Spain's bad bank underscores depth of Spain's bad loan problem

As I was reading the presentation from the Bank of Spain (hat tip Zero Hedge) on the bad bank to hold troubled real estate loans, it was clear that Spain's taxpayers and its real economy would be much better off if the Spanish banks were required to recognize upfront the losses on the bad debt that they would realize if the debt went through the long process of default and foreclosure.

One reason that bad banks do not work is the price that the bad assets are transferred to the bad bank at is not determined by the market.  Instead, it is determined by financial regulators.  This can lead to a host of problems.

For example, if the price for the bad assets is too high, it is effectively a subsidy of the bank by the taxpayer.  Private investors will not invest in the bad bank because the assets cannot generate the return necessary to compensate for their risk.

The primary reason that bad banks do not work is that unless the banks are required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details nobody knows what other losses are hidden on or off their balance sheets.

The Spanish government, at the Troika's request, lays out this nice plan.  First, we stressed tested the banks to determine how much capital was needed.  Second, we take out the bad debt.  Third, we inject new capital.

Unfortunately, each step of the plan is fatally flawed.

• First, the stress tested banks have far bigger losses than envisioned by the stress tests.

• Second, the bad bank isn't taking all of the bad debt off the balance sheets of these banks.

• Third, the amount of capital being injected doesn't make the banks solvent.  

If Spain wants to fix its banking system, it will follow Iceland's lead and require its banks to recognize all their losses upfront.

Next, it will implement ultra transparency so that market participants know that all the losses have been taken.

Then, banks that are capable of generating earnings and rebuilding their book capital levels will be allowed to continue operating.  Banks that cannot generate earnings will be resolved.