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I am a sucker for a good argument presented with the correct dose of eloquence and cold facts, and John Hempton's latest tour of the balance sheet of the Spanish bank BBVA is just that. Essentially, John sets out to address the question of whether Spanish banks are hiding their losses or, as John ultimately goes on to argue, front-loading their eventual losses by extending credit to bad debtors in stead of writing down on the balance sheet.

Of course, this is not only a question of the practices of BBVA and whether you buy John's extrapolation from the case of BBVA to the case of the entire Spanish banking industry and on to the Spanish economy and the Eurozone itself, I believe the analysis and underlying points deserve a closer look. Personally, I do think that this is one of the most important questions we face in the context of the ongoing financial crisis, namely the extent to which the periphery of the Eurozone (and in particular Spain) harbour the ingredients to pull the whole edifice down or very close to the brink as a result of an unravelling which lies ahead in the beginning of 2010 as government and monetary stimulus begins to wane and/or the pressure from deleveraging and internal devaluation becomes too much.

Readers with a good memory or just a specific interest in this topic will remember the debate that arose in the context of the report by Variant Conception that essentially attempted to call the emperor, in the form of the Spanish banking industry, with not clothes. The VP report stirred up quite a flurry with for example an Iberian Equity piece that specifically targeted the arguments of Variant Perception. I have a good overview of the initial skirmish here if you want to read up on the background on this (although John draws up the playing field very nicely in his piece). As you will see, I am with the bears here, but I do think that we need to settle this with facts and good reason and to this end I would rate John's piece very highly, even if it also tends to conform with my world view.

Now, the basic point made by Hempton is, as far as I can see, the following;

There is a time honoured way of hiding losses in banking – a method that Variant Perception suggests is being done on a breathtaking scale in Spain. The method is rather than call a bad loan bad – to just extend it a bit more credit. If the borrower can’t pay the interest give them a bigger loan or line of credit. They will use the loan to become current. The slogan is that a “rolling loan gathers no loss”. Even the most diabolical subprime mortgage book in the US showed only small losses until the market stopped rolling the loans.

Together with this qualifying comment at the end;

All these problems of the same type that Variant Perception alleges in Spain – but none are of the scale Variant Perception alleges in Spain. In other words I can unequivocally support the notion that the Spanish banks are hiding their losses – but support for the notion that these losses are so large that France and Germany will be left “holding the bag” is not to be found in the US data.

What the Spanish bankers have been telling us about their credit is – at least on the American data – easily shown to be lies. We just don’t know whether they are big lies.

For the sake of Europe I hope they are not.

This last point is naturally important and somehow goes to the heart of the problem at hand here. Are we dealing with one, or a few, rotten apples or is the whole plantation sour? At this point, we can only speculate on the basis of the facts that are on the table. For me personally, it is thoroughly outside my realm of analytical ability to say whether this is a widespread practice among Spanish banks although the extent to which it is, we should be very worried with respect to the Spanish macroeconomy which is already, as Edward noted recently, in an exceptionally dire state.

But more importantly, the arrows of causation may run in both directions here. Specifically, (and I may be reading too much into Hempton's analysis here but still), one important underlying current seems to be that with the absolute horrific situation in which the Spanish economy finds itself we should be seeing a lot more pain in the banking sector in the form of loan writedowns or simply deleveraging. And of course, the extent to which we aren't suggests that Spanish banks are trying to front-load their inevitable losses and the further this goes on the more grim it will be when the penny drops. This, I should add, has been my colleague's Edward Hugh's point (and to some extent my own too) right back from the summer of 2007 when it became clear that the subprime crisis was not merely a US undertaking. Basically, better rattle the closet well and good in the beginning and face all the skeletons than have a bunch of them come knocking you out later on, when you have grown, potentially, complacent.

To finish off with my own, albeit modest, contribution to the discussion it is worthwhile taking a look at the chart I have prepared from ECB data on the aggregate balance sheets of monetary financial institutions in France and Spain, where the former is naturally present as a benchmark case.

click to enlarge

Essentially the graph plots of a moving average of a weighted value [1] of loans to households, loans to non-financial corporations and loans for household purchases in France and Spain (stock value, end of period). The change is month on month and then smoothed with a 6 month moving average. On the basis of the my remarks above the hypothesis to test here would be the extent to which Spain has clearly had a larger boom and subsequent bust than France, the degree and pace of deleveraging should also be comparatively larger and faster in Spain. Clearly, and even though the process of deleveraging in Spain is moving faster than in France, it does not correspond to the macroeconomic differences between the two economies. Could then be evidence of a macroeconomic pendant to practices shown by Hempton to prevail at BBVA? This is to say, is the apparent lack of fast paced deleveraging in Spain evidence by contraposition to the argument Hempton implies in his analysis?

This is difficult to say and clearly this is no smoking gun since we cannot see beyond, well, what we cannot see and thus Spain may just be about to hit sh't in the second half of 2009. Also, a larger sample size would aid the hypothesis significantly, but it does at least makes me think that there may be more to this than meets the eye.

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[1] I constructed this myself and it is not complicated. Mail me if you really want to know what I did.

Source: John Hempton on the (Hidden?) Losses of Spanish Banks