'A Real Free Lunch' How German Banks Are Cashing In on the Financial Crisis

By Beat Balzli, Armin Mahler and Wolfgang Reuter

Part 2: Toxic Assets and Hidden Losses

Banks still have unimaginable amounts of toxic securities on their balance sheets. The International Monetary Fund (IMF) estimates that potential global write-downs resulting from the financial crisis could be over $4 trillion (€2.85 trillion). Crisis-related write-downs to date amount to only about $1.5 trillion (€1.1 trillion).

Although new, more generous write-down rules have eased the problem, they have not solved it. And the real solution, the establishment of functioning bad banks, is something the German government has been struggling with for months.

So-called "bad" banks are companies into which banks can deposit their toxic securities. This removal of troubled assets from balance sheets frees up equity capital otherwise needed as a buffer against risk. It also prevents banks from being further downgraded by the rating agencies, which would mean that they would have to establish even larger buffers.

In return for relieving the banks of their toxic assets, Germany's center-left Social Democrats, and some members of the center-right Christian Democrats, have pushed through strict rules that would hamper the banks for years should they participate in the bad bank program. Under one of these rules, the banks are required to immediately pay the federal government 10 percent of the book value of the transferred securities. Exceptions are only permitted if such a payment would reduce a bank's capital base to such an extent as to sharply curtail its ability to compete.

All other potential losses are estimated and must be paid in installments over a 20-year period. A bank is only permitted to pay a dividend if its profits exceed the payment it owes the federal government. But a bank that is restricted in this way would be unable to raise money on the capital markets -- and therefore would have no capital to invest. In the worst case scenario, the bank would exist in a comatose state for decades.

More generous rules were not feasible, for political reasons. Bank bailouts are unpopular -- especially at the moment, when parties are campaigning in the run-up to Germany's Sept. 27 national election. It is difficult to convince voters that such aid averts far more serious consequences, especially when banks are reporting profits and their share prices are rising sharply.

The current debate over an amendment of the law governing Germany's ailing state-owned regional banks, the Landesbanken, is even more strongly marked by partisan interests. Ironically, it was precisely these publicly owned banks that enthusiastically snapped up the exotic high-yield securities that have since proven to be toxic during the boom years. Should they be written down, some of the state-owned banks would be forced into bankruptcy. And should a Landesbank go bust, the state that owns it could also go bankrupt, a scenario which currently looms over the northern state of Schleswig-Holstein, for example.

Hence the state-owned banks are in particularly urgent need of a way to dispose of their toxic assets. Finance Minister Peer Steinbrück is aware of this, and he is demanding something in return. He wants the governors of the states in question to finally move forward on a long-overdue consolidation of the Landesbanken. But the governors, who perceive the pressure from Berlin as unreasonable intervention, want to be allowed by law to establish their own bad banks -- while at the same time wanting the federal government to take on much of the risk associated with those institutions.

It is unclear how the dispute will end. If the legislation is not passed, the German parliament, the Bundestag, will be forced to convene during the summer recess to save one or perhaps several of the state-owned banks from bankruptcy.

The Capital Trap

Two years since the start of the financial crisis, many banks are still on the brink of disaster -- with devastating consequences for the real economy. Hans-Werner Sinn, the president of the influential Munich-based Ifo Institute for Economic Research, sees the "under-capitalization of the banking system and the high levels of hidden losses that have not yet been disclosed" as the main obstacle to Germany's further economic development.

Graphic: A flood of cheap money

Graphic: A flood of cheap money

No matter how much additional liquidity ECB President Jean-Claude Trichet and his staff pump into the market, banks' capital ratios remain a limiting factor when it comes to issuing credit.

The core capital ratios of German banks have declined in the wake of the crisis, but many are reluctant to bolster their capital base with the help of the government's special Financial Market Stabilization Fund, known as Soffin. The program has significant strings attached, including restrictions on bankers' salaries. Other countries, like the United States, have taken a more rigorous approach, forcing their banks to accept an injection of government capital.

A bank is only permitted to lend money or sell debt securities if a certain portion of the underlying funds is backed by bank capital. The riskier a loan or customer, the more capital the bank is required to keep in reserve as collateral.

The credit ratings of US subprime mortgages or corporate borrowers are now declining faster and faster. The repackaged and resold mortgages on houses in low-income neighborhoods in the United States often lose their entire value at one go.

A similarly disastrous development is beginning to emerge among companies. According to Creditreform, a German company that collects creditworthiness data, 16,650 companies with a total of 250,000 employees have had to file for bankruptcy since the crisis began. Experts predict German banks will be hit by up to €170 billion ($238 billion) in recession-related loan defaults by the end of next year.

The effect on bank balance sheets is devastating. Their relatively thin equity capital reserves are either evaporating or suddenly being tied up as mandatory reserves -- thanks to Basel II, an international set of regulations which banks agreed to in 2005 and which came into force at the beginning of 2007.

Basel II was created to make it more difficult for banks to issue loans recklessly, in a bid to prevent crises. Now it is only making the current crisis worse.


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