Anatomy Of A Tainted Merger

A probe exposes the clubby practices of German banking

Workers at Munich-based HypoVereinsbank were still sipping their morning coffee when the raid began. Escorted by police officers, investigators from the state attorney's office seized boxloads of files from the bank's credit department. Elsewhere around the Bavarian city, other examiners searched the posh homes of former bank executives. The questions they wanted to answer: Did a healthy bank knowingly merge with a sick one to fend off a takeover? And was the public deliberately kept in the dark?

The Mar. 10 raids were the latest blow to the Sept. 1 merger of Bayerische Hypotheken- und Wechsel-Bank and Bayerische Vereinsbank, which created Germany's second-largest bank. In October, the newborn institution had to set aside $1.94 billion to cover the former Hypo's shaky real estate projects. That prompted the investigation into whether top executives of the former HypoBank, including CEO Eberhard Martini, fraudulently concealed the extent of problem assets.

No one has been formally charged with any wrongdoing. But shares of the merged bank have fallen 17%, to $58, in the past three months. In an effort at damage control, HypoVereins on Mar. 28 nominated Kurt F. Viermetz, 59, a former vice-chairman at J.P. Morgan & Co., to step in as head of its supervisory board.

Critics say the merger provides an object lesson in what German banks and companies often do wrong: forming alliances for mutual protection rather than strategic wisdom. Such symbiotic ties are common in Germany, where a major hostile takeover has never taken place. But the aftermath of the HypoVereins deal is certain to subject future mergers to greater scrutiny.

The sad irony of the mess at HypoVereinsbank is that many analysts approve of its strategy. Unlike some rivals, HypoVereins isn't spending huge sums on investment banking, a crowded market dominated by U.S. firms. Instead, it's focusing on property lending in northern and eastern Europe. Despite the scandal, analysts say the idea of building a Europewide mortgage bank is a sound one, if HypoVereins can put its current woes behind it quickly.

The problems began in 1990. Convinced that German reunification would touch off an economic boom, banks rushed to fund projects in the East. Few were more aggressive than HypoBank. It bought dozens of sites and fitted them out with offices, roads, and even rail links. After the boom failed to materialize, HypoBank admitted its holdings were overvalued. It set aside $833 million in 1997 to cover the risk--assuring investors that was enough.

Meanwhile, in 1996, Deutsche Bank revealed that it had acquired 5.5% of Vereinsbank's shares. The announcement signaled that Frankfurt-based Deutsche had designs on Vereinsbank--a threat not only to the bank but also to Munich's claim to be a European financial capital. Vereinsbank CEO Albrecht Schmidt went to HypoBank's Martini with a proposal. If they could combine their strengths in mortgage lending to create a superregional powerhouse, they could fend off the northern invader. They would also be arming themselves for the euro, which would bring new banking competition from outside Germany.

Schmidt and Martini enlisted support from their key shareholders--all venerable Munich institutions with interlocking financial and personal connections. These included insurer Allianz--an archrival of Deutsche Bank--utility conglomerate Viag, and the Bavarian state government. Helpfully, state officials ruled that the transaction would be tax-free.

The arrangement backfired almost immediately. Just two months after HypoVereins was officially created, CEO Schmidt disclosed that HypoBank's real estate holdings were profoundly overvalued, requiring an additional $1.94 billion in loan-loss reserves. Schmidt insisted he had known nothing of the problems before the merger. Some observers find that hard to believe.

For now, though, many people give him the benefit of the doubt. "I can't prove otherwise," says Klaus Grunewald, who represents bank employees on HypoVereinsbank's supervisory board. Prosecutors aren't investigating Schmidt. And Schmidt is doing his best to clear the air. On Mar. 25, he announced plans to commission an independent audit and laid out a turnaround plan for the unprofitable corporate lending business. He vows to more than double the bank's return on capital to 15% by 2003.

SHAREHOLDER REVOLT? But the bank remains tainted. Martini, denying wrongdoing, has defied calls to resign from the supervisory board. And more unpleasant revelations could result from the probe. The auditors' report could prompt former Vereinsbank shareholders to claim they were cheated because HypoBank's worth was exaggerated. Dissident shareholders are planning to raise a stink at the May 6 general meeting.

The bank's image may get a boost from Viermetz, whose credentials make him one of the most successful Germans ever to work on Wall Street. He could be in an awkward position, having advised Schmidt and Martini in the merger. "I know both gentlemen pretty well," he says. Yet he may be enough of an outsider to bring a much needed blast of fresh air to this very German merger.