Questioning Europe's Numbers: EU Taxpayers Paying The Price For Spain's Accounting Gimmick

| About: SPDR EURO (FEZ)

On Friday, Spain announced it would inject somewhere between 4 billion and 5 billion euros into nationalized lender Bankia, after it posted a 4.45 billion euro loss for the first half of the year. Although the loss was expected, the decision to recapitalize Bankia immediately is rather amusing, given that it is already set to receive 19 billion euros once its reorganization plan is approved in November. For the time being at least, this is yet another example of a European entity needing a bailout on top of a bailout, although Spain is apparently calling the injection an "advance".

While it probably wasn't meant to be taken this way, an excerpt from The Wall Street Journal article which discusses Bankia's first half loss is particularly telling regarding one of the reasons why Spain's banking sector is in so much trouble:

"Bankia's...clean-up plan...which is considered essential to insuring that Bankia receives funds from the European Union, consists of taking higher provisions linked to losses stemming from the real-estate sector."

'Higher provisions from losses in the real-estate sector' is indeed a familiar refrain since 2008 and investors are no doubt tired of hearing it, but ironically, had Spain turned the volume up a little louder three years ago, rather than seek to use a noise dampening accounting trick called 'dynamic loan loss provisioning', they might not be going deaf right now.

In July of 2009 Jesus Saurina published an academic paper entitled "Dyanmic Provisioning: The Experience of Spain". At the time, Saurina was the director of the Financial Stability Department at the Bank of Spain. The idea behind dynamic provisioning is fairly straightforward. Consider that during times of credit expansion, overzealous lenders may fail to put aside adequate provisions to account for the risks they take when reaching for yield in a low interest rate environment. Conversely, when credit contracts during recessions, lenders may find that fear and the desire to ensure compliance with regulatory frameworks results in loan loss provisions exceeding what is necessary or even prudent. The purpose of dynamic provisioning is to 'smooth out' the procyclical nature of loan loss provisioning. In the words of Bloomberg columnist Jonathan Weil, the practice essentially involves

"...set[ting] aside rainy- day loan-loss reserves on the books during boom years [in order] to build up a buffer in good times for use in bad times".

Consider also the following chart from Saurina's paper which, in his words,

" based on a simulation of a lending cycle with a recession in the middle period [and] shows that at the peak of the recession dynamic provisions would be 40 percent lower than the traditional provisions"

Click to enlarge

Click to enlarge

So as you can see the idea is that provisions will be slightly higher during long boom cycles and dramatically lower during short bust cycles.

Spain's banks were required by the Bank of Spain to begin using this method in 2000. This method of accounting may sound good on the surface, but what it amounts to is using profits from the past to cover future losses, so it isn't any wonder that Spain's banks weathered the 2008-2009 crisis so well. The rather obvious problem with this (aside from the fact that it generally is not deemed acceptable by accounting standards) is that it is backward-looking. As Saurina put it,

"A dynamic provisioning system is usually designed using information on credit losses over the previous lending cycle. But there is no guarantee that a system designed in this way will be enough to cope with all the credit losses of the next downturn."

In other words, the inputs to the general provision formula are based on the past. Should the current recessionary period prove longer or the recession deeper than those normally experienced, one cannot go back and adjust the inputs to account for the severity of the new downturn - the provisions were already put aside and those provisions were based on inputs derived from past experience. Because dynamic provisioning leads to lower provisions in recessions, in the event of a severe downturn, the amount set aside will be even more deficient than it would have been under normal accounting standards. This is what has happened to Spain.

It wasn't as though no one saw this coming. The Economist published an article on the subject in 2008 that warned that

"...the statistical provision, which the Spanish banks calculated using data from two business cycles, is based on the assumption that all cycles are roughly similar, which they plainly are not. Liquidity is drying up: in the years before the crunch Spanish banks had come to rely more on wholesale markets for funding, and many have turned to the European Central Bank for help."

Even more ominous was an article that appeared on FTAlphaville in 2009 entitled "Are Spanish Banks Hiding Their Losses" - which cited a report by Varient Perception that flatly asserted that dynamic provisioning was resulting in a rather unfortunate situation wherein Spain's banks were thought to be among the strongest in the world.

Given all of this, some commentators including "Out Of The Box" author and 37-year Wall Street veteran Mark Grant, have begun to question whether the 'official' data out of Europe is even worth analyzing. Grant notes that:

"Spain and her official admission of "dynamic provisioning" has raised all kinds of questions in my mind and has unsettled my belief in the data provided by Europe to such an extent that I have been forced to totally re-examine the numbers that [Eurostat and The Bank of International Settlements] have provided. A careful reading of the methodology utilized at Eurostat and the Bank for International Settlements reveals what I suspected; they accept the data from each country in Europe prima facie; nothing is checked or audited."

Perhaps this offers some insight into why the numbers out of Europe keep getting worse, and worse: the official data is manipulated and made to look better than it actually is. Like any financial coverup, the idea is to keep the lie going for as long as possible and only admit what you have to and even then, only in increments. This is why nobody ever hits deficit targets and why no promises are ever kept - because all covenants are entered into under false pretenses.

I believe this discussion is important because it gives investors an idea of how things in Europe may well be worse than they appear and are likely to keep getting worse. This also points to the fact that the ECB, in considering the purchase of Spanish sovereign debt, is complicit in supporting a government who for the past twelve years, knowingly sanctioned the use of a spurious accounting practice. In the end, it is of course EU taxpayers that ultimately pay the bill.

Just as the discovery of accounting irregularities would lead a prudent investor to sell shares of a public company, so too should the revelation of Spain's 'dynamic provisioning' be cause to bet against Spanish bonds, Spanish equities (iShares MSCI Spain Index ETF: EWP), and European stocks in general (SPDR EURO STOXX 50 ETF: FEZ). As I have said before, there will be no salvaging the eurozone in its current format. Something has to give.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.