Dealing with toxicity

IFR Germany Report 2009
15 min read

Germany, along with many other countries, has been wrestling with the idea of establishing “bad banks”, to free its existing financial institutions of the distressed assets they have accumulated on their balance sheets, and, in so doing, hopefully revive banking activity. Dr. Klaus Grossmann, partner at Reed Smith, outlines the latest thinking of the German government.

Since the introduction of the German Financial Market Stabilization Act in October 2008, it has become clear that certain amendments are needed if it is to achieve its objective of effectively stabilising German financial market institutions. However, the glut of bad news hitting the markets, and the headlines, over the past months has continued to fuel the debate as to whether Germany needs a comprehensive bank rescue plan. Despite the government’s attempts to avoid a general public debate, the discussion amongst economists, politicians and bankers intensified on an almost daily basis earlier this year.

The government, apparently a discussion leader behind closed doors, was expected to unveil its theory on how to stabilise the banking sector in late February - particularly since the world’s leading economies and financial markets apparently cannot agree on a common multilateral approach. However the discussion calmed down in March and early April. It was as though the media, the markets and the government had agreed to take off the heat – which had been unhelpful in shaping the right approach for the biggest challenge that the financial markets and the modern economies have faced in their entire history.

Germany, apparently aware of its relative strength compared to other leading economies, certainly does not want to take the lead. It is, unlike the US and the UK, apparently not convinced that massive deficit spending is the right approach. Rather, the German government would like to rely on the markets and its recovery forces. It does not adhere to a “strong government intervention” approach.

Since the end of 2008, it has become apparent that Germany’s private banking sector needs a “bad bank”. Today, it seems likely that the Berlin government will indeed introduce such a concept. Yet it remains unclear at the time of writing which “bad bank” concept will, or should, eventually be adopted.

What is clear is that it will be the “how” – rather than the “if” – that will be key in determining the success of this project.

History holds limited examples of the “bad bank” concept. All the available examples have been responses to particular - often isolated – circumstances. They are, therefore, unsuitable as a generic model for the current worldwide banking crisis. This is particularly true of the US crises in both 1932, with the failed Reconstruction Finance Corporation, and again in 1989, with the successful Resolution Trust Corporation, which was set up to end the US savings and trust crisis.

The Swedish banking crisis in the early nineties has probably seen the most innovative and successful “bad bank” concept, but doubts surface as to whether it can be applied to larger economies and a global crisis without modification.

In light of the strengths and weaknesses of the various models, it seems likely that Germany will create its own model to respond to the crisis. In doing so, several considerations can be clearly identified. On the one hand, there is the requirement that a bad bank concept must be strong enough to stop the financial market erosion immediately to re-establish confidence in banking institutions. Most importantly, it must restore liquidity by granting credit to private banks. On the other hand, there is a very strong sense in Germany that the taxpayer should not bear the costs of such rescue operations, but should only pay for the ultimately inevitable costs, should all other means of rescue fail.

The more the merrier

In order to reconcile those needs and requirements and create a commercially and politically acceptable model, Germany is probably best advised to set up a number of privately held “bad banks”. Under such a “bad bank light” concept, the government would allow individual banks, or groups of banks, to create their own privately held “bad bank”, to which toxic papers could be dispersed. Through the Soffin, state-owned funds established pursuant to the FMStG, the government would give warranties to the bad banks and provide fresh equity to the remaining good banks, thus taking its share of responsibility.

Instead of a single state-owned toxic waste bank, there would be a number of private bad banks, for which the owners of the good bank bear the risk in the first place, and the government and taxpayers only in the second.

It is an undesirable, yet unavoidable, side effect that the government will temporarily become a significant, and in many cases, even a controlling stakeholder in the private banking landscape. From there, it is only a small step to allow for a temporary nationalisation of banks that are likely to become insolvent. Legal conflicts with the German constitution must of course be eased, but that is feasible and a relatively small price to be paid.

And indeed, the German Parliament and, subsequently, the Federal Council have passed legislation on 3 April 2009 in the form of the so-called Rettungsübernahmegesetz (Rescue Takeover Act), which allows for a limited and short time period in 2009 of nationalising banks as a means of last resort and in order to prevent their immediate insolvency.

However, the Act is actually only aiming to rescue the factually insolvent Hypo Real Estate, the world’s largest issuer of mortgage debentures, which has a balance sheet about the size of Lehman Brothers. This is a practical consideration, as any nationalisation pursuant to the Act needs to be commenced before the end of June this year. Also, the government is obliged to privatise a nationalised bank as soon as it has been “enduringly stabilised”. It is rather apparent from the Act that the government has no interest in any nationalization, but is bound to temporarily protect the economy and financial markets from disastrous failures of key banking institutions.

Yet as a knee-jerk rescue, the Rescue Takeover Act does not provide any clues as to the Government’s thinking with regards to the “bad bank” concept. There are approximately 450 banking institutions in Germany, of which apparently less than 25 banks – including some of the largest ones – struggle with toxic papers. (This is a misnomer as those papers are not toxic at all, simply worthless.)

If the crisis can eventually be solved, the government may even make a profit, as did the government in the Swedish banking crisis in the early nineties. In any event, the good bank owners assume a significant share of the risks of the respective bad bank and are bound to render their share in cleaning those up, however without running the risk of its own insolvency.

Contrary to the former RTC in the US, Germany is not likely to create one large state owned bad bank. The RTC had more than 9,000 employees at its peak – and the crucial issue of evaluating and pricing of the toxic papers will be largely left to the private institutions. Equally, by creating various toxic pots, the taxpayer stands a much better chance of not having to bear the financial risks associated with one large bad bank.

The US apparently still adheres to the idea of one large “bad bank”, a concept that many view as unfair to the taxpayer. However, more recent news indicates that the US Treasury is investigating whether private investors could be involved. This seems to lean towards the likely German model in the sense that the taxpayer is only a “guarantor of last resort”.

Contrary to the above, the UK approach does not provide for a “bad bank” at all but works on an insurance basis. Such a model is viewed by many as impractical and its suitability to stabilize the banking sector as uncertain; it is probably neither black nor white. But, given the historic dimension of this crisis, who can tell?

Klaus Grossmann is a partner in the corporate team in Reed Smith’s Munich office. He can be reached on +49 (0)89 203041 51 or via kgrossmann@reedsmith.com.

All German loans 12M
13/4/2008–13/4/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1Commerzbank14,825.812.536
2UniCredit Group12,869.710.920
3RBS9,525.08.012
4LB Baden-Wurttemberg9,073.67.712
5Deutsche Bank6,552.05.516
6UBS6,531.35.53
7BNP Paribas6,163.95.210
8Barclays Capital5,508.44.78
9Calyon5,488.54.68
10JP Morgan5,027.54.26
11WestLB AG3,903.63.311
12Credit Suisse3,236.22.74
13Societe Generale3,151.42.79
14HSBC2,940.82.54
15Citi2,603.12.23
16Mitsubishi UFJ Financial2,293.61.92
17Bayerische Landesbank Giro2,069.01.78
18LB Hessen-Thueringen1,692.01.46
19Santander1,621.61.44
20DZ Bank1,521.41.36
21Intesa SanPaolo1,149.31.02
22Natixis855.50.73
23HSH Nordbank847.90.75
24Bank of Ireland620.10.55
25DGZ-DekaBank603.50.53
Total118,569.3100.063
Source: Thomson Reuters
All German euromarket 12M
13/4/2008–13/4/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1Deutsche Bank46,483.015.499
2UniCredit Group33,901.411.269
3Commerzbank21,750.37.249
4Barclays Capital18,932.96.371
5BNP Paribas18,117.56.041
6RBS14,190.04.736
7DZ Bank13,925.54.643
8JP Morgan13,691.84.538
9HSBC12,356.34.141
10LBW11,735.33.931
11Morgan Stanley9,979.33.326
12Societe Generale9,931.03.319
13Bayerische LB9,047.63.020
14Citigroup7,297.72.417
15Goldman Sachs7,139.72.410
16BofA Merrill Lynch6,473.72.115
17Calyon6,113.32.011
18Credit Suisse6,102.52.011
19UBS5,978.12.013
20WestLB5,708.81.917
21Nord/LB4,089.41.417
22ING2,460.20.86
23RBC CM2,411.80.820
24HSH Nordbank2,145.90.75
25Fortis1,684.60.64
Total302,114.9100.0399
Source: Thomson Reuters
All German securitisation 12M
13/4/2008–13/4/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1UniCredit Group1,449.927.91
2BNP Paribas1,375.026.51
3Fortis793.215.31
=3Societe Generale793.215.31
5Deutsche Bank715.513.85
6RMB Holdings57.41.11
7HSBC6.20.11
Total5,190.3100.010
Source: Thomson Reuters
All German pfandbriefe 12M
13/4/2008–13/4/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1UniCredit Group5,416.714.414
2Deutsche Bank5,076.213.515
3Commerzbank4,843.312.916
4Barclays Capital3,308.58.817
5LBW2,934.07.89
6DZ Bank2,068.85.511
7Societe Generale1,900.35.15
8Bayern LB1,881.65.05
9Morgan Stanley1,555.34.13
10BofA Merrill Lynch1,545.24.15
11Citigroup1,311.83.54
12BNP Paribas1,290.93.45
13JP Morgan1,000.82.77
14Credit Suisse893.82.46
15Natixis507.91.42
16UBS365.81.02
17Nord/LB309.90.81
18HSBC299.20.82
19ZuercherKB274.50.72
20Danske Markets270.70.71
21Lehman Brothers200.00.51
22RBS125.80.32
23WGZ97.30.31
24HSH Nordbank95.70.32
25WestLB84.50.22
Total37,658.3100.058
Source: Thomson Reuters
All German bonds 12M
13/4/2008–13/4/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1Deutsche Bank54,219.514.6107
2UniCredit Group34,536.19.375
3Commerzbank24,444.46.651
4Barclays Capital23,088.66.274
5BNP Paribas22,143.76.047
6HSBC20,750.95.646
7JP Morgan18,685.45.042
8DZ Bank16,001.94.344
9RBS15,254.04.141
10Credit Suisse15,178.94.135
11Morgan Stanley13,061.33.529
12LBW11,735.33.231
13Citigroup11,274.03.021
14Goldman Sachs10,102.42.715
15BofA Merrill Lynch9,950.82.720
16Societe Generale9,931.02.719
17BayernLB9,047.62.420
18UBS7,994.82.222
19Calyon6,113.31.711
20WestLB5,708.81.517
21Nomura5,129.91.47
22RBC CM4,777.61.325
23Nord/LB4,089.41.117
24ING2,460.20.76
25HSH Nordbank2,145.90.65
Total370,876.8100.0471
Source: Thomson Reuters
All German bonds Q1 08
1/1/2008–31/3/2008
BookrunnerTotal (US$m)Mkt share (%)No of issues
1Deutsche Bank17,396.016.337
2RBS9,472.08.924
3HSBC8,907.98.424
4Barclays Capital6,985.86.626
5UniCredit Group6,408.36.020
6Citigroup5,388.95.19
7Morgan Stanley5,052.44.713
8JP Morgan4,871.04.612
9Commerzbank4,603.94.318
10RBC CM4,600.04.317
11Credit Suisse4,576.84.318
12UBS3,735.13.511
13BNP Paribas3,519.43.312
14Lehman Brothers2,427.02.36
15Goldman Sachs2,311.92.26
Total106,515.8100.0218
Source: Thomson Reuters
All German bonds Q1 09
1/1/2009–31/3/2009
BookrunnerTotal (US$m)Mkt share (%)No of issues
1Deutsche Bank17,424.011.731
2UniCredit Group11,322.17.620
3JP Morgan11,175.87.521
4BNP Paribas11,069.67.422
5Commerzbank10,652.77.119
6HSBC8,528.85.720
7DZ Bank8,210.25.517
8RBS7,523.65.013
9LBW7,100.24.817
10Citigroup6,026.24.08
11Barclays Capital5,782.23.920
12Morgan Stanley5,441.63.610
13BayernLB4,924.23.37
14Credit Suisse4,464.63.010
15UBS4,012.32.76
Total149,524.3100.0132
Source: Thomson Reuters