Does bailout give Spain best chance to fix banks? No!

A Bloomberg article looks at the question of does the bailout give Spain its best chance to fix its banks.

Your humble blogger would say that the answer is 'no'.  The bailout effectively ties the Spanish government's hands in two ways.

• It 'caps' the size of the capital shortfall that Spain can identify as a result of its 'third party audits'.  If the audits confirmed the RBS estimate of a 450 billion euro shortfall, then the bailout further undermines the credibility of the government as they are claiming 100 billion euros is enough.

• It 'commits' the Spanish government to continue to pursue the policies reflected in the Japanese model for handling a bank solvency led financial crisis.  As a result, banker bonuses are protected while the impact of the excess debt in the financial system depresses the real economy.

From the article,

Spain’s request for as much as 100 billion euros ($125 billion) of European bailout funds should provide the country with enough money to shore up its banking system after three failed attempts in as many years. 

“Now that they have this money, it will hopefully finally be possible to recognize all the hidden losses and clean up the system,” Luis Garicano, a professor at the London School of Economics, said in a phone interview....

Regular readers know that recognizing the losses hidden in the banking system did not require Spain to borrow money.  It simply required Spain to adopt the Swedish model with ultra transparency and require the banks to recognize their losses.  Ultra transparency allows the market to confirm the losses are recognized.

Since Spain has a modern financial system that includes deposit guarantees and acces to central bank funding, the banks could then have operated for years supporting and real economy and rebuilt their book capital levels through retained earnings.

Mariano Rajoy, who took office in December and denied the need for a banking bailout as recently as May 28, will be under scrutiny as his government tries to complete the cleanup after past efforts fell short.

The way to not fall short this time is adopting the Swedish model with ultra transparency.

Doubts also remain whether the funds to shore up banks will be enough to fix Spain’s indebtedness, especially with the economy in recession and an unemployment rate higher than 24 percent. 

“We view this as a positive near-term development for Spain, and in particular for its banks,” Andrew Benito, senior European economist at Goldman Sachs Group Inc. in London, said in a note yesterday. “But it does not solve Spain’s overall fiscal and macroeconomic challenges, which remain substantial.”

In short, good for banker bonuses, bad for the Spanish citizens and their economy.

Apart from Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA, Spain’s two biggest banks, and perhaps Banco Sabadell SA, almost all Spanish lenders may be short of capital, said Daragh Quinn, an analyst at Nomura International in London. 

Santander and BBVA (BBVA) have been tarred by the nation’s banking woes even though they generate most of their revenue outside the country. Santander declined 34 percent in Madrid trading in the past 12 months, while BBVA fell 30 percent. They may benefit from the bailout if it cuts their funding costs and leads investors to recognize their relative strengths, said Quinn....

Without ultra transparency, there is no way to know SAN's or BBVA's direct and indirect exposure to the excesses in the Spanish banking system.  It is simply inconceivable that they could have the largest market share in Spain and have avoided the problems.

While the rescue plan may provide a respite to Spanish debt and the euro, whether it proves a success will depend on execution. 

“What a wonderful opportunity Spain has to sort all this out,” said Simon Maughan, a financial industry analyst at Olivetree Securities inLondon. “But I’m afraid they’re going to squander it.” 

Only a commitment by Spain to buy bad assets from lenders and manage them in a so-called bad bank will cure the ills of the country’s banking system, Maughan said.

“The money is there but the question is now how are you going to use it,” Maughan said in a phone interview. “If this money actually goes into the banks and allows for proper writedowns, then great -- but if just sits on their balance sheets, the uncertainty will continue.”...

There is no reason to put the money into the banks as a) the banks can already take the writedowns and operate with negative book capital levels and b) based on the Irish experience, it will be difficult to force the banks to take the writedowns once the capital has been injected (wouldn't want to hurt bank capital levels).

The next questions are which lenders will require the funds and how much they’ll need.

A question that can only be answered with ultra transparency.

Spanish authorities will weigh the findings of the IMF and the independent auditors, Oliver Wyman Ltd. and Roland Berger Strategy Consultants. The Bank of Spain, the country’s banking regulator, was accused in the IMF report of being too slow to tackle weaker lenders, a failure that allowed “growing vulnerabilities” to develop. 

“They will want to remove the uncertainty,” said Quinn. “The fact there is 100 billion euros means that there isn’t the same financial limitation on enforcing the provisioning needs that may be shown up in the audits.”...

It means that the audit will only find 100 billion euros as oppose to the more likely 450 billion euros.

For Maughan of Olivetree, Spain’s best chance of restoring confidence in a banking system burdened by more than 180 billion euros of toxic real estate assets would be to remove them from the lenders’ balance sheets. 

The Irish government, which sought a bailout in 2010, funded a bad bank to take real estate off lenders’ books, forcing write-downs of 58 percent. 

“The Irish forced the banks to take write-downs by saying we will take your loans off your balance sheet for you and we will buy them at 35 cents on the euro,” said Maughan. “If you really want to stand up and be credible and say 100 billion euros is the right number, use the money to take the bad loans off the banks.”

The problem is that in the absence of ultra transparency setting up a bad bank doesn't convince anyone that all the bad loans were removed from the banks.  The lack of ultra transparency is a give-away that the government and the banks are hiding something.