The Spanish banking system is insolvent and the Spanish government simply does not have the wherewithal to clean it up. This is the problem in Spain that has come to a head, particularly now after the rescue of Bankia, Spain’s fourth largest bank. Unless the European Union come to Spain’s rescue, there will be runs on Spanish banks, with contagion rippling outward.
In this essay I will outline the key issues starting with the history and working through to the present concerns and then speak briefly to the best temporary resolution.
Property bubble and bust
Last month I covered the Spanish fiscal situation in the post "Spain is in big trouble". While the fiscal situation is worrying, it is only a problem for Spain because of Spain’s banking system.
Spain had a terrific property bubble that burst beginning in 2007. House prices in Spain are down 22 percent from the 2007 peak so far. As judged by the cumulative decline in the General IMIE Index, a property index, prices are down 27 percent. But most analysts expect much deeper declines given the size of the run up and the declines in other economies with similar bubbles. For example, two years before the peak, the Economist noted that house prices in Spain had risen 145 percent from 1997-2005. These were the largest gains in the developed world outside of the UK and Ireland. Since the peak, for comparison’s sake, prices have declined by 34 percent in the United States and 49 percent in Ireland. Willem Buiter, chief economist of Citigroup, reckons Spanish property price declines are less than half complete. To wit, the most recent data from Spain shows that Spanish house prices declines are accelerating, with prices falling 7.2% in the first quarter of 2012.
Bank restructuring plans
Spanish banks therefore have a lot of underwater assets backing loans on their books. Accordingly, default levels at Spanish banks have risen to over 8%, the highest level since 1994, requiring extensive credit writedowns. Nevertheless, the value of Spanish property loans is considerably less than the value at which they are carried, making many Spanish institutions insolvent.
The Spanish government bank restructuring plans that began under the previous socialist government mirrored the Japanese strategy from two decades prior. The goal was to merge troubled financial institutions with healthier ones or to merge multiple troubled institutions together with a capital injection. Originally, the Spanish government wanted to employ the Geithner plan and conduct stress tests to calculate what the capital hole was. Afterwards they would have the financial institutions raise the lion’s share of the capital necessary via the private sector as in the United States. The Zapatero government was committed to getting between €20 and €120 billion in additional capital for this purpose as the Spanish central bank estimated that Spanish banks had a total of €180 billion of troubled assets on their balance sheets. It has not worked out as planned and the government is being forced to fill that hole themselves.
The Rajoy government has yet to release its formal bank restructuring plan but the government has asked institutions to increase their loan loss provisions to €166 billion euros. Reuters has reported that Spanish banks’ toxic asset transfer are to be voluntary. The incentive for banks is to only transfer as much as one can in order to not be deemed insolvent and resolved. So this scheme is doomed right from the start.
Worse yet for the Spanish government, their Japanese-style merger plan has backfired; the resultant institutions are larger and, therefore, more systemically important. Last week, the Spanish government revealed plans to partially nationalise Bankia, the nationalised Spanish Bank and Spain’s fourth largest financial institution that is the result of merger of seven Spanish savings banks. At the time, the Spanish central bank wrote that "BFA-Bankia is a solvent entity that continues to function quite normally and customers and depositors should have no concern". Yet, in European trading this morning, shares in Bankia plummeted 30% in reaction to the formalised nationalisation plan today. The plan is simply not credible.
Moreover, if one takes the Bankia example as a precedent, whereby the Spanish government has an open contingent liability without any burden sharing from existing bank creditors, it is clear that the Spanish government is exposed to significant contingent debts. And because Spain’s debt to GDP ratios at 69.3% are relatively low, lower than the EU average of 82.5% and lower than Germany’s 82.0%, it is clearly this concern about banks that is driving Spanish yields to a record spread above German yields.
Negative Feedback with sovereign
As the sovereign debt crisis has intensified, fewer and fewer foreign investors have invested in periphery debt. A good example is the Norwegian sovereign wealth fund’s acknowledgment that it was cutting its holdings of European periphery sovereign debt. The result has been a concentration of sovereign debt amongst domestic financial institutions in the periphery. These institutions are cut off from the interbank lending markets because of jitters about their insolvency. So they are forced to borrow from the ECB and national central banks directly. The ECB and national central banks will supply these institutions funding as lender of last resort only in exchange for collateral, usually the very sovereign debt which they have purchased.
This situation has created a negative feedback loop with the sovereign whereby spikes in sovereign yields expose periphery domestic financial institutions to greater losses, making them more beholden to central bank liquidity and more likely to need a bailout. The increase in likelihood that the sovereign must bail out its institutions then increases the contingent liabilities of the sovereign, driving yields up further.
In Spain’s case, last November when the euro crisis last flared, my argument was that questioning Italy’s solvency leads inevitably to monetisation because Italy was too big to bail. At the time, I also argued the end result of that monetisation would be investors piling in once the ECB figured out how to deliver. The point, especially for domestic financial institutions is that the only reason not to buy sovereign debt at 2 or 300 basis points over Bunds is because the government is not credibly backstopped by the ECB. Once the ECB actually offered an implicit backstop via the 3-year LTRO, domestic banks jumped at the chance to get higher yielding ‘risk-free’ government bond investments to use as collateral for cheaper funding at the ECB. This was a carry trade in essence. When the backstop lost credibility, yields spiked, saddling the banks with potential losses.
This brings the Spanish banks even closer to bailout territory.
The Irish and Icelandic examples
The best precedent here is Ireland. Like Spain, Ireland had a property bubble in part due to the ECB’s low interest rates driven by the weak German domestic economy. The bubble drove both private sector debt and public sector surpluses during the 2000s (see Spain is the perfect example of a country that never should have joined the euro zone). The critical factor in Ireland which makes its problem most acute is the banking sector bailout. Ireland was the first country to offer a blanket guarantee to it’s banks’ depositors. But when Ireland backstopped creditors as well, that’s when trouble began. Ireland’s banking sector is too large to credibly bail out via its national government alone.
For comparison’s sake, when Iceland attempted to socialise its three largest banks’ losses, the banking crisis became a sovereign crisis very quickly and depression ensued. When Ireland did the same, the result was also the same. Iceland eventually repudiated the bank debt, used the currency release valve and instituted capital controls. Despite going to the IMF for aid, Iceland was not subjected to the kind of anti-growth austerity that you traditionally see in these kinds of programs.They are on their way back to health, having regained investment grade status and access to international bond markets. The four biggest lessons from Iceland’s brush with national bankruptcy are that:
- first and foremost, one wants to ensure that losses in the banks were not absorbed by the public sector.
- the initial focus has to be exclusively on stabilizing the exchange rate, a lesson more pertinent to Greece than Ireland or Spain
- automatic stabilizers must be allowed to operate in full during the first year of adjustment — effectively delaying front loading fiscal adjustment
- rebuilding the financial sector must be done swiftly instead of dragging it out as they are doing in Spain
Meanwhile Ireland, overstuffed with bank liabilities, had to be rescued by the Troika and submit to a harsh austerity program. The Irish received 85 billion euros of Troika bailout money as a quid pro quo for protecting foreign creditors by extending a blanket guarantee for 440 billion euros of banks liabilities. Ireland’s debt soared from 44 percent of GDP in 2008 to 106 percent in 2011, according to figures from the IMF. Reuters claims that the real reason the Irish did this was because the ECB demanded it, worried that bondholder haircuts would spread contagion throughout the euro zone.
The Swedes also gave bank debt and deposit guarantees when their banks failed in the early 1990s. But the Swedish banks were not as large relative to the domestic economy as the Irish, Icelandic or Spanish banks are. The Swedish government could credibly backstop the banks and the debt guarantees.Moreover like the Icelanders, the Swedes have their own sovereign currency. That means currency depreciation helped the Swedes tremendously as the krona depreciated against the US dollar by some 40% after the bailouts. Most importantly, The backdrop for global growth in the aftermath of the Swedish banking crisis was more favourable than it is presently.
This all speaks to why Ireland is the best precedent for Spain in what to do and not to do, the key consideration being not to nationalise the banking system without having shareholders and creditors take the losses first.
Deposit flight and bank runs
With Bankia, Spain didn’t do this. And as in Ireland, depositors have taken flight. The Irish Independent writes today:
It emerged earlier that customers have pulled €1bn from the bank in the last week alone.
Bankia’s chairman, Jose Ignacio Goirigolzarri, said that depositors can remain "absolutely calm".
And Spain’s economy secretary Fernando Jiménez Latorre denied that the lender is suffering a run: “It’s not true that there is an exit of deposits at this moment from Bankia.”
He added that Bankia has everything it requires to become a success in the future – it just needs time.
According to Spanish daily El Pais, this capital flight is not an isolated incident as 128 billion euros left Spain in the nine months through the end of April.
Many analysts including myself believe that unless the European Union gives Spain aid to recapitalise its banking sector, the banks will collapse under the pressure from bank runs and increasing property losses. Barclays Capital estimated future expected losses earlier this month for the Spanish banking system at 198 billion euros. As Spanish banks had made 110 billion euros of loan loss provisions through to the end of 2011, that leaves 88 billion more euros of losses to cover. That said, Nouriel Roubini wrote last week that the Spanish sector would require 100-250 billion euros in recapitalisation funds to maintain a 9 per cent core tier one capital ratio consistent with planned Basel II capital requirements. According to Brussels-based research group Centre for European Policy Studies, the government target of 166 billion euros in loan loss provisions only covers the property developers and cannot begin to deal with the household mortgage debt problem. Doing so would bring provisions up to 270 billion euros, increasing the government debt load by 50 percent. Moreover, with targets for the Spanish economy continually slipping, creating a negative feedback loop on property prices and expected loan losses, any figure is a moving target.
The present problem is that the Spanish government has taken Bankia onto its balance sheet, making plain that the Spanish government is on the hook the 4th largest bank. This, just as the political economy surrounding Greece has deteriorated significantly with many talking about a Greek exit from the euro zone, precipitating deposit flight. And we all know that bank runs in 1931 after the failed Austrian bailout of Credit Anstalt precipitated the worst phases of the Great Depression.
What’s happening now?
There are a number of themes impinging on Spain domestically. The biggest is that ratings agencies downgrades are due later today. 26 Italian banks were downgraded on Monday by Moody’s and the ratings agency has warned that a slew of Spanish bank downgrades is coming today as S&P did at the end of April.
But the theme creating the most contagion risk externally is Greece. Greece is melting down and a bank run seems to be forming. I wrote about the collapse in bank deposits yesterday. This story has gathered steam and the worry now truly is that a bank run is forming in anticipation of Greece’s exit from the euro zone. Contagion to Spain and Italy could be forming. The question now goes to knock-on effects on the Spanish and Italian banking systems. Fears about Spanish and Italian exposure to the Greek economy has people talking about Greece’s bank run spilling over into Spain and Italy in sort of a modern day repeat of Credit Anstalt from 1931. The key thing to remember about 1931 was that the Austrian banking system had a negative feedback loop with the Austrian sovereign to bring down Austria and spread panic via bank runs throughout the global financial system. This is the real Armageddon scenario.
So that’s what’s happening now.
There’s one more theme I want to touch on. According to Edward Hugh, the Spanish press is saying the EU is pushing Spain to take EU bailout money after the country completes an independent evaluation of the banking sector by Blackrock and Oliver Wyman.
The other Edward says "It’s Time to Stop Using Chewing Gum And Chicken Wire In Spain". For me the key paragraphs in his explanation are these:
Not only has the [Bankia] issue placed in doubt the capacity of the country’s political and financial leaders to handle a crisis of this magnitude, it has once more raised question marks and doubts about the adequacy of data presented in commercial bank annual accounts. What brought matters to ahead was the publication on Friday 4 May of Bankia’s unaudited accounts for 2011 wherein the parent bank BFA still valued Bankia, in its individual accounts, at book value. In fact at the time Bankia was trading at around 0.3 of BV, while listed stakes in companies like Mapfre, NH Hotels, and Indra were by no means fully marked to market. The reason the accounts remained unaudited was that Deloitte, the bank’s auditor during the time of the stock market listing, had refused to sign off on them.
In fact, not only is the bank suffering from the falling value of its property assets, it is also feeling the squeeze of the sharp fall in stock prices, which affect the value of its commercial holdings. The country’s IBEX 35 Index hit its lowest level since October 2003 this week, and with holdings which some describe as the “jewels in the bank’s crown” down sharply, bank capital has taken a hit. Bankia’s holdings include a 5.4% stake in the troubled hydroelectric company Iberdrola, which is now only valued at 21 billion Euros, some 40% down from the 35 billion Euro valuation the company had only one year ago. A back of the envelope calculation suggests this drop alone has cost the bank 800 billion euros, making it unlikely that a forced asset sale of all holdings would bring in anything like the 3 billion euros some are estimating. However hard Mr Goirigolzarri, the new CEO, struggles to put a brave face on things (“contra mal tiempo buena cara”), and no one doubts his good will, the battle in front of him is enormous. Estimates in Spain suggest that in addition to the 4.5 billion Euros in Frob loans converted into equity, the bank may need a further 5 billion Euros in capital injection, just to cover the new provisioning requirements.
Concern about how the whole financial reform process was being handled by the Bank of Spain only grew with the acknowledgement by Bankia itself that it had renegotiated €9.9bn of assets in 2011 to avoid them from going bad. This is a practice which external observers had often suspected regulators at the Bank of Spain were permitting, but the latest revelations only confirm suspicions and raise worries that more of Spain’s banks are understating their problematic loans, particularly along the sensitive line which divides ”good” from “bad” developer loans. Indeed, many ask how five years into the crisis there can still be good developer loans in the system once guarantees are adequately valued .
Naturally the whole BFA/Bankia edifice is the first good example I will point to of the use of chewing gum and chicken wire in Spain, since it is hard to imagine a more complicated way of doing something that is almost guaranteed not to work. Basically BFA, the parent bank, was created as a bad bank, where the toxic property assets (largely land) of the seven participating savings banks were to be warehoused, supported by a mixture of preference shares, subordinated debt and own resources in terms of company shares, equity etc, plus a 4.5 billion euro “hybrid capital” loan from the government restructuring fund (FROB), which was to be paid 8% a year. Naturally the value of the toxic assets was bound to drop as time past, and I suppose the hope must have been to transfer earnings from new (“better” – not “good”) bank Bankia to both offset losses and service the FROB loan. But things weren’t to work out that way (as could have been anticipated), since Bankia itself was created with its own property exposure (especially in the form of developer loans, many of which were on the point of “souring”) as there simply were not enough resources available to warehouse everything. And when the new government introduced a law requiring more provisioning, well it was all over, bar the large injection of public money now needed to clean up the mess. Others were given the opportunity to kick the can a little further down the road by entering a merger, and thus offsetting the write-downs against capital rather than having to charge them directly to profit and loss. But Bankia was already too big, and too about to fall over, to be able to find a “dancing partner”.
I can go on but you get the picture: Bankia is deeply insolvent. Yet the government is propping it up in an open-ended way without administering haircuts to creditors.
My conclusions
The Spanish banking plan will not work. The Spanish banking system is insolvent and beyond the ability of the sovereign to backstop without significant creditor haircuts. The Spanish should want to resist nationalising their banks without forcing creditors to take haircuts. However, if Spain had let Bankia fail and had administered haircuts to bondholders, a Spanish bank run would have ensued. So the choices are limited. This all speaks to a EuroTARP, a topic which I covered three weeks ago in "Why the Spanish bailout may be to recap the banks instead of sovereign".
Now, if you bail out institutions during a depression, you need a credible comprehensive strategy or bank runs begin. How the EuroTARP is executed is critical in terms of popular sentiment. I believe the optimal way of dealing with this is to make it a systemic recapitalisation issue across Europe, thus preventing contagion when the most sick banks are allowed to fail, stripped of bad assets, and their subordinated debt written down. Europe needs to get rid of the bank problem once and for all. One could recapitalise the entire European banking system using public EFSF/ESM money as well as private funds under the guise of meeting Basel III requirements. while still allowing the most distressed banks, the deeply insolvent ones to go under and for their creditors to take haircuts.
I don’t think they have the political will to deal with this until crisis in Spain erupts into a full fledged crisis.