Spain's Pain Endures, Bank Reform 4.0

This is not a good day for Spain. The day began with the EU Commission revising its estimates for the Spanish economy. The contraction is now expected to be considerably deeper. Rather than contract 1% as the EU previously projected, now it is expected to shrink by 1.8%. The deficit this year, which was originally supposed to be 4.4% and PM Rajoy said would be 5.8%, before accepting a 5.3% target, is now likely to be 6.4%, according to the EU. The government is denial and even today is claiming the 5.3% goal is achievable this year and 3% next year.

Spain unveiled its new efforts to address the banking problems. It is the fourth one since the crisis began and the second one since Rajoy became PM. It is not likely to be the last either, as it seems largely to have failed to get ahead of the market expectations. In fact, today could mark the first time that the (generic) 10-year bond yield finishes the week above the 6% threshold in six months.

The key weakness of the earlier plans has not be addressed. Like them, the new plan appears to under-estimate the potential bank losses. Ironically, no major Spanish bank has reported an annual loss since the crisis began. If the news is too good to be true, it probably isn't.

Spain is forcing the banks to boost their loan loss provisions on real estate loans by 30 bln euros. They have already put aside about 54 bln euros. The Center for European Policy Studies warns that bank losses could be as high as 380 bln euros. Moody's estimates Spanish bank losses could be around 305 bln euros.

Spain's banks have 1.7 trillion euro loan book, which is about half again as large as the Spanish economy. Its housing bubble was roughly twice as large as the US. Housing prices have fallen about 30% in Spain since the peak in Q1 08. US house prices, by comparison, fell about 35% and in Ireland by about 50%. Spain reportedly has 2 mln vacant homes.

Spanish banks have stopped lending to property developers, construction and households. Instead they have stepped up their lending to the Spanish government. Spanish banks' holdings of Spanish government debt rose by about a third in the four months through Feb (the most recent data) to 231 bln euros. As sovereign bonds sell off, also undermines the banks' balance sheets.

As part of the measures announced today, Spanish banks will move their real estate related loans off balance sheet. Officials have been careful to avoid the stigma of "bad bank", but in essence each bank will create a "bad bank". It will hold the loans and then be evaluated by two auditors to value and prepare for sale. Why this could not and did not take place when the assets are on the balance sheet is not immediately clear. The government wants to call the off-balance sheet facility "holding societies".

Investors are not only worried about Spanish banks, but the linkages between the private and public sectors. The market fears that the bank debt will become the government's debt. The 5-year Spanish CDS--the cost of insurance-- is at new record highs today. At about 518 bp it is just below the cost of insurance on Hungary of 524 bp.

There still is a reasonable chance that the EU agrees to trigger a clause in the fiscal agreements that allow countries that are on track with reforms, to be given another year to reach deficit targets. Spain is a likely candidate, even if there is some additional conditionality associated. In addition the EU and European finance ministers are likely to make it easier for countries to tap the structural funds that have already been earmarked.

The best thing that can be said about Spain's banking reforms is that they are a step in the right direction. But the step is too small and new measures will have to be forthcoming. Perhaps it is the sense that Woody Allen tried to capture when he had his characters complain about a restaurant: the food wasn't good and the portions were small.