Fear of Bankia bailout undermines confidence in Spain

In his Wall Street Journal Heard on the Street column, Simon Nixon makes an argument for why Madrid's not explaining how it will recapitalize Bankia is undermining confidence.

Your humble blogger would advise the Spanish government to remind depositors that their deposits are safe as they are covered by a government guarantee.  Then, the government should say

• it will not bailout Bankia as the way Bankia will be recapitalized is through retention of future earnings including payment of bonuses in stock.  Regardless of how much Bankia recognizes in the way of losses today or in the future.  The expectation is that rebuilding book capital levels will take several years; and

• Bankia will provide ultra transparency and disclose all its current asset, liability and off-balance sheet exposure details so that market participants can independently assess that Bankia has recognized all of its losses.  To the extent that there are additional losses, Bankia will recognize these losses too.

• On-going ultra transparency will also allow market participants to exert discipline and restrain future risk taking.

This policy statement permanently breaks the linkage between the sovereign and the losses on the bank balance sheet.

Two weeks have passed since Bankia was part-nationalized, yet Madrid still hasn't explained how it plans to recapitalize Spain's biggest domestic lender. That is a long time to leave a systemically important bank in limbo. Unless the government acts fast to end the uncertainty, confidence in its ability to handle the crisis will continue to evaporate....

Hence the reason for the policy statement.

Madrid was poorly prepared to take control of Bankia ... The scale of the disaster at Bankia has, therefore, caught the government by surprise. 

This fact is one of the reasons that Bankia will provide ultra transparency.  In the future, no market participant, including the government, should be surprised by a bank.

There are no good options.

Actually, the option discussed above is a very good option.  The option is to embrace the Swedish model for handling a bank solvency led financial crisis.

The bad options all come from trying to continue pursuing the Japanese model for handling a bank solvency led financial crisis and trying to protect bank book capital levels at all costs.

The first step is to acknowledge the size of the capital shortfall. And that isn't straightforward since there are actually two capital holes. 

The first concerns the equity needed to absorb loan losses. BFA-Bankia has a combined €52 billion of toxic real-estate loans, of which just 11% are covered by provisions. Just to bring provisions in line with new government rules will require an extra €4.9 billion of capital, reckons J.P. Morgan. 

But that's not all: Many loans will probably need to be written off entirely; some performing real-estate loans may need to be reclassified as nonperforming, incurring further write-downs. Provisions against non-real-estate lending including mortgages and corporate loans are also inadequate. 

Total losses might reach 12% of the entire €190 billion loan book, according to a person familiar with the situation. That would suggest a €15 billion capital hole after existing provisions. 

The second capital hole concerns the equity held by the group. The bulk of BFA's capital comprises its stake in Bankia, which has until now been carried on its books at its pre-IPO value of €12 billion. But Bankia's market value at the end of 2011 was about €5.5 billion and is now just €2.8 billion. Depending on how far this and other minority stakes are written down, the hit to capital could be anything up to €5 billion.

The size of the capital shortfall is the reason that it will take several years of retained earnings to rebuild Bankia' book capital level.

Once the capital hole is identified, how should it be filled?...

Bankia has more than 350,000 private shareholders, almost all of them customers of the bank, who have seen the value of their stock halve since last July's listing....

By filling the capital hole through retention of future earnings, the shareholders retain a claim that has value (as opposed to being wiped out).

These are tough political decisions. Finance minister Luis de Guindos may be tempted to avoid inflicting too much pain on investors, perhaps by injecting capital in the form of convertible debt, although that won't impress markets.

Injecting capital won't impress the markets either.  The markets have clearly signaled that bailing out the banks puts Spain's sovereign debt at risk.

Meanwhile, he will be well aware any decision he takes regarding Bankia will also be scrutinized for implications for other Spanish banks.

It is a very good thing that Bankia will serve as a template for the other banks.  By not injecting capital today, but instead making Bankia retain future earnings, the finance minister is sending a strong message to the markets that Spain will not waste its scarce access to capital on unnecessary bank bailouts.

And if the total bill for bailing out the system is too high, the government itself may lose market access. 

The government's access to the markets should improve as the markets realize that the banks are going to pay the total bill for cleaning up the system (a bill the banks should pay given that they are responsible for every loan and investment they make).