Spain heads to London looking for investors for its bad bank

Reuters reports that Spain's Economy Minister will meet with investors in London to try to encourage them to invest in the bad bank Spain is setting up.

The bad bank will acquire the bad real estate debt currently on the balance sheets of Spain's banks for an average of approximately 50% of original book value.

My first question is who would invest in what is effectively a sub-prime mortgaged backed security without being able to see and assess each and every loan that would go into the bad bank?

My second question is who would invest when there is effectively no cushion for a price decline similar to what Ireland has experienced?

Regular readers recall that Irish property prices have dropped 60+% from their peak.  Spain's property prices have not done so, but undoubtedly will see a similar price drop when the bad bank starts to liquidate its assets.  After all, when there is 25% unemployment, there are not a lot of buyers around.

If I run the numbers correctly, the break-even for the bad bank is a 55% price decline [cost of bad debt: ((100% - 10% downpayment) * 50% discount on loans = 45% of original market value of property].

For the risk involved in investing in the bad bank, I would expect that the investors are looking for a 20+% annual return.  It doesn't appear that the bad loans are being purchased cheaply enough to meet the investors return targets.

Isn't this the same problem that killed the purchase of opaque, toxic securities from US bank balance sheets?

My third question is who runs the bad bank and tries to maximize the value of the assets?

My fourth question is where does the cash come from to pay for the administrator and the leverage in the deal?  Supposedly, these are non-performing assets so they shouldn't be generating any cash.  Is the Spanish taxpayer paying the interest on or guaranteeing the debt used to buy the bad assets?

Frankly, there is no reason to set up a bad bank.  It doesn't make the losses in the banking system any less.  Unless of course, Spain thinks it can find dumb investors who are willing to overpay for junk.

Spain's Economy Minister will meet investors in London on Thursday in the hope of tempting them to buy into a 'bad bank' that will house billions of euros of the country's soured real estate assets. 

Madrid hopes the newly formed asset management company will help unblock the credit flows to businesses and families that have been progressively choked off as the country's economic crisis has worsened....

Madrid could simply accomplish this by requiring the banks to recognize the losses without setting up the bad bank.

Spain expects private investment to finance more than half the heavily written-down assets - including foreclosed property and bad loans - that lenders will transfer into the entity, which is expected to be in operation by early December....

The assets to be transferred would be priced "very conservatively", and details would be given in coming days, he added....

They will transfer foreclosed property and bad loans to housing developers to the bad bank and receive state-backed bonds in return which can be used as collateral with the European Central Bank to get cash. 

Sound loans to real estate developers might also be parked there, de Guindos said.

Why would any bank transfer a performing asset?

The entity would be financed mostly through debt, with a 10 percent equity component subscribed by private investors and the state. 

The transfers would take place in the first quarter of next year, and the pricing of the assets should be seen in the context of the entity's 15-year lifespan, the minister added.

Pricing is key as it must tread a delicate balance between being low enough to attract investors and high enough not to force further losses on fragile lenders.

This is simply not possible.  The banks are willing to accept a lower return (pay a higher price for the assets) than investors who would be interested in this high risk investment.

"The bad bank will buy assets at very conservative prices and it will stimulate the Spanish housing market," de Guindos said. "It will bring housing on the market at reduced prices."

But who will buy?

Spain has already forced banks to write off 137 billion euros in bad real estate investments through two laws this year, giving lenders an average of 45 percent coverage against their book value. 

But banking sources expect a further 5 to 10 percent to be shaved off the value of assets before they are transferred to the entity in order to attract investors. 

The bad bank will be split up according to asset type in order to attract different investors, de Guindos said. 

"A finished home is not the same as a building plot, a house in an urban area is not the same as one on the Spanish coast," de Guindos said.

Clearly Spain understands that the investors are going to want to see and assess each asset.

To do this efficiently requires setting up a data warehouse.