Increase in bad loans casts doubt on clean-up of Spain's banks

So long as there is doubt about whether Spain will pursue the Japanese model for handling a bank solvency led financial crisis, there will be doubts about whether Spain can afford the damage this will cause to its sovereign finances.

Under the Japanese model, the level of bank book capital is protected.  Providing protection explicitly links the sovereign debt to the losses in the banking system.  The losses are socialized as governments are required to raise funds to provide capital to bailout the banks.

The alternative to the Japanese model is the Swedish model.  Under the Swedish model, banks are required to recognize all the losses hidden on and off their balance sheet today.  Bank book capital levels are then rebuilt through retention of future earnings.  The Swedish model explicitly decouples sovereign finances from losses in the banking system.

A Bloomberg article highlights the on-going problem with bad loans in the Spanish banking system and why there is a risk that the Spanish government will adopt the Japanese model and put substantial pressure on its sovereign finances.

The article also shows why pursuing the Swedish model with ultra transparency is the only viable solution as it cleans up the banking system, allows the banks to continue to support lending to the real economy and frees up the scarce sovereign resources to be used to support economic growth.

Spain’s surging bad loans are spurring doubt on whether the government can persuade investors that it can clean up the country’s banks without further damaging public finances. 

Non-performing loans as a proportion of total lending jumped to 8.16 percent in February, the highest level since 1994, from less than 1 percent in 2007, according to Bank of Spain data published today. 

The ratio rose from 7.91 percent in January as 3.8 billion euros of loans soured in February, a 110 percent increase from the same month a year ago. That takes the total credit in the economy that the regulator lists as “doubtful” to 143.8 billion euros. 

Defaults are rising and credit is shrinking at a record pace as 24 percent unemployment corrodes the quality of loans built up in the country’s credit boom and saps the appetite of banks to make new ones. 

Doubts about the extent of Spain’s non- performing loans problem is hurting bank stocks and driving up the government’s borrowing costs on investor concern that the expense of propping up ailing lenders may add to the debt burden. 

The fact that Spain has left open the option that it may bailout its banks is costing it money.

“One of our concerns in Spain is to what extent contingent liabilities could pass to the central government,” said Andrew Bosomworth, Pacific Investment Management Co.’s Munich-based head of portfolio management. Non-performing loans “will have to rise when you take into account the unemployment rate and what’s happening with the economy,” he said....

The concern is Spain will adopt the Japanese model and bailout its banks.

To eliminate this concern and lower the sovereign cost of funding, Spain needs to formally embrace the Swedish model.  The current government has been implementing the Swedish model in practice.

“A lot of our doubts are based on the grounds that non- performing loans should increase,” said Tobias Blattner, an economist at Daiwa Capital Markets in London, adding that he expects house prices still may fall by as much as 20 percent. “That could make a further hole in balance sheets of the banks.”... 

A hole that the banks can refill through retention of future earnings.

Rajoy’s government announced plans in February to force banks to take their share of costs of 50 billion euros ($65.6 billion) for building provisions and capital to make them recognize losses on real estate piled up on their balance sheets during the country’s housing bust. 

An indication that Rajoy's government will pursue the Swedish model.

The Bank of Spain said late yesterday that lenders will take a total of 53.8 billion euros to meet the new requirements, including 29.1 billion euros in provisions and 15.6 billion euros to create capital buffers. While most companies would be able to comply “without major difficulty,” the central bank would tighten its vigilance over lenders that may struggle to meet the requirements, it said.

The plan implies a loss ratio for those assets of about 25 percent based on the fact that banks have already made provisions of 50 billion euros against total real estate risk of 340 billion euros, said Daragh Quinn, an analyst at Nomura International in Madrid. 

Depending on how much the economy contracts and asset prices fall, further provisions of as much as 40 billion euros may be needed, said Daiwa’s Blattner. 

“In light of the bleak profitability outlook for the Spanish banking sector, we are concerned whether banks will be able to put aside the provisions the government has requested,” he said. 

So far the government’s efforts to bolster confidence in the banks has focused on making them recognize losses linked mainly to real estate. Banco Espanol de Credito SA (BTO), a Spanish consumer bank controlled by Banco Santander SA, said April 12 that first-quarter profit fell 88 percent as it made provisions to cover about half of the 1 billion euros in real estate charges the company must make this year to comply with the government’s order.

Still, Spain’s deteriorating economy means other classes of loans apart from those linked to real estate are also at risk of going sour, Blattner said. 

The primary reason that the government needs to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, is this restores confidence in the banks by allowing market participants to independently judge the risk of each bank.

Since ultra transparency applies to all assets, it lets market participants get their arms around what is happening with all types of loans.

The Bank of Spain, which says banks are burdened with about 176 billion euros of “troubled” real estate assets, lists about 21 percent of the 298 billion euros of loans linked to property developers as non-performing. The bad-loans ratio for industry excluding construction has jumped to 5.4 percent from 1 percent in 2007, according to the Bank of Spain. 

“The 50 billion euros of extra capital looks like it’s in the ballpark,” said Bosomworth, referring to the government’s cleanup plan. Still, the “balance of risks” suggests more funds may be needed given what’s happening in the economy, he said.

In the absence of ultra transparence, it is anyone's guess as to how much additional funding is needed.

One option open to Spain should it need to recapitalize banks further would be to take funds from the European Financial Stability Facility, the euro-area’s temporary bailout fund, said Daiwa’s Blattner. 

That would come with a “certain stigma attached” because it may signal the government has lost market access, he said. 

Spain can weather its troubles without a bailout and widening bond spreads are a “warning shot” from investors, Norbert Barthle, the parliamentary budget spokesman for German Chancellor Angela Merkel’s Christian Democratic Party, said by telephone yesterday. 

A warning shot to the Spanish government not to adopt the Japanese model and bailout the banks.

By staying with the Swedish model, the banks can rebuild their book capital level from retention of future earnings. This frees up the sovereign debt capacity to be used to support economic growth.

Spain has managed to stop the cleanup of the banking system from hurting government finances by making the industry absorb the cost by contributing more to the deposit guarantee fund. 

A further indication Spain is already on the path to implementing the Swedish model.

The fund has helped to finance the state’s sale of failed lenders including Caja de Ahorros del Mediterraneo and Unnim by covering future losses for buyers.

To be sure, investors have better information on the risks facing Spanish banks as the industry has shrunk and the Bank of Spain has made them unveil their real estate exposure, said Nomura’s Quinn. 

“Everyone, even the Eskimos, knows that bad loans in Spain are going up,” said Antonio Ramirez, a banking analyst at Keefe, Bruyette & Woods in London. “The sovereign is affected by the view in the markets that the banks are in difficulties and in a circular loop the banks are affected by the market view that the sovereign is weak.”