Although Sareb, Spain’s new bad bank, is a step in the right direction, its weak financial & operational structure suggests it will fail to achieve its ambitious objectives, keeping the pressure on Spanish sovereign bond yields.
The “bad bank” that the Spanish government was required to set up as a condition for the EUR 100 billion loan agreed with Europe’s leaders in the summer became fully operational on 1 December. (For more details on the background, see the text box “Why Spain needs a bad bank”.)
The role of this asset management company—Sociedad de Gestión de Activos Procedentes de la Reestructuración Bancaria, or Sareb—is to transition bad assets from the bank restructuring process. Its prospects for succeeding do not look that bright.
Objective is to take over bad assets
What exactly is Sareb trying to achieve—and why is it likely to fail? Its overall objective is to manage and divest in an orderly manner the portfolio of real estate loans and assets received from participating banks within a timeframe of no more than 15 years.
Initially, Sareb will transfer assets from the so-called “group 1” of banks, as defined in the agreements with the Troika (the EU, the IMF and the ECB). Group 1 consists of banks already operating under official government assistance. The bad loans being transferred will be subject to significant haircuts, ranging from 63% for foreclosed assets to 32.4% for finished building projects.
“Sareb will probably fail to achieve its objectives”
From an accounting perspective, Sareb’s objective is to separate its operations from the balance sheets of the commercial banks, thus freeing up liquidity for the banks involved. Eventually, this should induce renewed credit lending.
Sareb is also striving to separate its activities from central government. It is aiming for a high private-sector involvement—at least 51% of its funding should come from this source. With such a substantial participation by the private sector, Sareb will not be counted as a government activity in Eurostat’s deficit procedure.
A promising initiative
The first thing to say is that the Sareb initiative looks promising. The Spanish banking sector faces great challenges in the current process of deleveraging against a deteriorating macroeconomic environment. At the same time, it is clear that the ongoing recapitalization process needs an upgrade. With the ESM still unable to capitalize banks directly due to the absence of an EU-wide banking regulator, setting up Sareb is another preliminary step to improve banks’ balance sheets.
Overall, this initiative indicates that Spain is trying hard to resolve the intensifying crisis and to comply with the conditions of the Troika for dispensing the EUR 100 bln loan. This is a positive in itself. And that’s not all. It is possible to identify three other major positives:
- Sareb is specifically targeting the most troubled sector, housing and construction, alleviating banks’ pain by freeing up liquidity;
- This initiative is an attempt to break the vicious circle between the government and the banking sector, by taking on the role the Spanish government had to play in the first phase of the housing crisis; and
- The possibility for banks to restructure through Sareb could speed up the process of loan-loss recognition. That would create more transparency for financial markets.
Sareb faces serious problems
So far, so good. But there are some important caveats, which suggest that Sareb will fail to achieve its goals. For one thing, the IMF has already warned of spillover effects from Sareb’s price-setting behavior into Spain’s general housing market. According to the IMF, haircuts of 60% would signal that real estate prices could still fall by another 20-30%, causing a deepening of the recession in Spain.
We’re not so sure about this. While this may turn out to be the case, what happened with subprime mortgages in the US housing sector suggests otherwise. In that instance, the spillover effect from subprime mortgage resolutions into general-market pricing was limited.
Sareb negative #1: ceiling on loan purchases is too low
A more important issue appears to be the EUR 90 bln ceiling on asset purchases that has been imposed by royal decree. This ceiling is clearly too low. Not only have EUR 182 bln of bad loans been recognized already but the prospects for Spain’s real economy are deteriorating.
That will only make the situation worse. Independent consultant Oliver Wyman has concluded that EUR 270 bln of Spanish banking assets could—potentially—be lost in an adverse scenario. Using the statistical relationship between unemployment and NPLs, bad loans could easily increase from the current 10.7% of outstanding loans to 11.6% by the end of 2013.
Sareb negative #2: attracting private sector will be difficult
There’s more. Although the plan is for the private sector to hold most of Sareb’s equity, it will probably be difficult to lure external investors into the structure, despite the aim of realizing an annualized return on equity (ROE) of 14%. This is because there are still too many of what you might call “unknown knowns” that could have a seriously negative impact on the business case. Indeed, a toxic mixture of house prices that continue to decline, increasing foreclosures and rising unemployment could create further trouble for Spanish banks.
That said, strong demand for Sareb equity could be a positive signal for the prospects for resolving legacy debt in this way.
Sareb negative #3: separation from banking sector is flawed from the start
But the involvement of the private sector brings its own problems. Don’t forget that one formal objective of the bad-bank initiative is to separate Sareb’s activities from those of the commercial banking sector. And yet Spain’s largest domestic banks—Santander, Caixa and BBVA—have said that they intend to invest in Sareb.
“Spain’s government has clearly not been detached from the problems in the housing market”
The participation of these banks will probably be interpreted as an insurance premium paid to participate in a future Troika bailout in the event that the economic crisis hits these more-highly-rated banks. After all, these three banks are exposed to 43% of total outstanding domestic loans and may be unable to avoid contagion from a more adverse scenario.
But the issue isn’t limited to Sareb’s largest shareholders themselves being commercial banks. Sareb’s guidelines indicate that it can provide loans to banks to help their recoveries and to improve the value of their assets. This lending clause also clearly contradicts the formal objective of separating Sareb’s activities from those of the commercial banking sector.
Sareb negative #4: separation from government has not been achieved
This isn’t the limit of the flaws in the scheme’s set-up, either. That’s because the objective of separating Sareb from the government has not been met, given that Sareb’s debt issuance will be guaranteed by the Spanish government, thus increasing the latter’s contingent liabilities.
Sareb negative #5: severe operational challenges
Finally, the operational challenges are not to be underestimated. Creating economies of scale in a geographically dispersed portfolio will be difficult due to agency costs, despite Sareb’s intention of hiring the best mortgage-service providers.
Conclusion: failure to meet objectives will keep pressure on bonds
In conclusion, the financial structure of the vehicle does not appear to be strong enough to meet the ambitious objectives. Moreover, the operational structure makes it vulnerable and inefficient.
With Sareb thus likely to fail in reaching the objectives set by the Troika, the Spanish government has clearly not been detached from the ongoing problems in the housing market. If the Prime Minister, Mariano Rajoy, refrains from taking further reformist steps, this looming danger could keep the pressure on Spanish sovereign bond yields for a considerable time to come.
Why Spain needs a bad bank
Spain’s request in June for external financial assistance was prompted by the ongoing restructuring and deleveraging of its troubled banking sector. Spanish banks have been negatively affected by the bursting of the bubble in the housing sector, as well as by the subsequent recession. The rate of non-performing loans (NPLs) now stands at 10.7% of outstanding loans.
As chart 1 shows, the rate of NPLs closely follows the unemployment rate, highlighting the close link between lay-offs in the real economy and the trouble on banks’ balance sheets. The officially recognized amount of outstanding bad loans has increased to EUR 182 bln. At least 78% of this is related to construction and housing.
Chart 1: unemployment and NPLs are closely linkedSource: Bank of Spain, Bloomberg, Robeco
The Spanish government sought assistance under the terms and conditions set out by the European Financial Stability Fund (EFSF). On 20 July, European leaders agreed to loan Spain EUR 100 bln, though with strict conditions, which required Spain to take swift action on several fronts.
First, it needed to provide monitoring data on the sector, especially on the banks of systemic importance. In an earlier assessment, the IMF concluded that Spanish banking supervision was lax and had room for improvement.
Second, the government needed to prepare restructuring plans for its most troubled banks and to provide all the relevant information to an independent consultant (Oliver Wyman). The government asked Oliver Wyman to carry out stress tests on the banking system to point out the recapitalization needs. Third, banks that the stress tests revealed to be weak had to come up with restructuring plans.
Finally, Spain was required to set up an asset management company to clean up its bank balance sheets. In the past half year, Spain has made progress on these items—not least in establishing Sareb.