Meanwhile in Frankfurt and Madrid...

...we have some busy days ahead for the financial sector. Today, bondholders of Greek sovereign paper are to meet at Deutsche Bank's headquarters in Frankfurt to discuss the "voluntary" debt swap deal arranged on 26/10. The Institute of International Finance (representing 450 financial firms and chaired by DB CEO Ackerman) has organized the meeting with following items on the agenda : acceptance of 50% hairciut and negotiations on the terms of the swaps. Furthermore issues like interest rate payments & maturity, potentially linked to Greek GDP growth and how this would affect the value of the bond holdings. But developments in Spain are more eye-catching in view of the upcoming elections on 20/11. It seems the Partido Popular (PP) is in the driving seat and will most likely overshadow the outgoing Zapatero cabinet. And their main political agenda during election campaign was the clean-up of the financial sector.

Spain (EMU no4) was indeed one of the first and very hard hit nations within EMU following the 2008 financial sector blow-up. Its labour market today features a dramatic 20% unemployment rate while its banks - both the big ones and especially the smaller regional Cajas - are loaded with risky assets associated with mortgages and property developers. Like Ireland - but most likely a bit less Anglo-Saxon style leveraged - Spain's banking sector fell victim of negative real interest rates during the period 2002-2006 ("borrow your self rich !"). Now how bad is it ?

Since 2008, Spanish banks have set aside some 105 bio EUR (10% of current GDP) to absorb the property crash, leaving banks with unsold land, apartments and warehouses on heir balance sheets. The Bank of Spain classifies some 52% of more than 300 bio EUR of Spanish bank risk associated with property developers as "troubled". For the PP, it's exactly this trouble and the uncertainty of its size that should be lifted for once and for all off the table : "You have to remove any shadow of a doubt over the valuation of these assets on your balance sheets. Than calculus will most likely force banks to sufficiently recapitalize, like it or not. It's the only way by which we can make credit flow again through the Spanish economy". (future finance minister Rajoy and PP). This might be a popular expression and guaranteeing a big score, the big question still remains : how far have we progressed and how you gonna achieve this in practice ? How complicated are matters ?

When the Greek crisis burst in April of last year, the Bank of Spain enforced domestic banks to recognize more real estate losses. It imposed banks to set aside provisions to cover at least 30% of the asset value of properties on their books for 2 years. So far, Santander (no1) has about 31% of its non-performing real estate assets covered. For BBVA (2), the coverage ratio is 26%. So as far as the biggies are concerned, we have not an immediate problem. We do have still a problem for various regional cajas which most likely will trigger some form of recapitalization. But there is more. Even if credit should flow again into the economy, it will be at a different pace with deleverageing of balance sheets. Santander, which has to raise 5 bio eur extra before June 2012, has already allowed its Spanish loan book to shrink by an annualized pace of 5,6% September year to date. So you raise capital or decrease your loan book and both Santander and BBVA have already made progress in doing the latter as well.

Let's first have a look at market risk perception of the European financial sector and how the big European banks and insurers compare :

As you can see from the chart above, risk perception has taken a turn for the worst and is at higher levels than in 2008/09. After major bail-out operations across Europe (and elsewhere), banks' balance sheets are now also being loaded by some sovereign debt in trouble, hence the fear. How do European banks and especially Spanish ones compare. The following table ranks several senior financial players with comparative ratings (subordinated excluded, as are various cajas as well, still troublesome) :

Spain's big ones are not exactly the hot flavor of the day but on the other hand, the difference between them and other major players is not that significant. Or to quote Waldorf from the Muppet show after Stadler jumped from the balcony : "He shouldn't have jumped, the show wasn't that bad". And there are other possibilities as well. Some economists and politicians propose a "bad bank" solution by which the government would buy damaged assets from lenders. And this bad bank would seek to sell off the assets for as long as it takes for prices to recover. Maybe not a bad idea with some successful examples of re-privatization afterwards ; but there is still the problem of valuation. On bad bank, cfr TARP program US, oct 2008 and FED Maiden Laine + Fannie/Freddie programs :

http://en.wikipedia.org/wiki/Troubled_Asset_Relief_Program

The big question is then : how much space to manoeuvre has Spain left to organize this kind of budgetary operation ? Also here, Spain has a slight advantage over the rest of Europe :

The chart above shows the incredible collateral damage leverage triggered in the case of Ireland with a massive bank bail-out. And Spain, despite all its troubles is still relatively "safe" under the 90% Rogoff danger zone, the only one with Germany in EMU for that matter. So they have some spare - albeit limited - ammunition to act (5,8% current budget deficit). But for me, that's not the most important issue. Bad bank or not, bail-out or not, the real issue is that politicians are aware of the urgency, have already undertaken steps - or are bound to - on various fronts and banks are moving ahead as well in their quest for restoring capital buffers, one way or the other.

Meanwhile in Madrid, it's an urgent point and a priority. Meanwhile elsewhere, urgent matters have to step aside for other priorities.