Why Berlin Says U.S. 'Bad Bank' Plan Is Bad

German Chancellor Angela Merkel and her Finance Minister, Peer Steinbrück, have spent months saying they will never let irresponsible German banks off the hook by taking their toxic assets and putting them into some sort of government-backed bad bank.

But that was before U.S. Treasury Secretary Timothy Geithner unveiled his plan to do just that with the toxic debts of U.S. banks. The move has won plaudits on Wall Street and even a knowing nod from Main Street U.S.A., which understands that the plan is a necessary evil. In Germany, it has also fueled a fierce debate about whether Merkel is wrong and how Berlin might get toxic assets off German banks' books without making taxpayers foot the bill. (See 25 people to blame for the financial crisis.)

With an election just six months away, Merkel simply doesn't have the political capital with voters enjoyed by the newly elected Obama Administration. She already faces rising criticism and demonstrations against her policies to bail out the banks, such as the government stakes in Commerzbank and struggling mortgage bank Hypo Real Estate. Critics say during years of belt-tightening to cut public debt the government had no money for social programs, but now it is spending billions to bail out irresponsible banks.

In a speech to German bankers last week Merkel said her opposition to a bad bank was based on a need for fairness in resolving the crisis.

"Politically we have to be careful that in the spirit of justice we don't reach a point where the taxpayer bears the bad risks and the privately functioning banks in the end have all the good opportunities," Merkel said.

The Chancellor remains skeptical of the American initiative.

But in her speech to Germany's banking élite, Merkel also acknowledged that Europeans were under pressure to deal with the issue of toxic debt. "I am dying to see how the American model will work and whether private-sector incentives can actually sell the more difficult assets," she said skeptically. "But we can't dodge the issue because otherwise it will take far too long before the banks can return to their full strength."

But many Merkel critics say Germany needs to act now. Merkel's wait-and-see policy just isn't working, they argue. Economists now predict that Germany's export-dependent economy will contract by a record 7% this year. And the latest data from the European Central Bank show that despite the stimulus packages and bailouts across Europe, the region's banks still are not lending money. The volume of lending to the private sector in the eurozone, the 16 countries that use the common European currency, dropped 0.1% in February from the month before and lending to businesses also slipped 0.1%, the ECB reported.

German banks have an estimated $265 billion to $400 billion in bad debt on their books. Put another way: that's as much as 12% of German GDP. The U.S. bad-bank plans calls for purchasing up to $1 trillion in toxic debt, equivalent to 6.8% of U.S. GDP. German banks have about $550 billion in cash reserves. So, it's not hard to figure out what would happen to the real economy if the banks are left on their own to work through loan failure of this magnitude. "Germany has not succeeded yet in getting control of the financial crisis," says Klaus Zimmermann, president of the Berlin-based DIW economic research institute. "We must quickly extract the toxic assets from the system so that the banks can finally reassume their service role for the real economy."

There is a chance that Merkel will unveil something at the G-20 meeting to show that Europe's biggest economy is dealing with the issue. Axel Weber, president of the Deutsche Bundesbank, said talks between the banks, the finance ministry and SoFFin, the federal bank-stabilization fund, could produce a viable concept for a bad bank before the G-20 meeting. According to Weber, Germany would not create a central bad bank and it would not buy the toxic assets from the banks. Instead, German banks could split each bank into a good bank and a bad bank, allowing the banks to move the bad debt into their bad bank and in return receive fresh capital from the government for their good bank. The government remains skeptical of the plan but still has put no alternative suggestion on the table. The government wants to ensure that a bank's shareholders and not the taxpayer bear the brunt of any losses. "The previous shareholders will primarily have to share the losses and bear the risks," he told the Saarbrücker Zeitung newspaper.

The Federation of German Banks, which represents the main private-sector banks, has proposed something along these lines already. Rather than calling it a bad bank the banks call it a "mobilization fund." Each bank would park its toxic assets in an account with the government. This way the assets would be off the banks' books but each security would still be associated with its original owner rather than pooled together. "The mobilization fund is not about burdening the taxpayer with all the risks," Klaus-Peter Müller, head of the banking federation, told reporters.

DIW, the economic-research institute, suggests that the banks sell the toxic assets to the federal government at no charge. In exchange, the government would then provide the banks with equity by taking stakes in banks that participate. The toxic assets would be placed in a state-owned bad bank and sold back to the banks at a later date when a market for such assets reemerges. "This ensures that the shareholders and not the taxpayers have to bear the initial costs of the failure," says Dorothea Schäfer, DIW head of research.

Back at the finance ministry, no one seems happy with any of the suggestions currently on the table. "We are continuing to look for a solution that doesn't place the burden on taxpayers," a ministry spokesman says.

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