I thought it might be a good moment to take a broad look at Spain’s financial troubles and outlook. For those of you who tire of details, the executive summary is that is that it is bad and without a doubt going to get considerably worse over the next 6 – 18 months despite Spanish government and EU claims to the contrary.
On Friday (31st Aug) the Spanish Government passed what it said would be Spain’s definitive banking reform. This is actually the third such ‘definitive’ reform. The previous two were more blather than action. All the talk in this reform centres around the creation of a so called ‘bad bank’. Which, it is being claimed, will sort Spain’s ailing banking system once and for all. This despite the fact that Spain already has a bad bank, a really bad one, Bankia. I say this only half in jest. I’ll come back to Bankia.
First let’s deal with what a bad bank actually is and does.
A ‘bad bank’ isn’t a bank. It’s an ‘Asset Management’ company. A company is created, which buys all the rotten, failed, toxic, non-performing loans which Spain’s banks and it’s Caja’s have on their books. The company then ‘manages’ these assets. There, all better now?
Of course you might have a couple of questions. Like, who set’s up this company? With whose money? What does ‘manage’ mean? And if the company can make a profit from ‘managing’ the assets it buys from the banks, then why couldn’t the banks ‘manage’ them?
So how is it going to work, exactly? Well according to Spains Minister for the Economy,Minister Luis de Guindos, speaking at a news conference last Friday,
The aim is for private investors to take a majority stake in the bad bank .
He went on,
“The asset-management company should be viable and not generate losses and in the end not have any impact on the taxpayer,…”
Gosh, why didn’t we think of this before? Private investors are going to pay for the whole thing, and then it will make oodles of money and cost the taxpayer nothing. Oh really?
Before we go on with this fiction lets just stop to mention how the company makes money. The ONLY way it makes any money is if it pays a realistic market price for the assets it buys them. At the moment those ‘assets’/loans and repossessed properties are being held by the banks at mark-to-model,not mark-to-market values. Which mean if the new company/bad bank buys them at a market price then the banks will take a considerable loss. The amount of the loss will be the difference between what the bank originally loaned out/expected to get back during the bubble years and what it now selling that loan for in a deep recession. The size of that difference will be the loss taken by the banks, which will be the size of their next bail out. There is no way around the fact that the assets being sold have lost value. Setting up an ‘Asset Management company’ doesn’t magically get rid of that loss. The only question is who takes it.
Now, the company, if it is a real company set up to make a profit, will only buy the bad assets if it thinks that it can get them for a price that is in line with their actual worth today AND has a prospect of making money with them going forward. You don’t make a profit just by acquiring ‘assets’. You have to make money with them. So how will it make a profit?. First, even from really rotten assets – in this case securities backed by mortgages and loans to developers and builders – there will be some income from the fraction of the loans still being repaid. Second the company will attempt to sell the securities and loans to third parties who think they will be able to squeeze more repayments from the loans or who think they can sell the underlying land, property for a profit no one else has seen.
The obvious question is why doesn’t the bank write off the loss but then keep the marked down assets and make the residual profit themselves? The answer is time. Time is money. Spain’s banks, its Cajas in particular, have neither. It will take time to eventually see a profit from rotten loans. Spain’s banks need to be seen to be clear of debts soon.
The whole rational for a bad bank is to transfer the loss making ‘assets’ out of the banks because they need to borrow and do banking right now, while the Asset Management Company, does not. . The Asset Management company buys everyone time. The official plan is for the Bad Bank to,
…try to sell the assets over 10 to 15 years.
Who will remember in 10 15 years? The toxic loans will be safely hidden away, out of the politically sensitive banks and in company that will be less familiar and, even more importantly, rarely, if ever, reported upon.
How many people have heard of the ‘Asset Management companies which the Chinese government set up the last time it had to bail out all of its major banks? Anyone? We’ve all heard of the banks. They made massive losses on bad loans at the end of the 90’s. They would have all died except that bad banks were set up, one for each of them – to manage those bad assets. They too were going to cost the tax payer nothing and make money. None of them have made money from the rotten assets they bought from the banks. In fact after 10 years when they were supposed to pay back money loaned to them, they coudn’t. They were bankrupt and were only saved, themselves, by the government footing another bill in order to extend their loans for another ten years. Even today those companies have only recovered 20% of the value of what they bought. To add insult to injury, the FT reported last year, that those companies are now thought to be making stupid and toxic loans to businesses that can’t get loans from any of China’s other fine banks.
Bad Banks don’t make money. They just get the cost and embarrassment of a crisis off the front pages. The sorry saga of China’s bad banks will prove to be, I think, the blue-print for how Spain’s will unfold. The Spanish Government, however, all our governments in fact, would tell you I’m wrong and that bad banks are like a good fairies. They sprinkle fairy dust on disasters and turn them to gold. So, back to the fiction.
The Spanish government’s ‘aim’ is for private investors to take a majority stake. Well they are only going to if they see a profit. So how will they get a profit from assets that the bank can’t profit from? The key, of course, is the price the asset management company pays for the assets. The bad bank can only work if it pays a low price. A low price, however, would leave the banks with a large loss. Those banks would then not have bad assets on their books but would have a huge hole in their finances. Who will pay?
According to the Spanish government, as reported by Reuters,
Private investors in rescued banks will bear some of the cost of the clean-up. Holders of complex instruments known as preference shares will take a major hit, as the prices for those securities have fallen steeply.
Which sound like the Spanish government making ‘the bond holders’ and the financial world pay its share of the losses. Actually not quite. The government says it will make some junior bond holders and well as share holders take losses. I think the junior bond holders will challenge this and I wouldn’t be surprised to see Madrid trying to back out. The EU and IMF will try to force them to hold the line.
More importantly, much more importantly, however, are these ‘Preference shares’, described as ‘complex instruments’. Describing them as such makes you think they must be the sort of thing major financial institutions hold. And they should be. But sadly they are not – not in Spain. The Preference shares were offered to professional investors who largely refused to buy them. The government decided if the professional market wouldn’t buy them, then they would just have to be flogged to the ever trusting voters. The shares the professionals wouldn’t touch were sold to ordinary Spanish savers by ‘local banks’ as the article coyly puts it. Which ‘local banks’? Well Bankia for one. Bankia and the other Cajas, whose ‘rescue’ depended on the sale of these oh-so-safe shares, sold €22 billion of them to their own depositors and other small investors.
As recently as this May an article in Bloomberg – which I recommewnd you take a look at so you can verify that I am not making this stuff up – quoted Arturo Bris, a professor of finance at IMD business school in Laussanne, Switzerland, who said,
“A writedown of preferred shares placed with depositors would cause a social problem. It’s not really a feasible alternative.”
The article went on to note,
A spokeswoman for the Spanish economy ministry had no immediate comment. A Bankia spokesman, who declined to be identified, wouldn’t comment.
They knew then the unfeasable, unthinkable was probably what they were going to do all along. The government’s plan means that the up-coming losses in Spain’s banks are going to be heaped upon ordinary Spaniards, NOT their wealthier ruling class. As The Wall Street Journal reported,
The potential move would affect around 120,000 retail customers who poured their savings into these instruments. The products were sold by local banks as a low-risk, higher-yielding alternative to regular deposits, but have since plunged in value as Spain’s economic crisis has worsened.
So if the government makes the bank sell their assets at a market price – very little – then ordinary Spaniards who were sold preference shares as a ‘low-risk’ way to protect their savings – those savings will be lost. And then those same ordinary people will be forced to pay for whatever further part of the bank losses gets covered by another cash injection/bail-out.
Of course the government could avoid some of the political fallout from all this by insisting/agreeing that the Asset Management Company pay the banks way over the market price for the assets, nearer to what the banks should have got if the bubble had never popped. The banks would then lose very little on the deal. The loss wouldn’t go away, it would be rolled off the banks and on to the asset management company. The new company would have bought assets far above what they were really worth.
This second option would save the massive anger that will surely come when all those people who were sold preference shares see their nest egg for the future taken from them , but would make the Asset management company non-viable from the start. So it helps with one political nightmare but creates another. Because no private investors will buy in to that. Unless… the government sets up the company in a sly way so that the private investors are guaranteed to be first in line for whatever profits are made. In other words cheat the profit structure.
That is what I think will happen. The banks will be paid inflated prices. Not high enough to protect the small, Preference share holders. They are little people. They will get shit on. But the senior bond holders – the ones who have friends in government – who often ARE in government – the banks, the wealthy and the powerful – the big investors – the price set will be high enough to protect them. This will leave the bulk of the losses to be rolled in to the new company. Of course the government is still spending tax payer money. But it will be ‘hidden’. People understand a bank bail out enough to make them angry. So replace a feel-bad story with a fiction that hides the truth. In this new fiction there are no bank bail outs or are at least smaller. Instead there is the creation of a ‘bad bank’ which will make money and cost nothing. In place of a bail out we now have a wise investment. Oh joy!
By the time it is clear that private investors are not going to take the lead – and /or that to encourage them the eventual profits will go to them while the government will get very little, and that the investment was not at all wise and was never going to make a profit – by the time anyone hears any of this, those responsible will be retired and immune from prosecution.
In short, bad banks are rarely a real solution. They roll losses out of the public eye and in to the future. The loss is still as real as ever and it is still the tax payer who will foot the bill.
OK that is bad banks in general. Next question is what might actually be in this Bad Bank? Normally we would have trouble knowing. We are forced to buy the stuff but not allowed to know what it is because it’s ‘commercially confidential’ don’t you know.
In this case, however, we might be able to get a glimpse of the ugly truth, thanks to Bankia.
So that people don’t lose the will to live reading all this, I will break here and continue in a second part.