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Spain's Banks Cook the Books as House Prices Crash Accelerates

Interest-Rates / Eurozone Debt Crisis Jun 22, 2012 - 02:36 AM GMT

By: Raul_I_Meijer


Diamond Rated - Best Financial Markets Analysis ArticleThe results of the "independent" Spanish bank stress test by Oliver Wyman Ltd, just out, indicate that the banks will need €62 billion ($78 billion) in a worst case scenario (a 6.5% GDP shrinkage and a 60% home price plunge). Since €100 billion was the number the EU said would go towards the bank bailout announced last week, what's the problem, right?

Well, there are plenty. In a nice aside, the Bank of Spain reported a few days a go that its own stress test won't be published until September, because too much bank staff will be on holiday this summer(!) to do it sooner. Not much of a sense of urgency there, more like going to the beach when your house is on fire. And that might not work out well.

Or are they just trying to calm the markets, to create the impression that things can't be that bad as long as everyone is allowed to take a holiday? The logic and argumentation isn't always easy to follow. But it looks like that house is still on fire.

One main issue is that the €100 billion bailout will be made available through the Spanish sovereign, i.e. be added to Spanish sovereign debt. Therefore, the more you look at the issue, the more it looks like a prelude to a sovereign bailout.

If Spain should need a sovereign bailout, one of the likely consequences will be that Spanish banks, which have been buying much of the country's bonds issued lately, will suffer a substantial haircut on their holdings, just like all other creditors except for the ECB and others that execute the bailout, like the IMF. And that's not all: bonds issued by Spanish regions have also largely been bought by the same banks, and the regions almost certainly have to restructure their debt. Which means: another haircut for the banks, to which the Spanish sovereign in turn has huge exposure through various forms of guarantees. A vicious circle downfall.

Looking at that, I don't believe for a moment that the worst consequences were ever looked at in the Oliver Wyman report. It makes the results of the stress test look downright suspicious. The IMF may have set the amount needed by the banks at €40 billion, but estimates from other parties are in the €270 billion - €350 billion range. Even that may be in the low range.

Let's look at some of the things reported in the press. First off, Michael Casey at Market watch sees very dark clouds:

Let’s be frank, the euro’s days are numbered

Spain has already been pledged up to €100 billion from its EU partners to fix its banks. Translated into dollars and adjusted for the proportional size of America’s gross domestic product, which is 12 times that of Spain’s, the equivalent figure would be $1.27 trillion in the U.S., or $577 billion more than Congress authorized for the TARP bailout of U.S. banks in 2008.

So it is deeply disturbing that the fear du jour is that €100 billion won’t be enough. Between them, Spanish banks have a staggering €3 trillion in assets on their books, or about three times the size of the country’s GDP. Many of the doubtful debts among those will still need to be written down, the process of marking to market has been delayed by both poor accounting and a highly illiquid real-estate market, where otherwise depressed properties are withheld from the market because of inheritance rules that make it hard for families to sell.

Sean Egan, president of the Egan-Jones ratings agency, which recently slashed Spain’s debt rating to CCC+, seven notches into "junk" territory, believes the banking system may need up to €300 billion in fresh capital on top of the €100 billion that the EU has already pledged.

Such giant sums will only deplete the already limited EU bailout fund. What’s more, by taking Spain out of the club of contributing countries, the burden of sustaining the pool will proportionately rise on those that are left — including a similarly debt-laden Italy and a Germany whose citizens are steadfastly refusing to provide anymore backstops to their bankrupt euro-zone partners.

It’s hard not to conclude, in other words, that the euro is doomed. Not only is Greece’s exit seemingly assured, but Spain looks poised to become a dangerous domino from which contagion will spread to the rest of the euro zone.

Here’s the catch: This won’t happen overnight. With the failure of the radical left Syriza party in Greece’s election to garner enough votes with which to govern, there is still no government in the euro zone that openly wants to end the status quo by which all member states have made an explicit commitment to fiscal austerity and the integrity of the monetary union.

That's more like it for realistic numbers. The Bank of Spain says 8.72% of loans had gone bad by April . There's no doubt that's far too low a number, once more. In Ireland, it eventually added up to 24% or so. Let's be mild and put it at 15%. That puts the -unrecognized - losses at €450 billion. And counting, no doubt. And that's still just one part of the problem.

There's the bad real estate loans. There's sovereign debt holdings. There's regional debt holdings. And there's a huge capital flight. Take your pick.

It would be irresponsibly foolish to take the Bank of Spain at its word, since every Spanish institution thus far has tried to cover up bad news. Just two weeks ago, PM Mariano Rajoy still insisted no bailout of any sort was needed. And look now.

No, the percentage of bad loans is set to soar. Just look at what home prices are doing. Paul Day for Reuters:

Spain house prices fall at steepest rate on record

Spanish house prices fell at the sharpest pace since current records began in the first quarter, data showed on Thursday, deepening a property market slump and serving up more bad news for the country's battered banks.

Prices dropped 12.6 percent year on year, national statistics institute INE said. The fall was the biggest since the data series began in 2007, easily beating the previous trough of 7.7 percent in the second quarter of 2009. Spain's banks were left high and dry after a housing boom collapsed four years ago, saddled with billions of euros in bad debts related to the property sector, while sky-high unemployment has driven a sharp climb in unpaid loan rates.

The government said last weekend it will borrow up to €100 billion from Europe to help recapitalize the lenders, though many economists believe the aid will not be enough to avert a full sovereign bailout. With the banks struggling to stay afloat, loans for anyone wishing to buy a new home are declining rapidly, with mortgage lending suffering its largest fall in over six years in February. In a report earlier this month, the International Monetary Fund (IMF) said Spanish house prices could drop by almost 20 percent this year under an adverse scenario.

That's one side of the sovereign and bank trouble: bad loans. Here's the other one. Amanda Cooper covers the problems with the Spanish regions:

After banks, Spain faces fight to save regions

Spain's overspending regions have enjoyed a holiday from the headlines, content to let debt-laden banks take most of the blame for the Mediterranean country's slide into crisis. But most of the regions, which were largely responsible for Spain missing its deficit goals by a wide margin last year, could soon become an even bigger problem for the country and its banks if sovereign borrowing costs do not fall. Unable to get money from a government itself struggling to raise funds on the markets and reluctant to take up expensive short-term bank loans, some regions may need to restructure their debt holdings, meaning bondholders will lose out.

Those bondholders are widely believed to be the domestic banks, which already need a €100 billion euro ($127 billion) lifeline from the European Union to cover real-estate losses. "For the regions, it's a possibility. At some point, the government cannot take over all the debt," said Alessandro Giansanti, a senior rates strategist at ING. "The worst-case scenario? At some point, the regions will not be able to repay their bonds in the market and bondholders will need to suffer losses, when it will come out who the real holders of these bonds are. It comes back to the banks."

Spain's government had a tentative plan to throw the weight of its higher credit rating behind the regions by mutualising their debt through "hispanobonos" or guarantees for each region's bonds in return for meeting ambitious deficit targets. Most regions would qualify for such a mechanism after reporting a balanced budget for the first quarter because of multi-billion euro cash transfers from the central government.

But, after Spain's sovereign debt was cut last week to within one notch of junk status by Moody's, there are doubts over how Madrid will prevent its debt pile from exploding, let alone how it will rein in the regions, which have another 15 billion euros to refinance in the coming six months.

Fears are now mounting that Spain will join Greece, Ireland and Portugal in needing a state bailout. "Quite clearly the sovereign is struggling to finance itself and then the support for the regions will be increasingly more difficult to undertake," said Elisabeth Afseth, fixed income analyst at Investec. "It is clearly of concern that you have some of the regions trading at heavily discounted prices to existing debt and they are largely running deficits and need further funding."

The debt pile for the country's 17 autonomous regions grew to €145.1 billion, or equal to 13.5% of gross domestic product, in the first three months of the year, up from €140.1 billion at the end of last year.

Regional liabilities will only rise further as Spain grapples with a recession and a shrinking tax base that have helped make the country the focus of the euro zone debt crisis. The regions have in recent years financed their deficits by delaying payments to providers such as street sweepers and medical equipment suppliers.

Earlier this year, the government extended €27 billion in credit via the state credit agency, or ICO, to the regions for them to pay the mountains of bills owed to their suppliers. But raising more money for the regions through the ICO is not an option as the regions have exhausted its credit lines.

Worse still, Spain itself risks losing favor with investors. The benchmark 10-year sovereign is trading above the 7 percent level that is seen as unsustainable in the medium-term. "It's impossible (for the regions) to issue bonds, even with the government guarantee from Spain ... They would need to issue in the short term and I don't think the market would appreciate another increase in the debt/GDP ratio of Spain when we are already close to 90 percent," said Giansanti.

Spain's sovereign debt as a percentage of GDP hit 72.1% at the end of the first quarter, and is expected to grow to 90%this year, largely due to the bank bailout. Fitch Ratings said regional debt as a percentage of national GDP could rise to 17 percent over the medium term, and that dealing with the debt is just a short-term salve rather than a long-term solution.

The regional bonds barely trade and the gap, or spread, between the price traders quote to buy and sell the bonds is in some cases as much as 20 times wider than the buy/sell gap on sovereign bonds. Catalonia, Spain's largest region by GDP, has a total debt burden of €42 billion, the highest in the country. This has risen by nearly 15% from the first quarter of 2011 and accounts for almost a third of all regional debt.

In May, the Catalan government appealed to the state for help as it runs out of options to refinance the remainder of the €13.5 billion it had in outstanding debt this year, even after taking strict measures to control its budget. Catalonia has plenty of reason to worry. The yield on its two-year debt has doubled in the space of two months to above 13%, meaning investors demand more of a premium to hold its bonds in case of default than they do of Portugal, which was bailed out by lenders in May last year.

All Spain's big regions, Valencia, Madrid and Andalucia, face the same spiraling cost of paying their way, even if their economies and their debt burdens vary hugely. One option would be expensive short-term bank loans, a situation Catalan President Artur Mas, for one, has said he wants to avoid. Failing that, restructuring would be the only way out.

And then, of course, there's the fact that Spain's borrowing costs have risen to alarming levels, with the 10-year bond rising above 7% earlier this week, and today's sale setting new highs. Paul Day again:

Spain pays new record for medium-term debt

Spain's borrowing costs hit a new euro era high at a debt auction on Thursday, a few hours before it is expected to shed light on the dire state of its weaker banks and possibly make a formal request for European Union funds to rescue them. The auction proved the Spanish Treasury can still borrow on international markets, albeit at a high cost, and it made the best of solid demand by selling 2.2 billion euros ($2.8 billion) in bonds, above the targeted amount.

However, the rocketing yields contrasted with France's sale on Thursday of bonds maturing in 2014 for just 0.54 percent, as concerns that Spain might have to take a full sovereign bailout meant that international investors are opting for less risky debt. Madrid had to pay 4.706 percent for the same maturity.

The Treasury sold the bond due in July 2015 at a yield of 5.457 percent compared with 4.876 percent in May, while the longer dated July 2017 bond sold for 6.072 percent, up from 4.960 percent last month.

But to really understand the scope of the problems, to see the perhaps biggest issue of all, we need to know, or at least try to find out, exactly how (un-)reliable the numbers are. Here's thinking they're much worse than what we've been fed to date. Bloomberg's Jonathan Weil had some nice things last week:

The EU Smiled While Spain’s Banks Cooked the Books

Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

"Dynamic loan loss provisions can help deal with procyclicality in banking," Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. "Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis."

The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

In a follow-up piece called How to Say 'Deceptive Accounting' in Spanish , Weil recounts a conversation at that International Accounting Standards Board meeting 3 years ago:

The discussion here is between Charlie McCreevy, then the EU's commissioner for financial services, and Robert Glauber, one of the accounting board's trustees. Glauber is a former chief executive officer of the National Association of Securities Dealers and teaches at Harvard's Kennedy School of Government.

McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, said he knew Spain's banks were violating International Financial Reporting Standards -- and that this was a good thing. Glauber was aghast.

• Glauber: Perhaps I misunderstood Commissioner McCreevy. I thought he said that the reason Spanish banks had been more successful than others in navigating the financial crisis was that he had permitted them to violate accounting standards. Was that right?

• McCreevy: I didn't permit it, they just did it. But logically ...

• Glauber: Well, you didn't pursue them.

• McCreevy: We hadn't arrived at the situation of bringing infringement proceedings against them, but logically, that's what I should have done.

• Glauber: Well, I just ... I believe in the U.S. where we've had banks that have had difficulties navigating the financial crisis, my own personal view is that they would not have been more successful had we allowed them -- our regulators allowed them to violate accounting principles. I just don't think that's true, and I don't know where the evidence is. In fact, markets work best when they have confidence in the numbers that institutions, businesses publish, not where they have no confidence in those numbers. And you can't fool the markets. ... So I don't believe, whatever the reason is for the Spanish banks having navigated this crisis better, it wasn't that you didn't act to prevent them from violating accounting rules.

• McCreevy: They didn't implement IFRS and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS. The Spanish regulator did not do that and he survived this -- his banks have survived this crisis better than anybody else to date.

• Glauber: I don't mean to be criticizing you for acting or not acting, but I don't think that's the reason they survived better, that they failed to honor accounting rules.

• McCreevy: No, I'm making the point is that the rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them for doing this responsible set of actions. That's the point I'm making is the ludicrousy in my view of some of these particular rules. The Spanish ... and it's worked pretty well for them.

• Glauber: But, Charlie..

So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

Except now we know they didn’t. They merely postponed their reckoning, making it inevitably more expensive. Someday maybe the world’s leaders will learn that masking losses undermines investor confidence and makes crises worse. We can only hope they don’t manage to blow up the whole financial system first.

Not only did the EU secretly allow Spanish banks' - illegal - disregard for accounting standards, it actively encouraged it, because commissioner McCreevy didn't like them either. The banks used creative accounting, mark-to-fantasy, under a nice-looking term, dynamic provisioning (cookie-jar accounting).

If governments and banks are not held to accounting standards, whenever they feel like it, that will have - negative - consequences going forward. But those are in the future, not today. Today politicians and bankers want things to look as rosy as they can right now, because their own positions are at stake. Losses in the future don’t matter to them, because A) they won't personally have to pay for the losses, and because B) they will in all likelihood be long gone once the losses surface.

That is very predictable behavior, and that is why there are laws and accounting standards in the first place. But they mean zilch if bankers, regulators and politicians, in their incestuous relationships, don’t feel bound by the rule of law, because the rest of us don't call them on that.

Still, leaving the moral aspects alone for now (what morals are left in finance anyway?), it seems obvious that the conversation above provides some very strong indications - on top of all the others mentioned before- that the true loss numbers in Spain are perhaps an order of magnitude larger than what is being reported by politicians, "independent" agencies and media alike. Who, all of them, have vested interests in publishing unrealistically low numbers.

Thing is, Spain will receive very large sums of money from Europe, and who knows down the line even from the US. And I don't know, maybe Oliver Wyman Ltd. doesn’t see it as their responsibility to question the numbers the Spanish banks and government feeds them. Maybe they even get paid more not to ask too many questions, who knows?

But those large sums of money, say 400-500 billion euros when all's said and done, which will go from Spain to Spanish banks to the international financial institutions they owe their debts to, are handed out for no reason if the actual debts of banks and sovereign are 10 or 20 times higher than what the mark-to-whatever-you-fancy cookie-jar accounting seems to indicate. Well, no reason other than turning more private debt into public debt, that is.

At the end of the day, we can't have our own regulators, European or American, encouraging illegal reporting of loss numbers, and then base bailouts on those numbers instead of the real, much higher, ones. And we can't have so-called independent agencies issue reports based on fake accounting, and base bailouts on those. We need to demand the real numbers, no matter how painful they will prove to be. That seems to be the only way to put a stop to these futile fake bailouts, which are always followed soon after by more bailouts.

We know that Spain cooks its books. And we accept that because everyone else does the same thing. That will have to stop. The question is: how do we achieve that? Will we all have to brandish torches in a square near us? And if so, are we prepared to do that?

By Raul Ilargi Meijer
Website: (provides unique analysis of economics, finance, politics and social dynamics in the context of Complexity Theory)

© 2012 Copyright Raul I Meijer - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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