Spanish Bank’s Get Government Brokered Bailout

Madrid / Brussels. While Spanish Prime Minister Mariano Rajoy continues to deny Spain’s need to bailout its banking sector an informal agreement has been reached on the possibility of Spain taping 100 Billion Euros for the purpose of restructuring its banks. The agreement was apparently reached in less than two hours over the weekend at which time Spain was offered $125 Billion with virtually no strings attached. While the details of the agreement remain unannounced, previous rounds of austerity measures and structural reforms were enough to convince Northern Europe of Spanish fiscal credibility and bailout merit.

Whether the European Stability Mechanism will be employed to fund the European loan to Spain or whether the temporary European Financial Stability Facility will be used remains to be negotiated as the ESM is not slated to be in operation before the end of June 2012. Spanish borrowing needs till the end of the year amount to roughly 70 Billion Euros and estimates for a banking bailout in Spain have ranged from 40 to 90 Billion Euros, meaning the European loan could very possibly be large enough to cover all governmental liquidity needs till 2013. If that is the case the nominal yield on Spanish debt will matter little in for the short term and give Spain another 6 months to implement structural reform conducive to growth.

The loan will be provided to the Fund for Orderly Bank Restructuring (FOBR), a Spanish regulatory group created in 2009 to oversee bank mergers and acquisitions, with the objective to ensure that all banking groups in Spain remain solvent. With a war-chest previously estimated at 99 Billion Euros minus the Bankia bailout, the European loan will bring the FOBR’s capital firepower up to ~180 Billion Euros.

The downside of the loan is that it would bring Spanish debt to GDP levels up to ~90%, a historically undesirable number. Another worry for investors is whether the ESM or EFSF will be the loan issuers. ESM issued loans and rescue passages will have senior status and subordinate all previously issued bonds and treasury bills, while the EFSF originated loans have the same status as privately marketed debt securities. This uncertainty wiped out all the gain in Spanish bond prices initially generated by the announcement. It is widely speculated that the loan will not subordinate private debt as Germany and co. would like to see Spain return to capital markets to finance its deficits at reasonable yields.

Another concern is the continued slid in property values that could lead to higher bad loan ratios at the banks. Banking loans past due by 3 months have already reached highs not seen since the mid 90’s, at a staggering 143.5 Billion Euros. With property values continuing to slide and unemployment still at ~24% the risk of a continued slid in Spanish bank assets may eclipse the size of the current bailout proposal.

Negotiations are expected to resume once Mariano Rajoy has finished watching the Euro football championship, which might be soon seeing as the Spaniards could not even beat Italy in round robin play.

Letter for Spanish Bankers

Spanish Banks are in a tough spot. A commercial property collapse on the tails of the financial crisis and recession of 2008-2012 has investors wondering how safe spanish bank balance sheets really are. With the recent failure and oncoming bail out of Bankia most investors have stopped wondering. The real risk to spanish banks however is a run on deposits. The Greek banking sector is already suffering from capital flights on worries of forced conversion of Euros to Drachmas. With a new election coming up in Greece and mounting fears of a Grexit, the risk for contagion of depositor fear is now quite heightened. With balance sheets already substantially weakened by the property bubble burst the spanish banking sector can ill afford to fall pray to deposit redemption ‘en masse’.

The ECB under Mario Draghi has shown some inclination to incarnate the ‘lender of last resort’ role, while the scale of these intentions have been of a large magnitude they remain modest in scope. While the extending of Long Term Refinancing Operations’ maturities and accepting collateral composed of downgraded sovereign bonds was still accepted, represented a bending of the spirit of monetary hawkishness, these actions still respect the rules imposed on the ECB by its Bundesbank roots. So the political will and the monetary structures of the Eurozone will not be available to monetize spanish debts away. The reality is that to avoid a Greek downward spiral the solutions to Spain’s problems must come from within Spain.

One way to partially bypass the ECB’s reluctance to engage more forcefully in solving the oncoming spanish banking crisis is to create a private and local version of a central bank. A bank of banks could be created and capitalized by the largest banks in Spain. A rigorous stress test could be undertaken to determine which banks have the necessary capital buffers and risk management practices to be eligible to participate in the scheme. Once fully capitalized enough and large this bank of banks could provide liquidity guarantees to the banks having passed the stress test. This would represent the mutualization of risk in the banking sector, essentially reducing un-systemic risk for the participating banks.

The remaining banks could then either be recapitalized by the federal government through the purchase of equity by the government (as was the case in the US in 09) or be closed following a bank holiday as was the case in the 30’s. While this would be costly, with a large enough proportion of banks’ liquidity needs covered by the bank of banks hopefully the cost of bailing out the insufficiently funded banks would not be fiscally crippling to the nation.

While these actions could alleviate the risk of a system wide shut down and bailout as was the case in both Ireland and Iceland, the issue of systemic risk stemming from the property bubble burst would remain.

Only a jolt of growth could sustain property prices at levels high enough to preserve bank balance sheets. Liberalizing the spanish through labour market deregulation is a good way to grow an economy in the long run, but with the global economy still teetering, a rebound in industries outside construction seems unlikely. The only option remaining to banks to preserve their balance sheets would be to take a hit on their cash flows. To prevent a further deterioration in housing prices banks will have to consider the inconsiderable. Banks must collectively agree on some form of debt forgiveness. Preferably it would take the form of mortgage extensions and interest payment sabbatical. Such a move could alleviate the pressure on spanish consumers and avoid a series of foreclosures of a magnitude from which banks could not survive. After their stress tests the banks could agree on what levels of temporary interest forgiveness could be acceptable without sparking bank bankruptcies.

This would hopefully give the Spanish economy enough time to begin restructuring towards external sectors such as manufacturing for export. While the moral hazards are numerous and the conditions for success are many, only bold actions undertaken by the banks and acceptable to them will lead to a sustainable solution. These actions would lead to a temporary crimping of banking profitability, but it might preserve their balance sheets and offer their government the respite needed to find solutions to the underlying competitiveness issues that face the nation. Their shareholders may thank them one day, and so may all the indignados.