Hypo has so far received $128bn in guarantees from the state and fellow banks over the past year, but remains in dire financial straits.
Berlin has said the bank, which was hit hard by its exposure to the collapsing mortgage market in the United States a year ago and has spiralled downwards since, cannot be allowed to fail because of its key role in German bond markets.
But taking control of Hypo and preventing it from absorbing more taxpayer money has been complicated by the fact that JC Flowers, the US private equity firm, owns a quarter of its stock.
Berlin has been negotiating with Flowers, which bought the stock last June for $28-a-share before it plummet to just above $1.25, but has yet to reach a settlement.
Before taking a decision to confiscate the bank, Berlin has vowed to explore all other options.
The favoured solution appears to be a process which would push up the state's holding and allow it to squeeze out other shareholders.
The new legislation makes this possible by reducing the threshold needed to inject fresh capital to 50 per cent plus one share, from a previous threshold of just over 75 per cent.
"Only if this does not work would the last resort come into play, and that is an expropriation," Merkel said.
|The legislation must still be approved by parliament [AFP]
Peer Steinbrueck, Germany's finance minister, also evoked the possibility of a government takeover bid for Hypo, a statement which helped push the bank's shares up over 41 per cent to $2 in afternoon trading.
Hypo Real Estate is not the only German bank that has been hit hard by the global financial crisis and forced the government to intervene.
Last month, Berlin took a 25 per cent stake in Commerzbank, the country's second-biggest bank.
On Wednesday, Commerzbank reported an operating loss of $1bn for the fourth quarter and Martin Blessing, its chief executive, said the bank was going through one of its most difficult periods ever.
In a separate development, Volkswagen, the German car maker, said on Wednesday that its financial arm had secured credit guarantees worth up to $2.53bn from a German government bank bailout fund.
The German government launched its fund, worth up to $628bn, last October.