July 04,2012

Spain, which for years underestimated losses at its banks, is poised to overestimate how much they can earn in an economy mired in recession.

One of two outside advisers hired by the Spanish government to conduct stress tests on the nation’s lenders estimated that losses could reach 274 billion euros ($347 billion) in the next three years. The adviser, management-consulting firm Oliver Wyman, predicted banks could earn 23 billion euros a year before loss provisions, about what they made in 2011, even if the economy contracted by 6.5 percent under an adverse scenario.

While Spain’s two largest lenders, Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA), earn most of their income outside the country, smaller banks depend on domestic business. Most are paying higher rates for deposits than they earn on mortgages. Their most profitable trade — borrowing at 1 percent from the European Central Bank and lending to the Spanish government at 6 percent — risks bankrupting the country.

“As the economy keeps going south, the second-tier banks can’t generate earnings and their losses will rise more,” said Alberto Gallo, head of European macro credit research at Royal Bank of Scotland Group Plc in London. “There’s no end to plugging banks’ losses. The banks will eventually provide the straw that breaks the camel’s back.”

EU Bailout

Overestimating earnings could lead Spain to ask for too little financial assistance from the European Union to recapitalize its ailing banks. That increases the risk that the bailout will fail to restore market confidence in the nation’s banking system and provide only a short respite, as did four previous attempts since 2010.

The EU has agreed to provide as much as 100 billion euros to help Spain fix its banks. At a meeting in Brussels last week, euro-area leaders paved the way for Europe’s bailout fund to inject funds directly into lenders once they establish a single banking supervisor. Proposals for a unified supervision framework will be considered by the end of the year, the leaders said. The politicians also decided that the financial assistance Spain gets won’t subordinate existing bondholders.

The yield for Spain’s 10-year benchmark bond has declined 0.66 percentage point to 6.24 percent in the two days since the announcement. While the decision on the seniority of rescue funds helps ease investor concerns, Spain will need to borrow from the EU to recapitalize its banks until a direct-lending mechanism is in place, adding to its debt burden, said RBS’s Gallo.

“This gives them a reprieve of several weeks perhaps, but they still have to move swiftly to fix the banks bleeding with losses,” Gallo said. “Spain can’t wait for a year for the new bank mechanism to be set up.”

Bank Profits

The studies by Oliver Wyman and Munich-based Roland Berger Strategy Consultants GmbH, which found the capital needs to be between 26 billion euros and 62 billion euros, will play a significant role in determining how much aid Spain will request. The exact figure will be decided after a more detailed bank-by- bank examination by the two firms is completed in September.

The report by New York-based Oliver Wyman concluded that most of the potential bank losses could be weathered by profits, provisions and existing capital buffers. The Roland Berger analysis reached a similar conclusion, though it didn’t provide a breakdown of how much would be met by earnings.

Oliver Wyman said it expects more profit under its adverse scenario than its base case, in which gross domestic product falls by 1.7 percent between now and the end of 2014. The firm didn’t explain the logic behind improved earnings in a weaker economy. Oliver Wyman doesn’t comment on client work, spokesman Chris Schmidt said.

Second Recession

The Spanish economy, which contracted for six quarters beginning in 2008, entered a second recession in the first quarter of 2012 after growing less than 1 percent last year. The deterioration probably intensified in the second quarter, the Bank of Spain said last week. The International Monetary Fund and the EU expect the economy to shrink 1.8 percent in 2012. Unemployment has reached 24 percent, the highest in the EU.

Bankia (BKIA) group, Spain’s third-largest bank by assets, asked for a 19 billion-euro bailout in May. Newly appointed Chairman Jose Ignacio Goirigolzarri decided to make provisions for residential mortgages and loans to companies outside the real estate industry in addition to what the government required for loans to developers and construction firms.

Capital Needed

Bankia, formed from the merger of seven regional firms, accounts for almost one-tenth of all bank lending in Spain. Extrapolating its request to the rest of the system means lenders would need to raise about 210 billion euros of capital. Taking Santander and BBVA out of the equation would reduce the figure to 168 billion euros.

That’s in line with the 160 billion-euro Royal Bank of Canada estimate for what Spain needs. The RBC calculation takes into account the Bankia example as well as what Ireland did with its failed banks in 2010, forcing steeper writedowns and funding a bad bank to take some soured loans off their books.

“Even though every bank and every country is different, Bankia’s guidance and the Irish situation show that the EU bailout figure being discussed may not be enough,” said Patrick Lee, a London-based analyst covering Spanish banks for RBC.

Royal Bank of Scotland’s Gallo sees a capital need of 134 billion euros, with a worst case scenario of 180 billion euros. Others say a 100 billion-euro EU bailout is sufficient. Jonathan Glionna, an analyst at Barclays Plc, estimates the capital need at 80 billion euros. Under an “unlikely but plausible stress case,” that figure could rise to 116 billion euros, Glionna wrote in a June 13 report. The IMF said on June 8 the shortfall was 37 billion euros.

Underestimating Losses

Some Spanish bankers and government officials have warned against using Bankia as a benchmark. Economy Minister Luis de Guindos told parliament on May 23 that Bankia is a “specific case” without any implications for the rest of the industry.

Spain resisted acknowledging the extent of losses at its banks until last month. Regulators focused on getting firms to increase provisions only on commercial real estate loans, ignoring residential mortgages and other corporate lending.

Spanish government officials and bank executives downplayed potential losses on home loans by pointing to the difference between U.S. and Spanish housing markets.

In the U.S., a lender’s only option when a borrower defaults is to seize the house and settle for whatever it can get from a sale. The borrower owes nothing more in this system, known as non-recourse lending. In Spain, a bank can go after other assets of the borrower, who remains on the hook for the debt no matter what the price of the house when sold.

Irish Defaults

The same extended liability didn’t stop the Irish from defaulting on home loans as its economy shrank, incomes fell and unemployment rose. At the end of 2011, overdue and restructured home loans in Ireland reached 18 percent. The Irish government is softening its personal bankruptcy laws to allow homeowners to restructure mortgages and has pressed banks to do so even before the new rules take effect. That exacerbated bank losses.

“As the economy suffers more, the Spanish government will be pushed to copy the Irish and ease the burden on homeowners,” said Edward Hugh, a Barcelona-based economist. “If the government doesn’t cut them a deal on their mortgage debt, then people, especially younger generations, will start leaving Spain to avoid paying. That will hurt Spain’s economy even more.”

Delinquencies on all loans have been rising and were almost 50 percent higher in April than at the end of 2010, according to Spain’s central bank. That means less interest income for lenders as well as more loan losses. Even some loans that are performing don’t make money for the weakest banks, which pay a higher interest rate for deposits.

Moody’s Downgrades

The delinquency and default trends in mortgages securitized into bonds point to a tripling of losses for banks on their home loans, RBS analysts estimated in May.

Oliver Wyman’s 274 billion-euro loss estimate isn’t far off from the 287 billion euros that RBC’s Lee forecasts. Using the loss ratios of the 2010 Irish stress test on Spanish banks would increase the amount to 325 billion euros. The Centre for European Policy Studies, a Brussels-based research group, estimates even higher losses: 380 billion euros.

Last week Moody’s Investors Service downgraded Spanish banks’ credit ratings for the second time in a month, expecting rising losses and a weakening ability of the government to support the lenders.

‘Restore Confidence’

Counting on three years of profits that may or may not materialize to lower the capital needed by banks undermines the objective of the exercise, Lee said.

“Investors are demanding upfront mark-to-market writedowns of the loan portfolios and a front-loaded capital injection to counter that,” said Lee. “Anything short of that won’t have the power to restore confidence in Spain’s banks.”

Santander and BBVA accounted for more than half the pre- provision profit of the Spanish banking system last year, even though the two lenders held only one-fifth of the domestic loans. The weakest Spanish banks rely on ECB funding to stay alive and eke out a profit on lending, said Hans-Joachim Duebel, a banking and mortgage consultant based in Berlin.

Borrowing from the ECB by Spanish banks almost tripled in six months to 288 billion euros as of the end of May.

Last year when the banks managed to earn about 20 billion euros before provisions, the Spanish economy grew 0.7 percent, its best performance since 2008. About 25 percent of the banks’ total interest income comes from Spanish government bonds they hold, paying an average of 4 percent annually, according to data compiled by Bloomberg.

Borrowing Costs

As the government is currently paying more than that to borrow, banks could have higher profits in 2012 — assuming Spain can sustain such costly debt, which has reached 6 percent on five-year bonds. If borrowing costs come down significantly on investor optimism that EU leaders are breaking the link between troubled sovereigns and banks, Spanish lenders will be deprived of a lucrative source of income.

Most Spanish mortgages are floating-rate loans, charging 1.5 percentage points on top of the euro interbank offered rate, or Euribor. That would earn the bank about 2.5 percent on a home loan at current Euribor. Meanwhile some banks pay as much as 4.2 percent for deposits, according to Spain’s Expansion newspaper. That means they can only make money when funding with emergency funds from the ECB. Lending what they take in from deposits would result in a loss.

“There’s no real profit for most of the system,” Duebel said in an interview. “Just like German banks that were bankrupt but resisted acknowledging it after the 2008 crisis, the new incarnations of Spanish savings banks are using accounting gimmicks to look profitable so they can delay their insolvency. Most of them are zombies.”

Five Restructurings

Some smaller banks have improved interest margins and fee income as they’ve stolen market share from savings banks. Banco Popular Espanol SA (POP), the fifth-biggest lender in Spain, said net interest income jumped by one-third in the first quarter as fees rose by almost 10 percent. While borrowing from the ECB helped replace other funding, that’s not why interest income improved, the bank said in an April presentation.

Spain has announced four previous restructuring efforts in the banking system since 2010, each one giving the country a brief reprieve. Those attempts included merging the savings banks and injecting capital into some.

The timetable for the current rescue effort requires banks to submit proposals in mid-October for how they will address the capital shortfalls determined by the outside advisers following the next stage of stress tests. The financial institutions will then have nine months to implement the approved plans.

Delaying Resolution

Delaying the resolution forces more of the losses onto the public balance sheet, said RBS’s Gallo. Spain should seek to share the cost with bank bondholders, as Ireland did with owners of subordinated debt, he said. Spain is discussing such a plan with the EU.

“The longer they wait in doing this, the fewer bonds are left in the banks to impose losses on,” Gallo said. “Investors are taking their money and leaving when bank bonds mature, leaving the ECB as the creditor.”

Hugh, the Barcelona economist, said Spain should follow Ireland’s lead and move the most toxic assets to a so-called bad bank. Ireland forced writedowns of 58 percent on loans to builders and developers before moving them to the National Asset Management Agency. Spain might need to require a 70 percent discount on the same type of assets, especially if it wants participation by the private sector in the bad bank, Hugh said.

That would mean the cost of the bad bank alone could be about 100 billion euros, Hugh estimated, an amount equal to what the EU is proposing to lend Spain. The country would then need additional funds to reserve for losses on other loans, such as residential mortgages, Hugh said.

Public Debt

Spain’s public debt, including that of regional and local administrations as well as unpaid bills by governments, is already about 100 percent of GDP, according to RBS. An additional 100 billion euros for the banks would take the ratio to 110 percent, close to the 120 percent for Ireland, which has been shut out of the bond market for two years.

Irish government officials said last week’s decision by euro-area leaders on bank recapitalization would be implemented retroactively, helping Ireland replace the government debt it has taken on to rescue its lenders with direct funds from the EU. Gallo and other analysts questioned that interpretation.

While last week’s summit was a step in the right direction, there’s still work to be done before anyone can claim the crisis is over, said Edward Harrison, an analyst at Global Macro Advisors, an economic consulting firm in New York.

“One big problem is the lack of firepower the rescue funds have,” Harrison said. “They’re clearly not big enough to deal with either Italy or Spain, which are the third- and fourth- largest economies in Europe. And there’s still the danger of some countries not ratifying the rescue funds or some decisions reached in the summit. A lot still needs to be fleshed out.”