Friday, November 25, 2011

A modest proposal to save Spain from repeating the Irish mistakes in handling its banking crisis

A Bloomberg article reveals that Spain's newly elected government is seeking proposals for how to clean up its banking system.  This includes asking two academics for advice on setting up a bad bank to acquire the troubled real estate assets from its banking system.

Allow me to offer a modest proposal:  Before taking any action, require every Spanish bank to disclose on an on-going basis its current asset, liability and off-balance sheet details.

Since handling the banking crisis successfully requires that market participants think the crisis was handled, start the process of resolving the banking crisis by including the market participants.

Requiring that each bank provides ultra transparency does this.

With this data, market participants can independently assess each bank and value its assets.  This is the critical step if market participants are going to believe that the solution to the banking crisis actually solved the problem.

There is no way around doing this.  Like the Irish government, the Spanish government has already represented that the scope of the problem is less severe that the problem actually is.

To get around this, Ireland engaged a third party, BlackRock Solutions, to value the assets in its banking system.  Market participants confirmed the need for ultra transparency by effectively not believing the results and continuing their run on the Irish banks.

There are other benefits to ultra transparency including, but not limited to:

First, since each asset is being continually valued by the market, there is no reason for the banks not to work diligently to get the bad asset off their balance sheet.  Market participants are already anticipating the losses on the bad assets so there is no benefit to not addressing them.

Second, it eliminates the need for the Spanish government to recapitalize its banks.  So long as the Spanish government and European Financial Stability Fund guarantee the deposits and the guarantee is trusted, depositors will keep their money in the Spanish banks even if they are technically insolvent (market value of their assets exceeds the book value of their liabilities).

Three, it allows the banks to resume lending.  One of the biggest barriers to lending is nobody knows what the value of real estate pledged as collateral is.  By disclosing all the details on bank exposures, the market can determine a clearing price for real estate (that is what markets do after all).  With a 'market price', lenders can be comfortable taking real estate as collateral again.
Spanish Prime Minister-elect Mariano Rajoy has asked for at least two papers from academics on how to create a so-called bad bank, according to two people with knowledge of the matter. 
Both proposals outline mechanisms for a state-backed agency to buy soured assets such as real estate from banks at a discount, said the people, who declined be named because the process isn’t public. 
According to one of the proposals, Spain needs external financing of about 100 billion euros ($133 billion) to absorb the cost of transferring assets to the bad bank and should seek it from the European Financial Stability Fund or the International Monetary Fund, one of the people said. Both options call for valuations of real estate to be made by independent appraisers, the people said. 
The People’s Party, which won the Nov. 20 general elections in Spain by a landslide, has pledged a “cleanup and restructuring” of the country’s banking system to help restore the supply of credit in an economy where lending is shrinking at its fastest pace on record. 
Spanish banks, burdened with 176 billion euros of what the Bank of Spain terms “troubled” assets linked to real estate, are fighting to preserve profit as lending slumps and their cost of financing surges. 
Rajoy hasn’t been specific about how he’ll make banks deal with real estate on their books. 
His electoral program said his government would make it easier to “actively manage” the industry’s impaired assets so that they can be sold off....
Still, Faes, a Madrid-based research institute that is linked to the PP and chaired by former Prime Minister Jose Maria Aznar, favors creating a bad bank, Jaime Garcia-Legaz, secretary general of the organization, said in an interview on Oct. 24. 
Luis de Guindos, a former deputy finance minister under Aznar, said in an interview he wants to “eliminate all doubts” about valuation of real estate on the balance sheets of banks.
As Ireland has shown, the only way to do this is by providing ultra transparency to the market.  Not letting market participants have access to the data to assess the valuation fo real estate for themselves tell the market participants that there is something to hide.
The 52 percent of the more than 300 billion euros of assets linked to developers that the Bank of Spain deems to be “troubled” dwarfs other risky assets held by the industry such as the combined 13 billion euros banks own of Greek, Italian, Portuguese and Irish sovereign debt. 
Banks may face more than 60 billion euros of losses they haven’t covered with reserves as the economy risks tipping back into a recession, Banco Bilbao Vizcaya Argentaria SA (BBVA)’s research department said in a Nov. 8 report.

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