Saving banks clean-up fuels Spain bailout fears

 

Spain's ailing savings banks, struggling to attract fresh investment capital after an overhaul, could become the Achilles heel that forces the country down the same path to a financial bailout as Ireland.

Under new rules the unlisted regional banks, or 'cajas', may sell up to half their equity to private investors -- a key plank of a government scheme to reform a banking system that analysts say needs tens of billions of dollars of fresh capital.

But a fund management community already caught out by a bursting real estate bubble in Ireland is sensitive to concerns that cajas will drain more government money due to excessive exposure to another property sector sent into freefall by the global economic crisis.

"We are looking for corporates with much more exposure to global growth," said Bill Street, co-global head of active fixed income at State Street Global investors.

"We are not particularly positive about (the cajas) ...at the moment as Spain is struggling."

Set up hundreds of years ago to protect farmers from poor harvests and accounting for around half the Spanish banking system, the cajas are expected to meet a government deadline of Christmas to complete a merger process that will whittle their number down to 17 from 45.

Five of them failed Europe-wide stress tests in July.

The state fund set up to aid the mergers and provide capital to provision for bad loans, the Fund for Orderly Bank Restructuring (FROB), can borrow up to 90 billion euros guaranteed by the government on equity of 9 billion.

The fund has so far only issued one bond of 3 billion euros, bringing the total amount raised so far up to 12 billion, but markets believe the bill could climb much higher.

Credit rating agency Moody's estimates a net capital shortfall of around 17 billion euros for the Spanish banking system, which it said had only recognised half of economic lifetime losses through writedowns and reserves.

AN UNWELCOME PRECEDENT

UBS estimates Spain's banking sector would need between 70 and 120 billion euros to strengthen capital and provisions if it wants to offset sovereign risk concerns.

It said Ireland's experience had shown that waiting too long to restore confidence in the banking sector's credit quality leads to heightened pressure from the interbank markets to inject capital.

A rising tide of bad property loans eventually forced Dublin to seek outside help in managing its finances, and bailing out lenders there could end up costing taxpayers up to 85 billion euros, or over half of annual GDP.

In Spain's case, increasing coverage of banks' doubtful assets to 50 percent of the total would require 60 billion euros of additional provisions, equivalent to around 6 percent of economic output, UBS said.

To date in 2010, the FROB has stumped up about 10.5 billion euros for the savings banks but the last-minute integration of some small cajas into the merger process could take the bill to up to 12 billion euros, one senior banker said.

The Bank of Spain said on December 13 that it did not expect any more funds to be issued from the FROB in 2011.

"Some banks are going to raise capital independently, others through the FROB and if they need it, it is available," Bank of Spain Governor Miguel Angel Fernandez Ordonez said then.

The central bank has told the country's banks to give detailed quarterly reports which include exposure to property developers and bad loan ratios, and to outline financing plans.

"We believe market perception is much worse than reality," a Bank of Spain official said at a recent press briefing.

'A VERY HARD SELL'

But the market has already registered its unease.

The subordinated credit default swap on Caja Madrid, which will be the biggest savings bank after the mergers, trades at around 795 basis points in an illiquid market, one analyst said.

That means it costs 795,000 euros to buy protection against default on 10 million euros worth of Caja Madrid debt - a quarter more than the Irish sovereign five-year CDS.

That reflects investor perceptions towards a sector blighted by declining profit margins, poor quality assets and potentially confusing management structure following multi-stranded mergers.

"All of this will make it a very hard sell," said Dean Tenerelli, fund manager at T Rowe Price International. "The listed, well-managed banks are already trading very cheaply, so what valuation can that put on the cajas?"

Rising levels of unpaid loans and a deposit price war are eating into Spanish banks' income.

Spanish bank shares have fallen by around 30 percent since the beginning of the year. They have underperformed the European sector by around 23 percent during this period.

The cajas booked a 28 percent slump in net profit in the first 9 months of 2010, according to the Spanish Confederation of Savings Banks. Their profitability relative to their total assets is less than half that of listed banks in the year to September, Bank of Spain data shows.

POOR ASSET QUALITY

Some market watchers believe high-risk private equity funds may show interest in buying equity stakes, provided they are offered a big enough discount.

A stake in a merging bank that ends up being one of the dominant players could give an attractive return on equity, said one banker involved with cajas' road shows that have travelled to London, New York and Boston to drum up interest.

The problem is the underlying poor credit quality of assets on the cajas' books, he said. Economists expect unpaid loans as a proportion of total loans to continue creeping up next year.

A bank analyst at a leading U.S. fund management firm said investors might by assets in a top-ranking caja at just a small 'haircut', but for a savings bank that needed cleaning up "the typical discount on any capital raised would be roughly 40% and perhaps a bit more."