Bad banks – savior with pitfalls

The model is simple, but not free from pitfalls: The bad bank frees its mother from toxic papers and puts them back on the market with as little loss as possible. But the business of the resolution agencies does not go completely without losses, as the HRE-Bad Bank shows.

By Oliver Feldforth, HR  

Now it’s getting expensive again for taxpayers. FMS Wertmanagement, the bad bank of the former Hypo Real Estate (HRE), becomes a Billion grave. The FMS has existed since the summer of last year. To date it has had to write off three billion euros. The SoFFin bank rescue fund, i.e. the German taxpayers, pays it.

Poison in the basement

The FMS is an institution under public law. HRE contaminated sites amounting to 175 billion euros were relocated to their basement. So the HRE was able to start over again. Other financial institutions are doing business with her again. In the past quarter, HRE posted a profit of 163 million euros. She doesn’t have to hand it in for the bad bank. With the relocation of the risky papers to the institution under public law, the HRE is off the hook.

The Bad Bank FMS, on the other hand, is crawling – how could it be otherwise? She has already sold halfway usable papers worth more than one billion euros, but she has more than nine billion in the fire with the euro-shaky candidate Greece alone – the outcome is open.

Depreciation rules make the difference

The toxic securities bad bank model is simple, but not without its pitfalls. The basic idea: to free the parent company from the ballast of these bad papers and to make it afloat and creditworthy again.

Another advantage: a bad bank is not a bank in the legal sense and is therefore subject to different accounting regulations. "Like her mother, she doesn’t have to write off assets at their current market value, but rather hopes for better times and writes off gradually over the years," explains Reinhard Schmidt from the University of Frankfurt am Main. This in turn saves the bad bank’s equity. The parent bank would have lost equity due to the current depreciation obligation.

The taxpayer’s "loss compensation obligation"

In the end, however, someone has to foot the bill. In the case of the FMS, this is the German taxpayer via SoFFin. So HRE is out of its payment obligations. Here SoFFin has a "loss compensation obligation" – it simply pays for the damage. This is due to the special situation of the nationalized HRE, explains Bettina Belker from SoFFin. With the second current bad bank, the EAA, things are different. It emerged from WestLB.

For West-LB-Bad Bank, savings banks also have to stand up

The ailing Landesbank of North Rhine-Westphalia belongs to the state and the savings bank associations. Having run into financial difficulties due to risky transactions, 77 billion euros were outsourced in December 2009 to the bad bank called Erste Abwicklungsanstalt (EAA). The state of North Rhine-Westphalia and the savings bank associations want to share upcoming losses. But only up to a level of nine billion euros. Then the savings banks are out of the risk and all further debts are ultimately shared by the state and the federal government.

WestLB has another dormant monster called Phoenix. Phoenix is ​​a second WestLB bad bank that has existed for three years and has now been put under the umbrella of the EAA. Phoenix papers are considered to be particularly toxic and their real value is therefore particularly questionable. Originally, they were worth 23 billion euros to WestLB. NRW and the savings banks guarantee a loss of five billion euros – if it gets worse, the EAA’s loss mechanism takes effect.

Avoid falling into the abyss

The former finance minister Peer Steinbruck reported after his term of office that he had looked into an abyss during the HRE crisis. A bankruptcy would have triggered an uncontrolled chain reaction in the financial sector because of the wide spread of loans. It is not always better to let a bank go bust, says expert Schmidt. Because an HRE bankruptcy would have had similar effects as the collapse of Lehman Brothers in the USA. The bad bank is clearly the better solution.