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ONLY FOUR YEARS AGO, when Spain’s property market was still booming, some bank branches could easily have been mistaken for real estate brokerages. The spacious lobby of the Banco Bilbao Vizcaya Argentaria branch on Calle de Alcalá in the heart of Madrid exhibited a large model of vacation and retirement apartment towers that Spain’s second-largest bank had financed on the sunny Mediterranean coast and was filling with BBVA mortgage holders.

Today, Spanish banks have banished development projects from their lobbies. Getting them off their balance sheets is proving to be far more difficult. The collapse of the property market has left the coast littered with half-finished condominium high-rises and turned many of the country’s lenders, especially savings banks known as cajas, into zombie banks. The banking system has extended more than €300 billion ($400 billion) in loans—roughly equivalent to one third of the country’s gross domestic product—to real estate developers, many of which are now deep underwater if not bankrupt.

The banks’ woes now threaten to undermine the wider Spanish economy. Mounting loan losses have slowed the flow of credit, brought growth to a standstill and sent joblessness rocketing to 22.8 percent, the highest rate in the 17-country euro zone. The economic slowdown, in turn, has bloated the budget deficit and sent yields on government bonds soaring. The declining health of banks and the sovereign are closely intertwined here, as in much of Europe, with the government having already injected more than €17 billion in capital into ailing cajas and seized five lenders in the past eight months. Suddenly, Spain finds itself on the front lines of Europe’s rapidly worsening debt crisis, with an investor strike threatening the government’s ability to finance itself. The spread of contagion to Spain and Italy, moreover, is putting the survival of the euro itself at risk.

Reversing this tide before it turns into a tsunami is the urgent challenge facing Mariano Rajoy, whose Partido Popular routed the seven-year-old Socialist administration of Prime Minister José Luis Zapatero in the November elections and who was sworn in as prime minister on December 21. “The new economic policy will have two main pillars,” says Luis de Guindos, an economist who was named by Rajoy as the country’s new minister of Economy and Competitiveness, the government’s top economic policymaker. “The first is austerity in public spending. And then we have to push forward with more restructuring and consolidation of the banking sector.”

In his campaign Rajoy, an uncharismatic but dogged politician, promised to reduce the deficit to 4.4 percent of GDP by the end of 2012. That won’t be easy, considering that he has also promised not to raise taxes. The deficit, which stood at 9.2 percent in 2010, looks set to easily exceed Zapatero’s 6 percent target for 2011; economists at Citigroup project the deficit will hit 8.1 percent. The combination of public spending cuts and restricted bank lending is throttling the economy, which showed zero growth in the third quarter, and aggravating the country’s fiscal woes. “There already is a credit crunch for households and small and medium enterprises,” de Guindos tells Institutional Investor.

The same goes for the government. Just two days after the election, the yield on the government’s ten-year bonds surged to 6.65 percent, or 474 basis points more than German bonds—both figures close to euro-era highs. The markets all but ignored the fact that Spain’s public-debt-to-GDP ratio is only 65 percent, barely half of Italy’s 120 percent and well below Germany’s 80 percent. As a result, the new government will have to act quickly. Fortunately for Rajoy, his party won a resounding 186 seats in the 350-seat Parliament, giving him freedom to govern without the support of regional parties.

As for the banks, the government wants them to take more-aggressive action to write down their nonperforming loans and sell off foreclosed properties. “We have to speed up the process of removing these assets from the balance sheets,” de Guindos says.

Pressure isn’t coming just from the government. In October, Standard & Poor’s lowered the credit ratings of mighty Banco Santander and BBVA, the country’s two largest banks, by one notch, to AA–. It also reduced ratings on 13 other Spanish lenders to levels ranging from A– for Banco de Sabadell to BBB– with a negative outlook for Banco Financiero y de Ahorros, citing the depressed property market. In October the European Banking Authority ordered the five Spanish lenders most exposed to the country’s sovereign debt—Santander, BBVA, CaixaBank, Bankia and Banco Popular Español—to raise €26.2 billion in fresh capital to meet the European Union’s new 9 percent core tier-1 capital ratio by June 2012.

“They should be able to cover most of their capital needs internally by generating profits,” says José María Roldán, head of banking regulation at the Banco de España, the central bank. All five banks have disclosed plans to meet their targets by selling assets and using convertible notes. Santander, for example, has €7 billion of mandatory convertible notes outstanding that will convert into equity in October 2012, and part of those funds will be used to bolster capital. Such efforts have already whittled the banks’ capital needs down to €16.4 billion (including €5.22 billion for Santander, €7.09 billion for BBVA, €2.36 billion for Popular, €1.14 billion for Bankia and €600 million for CaixaBank).

In October, Santander sold a minority share of its U.S. auto-loan unit for about $1 billion. It also announced plans to sell 8 percent stakes in its Chilean and Brazilian subsidiaries to raise as much as $3.5 billion. But Santander tried and failed in October to sell €3 billion of foreclosed property assets to foreign investment groups.

Bank strategies for addressing the bad-loan problem vary widely. Banco Español de Crédito, or Banesto, a Spanish lender 88 percent owned by Santander, has written off close to one third of its bad real estate loans and is provisioning aggressively to remove another third from its balance sheet within three years. The moves contributed to a 33.8 percent drop in net profit in the first nine months of 2011, to €298.4 million. “We are recognizing our problem assets immediately,” says Banesto CEO José García Cantera.

Bankia, the behemoth formed in 2010 by the merger of seven cajas, has shifted the worst of its property assets to its holding company, Banco Financiero y de Ahorros, which owns stakes in profitable companies that can offset loan losses. Another large caja, Caja de Ahorros del Mediterráneo, hid the extent of its toxic assets until insolvency forced it to become a ward of the state in 2011.

Collectively, the cajas account for 42 percent of the Spanish banking system’s assets and one third, or about €100 billion, of real estate development loans. Fears have grown that the government may have to inject increasing amounts of capital to keep the cajas solvent, making a mockery of public deficit reduction efforts.

The Socialists sought to force the savings banks to abandon their profligate ways and become efficient commercial lenders. In the past two years, the government encouraged the consolidation of 45 cajas into 15 surviving institutions through the assistance of the state-financed Fund for Orderly Bank Restructuring, known by its Spanish acronym, FROB. The agency poured €10 billion into the equivalent of preferred shares in the cajas that agreed to merge. This investment carries a hefty 7.75 percent annual interest rate for up to five years and is designed to prod the cajas to speed up merger integration and repay the FROB sooner rather than later.

The FROB also injected €7.55 billion in equity capital into the merged cajas, and private investors contributed another €5.84 billion. “They have all been transformed into commercial banks that have the capacity to raise equity like any other private sector bank,” says the central bank’s Roldán.

But bankers and analysts insist that these lenders will need more capital because the underlying problem continues to worsen. At the end of June, nonperforming loans at Spain’s banks and cajas rose to €94.4 billion, of which €54.9 billion was property loans, according to central bank statistics. Those figures were up from €69.3 billion and €36.2 billion, respectively, a year earlier.

“There is still a mismatch between what the market perceives to be an adequate capital buffer against credit risks on the cajas’ balance sheets—many related to the real estate sector—and the funds actually injected,” says Antonio García Pascual, chief Southern European economist for Barclays Capital. Closing that gap, he estimates, could require a further €50 billion of capital.

The cajas have their roots in the Spain of more than a century ago. Some began as charitable pawnshops run by local Catholic churches; others were secular institutions that evolved into local lenders. In the post-Franco era, Spain granted a high degree of financial independence to its various autonomy-minded regions. Most cajas were managed directly or indirectly by local governments; they helped fund pet projects of politicians and made soft loans to favored businesses, especially in real estate development.

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