On Spanish banks and Greek bonds

Recently there has been mounting evidence that although the ECB’s 3 year LTRO has been successful in both supporting sovereign bonds and banking system recapitalisation, it is failing to restart lending in the private sector. To those who understand that banks are never reserve constrained, but capital constrained, this makes obvious sense.

However, it isn’t just reserves that banks have on the asset side of their balance sheets, it is loans as well. Which is why, although the LTRO can provide much needed liquidity, it can’t truly compensate the banks for the problems with their asset quality stemming from austerity based policy. And so we continue to see bad debts mounting up on balance sheets, particularly in places like Spain where most of the country’s debts are in the hands of the private sector.

In the European periphery we have seen banks attempting all sorts of trickery in order to meet new capital requirements by June 30. Under normal circumstances in order to raise capital banks would issue more stock and/or hold onto profits. But, as we know, these aren’t normal times in the EuroZone. Even though the EU banking watch dog wants otherwise, the periphery banks, particularly those from Italy and Spain, have gorged on the sovereign’s bonds under the LTRO program in order to reap profits from the differential between the interest rate on the ECB loan and the interest rate on the sovereign bonds they have purchased.

What you may not know, however, is that banks have also been using “model adjustment” which is a lovely term used by bankers to mean “dodgy it up”. If you have read any of Deep T’s posts on banking capital requirements you may understand what this means. For those who have not, it basically means that banks change the formulas they use to determine how much capital they need against each of their assets, including loans. In this way, undercapitalised banks can suddenly report they have enough capital because their “new” risk model tells them they do. It all sounds dodgy because it is, and in the wake of the GFC in terms of macro-prudential oversight I find this sort of behaviour incredulous.

Apart from this blatantly obvious fudge European banks have also been trying to sell assets, shed staff , hide non-performing assets in off-balance-sheet vehicles, yes that old cookie!, close down non-core services and basically trim up their business models in order to save money. The obvious fall out of this is that banks under stress simply don’t want to take on new loans.

To add to this some periphery banks are also seeing strong deposit outflows , something I have discussed previously in regards to TARGET2.

With the lack of new lending, additional taxes and less government spending the private sectors of periphery economies are suffering the consequences with higher unemployment and lower incomes. This obviously means that outstanding loans are coming under pressure. This is problem for banks because if a loan becomes “unserviced” then it must be written-off and in order to cover the loss banks must use some of their retained earnings. Retained earnings are of course capital, which means every time a loan is written off the banks capital ratio falls.

In order to compensate banks are becoming more “creative”, and much of this appears to be coming from Spain.

The key in a banking crisis is to keep the confidence of depositors. But while many countries relied on capital injections and government guarantees, Spanish banks have added a unique twist of effectively turning some depositors into equity holders. That puts customers on the front line.

Some banks started by persuading depositors to switch from low, interest-bearing accounts into preference shares, which paid a fixed, higher interest rate. The benefit for the banks was that these securities counted as core capital under banking rules. UBS says Spanish banks issued €32 billion ($42.7 billion) of such instruments from 2007 to 2010.

But as the crisis deepened, these instruments became illiquid, trading at deep discounts. At the same time, they ceased to count as core capital under new rules known as Basel III. So banks have encouraged investors to convert preference shares into either common stock or mandatory convertible notes, which pay a high initial yield before later converting into stock.

Liability to asset conversion. Very clever, and fair enough unless you are an existing shareholder. I just hope those depositors understand the risks of what they have just done.

As I explained above, one of the other ways to maintain capital is to keep existing loans from defaulting. This is difficult in a stressed economy, especially when you don’t actually want to increase the size of the loan book. If a holder of a loan becomes stressed the only real way to do this would be to find someone else willing to take the burden for them. This may not remove the risk, but it would certainly delay the loans write-off. Call it a “can kick”.

Consider the plight of many Spanish bullfighting companies. With the economy in a deep slump, they have been struggling to fill seats for the usually popular events. Organizers are struggling to pay for marketing and bull-ring maintenance, according to bullfight companies and their trade organization, who also said some are increasingly at risk of defaulting on loans with local banks.

So earlier this year, a Seville bullfight company, Empresa Pagés, struck an unorthodox deal with its lender, Banca Civica, soon to be part of national giant Caixabank SA. The bank agreed to lend money to cash-strapped bullfight fans to help them buy season tickets, which cost several hundred euros apiece. Empresa Pages gets the ticket revenue upfront. The fans generally need to repay the loans, with interest, within a year.

A Banca Civica spokesman said the agreement helps attract customers, and allows it to help its longtime client.
Similar bullfight-ticket-loan programs are sprouting up around Spain. “It helps people who want to buy the tickets, and it helps us a lot,” said Manuel Martinez, who says his San Sebastian-based bullfight company has such a deal with lenders.

And it also helps banks pretend that their failing loan book is in far better shape that it actually is. What happens in a year when thousands of unsecured loans fail?  Who cares, that is next year’s problem right !

Spanish banks had  lent €320bn to property developers during the decade long property bubble and most of that is against land. As of 2011 it was estimated that Spanish banks had exposure to €100bn worth of unused land either via their loan books or directly. With approximately 1.5 million too many houses for sale in Spain at the moment and ever-rising unemployment there is a limit to how creative the banks can be. I expect this to be a major issue over the next 12 months.

In other news, it looks like we will be hearing a bit more about Greek bonds over the next few weeks. You may remember that although the Greek PSI had dealt with bonds issued under Greek law there were outstanding issues with non-Greek law bonds. These particular  bonds were not dealt with under the original PSI deal because the collective action clauses added by the Greek parliament had no effect on this paper.

These particular bonds must have vote per tranche as to whether they will be declared for restructuring. There have been 36 of these votes and in 20 of the cases holders of the bonds have vetoed the decision. This leaves an approximately €12 bn in outstanding bonds that so far have no resolution. €450 million of these bonds are due for payment on May 15, although there is a 1 month grace period.

According to the Wall Street Journal Greece remains defiant and is refusing to pay, but you would have to suspect that anyone holding out on billions in bonds believes they have some pretty good leverage.

Greece is unlikely to pay off investors when a bond governed by non-Greek law falls due on May 15, possibly further hurting its status in international bond markets and embarking on what could be the first of several legal tangles.

A refusal to repay principal by a member country would be the first such case in the euro area since the common currency was adopted in 1999, but given the tiny ouststanding amount of the bond, the failure to pay isn’t expected to create ripples in financial markets.

Several investors in Greek bonds issued under foreign law have so far resisted taking part in a debt exchange, apparently hoping to get sweeter terms than what is currently on offer. They’re betting that Greece may look to avoid long, drawn-out court cases by just paying off remaining bondholders, possibly in full.

But market experts see such a strategy as risky, citing the Argentinian default in 2002 which saw investors battle in court for 10 years only to end up with nothing.

Something else to watch over April.

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Comments

  1. General Disarray

    Great post.

    It’s really hard to see how there won’t be more shocks coming out of Europe in the future.

  2. So much creative accounting, unsecured debt, bailouts, asset price depreciation, more bad debts…..

    I know of a business in the EU paying a 14% business loan and the bank in question is pushing hard to get part of the loan paid down within three months at 250K Euro’s a month. Yet they have almost a free ride from the ECB. The business is profitable, with a clear profit of 80K Euro’s a month, and yet the bank is acting like a thug. I’m sure this is not an isolated case.

  3. There is likely not much demand for net new funds either as
    1. countries are in recession,
    2. asset prices have fallen reducing equity and therefore borrowing capacity and
    3. un/underemployment is high.

    Maybe people would borrow EUR from PIIGS banks to deposit in German banks so they can use them to repay drachmas and pesetas in a year or two’s time!

  4. Not Spain or Greece, but this says a lot… no surprise.

    RTRS: “It was unrealistic to think that (the ECB liquidity) would be used for loans to industry” Bank of Italy executive board member Rossi