Spanish banks' bad loans look set to weigh on the economy for some time

The Bank of Spain released its latest data on the level of bad loans held by Spanish banks today. For the first time since January 2013, the value of bad loans has dropped - falling from €195.2bn in Feb to €192.8bn in March. However, it has stayed roughly constant as a percentage of total loans (13.4%).

Symbolically, even a small drop in the headline value of bad loans may be seen as important, especially given that previous declines were down to the transfer of assets to the Spanish bad bank (SAREB), rather than any change in circumstances of the loans. If this is discounted, the value of bad loans has simply continued to rise.

That said, as the graph highlights, these loans remain at very high levels and well above the loss provisions held by banks. This continues to tell us that:

• Spanish banks will continue to deleverage for some time to come. This puts a dampener on any hopes that they will show any rapid increase in willingness to lend and take on more risk to help fuel any form of Spanish recovery. This thereby increases the risk that any recovery will be ‘creditless’, and therefore more likely to be limited and temporary.

• This data is quite timely, as it also highlights the obstacles which the ECB is going up against in these countries when it comes to encouraging banks to begin lending again, particularly to small and medium-sized enterprises (SMEs). With their balance sheets still weighed down by these loans, it seems likely that banks will continue to be reticent to take on significant new lending, even if the ECB does offer them cheaper long-term loans.

• Given that many of these loans still relate to the real estate and construction sector, they will continue to weigh on prices in these markets. This suggests prices could fall further (although this will vary significantly based on location and regional markets), while the political hot topic of evictions could return to the fore again in the future.

An EU bank bailout facility?

Bloomberg reports on a potential proposal by the European Commission to alter the EU’s ‘Balance of Payments’ (BoP) facility to allow it to aid banks which may need to be recapitalised in the aftermath of next year’s ECB Asset Quality Review and the EU's bank stress tests.

As a reminder, the BoP facility was originally created to aid countries with currency crises that may impact the rest of the EU or the fundamental stability of the state. It has since been adjusted to apply to only non-euro members and seen its scope widened slightly with its budget increased to €50bn due to the financial crisis. It is guaranteed by the EU budget and therefore ultimately by the member states - with the UK underwriting around 14-15%.

What is the rationale behind this move?

• Next year’s stress tests are hopefully going to be the most stringent and comprehensive so far, yet there are fears that, without clear aid to help banks found to be in trouble, supervisors may shy away from revealing any deep problems.
• This is backed somewhat by the ECB’s insistence that the stress tests will not be able to be effective unless there are clear backstops for banks in place.
• The eurozone does have some form of backstop in the shape of the ESM which can provide aid to banks (via states) but also has a direct bank recap tool.

Can it be done?

• The most likely approach would be to use Article 352 (the flexibility clause) to adjust the regulation establishing the facility.
• However, the facility also has a treaty base, Article 143, which specifies lending to states. For this reason, it seems unlikely that a direct recapitalisation tool could be added but a credit line which is lent to states to solely aid banks could potentially be. This could come with less or more specific financial sector conditions than other loans (for example see ESM and Spanish bank bailout).
• This would require unanimous approval in the Council. So far, Germany and the UK have expressed scepticism based on the fear that a backstop would reduce the pressure on banks (and their governments) to reform and clean up ahead of the tests.

Could it be significant?

• Yes. If it were approved it would create a collective fund to salvage banks should a member state be unable to deal with the problem alone. If the UK were to approve the move it could open up the door for future pay-outs of funds to aid other countries' banks – decisions taken under qualified majority voting. 
• Furthermore, it also seems to be driven by events in the eurozone. Firstly, it seems an attempt to extend this centralised banking union model (to break the so-called sovereign-bank loop) to the entire EU - even though the other countries have already rejected this to a large extent. If they really wanted to join the banking union, which some might, there will be chances for them to engage directly.
• The creation of the fund would raise some serious questions. Will this backstop exist without strong influence over the amount of risk taken in or the relative size of banking sectors to governments across the EU? If so, surely that creates a moral hazard problem. If not, it would necessitate far greater powers over member states' financial sectors. 
• Lastly, it highlights the level of concern around the health of many of the EU's banks. This was furthered by the EBA's recent assessment that the largest EU banks are some €70bn short of where they need to be to meet the new Basel III rules.

Some ratings still matter in the eurozone

A general view seems to have come to pass (and not without good reason), that ratings actions in the eurozone have much less significance these days. This is mostly because the ratings agencies tend to 'lag' the market – meaning that a downgrade only comes once everyone already knows a specific country is struggling. The main outcome is usually a bad-tempered back-and-forth between governments and the agency in question, and then another call for EU regulation of rating agencies.

However, sometimes a rating change comes along that could have some material impact. In this case, it comes from a lesser known agency – Dominion Bond Rating Service (DBRS). In an interview with Spanish daily Expansión this morning, their Head of Sovereign ratings Fergus McCormick warned that Spain’s rating remains under pressure and that it is too early to tell if the crisis has bottomed out (as many in the Spanish government have suggested might be the case). DBRS' latest report on Spain, from March this year, also struck a more cautious tone.

This is interesting because, as Reuters pointed out in July, DBRS is the last rating agency to give Spain (and Italy for that matter) an A rating.

As the article also explained, this could cause problems for Spanish banks for the following reasons:

• They hold a large amount of Spanish government bonds as collateral for their borrowing from the ECB;
• Under ECB rules, the ECB judges collateral based on the highest single rating from four eligible agencies (S&P, Moody’s, Fitch and DBRS);
• The value of these bonds is subject to a haircut – for example a highly rated 10yr+ government bond would be subject to a 5% haircut, meaning a bank could borrow up to 95% of the bond's value under the ECB’s liquidity operations (see here for the full ECB collateral haircuts);
• However, once the rating falls, the haircut to such a bond jumps to 13%. This means banks using such bonds as collateral would have to reduce the amount they borrow from the ECB or produce more collateral to cover their current level of lending.

As of July 2013, Spanish banks were borrowing a combined total of €252 billion from the ECB, although this is well down from a peak of €411 billion in August 2012. This suggests that Spanish banks should have plenty of surplus collateral to fill any hole that opens - the muted market reaction so far also suggests as much. That said, the banks are currently de-leveraging significantly (selling off assets to reduce their balance sheets) and running a tight line in terms of balancing the books and trying to keep costs as low as possible. A hit such as the one described above is likely to be far from welcome.

Eurozone compromise on using ESM to directly recapitalise banks - a stopgap at best?

Eurozone finance ministers finally reached a compromise yesterday which will allow the ESM, the eurozone

bailout fund, to directly recapitalise ailing banks.

This is likely to be an important element of any ‘solution’ to the eurozone crisis, especially since it will probably be incorporated into the plans for a eurozone banking union and single bank resolution fund.

Below we summarise and analyse (in bold italics) the key points of the agreement:

€60bn limit: ESM funds available for direct bank recaps will be limited to €60bn out of the total €500bn, since this method of funding eats up the capital of the ESM more quickly. Given the size of the eurozone banking sector – around €34 trillion or 360% of eurozone GDP – this seems far from sufficient.

Burden sharing: National governments will have to contribute 20% of the funds for the first two years and 10% thereafter. Furthermore, ESM funds can only be injected once the bank has reached a core tier one capital buffer of 4.5% - any recapitalisation to achieve this minimum level will also fall on national governments. This is a logical compromise, but it means that the link between sovereigns and banks is not completely broken. It is only "diluted" (as EU Economic and Monetary Affairs Commissioner Olli Rehn put it). Combined with the above funding limit, this places some tight constraints on the level of capital injection possible.

Strict conditions: The funds can only be used for banks which are deemed 'saveable' and have no other alternative. These banks must also be systemically important (in the relevant member state at least). It must also be impossible for the member state to bailout the bank on its own without harming its fiscal sustainability. There must also be independent stress tests performed ahead of any ESM contribution. Any contribution will come with strict conditions both on the bank and possibly on the member state.

Bail-ins: The agreement states that “sufficient contributions from existing shareholders and creditors of the beneficiary institution”will need to be explored. This suggests that the final agreement on the Bank Recovery and Resolution Directive will play an important role in determining how and when this fund is tapped. The emphasis on bail-ins is of course positive but until related plans are settled uncertainty will remain.

Final liability: A subsidiary of the ESM will be set up to directly purchase equity in ailing banks. This allows final liability for the rescue programme to rest with the ESM rather than states.

Retroactive use (legacy assets): The funds can be used to retroactively takeover the burden of previous bank bailouts, although this will be decided on a case-by-case basis. German Finance Minister Wolfgang Schäuble described this as "a concession to our Irish friends". This gives hope to Ireland that the cost of its bank bailout can be shifted. However, given the above limits and the conditions, this still seems a distant prospect.

At first look then, it is positive that an agreement has been reached but this looks to be a stopgap at best. It is clearly tightly constrained by the limits on lending but also by the conditions – in particular the need for a strict independent stress test which could eat up precious time in a crisis. The hurdles to retroactive use are also significant – there is far from sufficient funds to cover for the Irish, Spanish and Greek bank bail-outs (up to €125bn in total), while opening a country's economy to further oversight is far from desirable.

To be fair, given how tied in this is with the single bank resolution mechanism, banking union and the Bank Recovery and Resolution Directive, it may be too early to fully assess how effective it might be. It's also worth noting that the plan will likely need approval from some national parliaments, notably the Bundestag (H/T Bruegel).

The most conerning point is probably that if this is a precursor to the eurozone's single resolution mechanism, it is likely to fall short of fully breaking the dangerous sovereign banking loop in the eurozone.

Aufstand im Bundestag: Who are Germany's most rebellious MPs?

On Thursday, the German Bundestag is expected to vote on the Cypriot bailout. The package is likely to be approved with a clear majority - the opposition SPD and Greens will mostly back it. In addition, the symbolically hugely important "chancellor's majority" - the threshold for the government to get an absolute majority with only the votes of its own MPs - is likely to be reached as well. Only around 12 MPs from the coalition parties (CDU, CSU, FDP) are likely to vote against. This is not particularly surprising. Remember, the bill for this rescue package was largely passed on to Cypriot depositors, and therefore enjoys much greater support in Germany.

Still, with the eurozone bailouts remaining ever-so contentious - and with a new anti-euro party on the German political scene - we thought we'd see how many coalition (CDU, CSU and FDP) MPs have so far rebelled on the various eurozone bailout votes. 

As the table below shows (click to enlarge), according to our calculations, at least 36 MPs have rebelled against Merkel on at least one occasion. Four MPs - Klaus-Pieter Willsch & Manfred Kolbe (CDU), Peter Gauweiler (CSU) and Frank Schäffler (FDP) - have a 100% record in rebelling on eurozone votes - for the rest, there's a surprising spread.

Is Spain using accounting tricks?

This is interesting from today's El País. The paper suggests that the Spanish government could have decided to delay various tax refunds due in December 2012 and pay them in January 2013 instead, in order to close the year with a lower deficit figure.

These refunds (around €5 billion in total) would have affected revenue from VAT and income tax, both individual and corporate. Had they been paid out in December, Spain's public deficit at the end of last year would have been around 7.2% of GDP. The target agreed with the European Commission was set at 6.3% of GDP.

El País notes that data from Spain's Agencia Tributaria (tax agency) show that tax refunds in January 2013 were 82.8% higher than in January 2012 (see the table on page 15). This seems to indicate that the Spanish government may have deliberately pushed back the refunds to send a lower 2012 deficit figure to Brussels.

The Spanish Treasury Ministry has denied the reports and given its own version. Basically, due to recent legislative changes, tax refund applications need to be looked through "with greater attention" - and stricter controls take longer. No accounting tricks are being used.

Both versions sound plausible. We would note, though, that even if the Spanish government did dodge including the refunds in last year's deficit, it will certainly have to factor them into this year's deficit. Not exactly a permanent fix, although we have seen very similar one-off measures used in Portugal to meet deficit targets (see, for instance, this post we wrote in November 2011).

With that in mind, we can't help but wonder whether the European Commission will want to know more details about this story, although Olli Rehn & co. seem to be more focused on structural deficit for now.  

Spain's slush fund scandal: This is not going away soon

New interesting details have emerged on the slush fund allegations involving Spanish Prime Minister Mariano Rajoy and his Partido Popular (PP). The party has said that it will take El País to court, because the 'secret' accounting books allegedly held by PP's former treasurer Luis Bárcenas are fake. However, the paper today reports that a couple of senior members of Rajoy's party have admitted that they did receive the payments registered in the books under their names.

A spokesperson for Pío García Escudero, the speaker of the Spanish Senate, said that Escudero actually asked the party for a 5 million pesetas (some €30,000) loan in 2000. He needed the money to repair his house in Madrid, which had been destroyed by an attack from Basque terrorist group ETA. Escudero says he paid the loan back in instalments of 1 million pesetas each, and stresses that he never dealt with Bárcenas personally.

Similarly, people close to Jaume Matas - a former Environment Minister and President of the Balearic Islands region - have confirmed that the party agreed to pay him some sort of 'transition allowance' between when he quit the cabinet and when he became PP's candidate for President of the Balearic Islands. Now, El País notes that Matas stepped down as Environment Minister in March 2003 and was elected as President of the Balearic Islands in May 2003. Perhaps just a coincidence, but the €8,400 payment to Matas is dated 2 April 2003 in the books.

Interestingly, during her press conference yesterday, the Secretary General of PP María Dolores de Cospedal (pictured) was asked about Escudero's admission. She said that specific payment "may be true", but this does not automatically validate the documents, because "some people ask for money in advance, this happens in all companies. It's no extra pay." Not an entirely convincing answer.

One last aspect is worth flagging up. El País stresses that, according to the Spanish law on the financing of political parties in force from 1987 to 2007, donations larger than 10 million pesetas (around €60,000) were forbidden. Therefore, 70% of the donations disclosed by the paper would have been illegal at the time when they were made - potentially quite a strong incentive to try and hide them in 'parallel' accounting books. 

Rajoy has convened a meeting of top members of his party, scheduled for tomorrow - but has yet to announce when (and if) he will speak to the press on this issue. Meanwhile, hundreds of Spaniards protested outside his party's headquarters in Madrid yesterday and called for him and his cabinet to resign immediately. This story is getting increasingly interesting, and is not going away anytime soon.  

Spain back under the spotlight soon?

We haven't blogged on Spain for a bit, but a couple of interesting developments have caught our attention today. Spain will presumably disclose its final deficit figure for 2012 shortly, and everything seems to suggest that Madrid will let its eurozone partners down once again.

Spanish Industry Minister José Manuel Soria (pictured) told a conference this morning that Spain's public deficit for 2012 will be somewhere around 7% of GDP - higher than the target of 6.3% of GDP agreed with the European Commission.

It is also probably not just a coincidence that Soria's words came just before the European Commission put out its latest update on Spain's compliance with the conditions attached to its bank bailout. The content of the report was not entirely new to us (and the readers of our daily press summary), given that a draft was leaked to El País last week. The document reads,  

Fiscal consolidation advanced in the third quarter, but the 2012 deficit target will likely be missed.

Most importantly, it adds,

The 2012 deficit target for the regions of 1.5% of GDP can...still be within reach for the regional level as a whole, but risks are substantial and a number of regions will most likely exceed their target.

You won't hear us say this very often, but well done to the European Commission for making the right prediction. Of course, we (and others) warned of the risk of several Comunidades Autónomas overshooting their deficit target as early as last July.

Anyway, Catalonia (Spain's wealthiest region) has just announced that its deficit at the end of 2012 stood at 2.3% of GDP - with the overall target for Spanish regions fixed at 1.5% of GDP. With the wealthiest region missing its targets, and few others likely to undershoot theirs to pick up the slack, it seems unlikely that the overall target will be met.

A day of bad news for Spanish Prime Minister Mariano Rajoy and his government - not least because Spain had already obtained a relaxation of its deficit target for this year. The risk is that, once the official deficit figures come out, Spain could face fresh pressure from the markets. Before complaining about being "underrepresented" in the EU institutions (see Spanish Economy Minister Luis de Guindos remarks from this morning), the Spanish government should probably do more to regain its credibility vis-à-vis its eurozone partners. Top EU/eurozone jobs would surely follow.

About that Spanish bad bank...

The Bank of Spain has just made an announcement regarding the country’s bad bank plan which fleshes out more details of the proposals following the recent consultation period. The press release and presentation are here and here, respectively.

Key points:

• The bad bank (known as Sareb) will be a for profit company (expecting a 'conservative' return on equity of 15%), majority owned by private investors (read other Spanish financial institutions) with a minority government stake. It will have 8% capital. 
• Its duration will be up to 15 years. 
• A transfer of up to €90bn of assets will take place in two stages. Stage 1 will see around €45bn in assets transferred from the most troubled (already nationalised) banks. Other banks will transfer assets in a secondary stage. (See picture below for the timetable). 

•  The valuation of assets will work from the baseline scenario of the Oliver Wyman stress tests (which we analysed here). It will be adjusted for the ‘costs’ of transferring the assets to Sareb. (See below for a breakdown of rough valuations). 

More details are still to come but here are some of our initial thoughts:

- One phrase that caught our eye was this: “The transfer price is not a reference for the valuation of non-transferred bank assets.” According to whom? Surely just asserting that this is not reference for the valuation of assets means nothing unless the market agrees? As we saw with NAMA, the market will still price broader assets of the prices used in the transfer, hence long standing market distortions in Ireland.

- The delayed/staggered nature of the transfer of assets could create a two tier market for similar assets, since the ones valued in the bad bank will be valued much lower than those kept on by the viable banks. This could hamper the viable banks attempts to sell off assets at reasonable values.

- The write downs, although substantial, still seem lacking in areas (not least due to the flaws in the OW baseline stress test scenario). For example, assuming foreclosed land will be worth 20% of previous value may seem substantial, but when there is an real estate oversupply which could take a decade to unwind the prospect of this land being worth anything soon seems unlikely.

- The timeline looks positive with significant progress expected in the near future, however, the full transfer of all assets to Sareb could run well into middle 2013. This delay could drag out the issue and further distort the price discovery in the Spanish real estate market. Also as Zerohedge points out, this timeline may be fine in a vacuum but with everything else going on in Greece, problems could escalate quicker than expected.

- As we’ve noted before, although the private investment is positive, it looks likely to come from mostly other Spanish institutions. This furthers the ‘nationalisation’ of banking sectors and intertwines the problem banks with the healthy banks. 

- The plan seems to be, since the institution is not a majority owned by the government, that it will not appear in general government liabilities. It's not clear whether this will pass muster with Eurostat, or how any losses/transfers from the public sector will impact government finances.

Overall then, a bit of a mixed bag. Some positive plans and it’s good that the plan is progressing (if a bit later than desired) but still plenty of potential pitfalls.

Spanish regional elections: Why the victory for Rajoy's party in Galicia should not be overplayed

Following the latest round of regional elections in Spain on Sunday, the foreign media clearly seem to have focused their attention on the victory of Spanish Prime Minister Mariano Rajoy's Partido Popular (PP) in Galicia (see, among others, this article from today's FT). Of course, the fact that outgoing Galician President and PP candidate Alberto Núñez Feijóo (pictured with Rajoy) has not only confirmed his absolute majority, but also managed to consolidate it by winning three more seats than he had during his previous term is remarkable, given the nationwide drop in the party's popularity.

However, the significance of the victory in Galicia should not be exaggerated, for a number of reasons. Firstly, Rajoy is Galician. Although, as noted by the Spanish press, he avoided appearing next to Feijóo during most of the electoral campaign, Rajoy did travel quite a lot across the region - and it would be naïve to think that his personal involvement did not win Feijóo a few extra votes.

Secondly, Galicia is a region with solid right-wing credentials. The region has been governed by centre-right forces for much of the time since Spain returned to democracy - including fifteen consecutive years between 1990 and 2005 under Manuel Fraga Iribarne, a former minister under Francisco Franco (a Galician native himself) and the founder of Alianza Popular in 1976, which became Partido Popular in 1989.

Therefore, we definitely think the results of the Basque elections were far more interesting - for one very simple reason. Unlike after the previous elections in 2009, Rajoy's Partido Popular and the opposition Socialist party together do not command a sufficient majority to stop the candidate of the Basque Nationalist Party (PNV) Íñigo Urkullu becoming the region's new President - although he will need the support of other parties to secure a majority in the Basque parliament.

It is not unusual for nationalist parties to be in government in the Basque Country, but the context looks quite different this time. During the electoral campaign, Urkullu has clearly said that he wants to make the Basque Country a "European nation". The expression must sound worryingly familiar to Rajoy and his cabinet, as it clearly echoes Catalan President Artur Mas's recent calls for Catalonia to become "a normal nation within Europe".

Incidentally, a new Feedback poll for Catalan TV channel RAC1 this morning credited Mas’s party with 67 seats in the 25 November regional elections – only one seat short of an absolute majority in the Catalan parliament. The same poll also found that over 70% of Catalans are in favour of pushing ahead with plans for a referendum on the relationship between Spain and Catalonia, even if the Spanish government prohibits it.

The Catalan elections are yet to take place, but there is clearly the potential for a major 'sovereigntist' headache here - and at a time when the Spanish government can least afford it.

Spanish regions: We hate to say 'We told you so', but...

In July, we published a briefing looking at the potential impact of regional debt problems on the Spanish economy. In particular, we noted that Spanish regions were expected to make swingeing cuts to meet the overly ambitious regional deficit target of 1.5% of GDP by the end of the year. Based on the size of cuts each region had agreed on with the Spanish government, we drew the 'traffic light' table below:

Three months later, it's time for an update. Following today's bailout requests from the Balearic Islands and Asturias, eight of 17 Spanish regions have decided to tap the €18 billion bailout fund set up by the Spanish government. And guess what? Four of them (Castilla-La Mancha, Comunidad Valenciana, Murcia and the Balearic Islands) are in the 'red' area of our table - i.e. among the regions that, according to us, had agreed to unattainable deficit reduction targets for this year. Catalonia, Asturias and Andalusia - top three in the 'amber' area - have also sought help from Madrid. To date, Canary Islands are the only surprise, as they have requested a bailout despite having to make the smallest deficit adjustment of all Spanish regions.

With only less than half of regions covered (although, of course, not all of them will need financial assistance), the Spanish government's bailout fund for regions (which totals €18 billion) has almost run out of money. Here is what each region has requested:

Catalonia: €5.4 billion
Andalusia: €4.9 billion
Comunidad Valenciana: €3.5-4.5 billion 
Castilla-La Mancha: €848 million
Murcia: €641 million
Canary Islands: €757 million
Balearic Islands: €355 million
Asturias: €262 million

TOTAL: €16.7-17.7 billion

So, if all regions obtained the entire amount they have asked for, there would be almost no money left in the pot - and two more regions in the 'red' area which may well need assistance (the case of Galicia is slightly different, as we explained in our briefing). This is why the Spanish government is trying to hold off on at least part of the loans. It has, for example, agreed to lend Andalusia only €2.1 billion, and €2.5 billion to Comunidad Valenciana - for the moment. However, regional governments will presumably push to get all the money they asked for - which in turn increases the likelihood that the bailout fund will need a top up.

We remain of the view that regional debt problems will not 'make or break' Spain financially, although depending on how the payments are handled they may increase Spain's deficit - as will the fact that the regions are still likely to miss their targets for this year. In any case, though, in the eyes of Spain's eurozone partners and the European Commission, every additional region tapping the bailout fund adds to the impression that the Spanish government is simply not capable of keeping regional spending under control. For once, we agree with the EU/IMF/ECB Troika on something.

A virtual Spanish bailout?

In case you’re wondering, we not talking about a bailout on Facebook or the like.

No, we’re referring to the quite strange comments by a Spanish finance ministry official reported in the press this morning. The official reportedly stated that Spain does not see a bailout request as imminent or immediately necessary but would be comfortable making the request for a precautionary credit line in order to potentially access the ECB’s new Outright Monetary Transaction (OMT) programme. All par for the course you would say, but the comments that really caught our eye were the following, via the FT and the WSJ:

"The credit line is not fundamental, it is circumstantial…One could say it's a virtual credit line,” adding that Spain will likely not access any of the money from the ESM, while the ECB may not even have to buy any bonds. 

Let us elaborate, because this seems to amount to a bailout without any money. Essentially, the suggestion is that Spain would sign a new Memorandum of Understanding (MoU), which wouldn’t include any new reforms or conditions, allowing it access to ESM money if it ever became necessary. This would supposedly satisfy the OMT requirements allowing the ECB to intervene in the secondary market for Spanish bonds if borrowing costs for Spain once more reach unsustainable levels.

A very neat idea in theory, as with most eurozone proposals, but we have a few concerns:

• We can’t imagine the ECB or Germany would go for it. Both would likely request stricter reforms and conditions (probably rightly, as we noted recently Spanish labour market reform has some way to go), particulary since it would need approval from the Bundestag. 
• More importantly, this may fail the ECB’s conditionality requirement. Although, details on the OMT are thin on the ground, the conditionality needs to be enforceable. The conditionality comes from a MoU which is tied to the ESM financial aid. Therefore if the ESM aid is not actually being accessed the conditionality is instantly voided since it cannot be enforced by withdrawing funding (since the funding is non-existent). 
• A strange situation could arise where the ECB is then buying bonds without the ESM lending money, while no new conditions have been enforced. We’ve warned of the moral hazard and other negative impacts of this at length before. 
• If the ESM is not lending to Spain but the ECB is buying its bonds surely the MoU and conditions essentially become a direct agreement between the ECB and Spain, putting pay to the view that these actions relate to monetary policy and maintain the independence of the ECB. 
• As the ESM guidelines on precautionary loans note, they are only available to countries where there are no “bank solvency problems that would pose systemic threats to the stability of the euro area banking system.” We’re sure this will be fudged, with the eurozone suggesting the bank bailout solves any remaining provlems, although we’d maintain that €40bn is far from enough to solve the problem.
• This is not to mention that Spain has huge funding needs and will in fact need real cash injections at some point, meaning the threat of intervention will surely not be enough to hold Spain over. 

We’ll end with an interesting, if somewhat mixed, analogy from the Spanish official:

“One does not just normally drop an atomic bomb. It has to be co-ordinated and discussed. But we [Europe] are all in the same boat.” 

Quite. As we’ve previously warned the OMT and Spanish bailout needs to be carefully structured, unfortunately a 'virtual bailout' is unlikely to do the trick.

Some preliminary thoughts on the stress tests for Spanish banks: lots of optimistic assumptions...

Here is the full report (and the bank-by-bank results) from the latest Spanish bank stress test exercise. Below we provide the key points and our initial thoughts on them.

The tests put the total capital needs of Spanish banks at €59.3bn, but Spanish Deputy Finance Minister Fernando Jiménez Latorre (in the picture) just told journalists during the press conference that, assuming that Spanish banks manage to raise part of the money from other sources, the Spanish government could ask the EFSF for "around €40bn" (as we anticipated here).

Key points: 

• 14 banks assessed, 7 found to be well capitalised, 7 found to need capital injection. Total needs put at €59.3bn. This falls to €53.75bn when the mergers under way and the tax effects are considered;

• €24.7bn of the total amount is earmarked for Bankia alone, with a further €10.8bn for CatalunyaCaixa and €7.2bn for NovaGalicia;

• The adverse economic scenario assessed was: 6.5% cumulative GDP drop, unemployment reaching 27.2% and additional drops in house and land price indices of 25% and 60% respectively, for the three-year period from 2012 to 2014;

• Cumulative credit losses for the in-scope domestic back book of lending assets are approximately €270bn for the adverse (stress) scenario, of which €265bn correspond to the existing book. This compares with cumulative credit losses amounting to approximately €183bn under the base scenario.

Open Europe take: 

• The base case scenario seems overly optimistic, the adverse scenario looks more realistic - although we expect a fall in house prices of around 35% rather than the 25% assumed. The prediction that unemployment will peak at 27.2% also seems optimistic given that there is plenty more austerity and internal devaluation to come while the structural labour market reforms are yet to take effect.

• Oliver Wyman's report strongly assumes that all the previous capital buffers and loan loss provisions have been well implemented with suitable quality of assets. However, this is far from assured;

• The level of non-performing mortgage loans seems incredibly low at 3.3% currently with losses only predicted to rise to 4.1% under the adverse scenario. This number could well be distorted by forbearance (delaying foreclosing on loans likely to default to avoid taking losses) by struggling banks. It will also massively increase if unemployment and economic growth turn out to be worse than predicted;

• The levels of recovery on foreclosed assets seem a bit too positive (admittedly a wide range of between 37% - 79% losses depending on type of asset) given the continuing oversupply in the real estate market in Spain. Until the market has fully adjusted, the huge mismatch between supply and demand is likely to keep resale value on foreclosed assets incredibly low;

• These tests do look to be more intense than the previous ones but ultimately the optimistic assumptions do instantly raise questions over their credibility. The structure of the bailout request is also unlikely to enamour investors, who like to see grand gestures, however, it always positive that taxpayer participation may be limited. 

 

Pressure mounts again for Don Mariano

Spanish Prime Minister Mariano Rajoy's trip to New York for the meeting of the UN General Assembly is coinciding with a particularly eventful week for Spain, on several fronts.

The Rodea el Congreso ('Encircle the Congress') anti-austerity rally outside the Spanish parliament building in Madrid turned violent yesterday, with 35 people arrested and 64 injured. The day before the rally, the Secretary General of Rajoy's party, María Dolores de Cospedal, recalled that the last time the Spanish parliament was 'encircled' was on the occasion of the failed military coup on 23 February 1981. The day after the rally, Spanish Interior Minister Jorge Fernández Díaz congratulated the police for handling the situation "magnificently". We assume these remarks have not done much to placate the protesters.

The demonstrations are clearly not good news for Rajoy and his cabinet. The Spanish government is due to unveil a new reform plan tomorrow, which may constitute the basis of the new Memorandum of Understanding, if (or should we say 'when'?) Spain decides to make its official request for EFSF/ECB bond-buying. As Rajoy himself anticipated in an interview with today's WSJ, the plan will include measures to cut the number of early retirements and the creation of an independent body in charge of monitoring Spain's compliance with EU-mandated deficit targets. Expect further protests fairly soon.

Meanwhile, the deficit of the Spanish central government stood at 4.77% of GDP at the end of August - with the target for the entire 2012 fixed at 4.5% of GDP. The Bank of Spain has this morning warned that, based on data available so far, Spanish GDP is continuing to fall "at a significant pace" during the third quarter of the year.

On the regional front, the rift between the Spanish government and Catalonia seems to be widening by the day. Catalan President Artur Mas announced yesterday that early elections will take place in Catalonia on 25 November. The autumn is going to be very tense, given that the Basque Country and Galicia will also hold early elections on 21 October. Crucially, Mas went one step further this morning, when he made clear that the Catalan people will be consulted on the issue of independence, with or without the authorisation of the Spanish government.

Furthermore, Andalusia's Treasury Minister Carmen Martínez Aguayo said yesterday that the region will “very likely” seek a bailout from the Spanish government. If confirmed, the request would be for a loan of over €4.9 billion. This means that Catalonia, Comunidad Valenciana, Murcia and Andalusia would, in total, need around 80% of the money in the bailout fund set up by the Spanish government to help all the 17 Comunidades Autónomas.

What else? Oh yes, in case you were wondering, Spain's borrowing costs are going up again. The interest rate on ten-year bonds is above 6% today.

In this context, it looks like Rajoy will not be able to hold out for much longer. The time for key decisions looks to be approaching - potentially marking a turning point for the future of Spain and the eurozone crisis.