What links the honest burghers of Saxony with the mayhem and chicanery of the American sub-prime mortgage market?

Two state-backed German financial institutions have been rescued over the past two months, brought low by their ventures in the US housing sector. The multibillion-euro lifeboats for IKB of Düsseldorf, a lender part-owned by a government development bank; and Sachsen LB, one of Germany’s local authority-controlled landesbanks, are causing ructions in the German financial sector.

The revelation that a clutch of dull regional banks were punting in exotic markets caused investors to panic. Shares in even the big institutions, Commerzbank and Deutsche, have been hammered and the chief executive of West LB, the biggest landesbank, gave warning that foreign lenders were beginning to shun the German banking market, worried that Sachsen and IKB represented the first gusts in a gathering storm.

For these two banks, trouble is not over because the European Commission is launching an inquiry into the rescue packages to determine whether they breach state aid rules.

IKB is a tiny bank, but in July the German federal Government arranged an €8 billion (£5.4 billion) bailout through KfW, the German state development bank and principal IKB shareholder. Last week, Sachsen LB was propped up with an emergency €17 billion credit line. It called for help after struggling to sell its commercial paper to finance Ormand Quay, a Dublin-based affiliate active in the American asset-backed securities market.

Ormond Quay was a conduit – banking jargon for an off-balance sheet vehicle that issues commercial paper, a form of loan, to raise short-term funds at cheap rates. The money is invested in long-term asset-backed securities, such as mortgages, which pay much higher rates of interest. The margin between the cheap cost of the commercial paper and the higher yield earned from the mortgages is the bank’s profit. The problem is that the bank must return to the market frequently for new funds as each batch of commercial paper falls due for repayment.

Why was Sachsen LB, an institution whose declared aim is to stimulate development and create jobs in the Free State of Saxony, buying mortgage-backed American securities through an Irish tax shelter?

The answer is: because it could. More specifically, the answer is that it could do so without risk to its own lenders. Sachsen’s awfully big American adventure was supported by the sovereign guarantee of Saxony.

If the root cause of this credit crisis is bad risk management, then what better example than a state-owned bank dabbling in speculative foreign credit markets, using its sovereign guarantee as ultimate security? In its formal statement disclosing the €17 billion rescue, the bank indicates that the Free State of Saxony is standing by the loans. “For the banks providing the credit, there is thus no impairment risk.” In other words, if it all goes queer, the taxpayers of Saxony will clean up the mess.

Most bankers are not old dogs but young pups, so they can learn new tricks. The trouble is that when the silly pooch has understood the game of fetch the stick, it wants to do it again and again and again.

The German landesbanks have been looking for new tricks since 2005, when the European Commission cracked down on their use of sovereign guarantees to boost credit ratings, allowing them to secure cheap funds. After a complaint from Germany’s private banks about unfair competition, the landesbanks were ordered to pay back €4.7 billion in illegal state aid. Still, Sachsen's statement indicates that grandfather provisions in European Union regulations ensured that the Ormond Quay structure benefited from the guarantee from the state of Saxony.

Ormond Quay had €13 billion outstanding, of which 43 per cent were American assets and a large proportion mortgage-backed, but Sachsen says that they were top-grade triple-A rated.

That is of little comfort when lenders are spooked and appetite for risk switches overnight from ravenous to sated. The question now is whether Germans still believe that they can afford to maintain these cosseted local government financiers. The chances are that Saxony’s landesbank will be sold. So, too, should all the others.

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