Ifo Viewpoint No. 105: Bad Banks and Bad Ideas

Hans-Werner Sinn
Munich, 10 June 2009

The German government has decided to set up so-called bad banks. The structured securities of American origin that the banks still have on their books are to be transferred to the bad banks. The market value of these securities, which arose via the securitisation of credit claims vis-à-vis American real-estate owners, is now only a fraction of their nominal value. Papers in the so-called equity tranches have a market value approaching zero, and even papers in the AAA category are being traded at only a third of their nominal value. This decline in value can be traced back to the institutional deception in which American rating agencies, the lax regulation of the investment-banks, the legal institution of limited liability and not least the US housing policies all played a part.

The balance sheets of German banks still largely list such structured securities at values far above their market values. This is partly because the European Union last autumn, after the collapse of Lehman Brothers, gave the banks the possibility to shift these papers retroactively to July 2008 from their trading books to their investment books, thus protecting them from the valuation adjustments that became necessary after the collapse of the interbank market. In addition, the banks had considerable leeway to assess their loan claims using the fair-value method by means of discounting of estimated loan repayments. No one is forcing them to write off these claims if losses are not yet inevitable but may only occur with a certain degree of probability.

How large the hidden liabilities in the banks’ balance sheets still are becomes clear when we compare the actual write-offs and market valuation adjustments made by Bloomberg with the forecasts of such write-offs and valuation adjustments made by the International Monetary Fund (IMF). The former stood at 1.1 trillion dollars worldwide at the end of February. The latter, in the April IMF forecast, was 4 trillion dollars for the US, the euro area, the UK and Japan. According to the IMF figures, only a fourth of the expected valuation adjustments have been carried out. This, to be sure, is only an average figure for the whole world, but since there is no reason to assume that the Americans sold the better papers within the rating categories to Germany and kept the worse ones for themselves, we must assume that the IMF figure applies proportionally also for the structured US securities deposited in Germany. Up until February only 22 percent of the capital reserves on aggregated German bank balance sheets were lost as a result of valuation adjustments of toxic assets. If this percentage figure were quadrupled, German banks would be broke, on average, because with the little capital that remains they can no longer meet the operating requirements laid down by the supervisory authorities. It is only small comfort that the American and Swiss banks are in an even worse predicament.

According to official information of the Federal Financial Supervisory Authority (BaFin), the stock of structured assets that could be transferred to the bad banks stands at about 200 billion euros. Unofficially, the stock of toxic papers, as reported by the Frankfurter Allgemeine and the Süddeutsche Zeitung, is 800 billion euros, not including non-performing loans to companies. In light of capital reserves of only 300 billion euros in the consolidated bank balance sheet, this information is unfortunately not any better than the comparison of the IMF and Bloomberg figures.

To say that the German banks have a liquidity problem would be an understatement. In truth they have a serious solvency problem. A great deal of capital has already been lost and much more will be lost when the truth is revealed about the structured assets. To avoid a persistent credit crunch and subsequent damage to the real economy, ways must be found to provide German banks with fresh capital.

Bad banks, if they do not cost the state anything as the politicians maintain, are not the way to reach this goal. The state can only provide the banks with fresh capital if the bad banks are expensive for the state and not if they do not cost anything.

It is to be feared that the taxpayers will foot the bill for the bad banks, because since participation is voluntary, the banks will only join if they expect advantages. At first glance the construction seems to be designed fairly insofar as the banks must pay off the losses of the bad banks over time from their dividends. They must also pay fees for the guarantees assumed by the Financial Market Stabilisation Fund (SoFFin) for the interest-bearing securities that the bad banks issue in exchange for the toxic securities. However, since any bank could also buy guarantees on the market, the bad banks are nothing more than contracts by which banks are surreptitiously given money.

The real problem is that the state has no money to give away. A better and more transparent solution would be for the state to openly transfer the necessary capital to the banks in return for stock. It could hold the stocks until the crisis is over and then sell them, perhaps even at a profit.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published as "Bad Banks und Bad Ideas“, WirtschaftsWoche, No. 22, 25 May 2009, p. 43.