Germany’s Bad Bank Plan
This post was written by Karl Whelan
The German government announced a plan last week for dealing with problem assets on the books of its banks. This plan has been compared favourably to NAMA by a number of Irish commentators but I’m not really sure why.
The essence of the plan, as described by the Wall Street Journal, is as follows
banks will have the option of putting structured products, such as mortgage-backed securities, into special-purpose vehicles at 90% of their present book value, which is often far above the assets’ likely market value if sold today.
In return, the vehicle would give its parent bank a note promising to repay it an equivalent amount in up to 20 years’ time. The German state would guarantee the repayment in exchange for a fee from the bank, which would free up capital by swapping toxic assets for a risk-free note.
In addition, the bank would have to pay the vehicle the difference, spread out over as long as 20 years, between 90% of an asset’s book value and its estimated ultimate value when it matures. If an asset’s ultimate value turns out to be less than auditors’ estimates, the bank will have to pay dividends to the German state instead of to shareholders until the full loss is covered. If assets perform better than expected, the bank gets the upside.
A couple of observations about this plan.
First, it has been argued that the German plan provides better protection for the taxpayer. However, this appears to be ignoring the post-dated levy that the government says would be implemented should NAMA make a loss. In this sense, the two plans are quite similar. Both see the government effectively providing the funds to buy assets well above their current value with losses sustained being paid back slowly over time. (Perhaps one can argue that the SPVs are providing the funds, not the state, but these securities are guaranteed by the German government, so I’m not sure this is a useful distinction.)
Of course, as I have noted before, one has to be very careful about what actually constitutes being paid back. Paying back a hundred euro in five euro instalments over twenty years does not, in reality, constitute getting back the full economic value of the funds provided.
Second, as far as I can tell, the banks will manage their own Special Purpose Vehicles, and may still have incentives to hide losses or hope the value of these assets somehow turns up at some stage. Who wants to invest in a bank whose SPV is going to make a huge loss that then has to be paid back to the German taxpayer? This scheme seems unlikely to lead to a quick and fair assessment of the scale of the problem with losses on these securities. In this sense, a state asset management approach seems superior.
Third, there are some obvious differences between the nature of this scheme and NAMA. It represents a far smaller fraction of German bank assets than will be implied for NAMA, with the WSJ reporting that only €180 billion in assets will go into these vehicles. And the SPVs will only purchase complex structured securities, whereas NAMA will be buying property loans.
Finally, a general rule about economic policy is that one has to be suspicious of plans to deal with serious problems that are presented as having no costs to anyone. This plan is being presented as good for the banks involved, having no cost to the taxpayer, and still fixing the problem of undercapitalised banks. Most likely it’s a plan that will have economic costs for the German taxpayer but that these costs are small enough that the problem of undercapitalised banks will not be fixed.
Wolfgang Munchau also doesn’t like the plan. His column in the FT brands it as “a giant accounting trick.”
Update: Interestingly, the US Financial Accounting Standards Board (FASB) is now moving to outlaw the kind of practice that the Germans see as the solution to their problems.
Tags: German Bank Plan, NAMA
May 18th, 2009 at 12:24 pm
It is an accounting trick.
In accounting terms it involves the non-recognition of actual losses (marked to market) on the basis that they will be covered by (contingent) future profits.
This is simply not possible under accounting rules (the events generating the future profits have not yet occurred, and may never occur).
The interesting point about this scheme which I haven’t seen commented upon is that it effectively allows the banks in question to operate with negative capital as, if they were to consolidate the SPV’s into their consolidated financial statements showing the CDOs at market value, they would in all likelihood show negative net equity.
Germany appears to be relatively Zen about this as long as it gets them past an election and, one imagines, liquidity can be achieved by discounting these SPV bonds with the ECB.
These two points:
1) Flexibility on capital requirements, and
2) ECB liquidity
would appear to form the core of the German response in establishing their bad bank.
Denial can’t be an approach to problems of this magnititude (apparently the full figure is over 800 billion euros, the 180 is just the first, simple, tranche) however the flexibility being shown by the German government in this regard may hold some indications of a path that could be followed (though by no means as far) in Ireland.
May 18th, 2009 at 2:05 pm
The Germans can do this as frankly its a (largish) fleabite on the economy. Meanwhile, in NAMAland, the system is broken.
Very different problems.
May 18th, 2009 at 11:05 pm
Karl,
I think a key distinction is that there’s no money up front. 50bn+ bonds at 5%+ p.a. over 10+yrs adds up.
The post-nama levy will be very difficult to implement. If given the opportunity, banks could contest every workout. I expect it will be dropped within a year in order to get credit flowing (of course).
In placing the assets in an spv, it is possible to define operating procedures for loan modifications and workouts. So yes, losses could be delayed but forced at loan maturity.
This seems quite good to me, so I must be missing some angle.
May 19th, 2009 at 4:02 pm
This is just a simple TRS.
Yeah, it’s an “accounting trick”
Lets use market values for everything, declare everything insolvent, blow up Interbank unsecured lending and make Lehmans look like a little bit of gas from a spicy curry.
As for Nama, doomed from the very start is one considers the Basel 2 requirments on 100% risk weighted assets.
May 20th, 2009 at 5:56 am
@ Noel
Though I’m sure you didn’t intend it that way, there may be some merit to your suggestion to “blow up interbank lending”.
If all surplus bank resources in the EMU were placed with the ECB and this latter institution conversely extended its “unlimited liquidity” to banks (this is largely already the picture ito some extent) everybody would get a counterparty they could accept. The necessary constraint would have to be the ECB receiving (i) guarantees from the banks receiving liquidity (overcollateralisation of funds advanced + general guarantee) and (ii) a government guarantee in countries with banks in as perilous a state as ours.
The ECB would essentially be a clearing house that enabled banks to stop worrying about their brethren (fraternal relations being fraught). It is similar to the idea that you need to go through Dublin to get from Sligo to Galway by train. It is also similar to Mr Geithner’s plans for derivatives.