bad bank is not really a bank at all. It is a special purpose vehicle, similar to those off-balance sheet vehicles that triggered this crisis

TO BE NOTED: From the FT:

"Germany needs more than an accounting trick

By Wolfgang Münchau

Published: May 17 2009 19:31 | Last updated: May 17 2009 19:31

After the US, the country with the biggest banking problem is probably Germany. Last week the German cabinet adopted a bank rescue plan worth looking at in detail. If you want to know how long the European crisis will last, this might give you the answer.

The Geithner/Summers plan in the US has two fundamental planks – a strategy to ring-fence structured finance products for which there is no market, and a strategy to recapitalise the banking system. Both seem to be based on unrealistically optimistic assumptions about the economic recovery. And both have been criticised sharply, mainly for that reason.

The German scheme is constructed very differently. It is a ring-fencing plan only and it is voluntary. Under the draft legislation put forward by the German government last week, a bank can apply to set up its own bad bank. A bad bank is not really a bank at all. It is a special purpose vehicle, similar to those off-balance sheet vehicles that triggered this crisis in the first place. The proposed SPV will have a shelf life of up to 20 years. It buys the structured securities from the bank at 90 per cent of book value – the price at which the securities are currently valued on the balance sheet. In return, the SPV issues new debt securities to the bank, guaranteed by the government. So if a bank shifts structured securities with a notional value of €10bn ($13.5bn, £8.9bn) to the SPV, it gets €9bn in good securities back. The state is the guarantor. The idea is to give the banks an incentive to lend again.

Will it work?

The answer is: not in the way that has been proposed. First of all, the plan is a giant accounting trick. Under fair-value accounting, it could not possibly work because the bank would have to make a provision for future losses of the SPV. This would, of course, defeat the very purpose of the plan. It is constructed in the same spirit as some of the more eccentric debt securities.

The fundamental problem is that the strategy might actually deter recapitalisation, which surely should be a priority. Under the plan the bank, not the government, is fully responsible for the SPV’s losses. So if the SPV sells the securities at a loss, the bank will have to pay for the loss out of earnings. So the bank will have to divert an uncertain proportion of its future earnings to pay off the SPV’s losses, and all this for up to 20 years. Which private investor in their right mind would provide new equity capital to a bank under such conditions?

A spokesman for the federation of Germany’s private banks made a good analogy when he compared the scheme to a deep freezer. The banks are trying to buy time. When the crisis is over, they hope that the structured securities can be sold at reasonable prices. Until that happens nothing is resolved.

Why did the government opt for such an obviously daft plan? The answer is because it costs next to nothing. There is only a cost to the government if the SPV goes bankrupt, which is not going to happen soon, if at all. The SPV even pays a fee to the government to cover the expense of issuing the guarantee. So the scheme tries to be the equivalent of a free lunch.

But it is only cost-free in a narrow accounting sense. The economic costs are huge. Last week the German government was told that the tax shortfall would be €300bn over three years – two-thirds of that due to the crisis. If you split the loss evenly over the three years, the pure tax effect of the crisis makes up some 3 per cent of gross domestic product for three years running. Not bailing out the banks will almost certainly end up being more costly than bailing out the banks. But a bail-out would be unpopular, and the government does not want to touch this issue until the federal elections in September. Until then, we have an insufficient ring-fencing plan only.

What about after the elections? Will there be a better plan then?

I am not sure. Peer Steinbrück, Germany’s finance minister, last week gave a characteristically belligerent comment about the US stress tests – effectively accusing the US authorities of fixing the results. His position is that recapitalisation is primarily a problem for the banks, not the government. If the state were to recapitalise the banks, his scheme might just work, but without it, it cannot. No sane private investors are going to pour money into a structure whose obvious purpose is to deceive them.

The German political classes have yet to comprehend that recapitalisation is necessary, and that it will end up costing the taxpayer a lot of money. The plan as it stands now offers no resolution, only procrastination. While US banks have already written off a fair proportion of the bad debts, the Europeans are adopting schemes that allow the banks to postpone resolution.

The more I think about it, the more I am reminded of Japan. But this might be unfair to the Japanese. They solved the problem eventually. If we freeze our toxic securities for 20 years, a Japanese-style lost decade will soon come to be regarded as the optimistic scenario."