Spain - The Big Squeeze

|
 |  Includes: EWP, EWQ
by: Acting Man

Bank Bailout Inflation

The famous cockroach theory states hat there is never just one cockroach – and so we must expect that more bad news will emerge from Spain. As it were one can augment the observation about cockroaches by a secondary one on the size of bank bailouts: they keep growing until they are much bigger than anyone thought they would be.

Bankia, an amalgamation of seven cajas, has just become such a case – the size of the bailout has grown from a putative €5 billion capital injection to €19 billion within less than three week's time. Less than a year ago the bank basically pulled a fast one on small retail investors by selling shares to them in an IPO (their loss so far: about 64%). Of course it will be said that at the time, the negative developments that have now rendered the bank insolvent could not have been foreseen. The problem with that line of argument is that it clearly was possible to foresee them and that a number of people have indeed done so. Not that such a forecast was a particularly noteworthy accomplishment – cursory knowledge of the size of the debt endangered by Spain's real estate bubble collapse and an ounce of common sense was all it really took. It is only worth mentioning because it represents such a stark contrast to the official line that has been spouted hitherto and no doubt will continue to be spouted, even in the face of ever more damning evidence.

Not to put too fine a point to it, officials in every nook and cranny of the political as well as banking hierarchy are routinely lying about the true state of affairs.

As theWSJ reports regarding the Bankia denouement:

Spain will pump €19 billion ($24 billion) into troubled lender Bankia SA, the bank said Friday, effectively nationalizing the country's third-largest bank in a dramatic effort to assuage concerns about the stability of its financial sector.

Worries about Spain's banks, which are saddled with billions in toxic real-estate loans, have heightened in recent weeks as Greece's political crisis has intensified and investors contemplate the knock-on effects of a potential Greek exit from the euro.

[…]

Though a capital injection for Bankia had been expected for days, the scale of the government's action went beyond what most analysts had predicted. The bailout would be the largest in Spain's history, doubling what Spain has so far spent to clean up a banking sector in the wake of the collapse of the country's housing bubble.

Word of the move came late Friday after Europe's markets closed, so it isn't clear whether the government's action will have the intended effect or simply harden doubts about the integrity of the country's banking system.

Bankia's Spain-wide operations and exposure to the country's troubled property market have made it a barometer of the health of the entire Spanish banking system. Bankia has been a particular focus after the International Monetary Fund raised questions about its health in a recent report and it was forced to restate its earnings.

From the beginning of the Greek crisis almost three years ago, Europe's leaders have worried about the contagion spreading to Spain. Due to Spain's size and complexity, a bailout of the country would test the euro zone's financial capacity and political cohesion like nothing before.

One worry is that the bigger-than-expected Bankia bailout could fuel speculation that more unrecognized problems may be lurking in other Spanish banks. That would raise questions over whether cash-strapped Madrid can handle such problems without the type of international intervention seen in Greece and Ireland.

Spain's state-backed Fund for the Orderly Bank Restructuring has around €9 billion left to support ailing banks. A government spokeswoman said the so-called FROB can issue more debt, but Spain's borrowing costs have spiraled higher at recent auctions, while demand has fallen.

Since its twin credit and housing booms turned to bust four years ago, leaving a bloated banking system saddled with more than one million unsold new homes, Spain has tried to hold down the price tag on the cleanup of its ailing banks, betting on a recovery that hasn't come.

Taking a wait-and-see approach to its banks, Madrid has offered institutions incentives to merge and injected convertible debt into banks through successive cleanup plans. Just a few weeks ago, it presented its fourth cleanup plan in three years and said it thought it would cost the government just around €15 billion.“

S&P downgraded its ratings on Bankia, as well as Banco Popular Español and Bankinter SA, to double-B-plus, one notch into junk territory, from triple-B-minus. It also downgraded Banca Civica SA to double-B, two notches into junk territory, from double-B-plus. It lowered its rating on BFA to B-plus, four notches into junk territory, from double-B-minus. It affirmed its ratings on nine other banks.

Hammered by concerns over Bankia, the S&P downgrade and an appeal for government financial assistance from the head of Spain's Catalonia region, the country's 10-year government bond yield, a key indicator of borrowing costs, rose 0.138 percentage point to 6.295%. A yield at this level is considered unsustainable in the long term.

(emphasis added)

When Spain's finance minister Louis de Guindos first mentioned that the government would only need to inject €15 billion to rescue the banking system, we commented:

As to Spain's banking plan, it is already ridiculed for the way too low cost estimates mentioned by finance minister Louis de Guindos, who opined that less than €15 billion in public funds will be required and that 'no effect on the public debt is to be expected'. In some other universe perhaps, but not in this one.

It actually does appear now that de Guindos referred to a country named Spain in a parallel universe. Or perhaps a de Guindos clone from a parallel universe was the one making the statement? In any case, it took only 10 days to reveal how ludicrously inaccurate his estimate was. A chart from the WSJ depicted below shows how Spain's bank bailouts have progressed from modest beginnings to reach over €20 billion prior to this latest injection meant to rescue Bankia. Now the total stands at €40 billion.

Click to enlarge

So all in all, €40 billion in public funds have so far been used to shore up the failing banks – and more is likely to come, given the size of the problem (for instance, some €360 billion in developer loans are outstanding of which at least €80 billion are currently non-performing. At the same time € 27 billion in non-construction commercial loans and €28 billion in household debt were considered doubtful as of mid April. This € 135 billion total (see this chart) is very likely just the tip of the iceberg in view of the continuing economic contraction and the many tricks employed by Spain's banks to keep defaulted loans current in ongoing 'extend and pretend' exercises (in fact, these NPL statistics are slightly dated by now – more recent information indicates that the total of officially acknowledged NPLs has grown to € 148 billion in the meantime) - click chart for better resolution.

We have previously discussed that there is less and less room for Spain's banks to hold reality at bay (see: More Pain in Spain, which discusses the use of SIV's by Spain's banks and the desperate attempt to keep various RMBS 'alive' by means of modifications, repurchases and substitutions, and Spain – Its Problems Mount, which discusses Spain's NPLs and various estimates on the likely recapitalization requirements of Spain's banks).

The problem is that even the worst case estimates regarding future capital requirements of Spain's banks are subject to the "moving target" problem – as the contraction continues and the value of collateral keeps declining, the potential loan losses in turn are looming ever larger.

Click to enlarge

The sordid history of Bankia's new shares from the IPO to the suspension of trading on Friday (the gap in the chart prior to the last candle) and resumption of trading on Monday

(click charts for better resolution)

Click to enlarge

5-year CDS on Bankia's senior debt – now that the government has rescued bondholders, they are actually declining sightly. Note however that the 'rescued' Bankia bondholders now depend on Spain's government remaining solvent

The Funding Squeeze

The International Financing Review reports that Spain's banks face a worsening funding squeeze, as evidenced by their declining cash reserves in spite of the fact that their borrowing from the ECB has soared. Many analysts are opining that yet another LTRO will be required to keep Spain's bank's liquid – but this is complicated by the fact that they are running out of collateral to pledge.

Moreover, the buying binge after the first and second LTRO in which the Spanish banks invested cash they got from the ECB into government bonds has now led to more unrealized losses decorating their books.

Although Spanish banks borrowed big under the first two LTROs, much of the money has already been put to use. Many used the cash to replace existing credit lines – JP Morgan estimates that Spanish banks only took €166bn in net borrowing at the December and February operations, and that only €90bn of that is left.

Others are more pessimistic. The Spanish investment banking head quoted above, who has been advising dozens of Spanish lenders, estimates that lenders have about €60bn left. Banks from the Mediterranean country had €53.4bn deposited at the ECB in April – down from €88.7bn in March – but may have additional reserves too.

Many banks took enough to see them through a year or two of debt maturities. But instead of sitting on the cash until the debts came due – and suffering the negative carry – many chose to temporarily invest in Spanish and other government paper. ECB data show Spanish banks hold €260bn in eurozone government debt, up €85bn since November.

That helped bring down Spanish 10-year government bond yields from 6.9% in November to 4.8% in March. But since then, prices have plummeted and yields have once again begun to climb, reaching 6.5% earlier this month. As a result, banks may be unable to sell those holdings to generate cash without taking big losses.

"The absurdity is that banks used the money to buy the bonds of their own governments,” said one London-based financial institutions banker who is also advising Spanish banks. “Some bought longer-term bonds because of the extra yield and now face some huge losses.”

“LTRO money was taken out to repay maturing unsecured debt, and funds were placed in bond markets until they were needed to repay funding,” Nomura fixed income analysts wrote recently, adding that quantitative easing and asset replacement from banks – not another LTRO – were needed.

Complicating matters is the fact that Spanish banks may lack collateral of sufficient quality to borrow more money from the ECB, even if a third LTRO were launched. Deutsche Bank believes Spanish banks may be getting constrained, but says that authorities could lower the quality threshold further – as they have done repeatedly in the past.

There is also potential that further downgrades of Spanish debt or other assets could prompt a series of margin calls, worsening banks’ cash and collateral positions. Mindful of their situation, banks have recently been trying to free up cash by selling industry holdings and other assets, but bankers involved in those attempted sales say banks are unwilling to accept market prices. Spain’s benchmark Ibex 35 equity index slumped to its lowest since 2003 this month.

“Equity markets aren’t helping,” said the Spanish investment banking boss, who asked not to be identified. “If banks were to sell they would make a loss, so they can’t do it. These assets are no longer in-the-money so they would be shooting themselves in the foot. They would be in a worse position.”

Another source of hope is that European leaders may decide to recapitalise Spanish banks, but there has been resistance to that so far. An LTRO, with reduced collateral requirements, may be the most politically palatable option for now.

(emphasis added)

This reads almost like the script of a black comedy. We have little doubt that the
"solution" will involve a further softening in collateral eligibility criteria, which should solidify the ECB's position as Europe's biggest "bad bank".

The biggest users of the ECB's LTRO's: Spain's banks, which are now neck-deep in Spanish government bonds that are losing their value.

Catalonia in Dire Straits

To make matters worse, Spain's wealthiest autonomous region, Catalonia, is now asking for a bailout too. Readers may recall our previous missive entitled The Catalonian Blunder, in which we first discussed the problem Mariano Rajoy's government faced with regards to the regions. Briefly, one of the methods used by the Zapatero government to meet its 'fiscal targets', or rather, pretend to meet them, was to starve the regions for funds.

Once Rajoy was sworn in, the regions had reached the end of the rope. As a result it turned out that no fiscal targets were met at all – on the contrary, there was a wide disparity between the actual and the initially reported budget deficit. Moreover, it became clear that the regions would require support from the center, so that the planned deficit target for this year had to be revised as well.

It seems almost certain that it will be revised again as time passes. Here is the latest word from Catalonia as of Friday:

“Spain's wealthiest autonomous region, Catalonia, needs financing help from the central government because it is running out of options for refinancing debt this year, Catalan President Artur Mas said on Friday.

"We don't care how they do it, but we need to make payments at the end of the month. Your economy can't recover if you can't pay your bills," Mas told a group of reporters from foreign media.

[…]

Catalonia, which represents one fifth of the Spanish economy, has more than 13 billion euros in debt to refinance this year, as well as its deficit.

All of the regions together have 36 billion euros ($45 billion) to refinance this year, as well as an authorized deficit of 15 billion euros. Last year many of the regions financed debt by falling months or even years behind in payments to providers such as street cleaners and hospital equipment suppliers.

This year the central government provided them with a special credit facility from the Official Credit Institute, or ICO, to pay providers, of which Catalonia has taken 2 billion euros.

The provider credit lines from the ICO run out in June and the central government has pledged to come up with a new mechanism for backing debt from the regions, which have been mostly priced out of international debt markets since the Greek rescue in 2010.

Catalonia's Mas, from the center-right Convergence and Union Party, said he is running out of options.

[…]

S&P credit rating agency cut Catalan debt by four notches on May 4, putting it at BBB-, just one notch above junk grade. Fitch has graded Catalan debt a couple notches higher, at BBB+.

Catalonia's deficit was supposed to be cut last year to 1.3 percent of gross domestic product, but the regional government overshot that by close to three times.

This year it is struggling to reach a deficit target of 1.5 percent of its economic output, a goal many economists see as impossible given that the Spanish economy is set to shrink this year by about 1.5 percent.

(emphasis added)

When it rains, it pours as they say. In Spain it is beginning to look like a veritable biblical flood is under way.

Nor surprisingly, the IBEX ended Monday's trading at a new low, further complicating the banks' efforts to sell assets (in fact, the stock market is likely inter alia falling so much because distress sales of assets held by banks are expected. Spain's banks are e.g. the biggest holders of shares in YPF-Repsol as well as many other industrial companies. These stakes are now yet another millstone around their necks).

Click to enlarge

Yet another new closing low for the IBEX.

Addendum: French Banks Get Creative

In the context of funding problems of euro area banks, one must occasionally also take a look at the French banks, given that the 'big three' alone hold assets worth 240% of the country's GDP, with the banking system as a whole holding assets worth roughly 400% of France's GDP.

Readers should keep in mind that the frantic attempts by French banks to reduce their asset base is one of the reasons for the weakness in industrial commodity prices, as a large part of the commodity trading business has been financed by the big French banks in the past. We have no recent information as to the extent the trading houses have been successful in lining up alternative credit sources, but it is clear that their ability to hold inventory and finance shipments has been much reduced in the meantime.

As Bloomberg reports, French banks are now even securitizing German car loans. This is done in order to have assets that can be used to access securitized funding as unsecured funding has become more costly and difficult to obtain. Both French and German banks also appear to be selling a lot of their bonds to retail investors, a practice that dimly reminds us of the grief retail investors in bank-issued securities are now facing in Spain.

It should be noted that the increased use of securitized funding contributes to the growing collateral shortage, which as noted above is the biggest constraint to further ECB liquidity injections in many countries.

French and German banks have far more flexibility in this regard than Spain's banks, but French banks were in big trouble last year when funding from the US money market fund industry dried up and fresh troubles are likely to erupt if the combined bank and sovereign debt crisis in the euro area deteriorates further.

As Bloomberg reminds us:

With mounting concerns of a possible Greek exit from the euro and the havoc it may cause across the region, French banks find themselves once again among institutions at risk even after they reduced exposure to the country’s sovereign debt by taking part in the largest debt-swap in March.

French banks were caught in the middle of Europe’s debt crisis last year because of their holdings in private and public debt in Greece, Portugal, Ireland, Spain and Italy. Their access to U.S. Dollar short-term funds evaporated after the summer.

French lenders held about $38 billion of private loans in Greece at the end of 2011, more than any other foreign borrowers, according to data from the Bank for International Settlements.

(emphasis added)

It is also noteworthy in this context that France's banks have begun to reposition their portfolios toward domestic assets, the holdings of which they have actually increased while they decreased their holdings of foreign assets. This tendency of banks to "re nationalize" their portfolios can be observed all over the euro area. It makes an eventual break-up of the euro both easier and more likely.