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Adrift on a sea of bad debt

by Matt Miller | Published June 11, 2012 at 2:42 PM

To understand the disastrous state of Spain's finances, suggests Madrid real estate lawyer Orson Alcocer, envision a shipwreck. For more than four years now, successive Spanish governments and the country's central bank have been waiting for the tide to rise and take the wreckage out to sea. Instead, the lawyer says, the ocean began to disappear.

The wrecked ship represents Spanish real estate. The ocean is liquidity.

After the global financial crisis in 2008, "the government had the muscle to do whatever it wanted," says Alcocer, a partner with DLA Piper Spain SL. Instead, it opted for "an extreme exercise in reality denial," hoping the property market would somehow, magically right itself.

The weekend announcement that the European Union would throw Spanish banks a €100 billion ($125. 3 billion) lifeline buys the country time. But the government of Prime Minister Mariano Rajoy, which spent this year denying a crisis exists, will be hard pressed to muscle through the kind of drastic reform necessary to right the system: nationalization of many of the country's savings banks.

Spain's crisis is extraordinary, not only for how long it's been festering, but for the length of time officials refused to admit what everyone knew was obvious. To keep the analogy going, most of Spain's regional and politically entangled savings banks, called cajas, drowned years ago in bad real estate loans. Authorities just continued to act as if the bodies had a pulse.

The cajas financed one of the biggest property bubbles in modern European history, with more than €500 billion sunk into development alone. (In 2006, at the peak of the building frenzy, Spain accounted for half of all housing starts in the EU.)

The market collapsed in early 2008. Absolutely nothing has changed except the gravity of the situation.

Some analysts point to America's savings and loan crisis, where the Federal Deposit Insurance Corp. swept through and shut down hundreds of banks awash in bad real estate, selling their assets to stronger institutions. A better illustration might be Ireland, where in 2010 and with the assistance of both the International Monetary Fund and the European Central Bank, Dublin took over the entire banking system, moving real estate loans to a giant government repository of bad debt.

Spain must do pretty much the same, although a few Spanish banks, including leaders Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, are sufficiently hedged with overseas assets to remain solvent.

The comparison with Ireland is useful in another way. In the months leading up to the Irish banking crisis, authorities and politicians colluded with bank management in playing down the extent of the bad debt, then expressed shock when it turned out to be so much worse.

Spanish counterparts have been complicit for years. The Bank of Spain allowed the banks to value the underlying assets on their books almost at discretion, demanding only modest, step-like reductions from the market peak. As a result, nonperforming loans remained manageable on paper. The central bank raised capital adequacy requirements, but they proved meaningless, as the amount of doubtful loans was fictitiously low.

According to the government, Spain's property market has declined only 30% from its peak. A Spanish university study last month found the real figure at more than 40%. Even that is suspect since banks that foreclosed on real estate shuttled assets into property subsidiaries, which propped up prices, preferring not to sell than take a substantial loss.

To supposedly shore up the banking system, the Bank of Spain also made a show of forcing the cajas to merge. Unfortunately, all that did was combine several banks with bad real estate into fewer larger ones with even bigger portfolios of junk. Think of U.S. authorities forcing, say, Washington Mutual to merge with IndyMac Bank.

The government's seizure last month of collapsed Bankia SA shows just how misguided the cajas mergers have been. Bankia is the result of seven combined cajas, led by one of the country's largest and supposedly strongest, Caja Madrid. The government's Public Prosecutor's Office is investigating whether Bankia and its predecessors overvalued assets. What would be shocking is if they didn't.

Bankia illustrates just how dubious the numbers are. In early May, Economy Minister Luis de Guindo proclaimed the entire banking system needed €15 billion to stay solvent. Two weeks later, Bankia alone begged for €19 billion.

Only last month did the government appoint independent auditors to determine how much the country's cache of bank-held property is actually worth. Don't be surprised if Spain's banks now sit on about $500 billion in bad real estate debt, a figure that makes the sinking of the Spanish Armada seem like a pleasant day's sail.

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