Regular readers know that your humble blogger has been making this point for months, so having a respected third party confirm it is very satisfying.
The problem with not telling the truth about the size of the hole in the banking system, as Ireland found out, is markets don't believe you when you adopt policies designed for a smaller problem. In fact, markets react by losing confidence in the government.
This loss of confidence leads to all sorts of problems like much higher yields on the sovereign debt and runs on the banks.
Spain is underestimating potential losses by its banks, ignoring the cost of souring residential mortgages, as it seeks to avoid an international rescue like the one Ireland needed to shore up its financial system.
The government has asked lenders to increase provisions for bad debt by 54 billion euros ($70 billion) to 166 billion euros. That’s enough to cover losses of about 50 percent on loans to property developers and construction firms, according to the Bank of Spain. There wouldn’t be anything left for defaults on more than 1.4 trillion euros of home loans and corporate debt.
Taking those into account, banks would need to increase provisions by as much as five times what the government says, or 270 billion euros, according to estimates by the Centre for European Policy Studies, a Brussels-based research group.
Plugging that hole would increase Spain’s public debt by almost 50 percent or force it to seek a bailout, following in the footsteps of Ireland, Greece and Portugal.
“How can you only talk about one type of real estate lending when more and more loans are going bad everywhere in the economy?” said Patrick Lee, a London-based analyst covering Spanish banks for Royal Bank of Canada. “Ireland managed to turn its situation around after recognizing losses much more aggressively and thus needed a bailout. I don’t see how Spain can do it without outside support.”...What is the true size of the hole in the Spanish banking system? The only way to find out is to require the Spanish banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.
With this information, the market can determine just how big the hole is.
Once this is known, the questions of how and when to fill the hole can be addressed.
There are many self-interested market participants who would argue that the Spanish banking system needs to recapitalized today and the source of funds should be the EU.
Your humble blogger would argue that recapitalizing the banking system today is unnecessary. With deposit guarantees and access to central bank funding, banks in a modern financial system can make loans to support the real economy and operate for years with negative book capital levels. As a result, banks can recapitalize themselves through retention of future earnings.
With ultra transparency in place, market discipline will ensure that the banks don't take excessive risk while recapitalizing or in the future.
Spain’s banks face bigger risks than the government has acknowledged, even with lower default rates than Ireland experienced. If losses reach 5 percent of mortgages held by Spanish lenders, 8 percent of loans to small companies, 1.5 percent of those to larger firms and half the debt to developers, the cost will be about 250 billion euros.
That’s three times the 86 billion euros Irish domestic banks bailed out by their government have lost as real estate prices tumbled.
Moody’s Investors Service, a credit-ratings firm, said it expects Spanish bank losses of as much as 306 billion euros. The Centre for European Policy Studies said the figure could be as high as 380 billion euros....Losses of this order of magnitude can only be covered by using the banks' future retained earnings and the sale of equity to private investors.
Even if the Spanish government could raise this amount of money, as the Irish bank CEO said, bailout money could be better used elsewhere.
The Bank of Spain has lost its prestige for failing to supervise banks sufficiently, said Josep Duran i Lleida, leader of Catalan party Convergencia i Unio, which often backs Prime Minister Mariano Rajoy’s government....Here is confirmation of your humble blogger's observation that not telling the truth by governments and financial regulators about the true condition of the banks results in a loss of confidence.
Rajoy has shied away from using public funds to shore up the banks, after his predecessor injected 15 billion euros into the financial system.
He softened his position earlier this week following a report by the International Monetary Fund that said the country needs to clean up the balance sheets of “weak institutions quickly and adequately” and may need to use government funds to do so....The IMF has a vested interest in having the government inject capital into the banking system. It is hard for the IMF to make a loan if there is no borrower.
In the case of Spain, there is no need to borrow from the IMF as the banks can be cleaned up and recapitalized without injecting funds or IMF assistance.
“Spain is constantly playing catch-up, so it’s always several steps behind,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a consulting firm in London specializing in sovereign-credit risk. “They should have gone down the Irish route, bit the bullet and taken on the losses. Every time they announce a small new measure, the goal posts have already moved because of deterioration in the economy.”
Without aggressive writedowns, Spanish banks can’t access market funding and the government can’t convince investors its lenders can survive a contracting economy, said Benjamin Hesse, who manages five financial-stock funds at Fidelity Investments in Boston, which has $1.6 trillion under management.
Spanish banks have “a 1.7 trillion-euro loan book, one of the world’s largest, and they haven’t even started marking it,” Hesse said. “The housing bubble was twice the size of the U.S. in terms of peak prices versus 1990 prices. It’s huge. And there’s no way out for Spain.”...By simply requiring banks to provide ultra transparency, the Spanish government addresses the buy-side's concerns. Once the assets are disclosed, market discipline will require that they are marked down.
With on-going ultra transparency, the investors can assess the risk of each bank and provide access to market funding at pricing that reflects the risk.
Spain, like Ireland, can’t simply let its financial firms fail. Ireland tried to stick banks’ creditors with losses and was overruled by the EU, which said defaulting on senior debt would raise the specter of contagion and spook investors away from all European banks.
Ireland did force subordinated bondholders to take about 15 billion euros of losses.
The EU was protecting German and French banks, among the biggest creditors to Irish lenders, said Marshall Auerback, global portfolio strategist for Madison Street Partners LLC, a Denver-based hedge fund.
“Spain will be the new Ireland,” Auerback said. “Germany is forcing once again the socialization of its banks’ losses in a periphery country and creating sovereign risk, just like it did with Ireland.”...By requiring ultra transparency and letting banks recapitalize themselves through retention of future earnings, Spain breaks the link between its sovereign debt and the banks.
Since the subordinated debt was put on during a time when banks did not provide ultra transparency and governments were claiming they were solvent, there is a moral obligation that the banks repay the debt.
In the future, with banks providing ultra transparency, new subordinated debt holders will be responsible for any gains or losses on their investments. This responsibility is the result of the simple fact that they have access to the information they need to independently assess the riskiness of the investment and to use this assessment in determining the amount and pricing of their exposure.
Spain’s government has said it wants to find private-sector solutions...Requiring ultra transparency and letting banks recapitalize themselves through retention of future earnings is the ultimate private sector solution.