New Spanish government tackles banks' bad real estate debt

The Financial Times published an article in which it says that the new Spanish government is going to require the Spanish banks to set aside an additional 50 billion euros against their bad real estate debt.

As the Economist Magazine said in its December 31, 2011 edition, "only transparency will prove if [the new Spanish government] is right."

Specifically, it is only if the Spanish banks are required to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details that market participants will have the data to evaluate if the banks have set aside enough reserves.

Without requiring this transparency, it suggests that the banks have something to hide.

More importantly, without requiring this transparency, saying that the Spanish banking system only needs to reserve an additional 50 billion euros puts the credibility of the new Spanish government in jeopardy.

Does this additional level of bad debt reserve pass a back of the envelope test?

• According to the article, the Spanish banks are holding 338 billion euros of property related debt of which 176 billion euros has already been identified as bad.

• Provisions have already been taken against 1/3 of these bad loans, so the 50 billion is the bad debt reserve for the remaining 2/3 of these bad loans.

• With the new bad debt reserve, the government is requiring banks to be able to realize a loss of 42.6% on the bad real estate debt [50/(.667*176)].

• Through the end of 2011, Irish property values had dropped by 60% nationwide from their peak and are continuing to decline.  
• For back of the envelope purposes, it is fair to compare Ireland and Spain as there is no reason that Spain cannot experience similar declines in real estate values.

• Bottom-line, if the decline in Spain's real estate market mimics Ireland, depending on how much equity the borrowers originally put up, banks could need to reserve another 20+ billion euros for the identified bad real estate debt.  So the 50 billion euros appears to be in the general ballpark of what is needed.  

• Of course, this assumes that no additional reserves are needed against the 162 billion euros of "good" bank real estate debt.

Requiring banks to set aside 50 billion euros is a step in the right direction.  As the Economist magazine pointed out, it is a step that needs to be accompanied by transparency if it is to restore confidence in the Spanish banking system.

Spain says it expects its banks to set aside up to €50bn in further provisions on their bad property assets as part of a new round of reforms for the country’s financial sector. 

Luis de Guindos, economy minister in the centre-right government that took office two weeks ago after defeating the Socialists, said on Wednesday it was essential that the banks clean up their balance sheets without imposing a burden on the treasury. 

The €50bn figure, equivalent to about 4 per cent of Spain’s GDP, is higher than private expectations by bankers. 

Some analysts had speculated that the Popular party government of Mariano Rajoy, prime minister, would set up a large, state-funded “bad bank” like Ireland’s Nama to absorb the non-performing assets of lenders hit by the collapse of the housing bubble in 2007 and the subsequent European economic crisis. 

However, strong Spanish banks such asSantander and BBVA opposed the “bad bank” idea, arguing that they could handle their own problems and that weaker lenders should if necessary be absorbed by their stronger rivals. 

That is the path now being taken by the government with Mr de Guindos saying there should be another round of consolidation among cajas, or savings banks. 

“If you take international valuations as in the case of Ireland, at the most you are talking about the need for €50bn of extra provisions [by banks in Spain],” he said. “In the great majority of cases, they can provide it themselves from their profits … and it could be done not in one year but over several years.”

By requiring the banks to provide ultra transparency, the Spanish government gets the provision for bad real estate debt made up front.

Then, and this is critically important, it has in place a tool to monitor the banks to ensure that they do not attempt to gamble on redemption and take excessive risk while they are rebuilding their capital base.

The US tried to do something very similar with its Savings & Loans and learned that without ultra transparency management take on much more risk in an effort to rebuild their capital base quickly.

Of the €338bn of property-related assets in the Spanish financial system, about €176bn are bad loans, substandard loans or repossessed properties and land, according to the Bank of Spain. 

The banks have already covered a third of these bad assets with provisions. They were expecting to be told by the government and the Bank of Spain to set aside a further 20 per cent. An extra €50bn – more than 28 per cent – would be more of a stretch, especially when they are simultaneously trying to increase capital ratios to meet European regulatory demands. 

Mr de Guindos said: “We have a property problem in Spain, but it’s manageable … This €50bn is about 4 per cent of Spanish GDP. This is not Ireland. It’s a completely different order of magnitude.”.... 

Spain has already bailed out or nationalised seven lenders, spending over €21bn in state aid, some of it repayable, and deposit guarantee funds.