Spain's Anglo?

SPANISH GOVERNMENT ministers haven’t gone on television to dismiss rumours of bailout talks as “ficción” yet – or “fiction” as Fianna Fail minister Dermot Ahern put it in the run-up to Ireland’s bailout in 2010 – but the deepening banking and economic crisis in Europe’s fourth largest economy is getting terribly familiar to Irish observers.

Madrid’s kite-flying this week about the possibility of a backdoor bailout of Bankia, the country’s third largest bank, through the European Central Bank seemed to be (to mix various metaphors) taking a leaf of the Irish banking repair manual. Spain wanted to give Bankia €19 billion in government-backed IOUs to be turned into cash by offering them as collateral with the ECB in Frankfurt.

The use of State IOUs is how the Irish Government is covering the black hole at Irish Bank Resolution Corporation, the undertaker bank in charge of the slow burial of Anglo Irish Bank and Irish Nationwide. The €31 billion of promissory notes put on IBRC’s books have been used by the run-down bank as collateral to borrow cheaply not from the ECB, but from the Irish Central Bank.

The Financial Times reported on Wednesday that the ECB opposed these plans to recapitalise Bankia by indirectly tapping the central bank for cash but the ECB and the Spanish government later came out to say that Madrid had not consulted Frankfurt on the plan. The ECB said that it “stands ready to give advice on the development of such plans”. Even assuming the mixed messages are accurate, a fine line is being tread here.

“The ECB will be mindful of wider recapitalisations of Spanish banks. If they agreed to the proposal for Bankia it could open the floodgates and the Spanish government could seek to use that again,” said Stephen Lyons, analyst at stockbrokers Davy.

Spain is pushing for a mechanism for direct European support for troubled banks, which should help Ireland’s case for a deal on the Anglo debt. The European Commission has thrown its weight behind the idea as Spain is coming under pressure to explain how it is funding the €19 billion Bankia bailout.

The Spanish banks are estimated to require anything between €7 billion and €100 billion to cover loan losses at banks that were lending heavily during a property-driven credit bubble in a market where prices have fallen between 20 per cent and 30 per cent, where unemployment has reached 25 per cent and youth unemployment is double that figure.

Spain’s property declines are not nearly as bad as those in Ireland and the US, for example, which would suggest that the market has yet to hit bottom. The wide parameters of what Spanish banks require reflects the uncertainty around the size of the hole in Spain’s banks. Repeating the Bankia scenario for seven Spanish banks implies that they required €25 billion in fresh capital, Goldman Sachs said in a note on Wednesday, though it said that this falls to €8 billion taking into account what the banks have already been forced to set aside.

Spain’s banks have been directed to set aside €82 billion against toxic property loans over the past three months. The Spanish banks have also been recapitalising over the past two years through debt conversions, tapping shareholders for new funds and government injections of capital. But this has not appeased the frenzied financial markets.

The Spanish banking system, however, has a bigger credibility deficit and given how investors are pricing Spanish sovereign debt – it is approaching the 7 per cent level for 10-year bonds that forced Greece, Ireland and Portugal into bailout programmes – the markets are betting that the loan losses booked by Spanish banks are not nearly enough.

The capital ratios of the Spanish banks stand at between 8 and 10 per cent. This is far below the 20 per cent-plus ratios at the Irish banks, which have been stuffed with capital in anticipation of further property declines and higher loan losses, following last year’s conservative stress tests verified by the US asset managing behemoth Blackrock.

Daragh Quinn, an Irish analyst with Japanese bank Nomura who has lived in Madrid for 12 years, says the Spanish banks require between €50 billion and €60 billion and he believes that every Spanish bank with the exception of the big international players, BBVA and Santander, will require capital support. There are between eight and 10 Spanish banks, he says, and they have an exposure of about €300 billion to the property developers and builders.

Quinn was “flabbergasted” that Spanish civil servants thought the idea of recapitalising Bankia using backdoor ECB funding was a good one. It raised questions about whether the government could afford a bailout of €19 billion and why Madrid would borrow the money at a time when investors are already concerned about Spain’s debt repayment capacity, particularly when Spain has €400 billion of old bonds maturing and new bonds to be issued up to the end of 2014.

He used the famous Irish “Gubu” acronym to describe the “grotesque, unbelievable, bizarre and unprecedented” situation Spain’s banks find themselves in and ponder whether they would be following Ireland’s path and “importing” the Irish bailout method.

“The capital required by Bankia is not actually a big number for the Spanish economy. It is a €1 trillion economy so it is just an extra 2 per cent of GDP. Overall, the Spanish banks require the equivalent of between 5 to 6 per cent of capital. But they have left it very late and the problems in the euro zone mean that even a small number is seen as a problem,” said Quinn.

The additional bailouts required by Spain’s banks compare with the 40 per cent of GDP cost of Ireland’s €64 billion recapitalisations.

The suggested method of bailing out Bankia may have parallels with the arrangement used to fund the capital hole at Anglo but the two banks are very different. About 13 per cent of Bankia’s €300 billion balance sheet is exposed to commercial property compared with well over half of Anglo’s overall €100 billion sheet.

Quinn isn’t sure if the Spanish government had an eye on the Anglo bailout model when the idea was floated. “I am not sure what they had an eye on because it is a very unorthodox approach to a capital concern. Anglo Irish is a very insolvent bank and in a long-term liquidation. Bankia does have a viable business model. It is more like an AIB or a Bank of Ireland than an Anglo. It has a lot of retail deposits and household mortgages.”

There are clearer parallels in Spain’s attempts to avoid what the markets might be pricing as an inevitability – that Madrid will require a bailout programme which would likely soak up most of the €500 billion in the European Stability Mechanism.

“I am sure that they are looking at how Ireland got forced into a bailout and looking at what to do to avoid a bailout,” said Quinn. “Spain is so big that the implications are massive compared with pushing say Portugal and Ireland into a bailout. The pressures in the euro zone are such that there is much more at stake here.”

If Spain requires help, eurobonds backed by euro zone members including Germany, which has so far refused to support commonly guaranteed debt, together with quantitative easing will be the only way to solve the crisis for Madrid, says Quinn.

“If that doesn’t happen the pressure on the system will be so great that Spain will struggle to fund itself. What will be required is euro zone funding for Spain; it is not a bailout in the same way as it was for Ireland and Portugal,” he said.

ANALYSIS:'EMERGENCIA TOTAL." You don't need to speak Spanish to understand the description of the situation Spain is in. These were the words of the political giant of the post-Franco era, former prime minister Felipe Gonzalez.

When such people say such things, you know the situation is grave. Nobody doubts that Spain is going critical. That means the risk of euro implosion is now greater than ever. Where to now?

There are many weaknesses in Spain. Within the euro zone, its property bubble most resembled Ireland’s, in terms of its size, duration and the extent of over-building.

The most obvious difference between Ireland and Spain until now has been the cost to the countries’ respective taxpayers of propping up their banking systems. In Ireland, the bill has come to a grotesque 40 per cent of GDP, among the most costly financial crises in world financial history. In Spain, the figure had been in low single figures. That always looked too good to be true.

Since the global financial earthquake in 2008 burst the Spanish property bubble there have been fears that the losses in the banking system would turn out to be much bigger than admitted to. The woes of Bankia, an amalgam of banks formerly owned by powerful regional governments in that highly decentralised country, show that there are strong grounds to believe that more big losses exist.

This week €19 billion was pumped into Bankia by the Spanish state. That brings to €23.5 billion the cost to date, or 2.2 per cent of GDP. Given that public debt in that country stood at 69 per cent of GDP at the end of last year (compared to 108 per cent in Ireland), the additional recap costs of Bankia alone will not break the Iberian economy.

But it is the fear that losses will be even greater, and the economy will sink deeper into recession, that have pushed Spain into its “total emergency” and to the point that its government cannot borrow to fund itself.

Spain is going down exactly the same path as Ireland did by backing the entire financial system. That is not working. Would an alternative tack produce a better outcome?

The Spanish could stand back and say that it will limit support to the banking system. Among many other things that would mean imposing losses on bank creditors. That could cause otherwise healthy banks to fail too.

It would certainly cause huge repercussions in the rest of the European banking system in different ways. First, the losses would be large and further weaken other European banks. Second, it would include a major change of policy in that senior bank bondholders would suffer losses.

As the dogs in the street in Ireland know, the European Central Bank believes that going down that route now could crash the senior bank bond market. That, in turn, could bring down the entire financial system.

Those who advocate this stance may well be correct in that purging the system is the quickest and cheapest way to proceed, but if all the risks associated with their preferred solution come to pass, the cataclysm that everyone had wanted to avoid would come to pass.

By far the safest route to containing the Spanish crisis is for a European response. No matter how big Spanish bank losses, they would be very manageable collectively. But taking on other countries’ debts has been a Rubicon that the stronger northern European countries have refused to cross.

It is not hard to see why. Political leaders from the Hague to Helsinki fear lynching if they were to tell hard-pressed taxpayers that their money is being used to pay those in other countries who have lent to Spanish banks.

And it wouldn’t end there. If Spain had its banking debts Europeanised, Michael Noonan would instantly demand equal treatment for Ireland. The Greeks and the Cypriots would come charging in behind him looking for cash for their collapsing banking systems.

So if the northerners won't back other euro area financial systems and the ECB won't allow the purgists have their way, we are stuck with the approach that has been tried to date. That approach is not working. Something very big will have to give. DAN O'BRIEN