Good news would be Spain not creating bad bank

In his Wall Street Journal Heard on the Street Column, Simon Nixon looks at the possibility of Spain creating a bad bank to absorb all of the troubled assets in its banking system.

If this bad bank is formed, it would be terrible news.

Regular readers know that Spain's banks are part of a modern financial system and are designed to absorb the losses on all of the bad debt hidden on and off their balance sheets.  As a result, there is no reason for the Spanish government to use any of its scarce resources to provide any financial assistance like capitalizing a bad bank.

Spain says it definitely isn't creating a bad bank. No way José. Sure, Madrid is looking at ideas to create a vehicle to take legacy assets off the Spanish banking system's balance sheet. But in its mind, that is different: There is no question of any government or international money. So it won't be a bad bank.... 

Madrid clearly needs to do more to restore confidence in its banking system.

This could simply be done by requiring the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This disclosure would restore confidence in the banking system because market participants would know exactly how much rebuilding of their book capital levels each bank requires.

Spanish banks now rely on the European Central Bank for 11% of their funding, according to UBS research. That reflects a deep loss of confidence by the bond markets—a big problem for a banking system with a deposit shortfall of €545 billion ($722 billion) relative to the value of its loans. Without access to markets, banks will continue to deleverage....

Adding to the Spanish banks funding woes is the on-going run on the banks.

Meanwhile, the government has forced banks to take collectively another €54 billion in provisions against their combined €343 billion of real-estate assets in addition to the €112 billion taken since 2008. As a result, problematic exposures to undeveloped land have been written down by 80%, enough to withstand an 87% fall in land prices from the peak, according to the Bank of Spain. 

Similarly, banks could withstand house-price falls of 56% on developers' finished but unsold houses. So far, house prices have fallen only 27%. 

But Spain's real-estate market is so illiquid that even written down to these levels, banks are struggling to remove legacy assets from their balance sheets where they soak up expensive funding. 

Meanwhile, the scale of the recession means concerns are now spreading to corporate loans and mortgages, where nonperforming loan rates are rising. Plus, so many loans have been restructured, the market doesn't trust the banks' asset valuations.

This is a critical reason for why banks must be required to provide ultra transparency.

Removing legacy assets from bank balance sheets could help revive confidence in the system.

In reality, removing legacy assets does not revive confidence in they system.

In the absence of ultra transparency, market participants are never going to believe that all the bad assets have been removed.

But crucial details have yet to be worked out: Who will decide which assets should be included and how they should be valued? Who will provide the equity for the new vehicle? How will it be funded? How can Madrid ensure the participation of all the Spanish banks? What if the exercise reveals deep capital holes in some institutions?

These question were the reason that the US abandon buying the opaque, toxic mortgage-backed securities.

Three conclusions seem clear. 

First, any "legacy asset vehicle" will work only if there is a full external audit of the loan books of all the Spanish banks, as there was in Ireland.

Ireland tried the external audit approach two times.  It doesn't work for the simple reason that if the banks no longer have anything to hide, then why are they not disclosing all of their exposure details?

Second, the scale of the transfers should be big enough to eliminate the banking system's reliance on ECB funding.

As a practical matter, the banking system is going to be reliant on ECB funding until private investors are comfortable funding the banks.  This is going to require ultra transparency as the private investors are going to need to be able to assess the risk of each bank before they are willing to invest.

Third, the equity to fund the new vehicle needs to come from outside the system and not, as has been suggested, from the banks themselves.

A modern banking system is designed so that banks provide today all of the capital necessary to absorb the losses on the excesses in the financial system.  After absorbing the losses, banks then rebuild their book capital levels through retention of future earnings.