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.

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. 

 

So Bankia is still a viable bank...?

Spain announced its plans for cleaning up its banking sector earlier. With the full legislation only just released, we are still looking through it and will bring you the pertinent points in due course. But there was also another interesting development with regards to the ailing lender BFA-Bankia.

The Spanish government announced this afternoon that BFA-Bankia will receive an "immediate capital injection" from Spain's bank restructuring fund (FROB). Nonetheless, Spain has decided not to request the early disbursement of part of its €100bn bank bailout package. This is despite the fact that €30bn had been set aside for emergencies, as the Eurogroup noted in a statement issued earlier this afternoon. The funds will therefore be paid out in advance by the FROB and will be eventually incorporated into the Spanish bank bailout when it is fully dispersed.

This raises a couple of interesting questions. Firstly, why is Spain so keen to avoid tapping the €30bn kept in reserve? The money is there for just such an occasion, and in fact it was fairly obvious that this exact situation would arise. What's more, the money will be folded into the bailout anyway. Therefore, we can only imagine that the Spanish government is keen to avoid some kind of negative stigma – although this seems slightly strange since the bailout is already confirmed. It is worth keeping in mind the constraints of the EFSF vs. ESM funding (which we covered here), so it is possible that Spain and the eurozone have decided they want to wait until the ESM is fully operational before tapping the funds.

Reading the press release, it is also clear that this is a restructuring of BFA-Bankia, meaning it is still viewed as a viable bank. This seems almost outrageous for a few reasons:

• Bad loans held by Bankia jumped by 44% (to 11%) in the past six months alone
• The group just posted a loss of €4.45bn, compared to a slight profit a year ago
• In the past six months the banking group has lost a staggering €37.6bn in client funds, a massive 28% fall. 

It’s been clear to most for some time that Bankia is no longer viable. The latest government plans for dealing with the banking sector provide for an “orderly resolution” of unviable banks and a template for splitting up its assets and winding down the institution. It is not entirely clear why this is not being applied here, although protecting retail investors could be part of it. In the end, though, investing further public funds into a failing institution will do everyone more harm than good.

Regional debt, national problem: Is Spain heading for a full bailout?

As Spain seems to have wiped anyone else away from eurozone crisis-related headlines, we have published a new briefing looking at how the Spanish crisis could evolve in the near future – focusing our attention on the role of the regions and potential bailout scenarios.

Forgive us a bit of self-praise, but we have repeatedly stressed the risks involved in Madrid being unable to rein in spending at the regional level (see here and here, for instance). In our new briefing, we argue that, at the end of the day, the regions alone will not make or break Spain financially (more likely, it will be the banking sector, a risk which we also highlighted at length). In fact, if they continue to rely on the central government for funding, this could increase Spain's financing needs for this year by an extra €20bn - not pocket change, but still around only 2% of the country's GDP.

However, further damages to the credibility of Mariano Rajoy's government vis-à-vis its eurozone partners would be inevitable. Furthermore, we believe regional problems combined with banking sector issues and other pressures could ultimately push Spain into a fully-fledged bailout.

But would there be enough money in the pot if this happens? 

Probably not. In fact, we estimate that taking Spain off the sovereign debt markets for three years in a Greece-style bailout would cost between €450 billion and €650 billion. This is both economically and politically impossible at the moment, given that the lending power of the eurozone's two bailout funds, the EFSF and the ESM, will only total €345 billion this year, and will rise to €500 billion in mid-2014.

Therefore, we suggest that the most likely scenario is a combination of measures, involving a precautionary loan of around €155 billion combined with a new bout of ECB liquidity. However, even that could, at best, only buy Spain six months to a year.

Do not adjust your television set, this is not a Spanish rescue (despite looking an awful lot like one...)

Well, that was the line that Spanish Economy Minister Luis de Guindos was spinning yesterday. Sorry Luis, this is essentially a Spanish rescue - external funding sources filling a gap which the state can't (check), monitoring of a large chunk of the economy (check), involvement of all the big international organisations (check - EU, IMF, ECB etc.), the list goes on.

Meanwhile, the oft absent Spanish Prime Minister Mariano Rajoy held a press conference today, declaring the package a 'victory' for the euro and stating that if it were not for the current government's reforms it would have been a full bailout package. If this is a victory (finally dealing with a glaring problem after four years) then we don't want to see a defeat, but at least Rajoy made a public appearance this time. That said, in the midst of the worst crisis his country has faced since the financial crisis hit, Rajoy is now jetting off Poland to watch Spain vs. Italy (a mouth watering prospect admittedly but his timing could take some work), while the likes of the Education Minister are heading to Roland Garros to watch Rafael Nadal - the Spanish government not quite in crisis mode then, we're not sure if that should inspire confidence or not...

In any case, as we predicted over two months ago, European assistance to help Spain deal with its banks is now official, so what does this rescue mean for Spain and the eurozone, below we outline some of the key points and our take:

The plan
Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the bank restructuring fund) but will still be a state liability (it will not go directly to the banks). However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector.

Open Europe take:
Firstly, the ESM will not be in place in time to provide the loan (the treaty is yet to be ratified by numerous countries and has faced many delays) so at least initially it will come from the EFSF. As others have pointed out, this is important because ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with (as it removes the threat of legal challenges based on clauses in other Spanish sovereign debt which could be triggered if it suddenly became junior), however, Finland has already raised concerns over its exposure and role in the rescue - an issue we tackle in more detail below.

The lack of additional fiscal conditions is fair given that Spain is already subject to a deficit reduction programme and that this is ultimately a financial sector problem. There are questions over conditionality and moral hazard though - we would like to see bank bondholders and shareholders sharing more of the burden (bail-ins) to ensure the necessary reforms take place. As things stand its hard to see how the banks will 'pay' for this capital, particularly given the Spanish regulators previous failures (during and after the property bubble).

De Guindos confirmed that the funds would be counted as Spanish debt, so Spanish debt to GDP could be about to jump by 10% in the near future and given its current path this could put Spain over 90% debt to GDP (the level beyond which sustainability becomes questionable) much sooner than had been anticipated. This will require adjustments in its reform programme and lead to increasing market pressure.
 
Size - is it enough?
This is the key question - the total amount has been put at "up to" €100bn. That is much higher than was suggested by the IMF assessment released on Friday night, which suggested €40bn.

Open Europe take:
It sounds like a big number, but upon closer inspection it may not stretch as far as many expect. Consider that Bankia requires €19bn, while three other very troubled cajas need around €30bn (Banco de Valecia, Novagalicia and Catalunya Caixa) meaning half the money could already be eaten up, leaving only €50bn for the rest of the huge banking sector.

This compares to around €140bn in doubtful loans, and a total €400bn exposure to the bust real estate and construction sector. Doubtful loans to this sector total around €80bn currently, but we expect house prices to fall by a further 35%, broadly meaning that the number of doubtful loans could easily double. On top of this we have further losses on mortgage loans as well as losses on other corporate debt and a decrease in the value of Spanish debt held by banks. So huge number of issues - putting a clear figure on it is difficult due to the difference between tier one capital and 'loss provisions' (tier two capital). But even if this €50bn is given in tier one capital and stretched to increase provisions its hard to see that it will be enough given the huge exposure to mortgages and the bust sectors, especially at a time when growth is falling further and unemployment continues to rise.

Finland and Ireland - flies in the ointment?
If the EFSF is used (which looks likely) the Finnish government is obliged to ask for 'collateral' as it did with Greece - the noises coming out of Finland suggest it will, especially given its objection to 'small' countries bailing out 'larger' ones. Ireland has also suggested that if Spain is able to avoid fiscal conditions on its bank bailout then it could request similar treatment (i.e. a loosening of 'austerity').

Open Europe take:
The Finland issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will help the (True) Finns who are already launching a campaign against further bailouts. It could also lead to legal challenges - as we pointed out with Greece, it could trigger 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain. Not guaranteed, but a legal grey area which adds to the confusion.

As for Ireland, they have a fairly strong case here. Ultimately, their fiscal troubles stemmed from bailing out their banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system - this will only add to this ill feeling. Given Ireland's perceived 'success' in Germany some flexibility may be forthcoming but we doubt enough to assuage Irish anger.

Impact on the UK?
The IMF will only play a 'monitoring' role, meaning the UK will not be liable for the money provided to Spain. However, given the links between the UK and Spanish banking systems it is imperative that the problems in the Spanish financial sector are finally dealt with - whether that will happen this time around is yet to be seen but given the points above it is not off to a great start.

Impact on the eurozone - Open Europe concluding remarks:
Markets responded positively to rumours of external aid for Spain on Friday afternoon, but, given the points above, a huge amount of uncertainty remains which will keep markets jittery and increase pressure on the eurozone. That is far from needed given the uncertainty surrounding the Greek elections. Given the ongoing assessment of the actual needs of Spanish banks the rescue will now enter a state of limbo as attention turns back to Greece, in the meantime Spain is likely to find it difficult to access the market (since this is broadly an admission it cannot raise any substantial funds itself).

Questions will also arise over the strength of the eurozone bailout funds - Spain guarantees around 12% of them, surely its guarantees are now worthless or would do more harm than good. Additionally, now that one of the larger countries has asked for support pressure will intensify on Italy (particularly with the falling support for the technocratic government and the slow pace of reform).

Catching depositors in your web

What's the best way to stop a bank run? Well, ask Bankia. According to Spanish business daily Cinco Días, The Spanish bank - which is set for a multi-billion state bailout - has launched an initiative called "The amazing Spiderman".

The plan is to convince Bankia's youngest depositors not to pull their money out as things are looking a bit shaky, by providing some impossible-to-resist incentives. First, any customer that can muster an account balance of €300 or more by the end of May will get a Spiderman themed beach towel. As if that wasn't enough, a lucky few winners will also be in line for:

• A trip to New York;

• Twelve PlayStation Vita consoles;

• 1,050 tickets for the new movie, "The amazing Spiderman" - with 50 of the tickets to the very première.

The winners will be announced on 12 June.

And we were just starting to worry about the reported €31.44bn drop in  private Spanish bank deposits last month. This should sort it...

Spain races against time

Things are looking sticky in Spain.

Firstly, the Spanish government announced a bail out of Bankia to the tune of €19bn in addition to the €4.5bn already put in - and is currently looking at the least painful way of getting cash to the bank. The plan is still up in the air. Yesterday there was talk about swopping government bonds for shares in the bank (Bankia could then use the bonds as collateral to get more cash from the ECB). This made a lot of people nervous, not least the Germans, who already worry that the link between states and ECB funding, via banks, is getting a bit too strong. Today's talk has instead focused on issuing bonds from Spain's specific bank bailout fund, FROB, to raise the cash Bankia needs.

Secondly, Catalonia - Spain’s wealthiest region - has asked the central government for financial assistance to repay its €13bn debt; bad news for the central government's debt and deficit. Thirdly, the the spread between Spain and Germany’s ten-year bonds reached its highest level since the introduction of the euro, with Spanish ten year bonds currently at around 6.4%.

There are a huge number of issues on the table here, but these events highlight three things that we pointed to in our April 3 briefing on Spain:

• Despite Spanish PM Rajoy's remarks to the contrary, it looks increasingly as if Spain is slowly realising that it may not be able to afford to directly fund Bankia or other banks that run out of cash. And the numbers could well go up. This, in combination with talks and leaks over recent days that European money will be needed to backstop the Spanish banking system (Rajoy is very keen on more from the ECB), indicates that Spain is now moving ever closer to bank bailout via the EFSF.

• A huge battle looms over the finances and economic autonomy of Spanish regions, that remain a massive liability for the central government's attempt to cut its debt and deficits.

• Spain is racing against the clock. Naturally it will take time for the structural reforms that Spain is pursuing to have an impact - time that markets just won't give it at the moment.

Instead, it looks as though that time may soon have to be bought by eurozone taxpayers.