The Never-Ending Banking System Headache
Spain's banking system continues to make waves and unwelcome headlines. On Friday, it became known that the banks have borrowed a record €316.3 billion from the ECB as of March, up from €169.8 billion in February - 28% of the gross borrowings of all banks in the euro area (in terms of borrowings from the ECB, it represent an even bigger percentage). This means Spain's banks have little to no access to the interbank market or other private funding and have evidently made maximum use of the second LTRO.
"Economist Martin van Vliet at ING Bank said: "The ECB's three-year LTROs have done little to fundamentally improve the solvency situation of either the banking sector or the sovereign, which is where recent investor concern has centered on."
He added: "For this to happen, we would likely need to see a sustained return to economic growth and an imminent end to the real estate slump, both of which currently seem a long way off."
That, in a nutshell, is the problem. Spain is in no position to 'grow its way out' of the situation. Au contraire, the country's economic data keep worsening. The latest in the litany of woes was yet another slump in industrial production in February.
"Output at factories, refineries and mines adjusted for the number of working days fell 5.1 percent from a year earlier, the National Statistics Institute in Madrid said today in an e- mailed statement. That compares with a revised decline of 4.3 percent in January."
These are obviously somewhat less than reassuring numbers, especially in view of the unemployment rate hovering close to 23% .
Meanwhile, every time a bank merger is consummated, it turns out that the losses of the weaker banks are far greater than was previously assumed (or rather, admitted to).
As a result, Spain's deposit guarantee fund (DGF) has run out of money. The solution to this particular problem the authorities have hit upon is comparable to the most recent exercises in financial creativity in Greece (it is the extent of creativity that is comparable). The government doesn't want to contribute anything to the fund in order to be able to meet its deficit target, or rather, not miss it too badly. So the banks are going to lend the fund €24 billion, with their individual contributions graded by their market share (initially, €12 billion will be disbursed).
If you're still with us, the short version is that the banks are going to lend the fund that is supposed to bail out the banks the money to bail them out. As Exane's bank analyst Santiago Lopez Diaz notes, although the loan is a true contingent liability, it won't (at least at first) be influencing earnings statements - except perhaps positively, as the banks will book interest on it! As he notes, this is simply astounding financial alchemy.
Meanwhile, Fitch recently remarked that Portuguese RMBS (residential mortgage backed securities) are performing far worse than is officially reported.
A quote from the Fitch report:
"Fitch Ratings-London-11 April 2012: Fitch Ratings says in a new report that performance indicators for Portuguese mortgage loans securitised in RMBS transactions are misleading, as originating banks' support for borrowers is masking the true extent of past underperformance. In addition, house price indices that are typically quoted as indicators of the health of the market significantly understate the value declines witnessed on properties sold under 'forced' circumstances. This hides the full extent of future risks for Portuguese RMBS transactions.
Fitch expects the pressure on macroeconomic fundamentals - especially increased unemployment - to translate into weaker performance of mortgage loans. However, the weakness of the Portuguese mortgage market is not yet fully visible in the reported performance of RMBS transactions.
"The true extent of loan underperformance continues to be masked by support from the originating banks, through a combination of loan modifications, substitutions and repurchases," says Gioia Dominedo, Senior Director in Fitch's European Structured Finance team. "On average, 11% of the collateral backing RMBS transactions has been affected by loan modifications, but this figure is as high as 50% in certain cases. In addition, an average of 12% of loans has been repurchased or substituted. This intervention makes estimating the real risks associated with the underlying mortgages far more challenging."
We mention this because the same thing is happening in Spain. See e.g. this recent rating action by S&P on a Spanish RMBS structured credit product. Apparently Spain's banks make ample use of conduits (i.e., the very SIV's that became so infamous during the US mortgage credit crisis). The risk from these conduits is considerable, as similar to how this scheme worked in the US, the banks are the guarantors of the conduits' funding and liquidity.
Moreover, as we have frequently mentioned, officially quoted real estate prices as per the price indexes used by the banks and approved by the Bank of Spain are a complete sham. It's not only the fact that the biggest appraisers are an oligopoly owned by the banks. As a friend pointed out to us, the real estate market is basically dead, so the majority of transactions that does take place involves banks repurchasing properties from clients at artificially inflated levels.
If these properties were appraised correctly, then the banks would have to take the losses from previously purchased properties and/or loans collateralized by such properties. One reason why it is well known that the valuations are not credible is that the banks refuse to create new mortgages based on these appraisals, unless they are for properties on their books.
Alphaville recently reported on Fitch taking a closer look at over 8,000 properties that were repossessed in RMBS it has rated in Spain. It remarks precisely on the practices described above, whereby the banks shuffle properties around, often within the same banking group, for the sole purpose of creating the artificially inflated prices that can then be used to carry on with this particular extend & pretend scheme.
"What Fitch is noting here is that the properties fell a lot more from their original valuation than what an official house price index says it should have fallen by at this point in Spain's post-bubble economy. This difference pops out first when these properties were repossessed, and then, even more so when they were sold at a forced price."
But, as Fitch said above, loan servicers and the originators (banks) have been pretty idiosyncratic about writing down real estate… and about the eventual destination of the distressed assets. Some banks are selling them on quickly. Others, interestingly, are still holding on to them or shuffling distressed loans around their balance sheet. As the Fitch analysts add:
For example, properties managed and serviced by Catalunya Banc/CX have the lowest recorded depreciation rates (20%) of all transactions in this analysis; however, this level is maintained artificially low due to a large volume of sales to intra-group companies at above-market prices. Elsewhere, properties managed and serviced by EdT/BBVA have higher depreciation rates (58%), driven by a commercial strategy that results in one of the shortest time-for-sale ratios (11 months) when compared to other transactions.
The question, to get our real point, being what happens next.
Fitch already notes that some Spanish banks are unlikely to have the capital on their own to absorb defaulted loans much longer. But if they accelerate foreclosures, the price decline is huge. Fitch's data set here strongly suggests this. Ultimately this plugs into the debate over Spain setting up a bad bank - in this case to take toxic loans to real estate developers from banks' balance sheets. Discounts applied to loans in that operation could also be severe."
It's enough to make one feel dizzy.
The upshot of the above is that the markets have apparently become increasingly aware of the problem of late and are interpreting it to mean that Spain's government will end up in even bigger fiscal trouble than hitherto suspected, as it is easy to see that the banks will require much more support (we are by now assuming as a matter of course that the socialization of bank losses is official policy all over Europe). We repeat: although Spain's banks are well known for sweeping everything under the rug, they are now slowly but surely running out of rug.
Portugal and Spain have very close financial ties (Spain's banks have credit claims amounting to some €76 billion in Portugal), so the two countries will undoubtedly get into trouble jointly.
Markets Back In Crisis Mode
The recent market concerns over Spain have begun with a sequence of events that is eerily reminiscent of how Greece's troubles initially erupted.
To wit: first the new government announces that the predecessor government's data on the deficit were incorrect and that it came in much larger than originally admitted to. Then it turns out that this year's originally envisaged target can also not be reached (as a consequence of the regions having been starved of funds last year), whereby the new deficit target is not any more believable than the old one was (the effective January/February deficit was already worse than last year's at nearly 2%/GDP per month). To top things off, not a day passes without some or other official being wheeled out to assure everyone sotto voce that 'Spain's fundamentals are fine' and that by implication, the markets are getting it all wrong.
Right. These people all have a second career as bridge salesmen in Brooklyn awaiting them.
Spain's stock market has crashed to new lows over the past several weeks, mainly driven by weakness in bank stocks:
Spain's IBEX continues its headlong fall out of bed.
In case you were wondering about Portugal, its stock index has yet to fall to a new low, but ended last week barely above the lows of 2011:
Portuguese stocks end the week only a smidgen above last year's closing low.
Evidently these markets have seen more cheerful days once upon a time.
Spanish bond yields keep soaring as well and CDS on Spain have reached a new crisis high last week. The former is an additional problem for the banks, as they have been huge buyers of government debt in the wake of the LTRO funding rounds from the ECB.
Via CLSA: both in Italy and Spain the banks have been huge buyers of government bonds.
Charts by: Bloomberg, StockCharts.com