Woes of Banks Intensify

The latest data releases from Spain show a – not entirely unexpected – worsening of the banking system's problems. Although no-one can be surprised by this, it is a reminder that the planned bailout may find itself a few euros short in the end. How many euros exactly no-one knows yet: as we always point out, this is very much a moving target – and a fast moving one at that. The current plan provides for €100 billion or 'hopefully less'. The size of the bill will of course also depend on whether there will really be haircuts for the various species of bondholders. As we have pointed out previously, the plan to let subordinated creditors take a loss is a political hot potato and may yet end up saddling Spain's government with a big bill.

The ECB's idea to let senior creditors also take losses meanwhile is not really popular with the euro-group – officially due to contagion fears, but unofficially also because this would presumably require altering the approach to Ireland's bailout retrospectively. The latest development on this particular front is that Mario Draghi announced that the ECB's policy stance on the topic is still 'evolving'. We could become witnesses to an example of accelerated evolution in this case, depending on the speed at which the situation deteriorates.









ECB chief Mario Draghi: the policy on the status of bondholders in bust banks is still 'evolving'.

(Photo via the web)



Here are a few excerpts from a WSJ article summarizing the Spanish data releases:

“Spain's housing and banking sectors continue to deteriorate, grim new government data showed Wednesday, providing the latest indication that the country's economy remains caught in a protracted recession.

House prices declined at the fastest pace since the start of the crisis in the second quarter, the public ministry said, while bank deposits saw a record decline in May from a year earlier, and bad loans increased for a 14th month in a row, the Bank of Spain reported.


Total private-sector deposits held in the country's banks shrank 5.75% from a year earlier in May to €1.327 trillion. Some €7.4 billion were withdrawn compared with April, the data showed. The pool of bad loans jumped to €155.84 billion, or 8.95% of total loans, up from 8.72% in April.

"The numbers confirm that there is an actual outflow of deposits from Spain right now," said Carlos Peixoto, a bank analyst with BPI Banco in Portugal.

The drop in deposits in May coincided with the Spanish government's emergency takeover of one of the country's largest lenders, Bankia SA. The Rajoy administration agreed to pump €19 billion into the troubled bank, and since then, worries about the rising cost of cleaning up the local banking industry pushed the country's financing costs higher.

The yield on Spain's 10-year bond rose to 6.9% Wednesday, approaching the 7% threshold that analysts say is too high for the government to continue to finance its deficit.

Mr. Peixoto said the shrinking loan volumes and new rise in bad debts were roughly as bad as expected. Credit volume in Spain—which during the boom grew at annual rates of almost 30%—has been falling every month since February 2011, and in May was down 3.82% on the year.

Spain's bank problems are tightly intertwined with the decline in its real-estate sector, with lenders struggling to digest billions in bad real-estate loans. The country's house price index dropped 8.3% from a year earlier in the second quarter, indicating that the free-falling real-estate market has yet to find a floor.


So there is a healthy dose of deleveraging underway, but there is actually good reason to expect it to get a whole lot worse. Below are a few charts we have taken from a report by BNP Paribas that illustrate the situation.

The first one shows non-performing loans as a ratio of bank loans as well as the monthly growth rates in millions of euros. There are two things worth noting about this. First of all, the NPL ratio is still below the all time high of 1994, which was also the result of a property bust, but a much milder one than the one currently underway. It stands to reason that this old record will soon fall. Looking at the monthly increases, we can see that after the big spikes in 2008/9, things appeared to calm down in 2010 and since then the trend is worsening again. We would submit that this is not only due to the deterioration in the economy's performance, but is mostly a result of the 'dynamic provisioning' Spain's banks engaged in and the various accounting tricks that were used to mask NPL's. As we have pointed out previously, the problem with sweeping stuff under the rug is that one sooner or later runs out of rug. This point seems to have been reached for a number of banks.



Spain's NPL ratio and monthly NPL growth in millions of euros. The NPL ratio is now at 8.95%, only a tiny bit below the 1994 record high. Given the uptrend in monthly increases, we expect it to be broken soon – click chart for better resolution.



There is a bit of devil in the details. Readers may recall that analysts have long wondered how it was possible for defaults on residential mortgages to remain so low in the face of depression-like unemployment in Spain and the bust in house prices. Many suspected that numerous distressed mortgages were simply amended to make them look current on the banks' books. For instance, the head of credit research of Legal & General PLC in London had this to say in late April:


There does seem to be a strange contrast between the high level of unemployment and the surprisingly low level of delinquencies on mortgages,” said Georg Grodzki, who helps oversee $515 billion as head of credit research at Legal & General Plc in London. “This raises the issue of whether loans have been amended to make them look current when in fact they are distressed.


(emphasis added)

However, Santander CEO Alfredo Saenz declared that it was another reason entirely that accounted for the seeming discrepancy. It's not a matter of one's financial situation apparently – instead it is a 'sociological thing'. At a press conference at the bank's headquarters he announced sotto voce:

That’s nonsense. Mortgages get paid in good times and in bad. Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. It’s a sociological thing and that’s how it is. The data is good so let’s not start debating the quality of the information. Mortgage arrears are not a problem and are not going to be a problem.”


One doesn't have to be a cynic to realize that there has to be more to it than that. No matter how culturally ingrained the desire to remain current on underwater mortgages allegedly is and no matter how dire the consequences of failing to pay are – mortgage debt is full recourse in Spain – if one is unemployed and one's savings run out, it's game over.

It appears from the disaggregated NPL data that this moment is now arriving for more and more borrowers:



'Other' NPL's and mortgage NPLs (as a percentage of loan type) – the latter are now beginning to turn up from the base that has been built in recent months. If they were a stock, we'd buy it. Meanwhile, the biggest headache remain real estate developer NPL's, which have reached a truly staggering 23% of all outstanding developer loans and represent 44% of the NPL total – click chart for better resolution.



As time passes, we suspect that even more developer loans will turn out to be non-performing, as the property bust is far from over and Spain is drowning in residential real estate. The glut is best illustrated by this data point: there is one house in Spain for every 1.7 inhabitants. There seems very little reason to build even a single additional home for the moment.

However, mortgage NPL's appear to have more upside overall, simply because they are still at such a low base. If one considers the glut of homes and the unemployment rate of 24.6%, then it doesn't take too big a leap of the imagination to see that a sharp increase in mortgage defaults could be in store in the near future.

Meanwhile, the fall in house prices is accelerating amid a relentless collapse in transaction volumes. This is putting ever more borrowers below the waterline, something that has very detrimental effects beyond the immediately obvious ones. For instance, it lowers labor mobility. People cannot leave their homes anymore to take up work elsewhere, because selling means being left with a huge mortgage balance and no abode to show for it.



Official change in house prices, quarter-on-quarter and year-on-year – click chart for better resolution.


Tinsa house price index – click chart for better resolution.



Transaction volume collapses: year-on-year growth in urban home sales – click chart for better resolution.


Credit Contraction Accelerates

The banking system's asset base has not surprisingly begun to shrink, along with deposits. The trend has become a persistent one and is reminiscent of the time when credit growth went negative in Japan in the 1990's. Japan eventually went through 60 consecutive months of negative credit growth.

Mortgage lending and lending to developers is naturally contracting the fastest, but as BNP's bank analyst Santiago Diaz Lopez remarks in his latest report:


“The rate of decline in mortgage lending has accelerated, for the 27th consecutive month, to -7.3% y/y at the end of May 2012. The decline in non-mortgage lending has also worsened to just +0.8% y/y (3.0% y/y growth one year ago).

We believe that the rate of decline would have been even worse if it had not been impacted by the common practice of restructuring real estate developers’ debt (and, more recently, retail clients’ debt).

New mortgage production has declined by more than 77% from its peak (and new home starts are almost 90% below the peak) but the total stock of lending to real estate developers still stands above 2007 levels (loans to the sector have barely started to adjust, having fallen just 8.9% from their peak).”


(emphasis added)

Moreover, as the above excerpt shows, these data are not really current – the data for June have not yet been compiled. In the early 1990's milder housing bust, loan growth nearly reached zero at one point, but never went negative year-on-year. This is yet another data point that is telling us that the official NPL ratio is probably understating the true state of affairs. As more and more of the 'dynamic provisioning' wiggle room runs out, the NPL ratio is sure to increase further. When nearly 9% of all outstanding loans are in default in a fractionally reserved system that has allowed the banks to become 'loaned up' to their eyebrows, the situation is already extremely dire. Alas, it is set to become still worse in this case.



Spain's overall loan growth year-on-year and month-on-month rates of change. As can be seen, this is now an accelerating negative growth trend – click chart for better resolution.



We have frequently mentioned to what a large degree Spain's banks have become dependent on ECB funding, as all but the biggest banks with large international operations are practically shut out from the interbank funding markets. Moreover, there is deposit flight, which so far continues unabated. One can surmise from the ECB's balance sheet data that ELA financing (emergency liquidity assistance) to Spain's banks must also have grown considerably.

As noted in 'Euro Area Capital Flight Revisited', both foreign and domestic depositors are engaged in a 'stealth run' on Spain's banks. It is not yet certain at this point whether this is going to be impacted in any way by the recent news that Spain's banking system will be bailed out, but obviously there are several angles depositors must consider, which undoubtedly include deliberations about the future of the euro as such. Our gut feeling is that the bailout agreement won't materially alter the trends that are currently in place.



ECB lending to Spain's banks stands at a record (it looks a bit like the chart of QCOM in 1999), while deposit flight continues to accelerate – click chart for better resolution.


Due to the fact that Spain's government must actually finance the initial stage of the bailout itself until the mechanisms for the EU bailout are all in place, investors remain extremely worried about the sovereign debt of Spain.

The yield on Spain's 10 year government bond is closing in on the 7% level again, which is widely assumed to be the 'pain threshold' beyond which it becomes literally impossible to finance the deficit, as interest charges would soon accelerate the debt spiral beyond the point of no return. One can apply a simple rule of thumb here: once the total public debt exceeds 100% of GDP, the weighted interest rate on the outstanding debt must – ceteris paribus – not exceed GDP growth if such a scenario is to be avoided.

Currently Spain's public debt remains well below 100% of GDP at 72.1% as of Qu.1 of 2012. It is currently expected to reach 79.8% at the end of the year, but these estimates have a way of going awry (although this particular one actually seems to have enough 'headroom' given the ratio was at 68.5% at the end of 2011).



Spain's 10 year government bond yield is almost back at 7% – click chart for better resolution.



Finland Gets Better Collateral Than Expected

Finland has meanwhile concluded negotiations regarding collateral with Spain, and got a better deal than initially thought – 40% of its bailout contribution will be collateralized with cash that will be invested in the bonds of the five highest rated euro area governments. In exchange for this, Finland won't get any of the prospective 'profits' the bank recapitalization might produce for the ESM. That sounds like a concession that was very easy to make. Still, Finland is taking some risk anyway, as it is unknowable at this point what the recoveries in a worst case scenario will turn out to be. Greece provides such a 'worst case' example, as its next default will definitely hit the public lenders. Nordea summarized the situation as follows:

“In return for the collateral, Finland will forgo any potential profits from the loans provided by the European Financial Stability Facility (EFSF) and later the European Stability Facility (ESM). As the lending rate via the EFSF basically totals its own funding and operational costs, the EFSF loans are not expected to lead to a profit. The exact terms of the help provided via the ESM have yet to be decided. It also remains an open question, whether in the future, once/if a common banking supervisor is in place, the ESM would have the prospects for notable profits as well as losses, if it recapitalized banks directly. Of course, if the ESM provided help with a preferred creditor status, Finland would not require collateral.

Purely from a financial perspective, Finland has thus reached relatively a good deal, and is in a better position compared to the other Euro-zone countries regarding the risks involved in the Spanish package. Still, it is much harder to argue that the collateral would cover the Finnish risks in its entirety. The 40% loss assumption, taken from analyses from Standard & Poors, is based on historical data, and if any losses surfaced, the recovery rate could basically be almost anything (as was seen in the Greek debt restructuring, though in that case public creditors were spared any losses – another Greek debt restructuring in the future would look completely different).

Going forward, it is good to remember that the Finnish stance continues to be that the country requires collateral in return of all upcoming bailout packages offered without a seniority status (which is planned at least in many instances in the ESM). As the introduction of the ESM has been delayed by several months, there could easily be the need to tap the EFSF again. In that case prepare for more collateral negotiations, something that may cause increasing frustration in other Euro-zone countries and further test the solidarity among Euro-zone countries.”


(emphasis added)

One thing is absolutely certain: getting cash that is invested in the five highest rated sovereigns is a whole lot better than getting shares in Spanish banks, the idea initially mooted by Finland's finance minister Jutta Urpilainen.


Post Scriptum:

The complete Exane Paribas report from which we have taken most of the charts above can be seen here (pdf).



Charts by: BNP Paribas, BigCharts



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5 Responses to “Spain’s Banking System: Circling the Drain”

  • worldend666:

    Hi Acting Man

    Great quality info as usual. I often wonder if Spain Italy or both defaulted what might happen in the huge chain of dominoes. Would any bank anywhere be safe? How interconnected are the banks? French banks would tumble for sure. German also. But Where else? East Europe, US? What’s the connection between Spain and South American banks? Is Asia likely to be unscathed since they have little connection to EU banking? If the banks go down what might the consequences be for holders of various assets? Is gold confiscation likely when it’s already too late?

    Or would the EU be able to solve the issue with a monster LTRO to save the day long enough to change the EU statutes and allow the LTRO to become permanent? If they did so might it also be accompanied by gold confiscation? Perhaps you could attempt a post addressing some of these issues? If you do, good luck with that … :)

    • JasonEmery:

      Great questions, worldend. If Actingman tackles those, I would hope there be some discussion of the Washington Agreements, 1 and 2. This was the 5 year program that limited selling by EU area central banks from 1999 to 2004, and was followed by a similar, unnamed plan from 2004 to 2009, as I recall.

      Given how recent those gold sales were, whether any physical gold changed hands or not, I don’t see how anyone with less charm than Hitler2 could pull off a confiscation. What would they say? “We now realize that it (WA and WA-2) was a policy error to sell all that sovereign gold. Sorry, but all privately held gold must be turned into the ECB so we can recapitalize the PIIGS.”

      I think that in order to have a chance at an orderly confiscation, they would have to let gold run to $2500/oz, or perhaps much higher. Since they can print dollars and Euros at will, and a confiscation is their only way out, that is my guess.

      First, they quietly accumulate as much as possible. Then they wade in with both fists buying, pushing the price up. Then they confiscate. Just guessing, lol.

  • This would all be funny if the situation wasn’t so dire. I wonder if Spanish bank accounting is like the USA, mark to fantasy, hold to maturity? If so, are they not recognizing any of the mortgage losses due to recourse of the borrower for losses? One of your articles said the developers were still building. I have seen this with the S&Ls here in the mid 1980’s, where they had to make the development loan look good by putting homes on the property. Of course, it all started out with an inflated land deal, 100% financed in JV, so the development was put on the property to make the land loan look good, which needed the houses to make the development loan look good.

    I wonder why 7% is the mark? If 7% is the mark, then none of these governments is going to make it. It hasn’t been that long ago they were all paying 7% and if they successfully inflate, we will be back there. I suspect that so much future production has been hocked in the use of Keynesian economics and reseve banking, it will all have to blow up first.

    If so much of the future has been spent up, and the payment of debt is based on future production and future production is dependent on future consumption and future consumption is dependent on more credit, where do we stand? Looks like we stand at a point where only more future bad debt can keep the game going. Finland only stepped up one step on the ladder. When an outfit is levered 20 to 1, it only has to lose 5% to go broke. The idea of making money out of the bailouts is only in the minds of people like Tim Geithner, Ben Bernanke and Barack Obama. They need the banks to continue deficit spending stimulus. Thus we have the philosophy of bailing out bankrupts on the credit of bankrupts.

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