Crossing the Rubicon – V

How to turn a bad bank into something worse

When economic crisis hit Sweden back in the early 1990’s their government performed a restructuring of the financial system (and of the economy as a whole for that matter), so deep that the paradigm of welfare state became more market orientated than the countries that looked upon the Swedish model with reverence while their leaders cried not enough was being done to be like them. Swedish free-market defendants might object to this view as they still endure high taxes and government intervention but things are better not worse than elsewhere.

The irony is that in order to reform their financial system they had to nationalize, or at least bring the state in as shareholder of their banks. This is very odd as state is the most inefficient of all managers simply because it subdues the mission and values of nationalized companies to the personal and collective ends of bureaucratic elites. A simple explanation might be one that I heard so long ago to remember where: post war politicians talked about socialism but implemented free-market reforms (mostly to pay for their otherwise unattainable welfare state), while post-Soviet politicians talked about free-markets while implementing regulations and restrictions to those same markets.

The point is, from 1991 to 1994 the Swedish state bought their way into the banks, diluting ownership, but allowing the survival of those banks by giving them enough capital to not force the liquidation on their assets. And later, it is even assumed that those shares were sold with profit, although increased taxes and debt used to finance the whole operation are not fully taken into consideration.

Jump 20 years and the Spanish banks find themselves in a similar situation. But this time if the Spanish government thought it could do the same thing, it had to look again as it cannot finance the operation. Credit from abroad is highly conditioned and taxes are already higher than the ones paid in Sweden. But as rulers like to believe that reality is what it seems and tend to scorn upon what Greeks called hubris. They think that by shuffling and moving things around garbage can be turned into gold.

Thus enters Sareb, the “bad bank”, a creature spawned by the Spanish government to “solve” the problem of bad loans related to real estate that uncomfortably lie in broken banks’ balance sheets. This is how the whole thing was devised: The state puts up half the money (up to 49.9% to be more accurate meaning they cannot impose their will against other partners if they act unanimously, this acting as bait of course) and private partners come up with the rest of the money. The troubled banks themselves cannot join as shareholders. Nonetheless they are given bonds in return for their toxic or troubled assets. On paper, this bank is promising a return on equity of 15% for the next 15 years which, in times of imposed low profitability on capital, seems a very attractive deal. This implies one of two things, possibly both: a) assets are bought at an attractive discount and b) the company is leveraged, equity being a fraction of total assets.

The problem with assets being bought at a discount is that it would imply troubled banks taking a loss that would make their delicate situation worse. To put it bluntly, institutions that are otherwise broken can only maintain a semblance of solvency by arguing that the asset side of their balance sheet is enough to meet their liabilities in the long run. A discount on those assets is equivalent to a death certificate. If those banks had no choice, those assets would have been sold at a discount, shareholders wiped out and bondholders brought in to take their place while taking themselves a cut on their principal. If the whole idea is to prevent this from happening, then troubled banks cannot be forced to give their bad loans at a discount.

On the other hand, the only willingly (or maybe not so willing) private partners the state found were the domestic banks (BBVA rather tellingly missing), foreign banks with important operations in Spain (Deutsche Bank and Barclays) and some local insurance companies. These banks are not pleased to buy at book value (or even market value for that matter) but they have themselves a big inventory of real estate to place in the market, so if these assets are kept outside the market long enough it would give them time to get rid of their own pile of manure.

I do not know at what price those assets have been brought into Sareb, but homes are being offered to the market at prices some 30% higher than they had been offered by troubled banks before. Besides, international investors willing to make a buck were dismissed. Papers said “vulture funds” were prevented from taking advantage of the discounts failing to see that in finance, like in nature, vultures play a part in the balance of the whole eco-system.

This leaves us with leverage. The problem with leverage is that it works under two assumptions: a) return on assets is higher than the cost of debt and b) asset valuation cannot drop more than the small equity size, or new capital will have to be put forth. This means effectively that whatever the price being paid (well, bonds issued) the market value of those assets cannot decrease more than 8% and the return on those assets must be enough to pay coupons on bonds. The trouble is I very much doubt those houses are being rented (or mortgage holders are at least paying interest on their loans) so there is a negative carry that needs to be funded. More debt or capital are required.

So after deep restructuring, the Spanish troubled banks own bonds on a company as leveraged as themselves, with negative carry and expensive assets. The not-so-troubled banks invested in that same company expecting (or at least wanting to believe) they would have a 15% annual return that, for the time being, seems like a mirage. To further add to their misery, stage two is drawing near where an additional 2.5 Bln. euros of equity are required (the taxpayer paying for half of it, well 49.9%), vulture funds being put off and domestic banks showing an understandable lack of appetite.

Yesterday big news was Iberdrola coming in with 2.5 million (yes folks, a whole 1% of the total required), this after we had been informed they would probably invest 10 million. Thus a company in a highly regulated market, holding a big government debt already (from the differential between the return regulation promises for their assets and the price it is allowed to charge to their clients) is performing in all likelihood lip service and a very expensive one for that matter.

To add insult to injury, the original bank project said the board would be composed by between 5 and 15 members and I will let you guess how many are there in place. Besides, rumours came out that the troika (whom unofficially run the country) are not pleased and asked for a revised (meaning completely new) plan than is being drafted by KPMG. One would expect bankers chosen by government to be at the bulk of such important reforms being able to make their own business plan.

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One thought on “Crossing the Rubicon – V

  1. I just read the reason the Spanish state does not own over 50% of Sareb is so it does not have to consolidate it with their national accounts keeping Sareb out of the deficit calculations. Just to show when I think I’m being a bit harsh in my rant, reality turns out much worse. The whole thing is an exercise where banks exchange bad assets for a state guarantee, that the state itself keeps out of their balance sheet.

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