEs (Mittelstand). It is also the central bank of the savings banks in Baden- Württemberg, Rhineland Palatinate and Saxony. With a balance sheet of about EUR 450 billion, the bank is the fifth largest bank in Germany. The bank had about EUR 180 billion risk weighted assets as of end (7) The bank is owned by the Land Baden-Württemberg with % (Land-BW), the Savings banks association of Baden-Württemberg with % (SVBW), the city of Stuttgart with % (Stuttgart), and the Landeskreditbank Baden-Württemberg with % (L-Bank). All shareholders are either public entities or owned by public entities. 2. EVENTS LEADING TO THE MEASURE (8) In the beginning of 2008, LBBW bailed out SachsenLB, the Landesbank of the State of Saxony. Sachsen LB had become illiquid after the market for commercial papers had dried up in the summer of It was not able to refinance several special purpose vehicles (SPV) that were holding structured assets, which were at this time not impaired. As part of the take over, LBBW agreed to take some structured assets on its balance sheet (they are now part of the below described ABS portfolio) and to provide refinancing for a newly found SPV, the so called Sealink portfolio (also described in detail below). The loan to Sealink amounts to EUR 8.75 billion but is protected through a first loss guarantee by the State of Saxony of EUR 2.75 billion.

3 The Commission has approved the restructuring of SachsenLB and found that the sale to LBBW at a negative price (due to the guarantee) did not constitute State aid. 1 (9) The deepening financial crisis affected i.a. LBBW's securitisation portfolios. Overall, the bank made a loss of EUR 2.1 billion in (10) Since the beginning of the year, regulatory capital requirements for its portfolios of securitized assets (partly stemming from the Sachsen LB acquisition), the so-called ABS portfolio and the Sealink portfolio, increased significantly. Regulatory capital requirements for both portfolios were on 30 May 2009 EUR [>3] billion. (11) As a consequence of the massive rise in regulatory capital required, the bank's total capital ratio fell short of the regulatory requirements and decreased to [ ]% at the end of Q1/2009, thus below the regulatory minimum of 8%, while the tier 1 ratio was [ ]%, remaining above the regulatory requirement. Projections of the bank show that capital ratios without the measures are likely to deteriorate further at the end of Q2/2009 to [ ]% for the total capital ratio and to [ ]% for the tier 1 ratio. (12) BaFin, the German supervisory authority, postponed initiating measures against the bank given the willingness of its shareholders to provide LBBW with the required capital. 3. THE AID MEASURES (13) The foreseen aid measures for LBBW are composed of a capital injection and asset relief for two portfolios of structured assets The capital injection (14) LBBW's owners will inject EUR 5 billion of tier 1 capital (Kernkapital) in the form of a new class B of ordinary shares. The capital will be injected on a pro rata basis. However, the Land Baden-Württemberg and L-Bank would inject its capital via a subsidiary. The B shares will be designed in such a way that they will be less subordinated (i.e. more senior) than the existing shares. (15) The capital injection will amount to about 2.8% of the bank's risk weighted assets (RWAs) when using the audited end-2008 figures. (16) The bank will pay an overall remuneration of 10% for the capital provided. The bank intends to pay a lower rate in the beginning ([ 8]%). Another [ 2%] is intended to be retained, and paid beginning in 2014 together with the interest accrued. The Commission understands that an effective interest rate of 10% is achieved over time. The bank plans to start repaying the capital in 2014 with 5 yearly instalments. 1 See Commission decision of 4 June 2008 in case C9/2008, not yet published.

4 3.2. The asset relief The guarantee structure for protecting two portfolios (17) The asset relief for LBBW is to be achieved via a guarantee structure by the State of Baden-Württemberg, not through a sale of assets. The guarantee protects LBBW against credit losses potentially resulting from two separate portfolios of securitized assets. Regarding both portfolios LBBW will retain the risk of defaults of principal and interest up to a certain amount (first loss piece), while the State will bear potential losses exceeding this amount (second loss piece). (18) The guarantee covers two distinct portfolios. The first one, the so-called ABS portfolio, is a portfolio of structured products in the amount of EUR 17.7 billion, which are held by the bank directly. The second part relates to a loan in the amount of EUR 8.75 billion granted to a special purpose vehicle holding a portfolio of structured products, the so-called Sealink portfolio. 2 All items are booked in loans and receivables from an accounting and in the banking book from a regulatory perspective. (19) The first loss to be borne by LBBW in the ABS portfolio is EUR 1.9 billion 3 and the State will guarantee up to EUR 6.7 billion (second loss). In the case of the Sealink portfolio, the first loss amounts to EUR 2.75 billion. 4 The second loss amounts to EUR 6 billion, which will be guaranteed. (20) As the guarantee shields the bank from the risk of EUR 12.7 billion stemming from the portfolios mentioned above, the bank does no longer have to hold the same capital as a buffer for unexpected losses as before. Given the risk weighting of the assets within the EUR 12.7 billion exposures the capital relief was determined by the German authorities at EUR [>3] billion. 5 (21) The guarantee is provided for a term of five years and can be terminated at the request of LBBW. In return, LBBW commits to pay an initial fee based upon a capital relief effect of EUR [>3] billion, to which a 7 % interest rate is applied. For the first year, the fee will amount to EUR [ ] million and will decrease the next years pro rata For a more detailed description including valuation compare paras. 20 et seq. Initially the intention of LBBW was to fully bear the losses on the riskiest assets (Cluster 4), which amount to EUR 1.9 billion, but not the losses on the remaining EUR 15.8 billion for which LBBW wanted to ask a State guarantee. This change in the guarantee structure was committed at a very late stage of the procedure in order to achieve a "true" first loss piece on the ABS portfolio. As indicated above, the Sealink structure results from the restructuring of SachsenLB. LBBW committed to provide a EUR 8.75 billion junior loan to a special purpose vehicle that holds the Sealink portfolio, next to an initial EUR 8.75 billion senior loan granted by other Landesbanken. The junior loan was protected by a first loss protection from the State of Saxony of EUR 2.75 billion which LBBW negotiated as part of the takeover of SachsenLB for a negative price (this was approved by the Commission (See Commission decision of 4 June 2008 in case C9/2008)). The transaction, however, will not allow the bank to release provisions. Nor will it reduce the amount which has to be deducted from regulatory capital to cover a potential shortfall of risk provisioning. (Banks need to compare expected loss calculations with the total amount of provisions they have made. Any shortfalls (where the expected loss exceeds the total provisioning) resulting from the incurred loss concept used by the IFRS must be deducted from capital and any excesses may be eligible as Tier 2 capital.)

5 in line with the amortization of the guaranteed portfolio and subject to review in the restructuring procedure Description of the assets in the ABS portfolio 6 (22) The portfolio, with a nominal amounting to EUR 17.7 billion as of 31 March 2009, is divided into four different clusters. Cluster 4 is made up of the riskiest tranches and has a total nominal value of EUR 1.9 billion. LBBW only sent information on the assets of the ABS portfolio that are not in Cluster 4, as Cluster 4 assets were initially not within the scope of the State guarantee. (23) The part not including Cluster 4 consists of [>700] securities and is mostly made up of residential mortgage-backed securities (RMBS) in the US and in Europe ([35-40]%), commercial mortgage-backed securities (CMBS) ([20-25]%), asset-backed securities (ABS) with different underlyings ([15-20]%), CDO's ([10-15]%) and collateralized loan obligations (CLO's) ([10-15]%). The exposure of LBBW to the ABS portfolio is a direct exposure, as LBBW holds all the assets in its balance sheet. [More than 90]% of the securities have investment grade ratings, of which a very large concentration on AAA ratings ([>66]%). The remaining [<10]% of the securities are sub-investment grade, with the largest focus on CCC ratings ([<5]%). (24) For RMBS, the largest exposures are in UK RMBS, in Spanish RMBS, in US Alt-A RMBS and in Italian RMBS. For CMBS, the largest exposure is in European CMBS. For ABS, the largest exposures are in European consumer loans, in European leasing, in US credit cards and in US student loans. For CDO's, the largest exposures are in Trust Preferred Securities (TRUPS) CDO's, in ABS CDO's and in US CDO's. For CLO's, the largest exposures are in European and US CLO's Description of the assets in the Sealink portfolio (25) The portfolio, with a nominal and book value amounting to EUR 15 billion as of 30 April 2009, consists of [>500] securities and is mostly made up of residential mortgage-backed securities (RMBS) in the US and in Europe ([60-65]%) and of commercial mortgage-backed securities (CMBS) ([20-25]%). The remaining [10-15]% consist of asset-backed securities (ABS) with different underlyings (mostly consumer loans, student loans, credit cards, auto loans) and collateralized debt obligations (CDO's). [More than 55]% of the portfolio has investment grade ratings, of which a very large concentration on Aaa ratings ([>40]%). The remaining [<42]% of the portfolio is sub-investment grade, with a major focus on Caa ([20-25]%) and Ca ([<15]%) ratings. (26) The RMBS portfolio (the largest exposure of the Sealink portfolio) is primarily made up of US Subprime RMBS, US Alt-A RMBS, European Prime RMBS and European non conforming RMBS. Most RMBS are exposed to US assets. The US Subprime RMBS portfolio is mostly exposed to 2006 and 2007 vintages, which are the riskiest vintages in the mortgage market. The US Alt-A RMBS portfolio is primarily made up 6 A more detailed description of both portfolios is provided in the annex.

6 of Option ARMs 7, ARM 8 and Mixed 9 RMBS, which are riskier than Fixed RMBS, for which LBBW holds a lower amount. Again noted is a significant concentration on 2006 and 2007 vintages for the Alt-A portfolio. The European non conforming RMBS portfolio is mostly focused on the UK, while the European prime RMBS portfolio is mainly spread over Italy, Spain and the Netherlands. The CMBS portfolio (the second largest exposure of the Sealink portfolio) is mostly focused on European assets Valuation of the portfolios by the experts of LBBW (27) LBBW appointed [ ] to assess the ABS portfolio (excluding Cluster 4). As of 31 March 2009, the real economic value was estimated at [>95]% (base case) of the nominal value, while the market value amounts to [>63]% of the nominal value. No stress case real economic value was provided to the Commission for the ABS portfolio. (28) [ ] as the asset manager of the Sealink portfolio provided relevant information on the Sealink portfolio. As of 30 April 2009, the real economic value was estimated at [80-84]% (base case) and [>72]% (stress case) of the nominal value, while the market value amounts to [>53]% of the nominal value. (29) The table below summarizes the main valuation results. Table 1 In EUR million ABS Portfolio 10 As of 31/03/2009 Sealink Portfolio As of 30/04/2009 Total Nominal value 11 [ ] [ ]% [ ] [ ]% [ ] Book value [ ] [ ]% [ ] [ ]% [ ] First loss n.a. 12 n.a. [ ] [ ]% n.a. Guaranteed value [ ] [ ]% [ ] [ ]% [ ] Real economic [ ] [ ]% [ ] [ ]% [ ] value (base) Real economic n.a. n.a. [ ] [ ]% n.a. value (stress) Market value 13 [ ] [ ]% [ ] [ ]% [ ] These are securities backed by adjustable rate mortgages for which there is no scheduled amortization of the principal repayment, leaving it at the option of the borrower. These are securities backed by adjustable rate mortgages. These are securities backed by both adjustable rate mortgages and fixed rate mortgages. The mentioned values do not include Cluster 4 as information on book value, real economic value and market value for Cluster 4 were not provided due to new commitments as explained before. This nominal value excludes cluster 4. No valuation was provided. The EUR 1.9 billion was initially aimed at covering only losses on Cluster 4 assets, but the latter were not included in the calculations of the table because no information on book value, real economic value and market value for Cluster 4 assets were provided. Market values were provided by LBBW experts and not verified by the Commission experts.

7 (30) In order to calculate real economic values, the [ ] formulated assumptions on, inter alia, default probabilities, default correlations, house price evolutions, recovery rates and prepayment rates. III. GERMANY'S POSITION (31) Germany requests urgent temporary approval of both measures in order to prevent supervisory action leading to bank resolution. The urgency of the rescue measures is also confirmed by a letter provided by the German financial supervisory authority (BaFin) from 18 June 2009, which reiterates that both measures are required before the end of Q in order to prevent supervision measures. (32) Germany submits that LBBW is a distressed bank. (33) Germany does not contest that the measures constitute aid. However, in view of the risk that LBBW could lose its banking license and the serious consequences this would entail for Germany's financial system leading to a serious disturbance in the German economy, Germany argues that the measures are compatible with the common market under Article 87(3) (b) of the Treaty. (34) Germany submits that without the guarantee measure provided by the Land Baden- Württemberg, the other owners would not have provided the capital. (35) Germany commits that all the assets in the ABS portfolio will be managed separately from the bank from a functional and organisational point of view by end October (36) Germany, Land Baden-Württemberg and the other owners commit to pay a remuneration on the basis of a regulatory capital relief on 30 May 2009 of EUR [>3] billion applying a rate of 7 %, i.e. EUR [ ] million until the final decision on the restructuring plan. The commitment is given with the understanding that the remuneration might be reduced if the first-loss part for the ABS portfolios exceeds the real economic value. In addition, Germany points out that the remuneration fee will decrease in line with the amortisation of the overall portfolio. Germany also states that the remuneration might need to be adjusted in line with outcome of the valuation exercise. (37) Germany, Land Baden-Württemberg and the owners commit to notify an in-depth restructuring plan within 3 months. Furthermore in order to avoid disproportional distortion of competition Germany will ensure during the rescue phase that (i) the state measure is not used for marketing purposes as a commercial advantage, (ii) remuneration of management is limited and the bank will review its internal incentive systems as regards a sustainable business model, and (iii) lending to the real economy is sufficiently provided. (38) Until the Commission has taken a final decision on above mentioned restructuring plan, Germany commits that the bank will not pay a coupon on hybrid capital instruments if the bank is loss-making, except in case of legal obligations. Also the bank will not dissolve reserves or silent reserves for making such hybrid coupon payments.

8 IV. ASSESSMENT 1. EXISTENCE OF STATE AID UNDER ARTICLE 87(1) OF THE EC TREATY (39) As set out in Article 87(1) of the EC Treaty, any aid granted by a Member State or through state resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the common market. (40) Both the recapitalisation in the amount of EUR 5 billion and a guarantee in the amount of EUR 12.7 billion are granted by the shareholders. All shareholders are either public entities such as regions or municipalities or owned by them. As all shareholders of LBBW are either directly or indirectly attributable to the State, the Commission concludes that the resources for the capital injection and the guarantee are State resources within the meaning of Article 87 (1) of the Treaty. (41) When public authorities make resources available to a company, the Commission examines in principle whether the State s behaviour in making the investments under consideration was in conformity with the market economy investor principle. That implies that it is necessary to assess whether, in similar circumstances, a private investor operating in normal conditions of a market economy ('a private investor') of a comparable size to that of the bodies operating in the public sector could have been prompted to make the capital contribution in question. 14 (42) There is no doubt that a market economy investor would not have provided a guarantee on impaired assets under the above conditions. 15 Moreover a market economy investor in the place of the shareholders would also not have accepted to make the capital injection. To this end, the Commission notes the statement of Germany that many of the owners of LBBW would not have provided the capital injection without the guarantee measure from the Land Baden-Württemberg. In result, the recapitalisation would not have occurred without the guarantee measure. In addition, no investor would have agreed on remuneration for a capital injection to a distressed bank of only 10 % in the current circumstances of the financial crisis. Given that LBBW is operating below the regulatory capital requirement since the end of first quarter of 2009, it is a distressed bank. (43) The measures are favouring only LBBW. They are selective and potentially lead to a distortion of competition. Furthermore, they affect intra-community trade because of LBBW's cross-border activities and due to the fact that the banking sector operates internationally. Thus, the Commission agrees with Germany that the measures in favour of LBBW constitute aid in the sense of Article 87(1) of the EC Treaty Cf. joined cases T-228/99 and T-233/99 Westdeutsche Landesbank GZ v Commission (WestLB) [2003] ECR II-435, paragraph 245. Based on Cases C-142/87 Belgium v Commission [1990] ECR I-959, paragraph 29, and, Case C-305/89 Italy v Commission (Alfa Romeo) [1991] ECR I-1603, paragraphs 18 and 19. Cf. Communication from the Commission on the treatment of impaired assets in the Community banking sector, OJ C 72, , p. 1.

9 (44) The Commission considers that the aid element involved in a capital injection into a bank in difficulty is in principle its nominal value, i.e. EUR 5 billion. On the other hand, regarding the impaired asset relief measure, the IAC states that the aid amount corresponds to the difference between the transfer value or guaranteed value of the assets and the market value. The guaranteed value of the portfolio is the value below which the state is responsible to cover portfolio losses (fully or partially) and amounts in total to around EUR billion. The market value, as assessed by LBBW experts (and not yet verified by the Commission), amounts to EUR [>18] billion. At this stage, therefore, the Commission can only observe that the aid for the impaired asset relief measure amounts to at least EUR [>9] billion. Calculations are detailed in the table below. Table 2 In EUR million ABS Portfolio Sealink Portfolio Total Guaranteed value 15,635 12,280 27,915 Market value 10,137 8,006 [>18] Aid amount 5,498 4,274 [>9] (45) At this stage, the total aid amount (including the capital injection) is thus at least EUR [>14] billion (EUR 5 billion for the capital injection and EUR [>9] billion for the asset relief measure). 2. COMPATIBILITY OF THE AID 2.1. Application of Article 87 (3) b of the EC Treaty (46) The measures could be compatible with the common market on the basis of Article 87(3) b) of the EC Treaty under which state aid may be found compatible with the common market if it is intended "to remedy a serious disturbance in the economy of a Member State". (47) The Commission acknowledged in its recent approval to the prolongation of the German Rescue package 16 that the threat of a serious disturbance in the German economy continues and that measures supporting banks are apt to remedy a serious disturbance in the German economy. (48) Given the systemic importance of LBBW and the significance of its lending activities for specific regional markets, its cross border presence, and its integration and cooperation with other public sector banks, the Commission accepts that its failure would have entailed serious consequences for the German economy. The aid must therefore be assessed under Article 87(3) (b) of the EC Treaty. 16 Commission Decision of 22 June 2009, N 330/2009 Rettungspaket für Finanzistitute in Deutschland.

10 2.2. Principles for assessing the compatibility of the measures (49) In line with the Banking Communication, 17 in order for such aid to be compatible, any aid or aid scheme must comply with general criteria for compatibility under Article 87 (3) of the Treaty, viewed in the light of the general objectives of the Treaty and in particular Articles 3 (1) g) and 4 (2) thereof, which imply that the measures are appropriate, necessary and proportional. (50) The three banking Communications 18 translate these general principles into specific compatibility conditions depending on the instrument chosen to support the bank. To this end the nature and the effect of the measures needs to be clarified. (51) The capital injection is a recapitalisation that needs to be assessed under the Commission's communication on recapitalisation. 19 (52) The asset relief measures, irrespective of their nature, need to be assessed under the Impaired Asset Communication ("IAC 20 "). The scope of the IAC is not restricted to transfers of assets, but encompasses all transactions which are intended to have similar effects. The guarantee is intended to protect the bank against the risk of future losses resulting from securitized assets. It has effects similar to that of a risk transfer. Especially, the guarantee allows LBBW to avoid write downs in the event of default and releases it from regulatory capital requirements. Therefore, it falls within the scope of the IAC Capital injection (53) Regarding the capital injection the Commission has already established in the recapitalisation communication that such measures are in principle appropriate to prevent an insolvency of a bank and thereby to serve financial stability as well as to support the provision with credit of the real economy. (54) The measure must further limit the distortions of competition to the minimum. In this respect, the recapitalisation communication requires a remuneration of around 10% p.a. 21 which LBBW will provide Communication from the Commission - Application of the State Aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis, OJ C 270, , p. 8. Communication from the Commission - Application of the State Aid rules to measures taken in relation to financial institutions in the context of the current global financial crisis, OJ C 270, , p. 8. Communication from the Commission - Recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition, OJ C 10, , p. 2. Communication from the Commission on the treatment of impaired assets in the Community banking sector, OJ C 72, , p. 1. Communication from the Commission - Recapitalisation of financial institutions in the current financial crisis: limitation of aid to the minimum necessary and safeguards against undue distortions of competition, OJ C 10, , p. 2. Communication from the Commission on the treatment of impaired assets in the Community banking sector, OJ C 72, , p. 1. Commission Decision of 18 December 2008 in case N 615/2008 BayernLB, OJ C 80/4 of

11 (55) Moreover, LBBW committed to provide a restructuring plan after 3 months in the light of the fact that the measures in favour of LBBW include asset relief and thus a restructuring plan is required within this shorter timeframe. Furthermore, as indicated in point (37), LBBW has also provided the required behavioural commitments required under the communication, in particular to lend to the real economy. Therefore all conditions of the recapitalisation communication are met and the recapitalisation can be considered as compatible Asset relief (56) The IAC leaves the methods and design for impaired asset relief measures to the Member States, but defines impaired asset relief as all measures whereby a bank is dispensed from the need for severe downward value adjustments of certain asset classes. This is also the case for the present measure. Therefore the present measure must fulfil the conditions for the compatibility of asset relief as spelled out in the IAC Eligibility of assets (57) As regards the eligibility of the assets, the IAC indicates in section 5.4 that asset relief requires a clear identification of impaired assets 23 and that certain limits apply in relation to eligibility to ensure compatibility. It notes that assets which have triggered the financial crisis and are subject to severe downward value adjustments appear to account for the bulk of uncertainty and scepticism concerning the viability of banks. In this respect, US mortgage backed securities and associated hedges and derivatives are mentioned. The IAC also notes, however, that an overly narrow relief measure would not be advisable and refers to a proportionate approach to extend eligibility to welldefined categories of other assets as well. The guaranteed portfolios mainly consist of assets such as RMBS, CMBS, CDO's, CLO s and ABS, which are typically assets for which there is a market failure and at which impaired asset relief measures are targeted. Therefore, the impaired assets in question are sufficiently identified and do not raise issues of eligibility Transparency and disclosure (58) As regards transparency and disclosure the Commission notes that the IAC demands in section 5.1 full ex-ante transparency and disclosure of impairments by eligible banks on the assets which will be covered by the relief measures, based on adequate valuation, certified by recognised independent experts and validated by the relevant supervisory authority. In other words the IAC requires that disclosure and valuation should take place prior to government intervention. (59) The Commission notes first that independent experts have been employed to valuate the assets For a first application: cf Commission Decision of 13 March 2009 in case C 9/09 Dexia, not yet published and cf Commission Decision of 14 May 2009 in case C 10/09 ING, not yet published To be categorized in baskets in line with Annex 3 of the IAC.

12 (60) Finally, the Commission notes that the requirements concerning transparency and disclosure concerning the asset portfolio covered by the relief measure are met in principle, with the exception of the issue of proper valuation that is discussed separately below. Full disclosure on the entirety of impaired assets on LBBW balance sheet has to be provided in the context of the restructuring plan. At this stage the provisions for transparency and disclosure are thus sufficiently addressed Management of assets (61) As regards the management of assets, the IAC in section 5.6 stipulates the necessity of ensuring a clear functional and organisational separation between the beneficiary bank and its assets, notably as to their management, staff and clientele. The Communication states in that respect that this should allow the bank to focus on the restoration of viability and to prevent possible conflicts of interest. (62) In that respect, the Commission notes, as regards the Sealink portfolio, that the assets are managed by third party service providers. In view of this arrangement the asset management is thus in line with the IAC. As regards the ABS portfolio, Germany has also committed to ensure a separated management of the assets in the portfolio by end October The condition of separate asset management is thus met Valuation (63) The IAC notes in section 5.5 that a correct and consistent approach to valuation is of key importance to prevent undue distortions of competition. The valuation of impaired assets should follow a general methodology established at the Community level, which should be closely co-ordinated ex-ante by the Commission and Member States. (64) The main aim of valuation is to establish the real economic value, given that this value represents the benchmark level in that a transfer of impaired assets and at this value indicates compatibility of aid ensuring the relief effect by exceeding current market value but keeping the aid amount to the minimum necessary. (65) The Commission notes that LBBW appointed [ ] to assess the ABS portfolio. As of 31 March 2009, the real economic value was estimated at [>95]% (base) of the nominal value. The Sealink portfolio was assessed by [ ]. As of 30 April 2009, the real economic value was estimated at [>82]% (base) and [>72]% (stress) of the nominal value. (66) The Commission has scrutinized the valuation and in particular the underlying general methodology in order to ensure a consistent approach at Community level. For that purpose the Commission has called on the technical assistance from external experts and from the ECB. In particular the Commission has contracted external experts in order to scrutinize the valuation. (67) The Commission notes that its external experts indicated doubts on the establishment of the real economic value of the two portfolios, in particular as regards (i) the choice of default probabilities for some assets, (ii) the choice of default correlations, (iii) the choice of some recovery rates, (iv) house price assumptions, and (iv) other valuation issues.

13 (68) Default probabilities assumptions used in the ABS portfolio for most CDO's and CLO's may not be conservative enough. They seem to be much closer to assumptions made by rating agencies in 2005, while they seem to be materially lower than the revised assumptions made by the same rating agencies in 2009 and lower than default probabilities implied by the market (derived for example from CDS levels). This is typically the case for investment grade ratings. Similarly, default probabilities assumptions used in the ABS portfolio for European CMBS positions may not be sufficiently conservative either. They do not seem to capture the levels of recent developments in delinquency rates reported by rating agencies. All things being equal, an underestimation of default probabilities typically leads to an underestimation of expected losses, which in turn leads to an overestimation of the real economic value of the portfolio. (69) Default correlation assumptions used in the ABS portfolio may also not be conservative enough. For several structured credit assets in general and for CDO's and CLO's in particular, assumptions on default correlations are key for valuing such assets. The main reason is that the risk of the entire portfolio as represented by its loss distribution depends on default probabilities, the recovery rates and the correlation of the default risk of the assets in the pool. The value of most tranches typically has a negative relationship with correlation. In other words, the higher the default correlation, the higher the losses and the lower the value 24. In contrast with recent market developments, the Commission understands that default correlation factors assumed in the ABS portfolio depend mostly on the judgment of the experts of LBBW. In 99% of cases, a correlation lower or equal to [35-45]% is used, while correlation factors derived from market indices or sometimes rating agencies are materially higher. All things being equal, an underestimation of default correlations typically leads to an underestimation of expected losses, which in turn leads to an overestimation of the real economic value of the portfolio. (70) Recovery rates assumptions used in the ABS portfolio may not be conservative enough for corporate entities and do not seem to reflect the latest observed recovery rates on defaulted assets. All things being equal, an overestimation of recovery rates typically leads to an underestimation of expected losses, which in turn leads to an overestimation of the real economic value of the portfolio. (71) Assumptions in the ABS portfolio on the future evolution of house prices in some key geographies such as the United States, the United Kingdom and Spain, which represent a significant proportion of RMBS securities in the ABS portfolio, may not be conservative enough, based on third-party research and on a confrontation of these 24 These tranches are typically exposed more to systematic rather than idiosyncratic risks. Since the start of the turmoil, this is exactly the situation which is observed in the market pricing of correlations (e.g. itraxx tranches for the European market), where the market-implied correlation has jumped up massively. For a long time, rating agencies and market participants assumed relatively low correlations in their pricing models. Since the beginning of the financial crisis, given the contagion effect of the financial crisis into several sectors of the economy and the relatively poor economic outlook in several regions of the world, such correlation factors appeared to be underestimated. Default sources such as default contagion (where the default of one entity causes the default of another entity) or inability to refinance debt will be much more common going forward and suggest an environment of high default correlations. Markets have realized this and a large increase in several correlation indicators over the last months has been observed.

14 assumptions with the experts that LBBW itself mandated, but for the other portfolio (Sealink). For example, in the United Kingdom, a 1-year decrease in house prices of 17.8% is projected, followed by increases of 1.2%, 9.0% and 5.6% in 2010, 2011 and 2012, then followed by yearly increases in house prices of 5.2%. In Spain, decreases of 9.6% and 3.0% are anticipated in 2009 and 2010, followed by an increase of 3.1% in 2011 and then yearly increases of 6.1%. Typically, house price assumptions directly impact the recovery rates. This means that too optimistic house price evolutions tend to inflate recovery rates, which in turn leads to an overestimation of the real economic value of the portfolio. (72) Additional inconsistencies have been identified in the outcome of real economic valuation calculations of both portfolios. For example, several cases were found, where, in a given asset class, the average real economic value (as calculated by LBBW experts) of higher rated securities could be materially below the average real economic value (as calculated by LBBW experts) of lower rated securities of the same asset class, while in principle it should be the opposite. It was indeed not rare to find CCC, B or BB securities with a better (or fairly close) real economic value than higher rated tranches. Similarly, it was not found obvious that some non conforming RMBS deals could be better valued than conforming RMBS deals, or that in some cases 2007 US RMBS deals vintages, which are highly likely to default, could be better valued than 2005 US RMBS deals. The two portfolios, ABS and Sealink, also showed a significant overlap in securities coverage, while presenting in several cases material differences in real economic valuation by the two LBBW experts. For example, based on the pool of securities present in both portfolios, it appeared that some CDO's and ABS in the Sealink portfolio were overvalued compared to the ABS portfolio. By linking this with the above-mentioned doubts on some assumptions in the CDO's and ABS of the ABS portfolio, the Commission at this stage also questions the valuation of these assets in the Sealink portfolio. (73) Given the fact that no information on Cluster 4 (EUR 1.9 billion) was provided to the Commission, the assessment of the real economic value of Cluster 4 could not be performed and therefore it was not possible to assess the real economic value of the whole ABS portfolio. (74) In sum, the Commission has [ ] doubts as to the valuation methodology and assumptions of the ABS portfolio and the Sealink portfolio and assumes at this stage that the real economic value is lower than that calculated by LBBW. In addition because no valuation has been undertaken regarding Cluster 4 this will be further scrutinised during the investigation. Also the Commission recalls that pursuant to point 20 IAC valuation needs to be confirmed by the supervisory authorities. Such confirmation was not obtained Burden sharing (75) As regards burden sharing, the IAC states in section 5.2 the general principle that banks ought to bear the losses associated with impaired assets to the maximum extent. That implies first that the bank should bear the difference between the nominal value and the real economic value of the impaired assets.

15 (76) In this case, since there is no write-down to the guaranteed value (as this is a guarantee measure and not an asset transfer measure), burden sharing needs to be achieved through LBBW's retaining a first loss commensurate to such write-down. (77) As there are doubts regarding the correct valuation of the assets the appropriateness of the risk retained by the bank cannot not be assessed. In other words should the real economic value be lower than assessed by the German authorities, the theoretical losses absorbed by the beneficiary could be insufficient Remuneration (78) Another element to be assessed by the Commission pursuant to point 21 IAC is remuneration. It shall, as noted in Annex 4, ensure that "any pricing of asset relief must include remuneration for the State that adequately takes account of the risks of future losses exceeding those that are projected in the determination of the 'real economic value'". (79) In order to assess the guarantee fee charged it must be recalled that the IAC considers that the remuneration of an asset relief measure should look as a proxy at the regulatory capital relief the beneficiary obtains through such measure. Then, the IAC suggests linking the remuneration for the State with, among other things, the remuneration of the corresponding recapitalisation, using the suggested return rate in the recapitalisation communication, reduced by the funding cost in the case of asset guarantees as such measures are not funded. (80) Germany commits that LBBW will pay EUR [ ] million in the first year, which corresponds to a rate of 7% applied to the identified regulatory capital relief effect of EUR [>3] billion. Following the submission that the remuneration is based on the capital relief effect and assuming no liquidity was provided the Commission finds the remuneration compatible at this stage. As remuneration is linked to valuation, the remuneration may need to be adjusted if the newly assessed real economic value proves to be materially different from the initially communicated real economic value. (81) The Commission agrees with Germany that remuneration might be counterbalanced by a high burden sharing, in particular if the first loss piece exceeds the real economic value Viability review and restructuring plan (82) As regards the need for an assessment of the banks balance sheet and activities the IAC states that an application for aid by an individual bank should be followed by a full review of that bank's activities and balance sheet, with a view of assessing the bank's capital adequacy and its prospects for future viability (viability review). (83) The Commission considers it therefore necessary that such a viability review is performed. 25 Footnote 15 of the IAC.

16 (84) Furthermore, the Commission notes that the German authorities commit to present an in-depth restructuring plan which shall comply in particular with the conditions set out in the IAC. The Commission understands that this plan will be presented three months after the date of this decision. The Commission notes that in the context of the sale of SachsenLB, aid was already provided to Sealink and that further relief is now sought in respect of the same assets, a factor that will be taken into account in assessing the depth of the restructuring required Temporary authorisation of the measure for six months (85) The Commission observes that if the transaction is not booked in the second quarter 2009, BaFin, the supervisory authority, would likely initiate supervisory measures leading to bank resolution procedures in the absence of both rescue measures. (86) In view of the fact that the measure complies with the criteria for eligibility of assets, asset management arrangements, transparency and disclosure and the remuneration, the Commission can consider approving the asset relief measure as a temporary measure for six months. 26 The Commission considers that any approval should in any event be limited to six months on the basis of Annex 5 of the IAC. (87) But according to Annex 5 this would normally require that all the conditions for compatibility as set out above are met. In the present case, the Commission finds that at this stage the conditions of the IAC on valuation and burden sharing are not fulfilled, and an in-depth investigation is needed. (88) However, it is not possible to complete the assessment of the portfolio valuation before the end of the second quarter The Commission further notes that financial stability may be at risk. Finally, it can not be excluded that the valuation of the portfolio will be confirmed after a detailed assessment, even though doubts are present at this stage. (89) The Commission therefore accepts the guarantee arrangement and the remuneration between the State and LBBW and will not request changes regarding the transfer for six months. This does not preclude the Commission from requesting changes in its final decision to the burden sharing of the measure by way of claw back or any other form of remuneration without compensating LBBW for it, if such change results from the Commission coming to the conclusion that the valuation of the portfolio underlying the portfolios or its burden sharing proves to be materially in contradiction with the EC State aid rules on impaired assets. 3. CONCLUSION (90) Both measures in favour of LBBW constitute State aid. The Commission finds that the capital injection complies with the requirements set out in the Recapitalisation 26 The Commission has taken similar decisions. For instance in Commission Decision of 13 March 2009 in case C 9/09 point 77, Dexia, not yet published, where it approved only some elements of compatibility. Similarly Commission Decision of 14 May 2009 in case C 10/09 ING, not yet published.

17 Communication. The asset relief measure does fulfil the conditions on eligibility of assets, asset management arrangement, transparency and disclosure and a guarantee fee as stipulated in the IAC. In view of the serious threat to financial stability, the Commission approves the measures for six months. At the same time, the Commission doubts at this stage that the asset relief measure complies with the conditions relating to valuation and burden sharing and opens an in-depth investigation. V. DECISION The Commission does not raise objections to rescue aid granted through a capital injection and an asset relief. With due considerations for need to preserve financial stability, the Commission has decided to approve the measures for six months. Three months from the date of this decision the beneficiary bank needs to provide a restructuring plan, which the Commission will assess in order to decide about a prolongation of the aid after six months. In the light of the foregoing considerations, the Commission has also decided to initiate the procedure laid down in Article 88 (2) of the EC Treaty on the asset relief to verify the conditions of the IAC regarding valuation (including the valuation methodology) and burden sharing of the measure. The Commission requires Germany to provide in addition to all documents already received, information and data needed for the assessment of the compatibility of the aid, in particular as regards (i) the term sheet with all the terms and conditions agreed between LBBW and the German State for the capital injection and the asset relief measure, including a detailed description of the set-up of the guarantee structure,(ii) a validation of the valuation from the head of the German supervisory authority and (iii) a detailed valuation report on Cluster 4 assets in the ABS portfolio. Germany is requested to forward a copy of this letter to the potential recipient of the aid immediately. If this letter contains confidential information which should not be published, please inform the Commission within fifteen working days of the date of receipt. If the Commission does not receive a reasoned request by that deadline, you will be deemed to agree to publication of the full text of this letter to agree to the disclosure to third parties and to the publication of the full text of the letter in the authentic language on the Internet site. Your request should be sent by registered letter or fax to:

18 European Commission Directorate-General for Competition State aid Greffe B-1049 Brussels Fax No: (+32) Yours faithfully, For the Commission Neelie KROES Member of the Commission

19 Annex The Sealink portfolio Split of total portfolio by asset classes Nominal value Proportion of total portfolio in EUR thousands in % RMB [60-65] % S CMB [20-25] % S Consumer Loans [0-5] % CD [0-5]% O Student Loans [0-5] % Leasing [0-5] % Credit Cards [0-5] % Auto Loans [<1] % Mutual Fund Fees [<1] % Other [5-10] % Total ,0 % The Sealink portfolio Split of ratings of the total portfolio

20 Moody's- Rating Nominal value Proportion of total portfolio in EUR thousands in % Aaa [>40] % Aa [5-10] % A [2-5] % Baa [2-5] % Ba [2-5] % B [2-5] % Caa [20-25] % Ca [<12] % C [<0,5] % Total ,0 % The Sealink portfolio Split of RMBS portfolio by sub-asset classes Nominal value Anteil am RMBS- Portfolio in EUR thousands in % US Subprime RMBS [20-25] % US Alt-A [25-30] % RMBS Option ARM [10-15] % ARM [5-10] % Mixed [0-5] % Fixed [0-5] % US Prime RMBS [0-5] % US Prime RMBS [5-10] % European Non conforming Prime RMBS [10-15] % HELOC (USA) [<1] % RMBS Total ,0 % The Sealink portfolio Split of CMBS portfolio by sub-asset classes