Spain’s Teetering Banks

THE FRAGILE STATE OF SPAIN’S BANKS MAKES IT MORE LIKELY THAT THE EURO ZONE’S FOURTH-LARGEST ECONOMY WILL NEED A RESCUE.

YALMAN ONARAN

DENIS DOYLE/BLOOMBERG

POTENTIAL LOSSES at Spanish banks are worse than the government cares to admit, at least to judge by the steps Prime Minister Mariano Rajoy has taken to put the lenders on more solid footing.

Rajoy in early May pushed the country’s banks to set aside another 30 billion euros ($38 billion) to cover bad debts — the fourth government intervention in just over two years. Loan-loss provisions now total €196 billion. As big as that number is, it’s only enough to write down about half of the banks’ loans to property developers and construction companies, which is what the Bank of Spain estimates will be needed in that category. Nothing is left over to cover defaults on more than €1.4 trillion of home loans and corporate debt in a country struggling with a burst real estate bubble and double-dip recession.

Spanish banks hold one of the world’s largest loan books, says Benjamin Hesse, who manages financial stock funds at Fidelity Investments in Boston. “They haven’t even started marking it,” he says, referring to the need for the lenders to set a realistic value on loans that might never be paid back. “The housing bubble was twice the size of the U.S. in terms of peak prices versus 1990 prices. It’s huge. There’s no way out for Spain.”

Altogether, Spanish banks may face losses totaling €380 billion, according to the Center for European Policy Studies in Brussels. Moody’s Investors Service, which on May 17 cut its ratings on 16 Spanish banks, has estimated potential losses at €306 billion. Plugging the funding hole the banks face could increase Spain’s debt by as much as 50 percent, raising the likelihood it will become the next euro-zone country after Greece, Ireland and Portugal to need a bailout from the European Union and the International Monetary Fund. Even as a political breakdown makes a Greek exit from the euro more likely, Spain, with an economy five times as big, may be the more important test as EU leaders try to stem the crisis.

Spain’s two largest financial institutions, Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, aren’t the problem. They have extensive international operations that account for most of their profit and provide the ability to raise cash and bolster capital if needed. Concerns center on domestic lenders such as Bankia group, created 1½ years ago to salvage seven troubled savings banks. Bankia has a €38 billion portfolio of property-development loans, about half of which are classified as “doubtful.” Rajoy’s government partially nationalized Bankia at the same time that it pushed the industry to boost loan provisions. Many smaller banks also have large collections of troubled assets. These are zombies that will, sooner or later, need government financial support, says Marshall Auerback, global portfolio strategist with Madison Street Partners LLC, a hedge fund based in Denver.

Spain in many ways resembles Ireland about two years ago, before it required a bailout: Loan losses are increasing in the aftermath of a property mania, and the government is announcing new measures every few months to shore up its banks. The rising cost to the government of supporting its banks shattered Ireland’s ability to pay its sovereign debt, and by November 2010 the country needed a rescue.

Ireland couldn’t let its banks fail because European leaders, concerned about contagion risk, opposed defaulting on their bonds. The Irish bailout protected German and French banks that held about $75 billion of Irish lenders’ debt at that time, Auerback says, and Spain will support its banks for similar reasons. “We’re just keeping the zombies alive instead of putting a bullet through their heads,” Auerback says.

Christine Lagarde, managing director of the IMF, takes a more generous view of the steps Rajoy has made. “These measures offer an effective response to the vulnerabilities of the banking system,” Lagarde said on May 11.

Bond investors, though, get the last word. Yields on 10-year Spanish debt jumped to a five-month high of 6.35 percent as of May 15, a market signal that Spain is following the same path as Greece, Ireland and Portugal.

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