Spanish Banks: New Look at Restructured Loans

Germany, the tightfisted task master, is encouraging Spain to draw down more than the 40 bln euros it already has of the 100 bln euro line secured from the ESM to recapitalize its banks. Spain's budget minister denies there is a need. Germany does not typically encourage countries to take on more debt needlessly. We suspect by late Q3 or early Q4, Spain will, however reluctantly, take Germany's advice as it will likely need more funds for its banks.

The continued decline in house prices, the contracting economy and high unemployment point to the likely increase in bad loans. While this may be generally appreciated, another problem is emanating from loans to households and businesses that have already been restructured.

The issue is that the loans have been restructured mostly because the borrower cannot service their debt. Banks seem to be hiding the full extent of the damage by classifying the restructured loans as if they are performing normally, in an example of "extend and pretend" or "delay and pray".

According to official statistics, Spanish banks have restructured loans of about 208 bln euros. Over a month ago, the Bank of Spain told the banks to review the classification of the restructured loans immediately. Apparently, either the banks were moving to slowly or were finding serious problems, or a combination of both.

Last week, the central bank gave banks until September to reclassify the restructured loans according to tougher guidelines.  In particular, it shifted the onus of proof:  restructured loans will be assumed to be substandard unless proven otherwise.  The substandard classification requires greater loan loss reserves.  

Overall Spanish banks have restructured about a seventh of their loan book (~208 bln euros)  About a quarter are mortgage-related and another third or so are loans to non-real estate companies.  Household and government loans account for about 40%.  

Of these restructured loans, about 37% are considered "doubtful" and 21% are "substandard".  The problem is with the 40% that are classified as performing normally, by which banks can avoid provisioning.  

Spain's three largest banks account for a little less than 40% of the restructured loans.  At the end of last year, Santander had almost 30 bln euros of restructured loans in its portfolio, BBVA had about 23 bln euros and Caixabank had almost 20.5 bln. 

Some estimates suggest as much as 50-60% of the restructured loans should be classified as substandard or less.   This will require greater provisioning.  Some banks will be able to do so through retained earnings, but others, especially some of the smaller and weaker banks may find it more difficult.  

Spanish banks have already transferred 50 bln euros of bad (toxic) assets to Sareb, the bad bank that has been established.  Difficulties into valuing these assets continues and finding buyers is also proving challenging.  In March, the government said Sareb was planning on selling 1.5 bln euros by the end of this year.  Wilbur Ross, the US billionaire, has become more impressed with Spain's efforts and, seems to reversed his stance in October last year by telling Bloomberg TV today that he is considering investing in a Spanish bank or acquiring a Spanish loan portfolio.    

The outlook is far from certain.  House prices have fallen by 40% from their peak six years ago.  S&P recently warned that prices can slide another 20% over the next four years.  Moody's warned today that Spain's residential mortgage backed securities were continuing to deteriorate.  On the other hand, Santander said last month that the real estate market was nearing a bottom. 

In terms of non-performing loans, the government estimates that the ratio edged slightly higher in March to 10.3%.  However, if one were to include the loans transferred to Sareb, part of the restructured loans discussed above, and the roughly 60 bln euros of foreclosed real estate assets, the non-performing loan ratio could rise toward 20% and nearly 30% of GDP.