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Last Friday, the Bank of Spain reported that 9.42% of all outstanding loans in Spain are nonperforming. Bad bank loans hit an all time high of 164.36 billion euros in June, up 8.39 billion euros from the previous month. At the same time, deposits declined by 6.59% YOY, also a record. Housing prices also fell sharply, down 8.3% as the country continues to spiral deeper into recession.

Eurostat reported last week that the Spanish economy contracted by 1% YOY and .4% sequentially in the second quarter while industrial production fell 6.3% in June alone after falling 6.5% in May and 8.4% in April. This reinforces economists' predictions that Spain will remain in recession well into 2013. A prolonged recession is expected to put further pressure on housing prices and cash strapped citizens which in turn will likely lead to even higher percentages of nonperforming loans.

All of this could not possibly come at a worse time for Spain. While the media has largely focused on whether and when Mariano Rajoy will formally request 'assistance' from the ECB, the issue of how to allocate the 100 billion euro bank bailout has seemingly gone by the wayside. What is known is that Spain will attempt to set up its own version of a 'bad bank' into which it will transfer some 200 billion euros worth of nonperforming real estate loans from the books of the country's ailing financial institutions:

"...the Spanish bad bank will initially be capitalized with 25 billion euros from the 100 billion euro rescue package earmarked for the country's struggling banking sector. The remaining 75 billion euros will be injected directly into the banks."

As I noted in the above cited article however, if those loans deteriorate further--and it appears they will--taxpayers will be on the hook for the losses as the Spanish government is backstopping the 'bad bank'. Indeed, Reuters has suggested that given the finite amount of the bank bailout, Spain may be tempted to overvalue the bad loans in order to limit the amount the government will have to contribute:

"Official data indicates that...property prices have fallen...26 percent...but the true drop could be 40 percent...The...danger is a fudge, with low discount rates and too generous a view of how quickly the property market will recover."

Perhaps the bigger concern is what happens if the loans continue to decline in value (like they did in the case of Ireland's bad bank NAMA) or worse, the amount of nonperforming loans continues to pile-up on the banks' balance sheets ever after the bad bank is established.

It certainly seems as though this might not be a problem unique to Spain. Recent data from accountants KPMG shows that eurozone banks have 1.5 trillion euros in nonperforming loans on their balance sheets. Surprisingly, KPMG notes that the banks simply haven't been attempting to unload the bad loans. Apparently, the ECB's LTROs have reduced banks' incentive to unload problem assets:

" Perhaps the most powerful factor in delaying much-needed deleveraging by European banks has been the European Central Bank's injection of more than €1 trillion of long-term refinancing operations"

This is tragically ironic. Cheap funding from the ECB has facilitated a situation wherein banks remain saddled with the bad debt which caused them to need the ECB loans in the first place and, coming full circle, has now necessitated bailouts funded by...the ECB. What is perhaps even more ironic than that is the fact that it seems highly likely given the ECB's relaxation of collateral rules, that the central bank has actually accepted as collateral for cash some of the bad loans that, were it not for the cash being dispersed, would already have been sold by the receiving banks.

In sum, European banks need to deleverage and the ECB's persistence in keeping up the circular funding charade is preventing it from happening. To put a figure on it,

"...the IMF estimates that European banks will have to shrink their balance sheets by 2.5 trillion euros, 75 percent of which is likely to come from asset sales."

Unfortunately, it doesn't appear that anyone save Germany, Finland, and the Netherlands is interested in a deleveraging of any kind. The longer 1.5 trillion in bad loans sit on banks' books, the greater the chance -- given the economic environment -- that they will decline further in value and the greater the chance that even more loans will have to be classified as nonperforming, perpetuating a vicious cycle.

These statistics are alarming (though not totally surprising) and given the ECB's complicity in the whole affair, it is reasonable to suggest that investors continue to bet against European financials (NASDAQ:EUFN) for the foreseeable future. Additionally it is reasonable to expect that further turbulence introduced into the market by the continued struggles of these financial institutions will have a tendency to increase volatility. Position accordingly.

Source: Bad News: European Banks Have €1.5 Trillion In Nonperforming Loans