One way or the other

The financial markets know it. Analysts know it. The bank's new CEO and a major financial investor have called for it.

So why is the German government so hesitant to admit it will soon be the new majority owner of deeply scarred public-sector and mortgage lender Hypo Real Estate Holding AG?

The subject surely came up on Feb. 4 when Chancellor Angela Merkel called in select members of her Cabinet to discuss the next step in the rescue of Hypo Real Estate, as well as the state's options for other troubled lenders.

Merkel's high-profile role is unusual but not surprising. It reflects the symbolic importance of the Hypo case, which has stirred a spirited and very much ongoing debate about the pros and cons of German state aid to the banking sector.

Despite the near failure of two midsized corporate German banks, Munich's Hypo Real Estate is the country's biggest victim of the global credit crunch. It borrowed short-term to cover long-term, public-sector loans at its Depfa Bank plc unit, and that choice proved fatal. As banks cut off short-term financing, Hypo Real Estate found itself seriously strapped for cash and only won a reprieve with €92 billion ($119 billion) in guarantees and cash from public and private sources. Now, under the leadership of new CEO Axel Wieandt, it hopes for state control.

Berlin is reportedly weighing two options. One would be a complete takeover that would involve a settlement with existing shareholders. Alternatively, the state could subscribe exclusively to a massive capital increase that would give it well over 90% but leave other shareholders -- most notably private equity house JC Flowers & Co. LLC -- with a pittance. Flowers picked up about 25% of Hypo Real Estate last year for €1.1 billion.

Either choice would be the first nationalization of a private German bank since World War II.

"Dispossession would obviously only be the final option and there would be adequate compensation. We have to keep our cool and make sure we do enough to offset the regulatory collapse. But of course we can ask ourselves where this leads us. I think we have to go so far because it's what this crisis calls for," Helge Berger, chair of monetary economics at Berlin's Free University, said in an interview with Stern magazine.

Resistance to the plan is almost entirely internal. Wieandt has openly pleaded for the government's assistance and JC Flowers founder, J. Christopher Flowers, has also pushed for government intervention as a member of Hypo Real Estate's supervisory board. Financial sources say he would like to cap the government's ownership at 90%.

The coalition government is itself divided. Left-leaning Social Democrats want to protect taxpayer funds by gaining a stake in Hypo. The right-leaning Christian Democrats resist nationalization but would stop short of letting the bank fail.

Meanwhile, the interior ministry, led by feisty Christian Democrat Wolfgang Schäuble, has serious doubts about the constitutionality of dispossession. Since the German constitution forbids such moves except when they will benefit the common good, few politicians seem to share his concerns. Hypo Real Estate is widely seen as a "system critical" lender whose bankruptcy would cause the German financial system to suffer Lehman Brothers-level carnage.

But how could the government absorb Hypo Real Estate and still deny faltering Schaeffler KG, a ball-bearing maker that amassed €22 billion in debt largely through an ill-timed acquisition of peer Continental AG? Schaeffler matriarch Maria-Elisabeth Schaeffler recently met with Economic Minister Michael Glos, of the Christian Democrats, to negotiate just such a deal, but the government turned her down.

Finance Minister Peer Steinbrück makes a simple case for that rejection: "We wouldn't be able to explain to anybody why we helped out a company that is backed by billions in personal assets," he recently told the Berliner Zeitung newspaper, referring to the Schaeffler family, which owns all of its namesake industrial group.

In any case, the government needn't decide hastily on Hypo. A shareholder meeting that could be required to vote on a rescue isn't planned for several months and the initial government capital injection should cover Hypo for that short period of time. And what about minority stockholder JC Flowers? It hopes to be bought out and fears to be wiped out.