Repeating Irish mistakes, Spain seen tying credibility to bank loan audit

As part of its effort to make the situation as bad as possible, Bloomberg reports that the Spanish government is seen as tying its credibility to the bank loan audit.

Spain’s ability to restore investor willingness to buy its bonds hinges on how credibly the nation audits the value of the deteriorating loans of its banks....

Why does Spain's access to the capital markets hinge on the credibility of the audit?  Because market participants believe that Spain will bailout its banks based on the results of the audit and claim that the problems with the financial system are fixed.

Market participants saw Ireland and Greece go down this path and now they expect Spain will too.

Unfortunately, the history of Ireland and Greece is that these audits didn't come close to uncovering the true amount of losses in the system.  They came much closer to what Ireland and Greece could obtain in bailout funds.

“If the independent firms report something similar to what the banks are saying about their loan books, the market would simply not believe them,” said Georg Grodzki, who helps oversee $515 billion at Legal & General Investment Management in London. 

Should the audit show big losses, questions are sure to emerge over “how the government can afford to plug the hole in the banking system’s balance sheet,” he said.

The highlighted text shows that the combination audit/government bailout must pass the "three bears" test.  It must show losses that are not too small, not too big, just right.

The audit is part of Spain’s fourth attempt in three years to clean up its lenders, which are poised to set aside about 30 billion euros ($38 billion) against real estate loans on top of the 53.8 billion euros of charges in February....

Evidence that the Spanish government doesn't have its arms around the true condition of its banks.

Economy Minister Luis de Guindos said today in Madrid that the auditors will have “complete freedom” to carry out the review and that the existing provision rules are “sufficient.” 

This statement appears to be somewhat self-contradictory.  It appears that the auditors have complete freedom to find that existing provisions are adequate and not to find out the true condition of the bank loan portfolios.

While analysts at Exane BNP Paribas and Nomura Holdings Inc. welcome the cleanup, they say banks must recognize greater losses on loans to individuals and non-real estate companies in a nation where joblessness exceeds 24 percent and the economy is forecast by the European Commission to contract in 2012 and 2013..... 

“We are still some distance away from Spanish banks becoming investable again,” Grodzki said in a phone interview. “The problem is the gulf between investors’ assumption about the writedown and equity needs of Spanish banks.”....

A four-year property slump has driven up loan defaults and heightened investor suspicions that firms’ balance sheets don’t fully reflect the scale of potential losses. The nation’s lenders carry 184 billion euros of what the Bank of Spain terms “problematic” real estate-linked assets. The ratio of bad loans to total lending rose to 8.37 percent in March from less than 1 percent in 2007. 

Analysts at HSBC Holdings Plc said in a May 16 report that Spanish banks may have a 97 billion-euro capital shortfall in 2013, assuming the commercial real estate market worsens and credit to households and companies deteriorates.

There is a sizable gulf.  Investors are estimating losses that are hundreds of billions of euros higher than the government is suggesting.

“It is unclear who will pay and how the bill will be paid and, depending on how big the losses might be and how the cleanup is implemented, the sovereign risk might remain at relatively high levels creating a circular problem for the system,” said Santiago Lopez, an analyst at Exane BNP Paribas in Madrid, in a May 16 report....

Loan-book audits can help, though it may be hard to convince investors they’re truly independent, Grodzki said. 

“The fact that the auditors are hired and paid for by the government may raise suspicions, but I would give them the benefit of the doubt for now and hope they won’t try to prove the number, which the government wants to hear,” he said. “Spain is walking a tightrope.” 

Of course, all of this concern goes away if the Spanish government simply announces that it is adopting the Swedish model with ultra transparency and that the banks will be the source of funds for recapitalizing their book capital.

Not only does this announcement separate the sovereign debt from the bank recapitalization, but it adds credibility to the audit.   Market participants know that the Spanish government would like the audit to show the true condition of the banks as market participants will shortly have the information under ultra transparency to confirm the banks' condition.