Dance Steps for Spain to Restore Solvency and Investor Confidence in Its Financial System

According to a Bloomberg article:

Spain plans a new round of stress tests to help ensure that savings banks needing capital can raise it on their own, with “limited” use of the state’s bank- rescue fund, Prime Minister Jose Luis Rodriguez Zapatero said.

Savings banks will be tested “immediately,” so lenders requiring capital can obtain it by “going to the market,” Zapatero said in an interview today with Onda Cero radio. “If any can’t, then they will have help from the FROB, but that will be limited,” he said.

Spain’s FROB bank-rescue fund, created in 2009 with 9 billion euros ($12 billion) and the capacity to take on another 90 billion euros of debt, has already committed about 11 billion euros to support a series of savings-bank mergers. The Socialist government is trying to convince investors that the financial system doesn’t pose a threat to public finances as the nation faces a surge in its borrowing costs.

Zapatero said the overall budget deficit in 2010 was “somewhat” better than the target of 9.3 percent of gross domestic product. He reiterated a pledge that the deficit would meet the goal of 6 percent of GDP this year.

Separately, the Bank of Spain has called on savings banks to publish additional data in the coming weeks on their exposure to the real estate market.

To be successful at restoring solvency and investor confidence, the order of the dance steps performed by the Spanish government should be:

1. Stress test to determine capital needs of savings banks;
2. Release the results to the financial markets;
3. Require the savings banks to release asset-level data for their entire real estate exposure so that the results of the stress test can be verified independently by market credit analysts;
4. Encourage the savings banks to then raise any additional capital that the market credit analysts identify that they need from the markets;
5. Inject funds from the FROB bank-rescue fund into those savings banks that are unable to raise money on their own from the markets.

The critical step in restoring both solvency in the savings banks and investor confidence is the release of asset-level data.  Market credit analysts can use this data to independently determine the capital needs of the savings banks.

Without asset-level data, market credit analysts are likely to continue to make worse case assumptions about the performance of the real estate assets.  Under this assumption, the savings banks have a massive capital shortfall that simply will not go away just because the Spanish government said that the savings banks passed a stress test or that they will receive equity injections from the FROB bank-rescue fund.