Property crisis drains Spain’s hopes of recovery

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By:
Louise Bowman
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As a seventh bank is taken under state control, Spain faces a race against time to deal with its bad real estate assets before they contaminate the entire banking sector. A bad bank could be the only solution, despite opposition from bankers and politicians.

 
Eurozone's future hangs in the balance amid Spanish crisis
Two hundred kilometres south of Madrid is a potent symbol of today’s Spain. It is large, debt-fuelled, real estate-backed, riddled with regional politics and nobody wants to buy it. It is Aeropuerto Central Ciudad Real, the country’s first privately constructed airport, which opened in December 2008 with capacity to process 10 million passengers a year and one of the longest runways in Europe. Less than three years later it is now bankrupt – the last flight out, by Barcelona-based budget carrier Vueling, left at the end of October. The owner, AeropuertosCR, stopped payments on its debt in mid-2010 owing €290 million.

The doomed project was financed by two regional savings banks – Caja Castilla-La Mancha and Cajasur – both of which have collapsed and been taken over by the state, exposing alleged corruption in the airport’s construction contracts and revealing that up to 50% of the building work might have been illegal. It might not be entirely true that nobody wants to buy the airport, however. Local newspapers have recently reported that a gang of drug smugglers had been trying to purchase part of it to ease their transportation of cocaine into the country. This is probably not what the politicians had in mind when the scheme was first proposed.

Ciudad Real airport is only an extreme example of the kind of real estate folly that Spain’s banks are now faced with either trying to get rid of or provision against. The fallout from the country’s cheap credit-fuelled property boom will take years to tackle and is the reason why Spain’s situation is so different to the eurozone patient with which it is so often compared: Italy.

The now bankrupt Aeropuerto Central Ciudad Real. Large, debt-fuelled, real estate-backed, riddled with regional politics and nobody wants to buy it
The now bankrupt Aeropuerto Central Ciudad Real. Large, debt-fuelled, real estate-backed, riddled with regional politics and nobody wants to buy it

Italy has a straightforward sovereign debt problem. Spain does not. It has a complicated combination of a highly leveraged private sector and a banking sector that is too big and struggling to deal with the impact of foreclosed properties and bankrupt developers – all against the backdrop of an unsustainable and growing regional debt burden.

It is a toxic mix, and one for which policy solutions are often mutually exclusive.

Spain’s new prime minister, Mariano Rajoy
The main enemy of Spain’s new prime minister, Mariano Rajoy, is likely to be the bond markets’ demands for ever-higher yields
THIS IS WHAT MAKES THE TASK facing the new right-wing Partido Popular administration of Mariano Rajoy, voted in on a tide of discontent on November 20, so difficult. After his landslide victory Rajoy announced: "There will be no enemies for me other than unemployment, the deficit, excessive debt and economic stagnation." That would be more than enough enemies for most people but he also has the bond markets to contend with. Three days before the country’s election Spain paid 6.975% for 10-year bonds and immediately afterwards spreads, rather than recovering, flirted with 7%. It was a brutal indication of investor nervousness and the risk that it doesn’t matter what Rajoy does – Spain’s fate now lies in the hands of the European Central Bank.

As Richard McGuire, senior fixed-income strategist at Rabobank in London, commented: "Political developments at a local level are of limited consequence. In short, changing the actors is of no consequence if it is the stage that is the problem."

In the bond markets, Spain seems to be partly paying the price for Italy’s debt problems – the country itself has a debt to GDP ratio of just 60% compared with Italy’s 119%. But it is private-sector real estate-backed leverage that has long distinguished Spain from the pack with the exception of Ireland. The real estate problem pervades any conversation about the banking sector in the country. Along with the kind suggestion of a café con leche or a glass of water at a recent meeting in Madrid, Euromoney was rather taken aback to also be offered a two-bedroom condo on the coast with delightful sea views.

The country’s problems simply cannot be dealt with until the crippling legacy of its real estate boom is purged from the banking system. This has been the driving motivation behind the bank restructurings that have been undertaken so far. And it will drive the likely forced transformation of Spanish banking that is to come.

Spain’s real estate problem is very different from that of many other countries since 2007. Despite the decade-long housing bubble and aggressive use of securitization by Spanish banks to fund it, this is not a structured-credit crisis. It is a traditional real estate crisis caused by bad lending. And it is a land problem, not a mortgage problem. Recent figures from the Bank of Spain show that nearly 18% of non-performing loans in the banking sector relate to real estate and construction while only 2% relate to housing.

The scale of the problem is daunting. Official estimates show that the banking sector is exposed to roughly €300 billion of loans to property developers – 52% of which are deemed to be at risk ($176 billion). While these assets may have been largely originated by now-defunct or nationalized regional savings banks, there is now a risk that the problem will end up at the door of the healthy national lenders. This is because of the way in which the loans were originated and the way in which the Spanish government has so far tackled the restructuring of the system.

In the boom years, Spain’s banks lent to real estate developers in three ways: through unsecured credit; through loans for down payment on land to be developed; and loans to finance the balance of the purchase after down payment. The loans were usually structured with bullet repayments and were paid down on sale of the developed properties.

After the housing bubble burst the banking sector was faced with a glut of soured developer loans and has set aside €105 billion since 2008 to absorb this. But with the latest figures showing bad property loans of more than €170 billion there is a yawning gap between the problem and the banks’ ability to absorb it.

Despite the decade-long housing bubble and aggressive use of securitization by Spanish banks to fund it, this is not a structured-credit crisis. It is a traditional real estate crisis caused by bad lending

Developers that have been unable to meet their unsecured loan repayments have often offered collateral instead – in the form of more land. In this way the foreclosed land has moved onto the balance sheet of the bank that made the poor credit decision in the first place – often a regional savings bank (caja de ahorros). The inevitable result has been the takeover of the worst of these lenders by the state.

The first to fail was Caja Castilla-La Mancha, which was bailed out by the Bank of Spain in 2009 after a failed attempt to merge with Unicaja. That bailout was supported by the deposit guarantee fund. By the time that Cajasur, a small lender controlled by the Catholic Church, was also bailed out in May 2010, roughly 30 cajas with €600 billion in assets were in merger negotiations. Cajasur was subsequently sold to BBK Bank.

It very soon became apparent that the deposit guarantee fund had neither the mandate nor the capacity to deal with the looming problem of the cajas and Spain’s bank bailout fund, Fondo de Reestructuración Ordenada Bancaria (Frob), was formed in June 2009 with firepower of €99 billion.

There were 45 cajas before the crisis and the Bank of Spain wants to get this number down to around 15. Frob has so far funded the merger of Cajas Manlleu, Sabadell and Terrassa; Catalunya, Tarragona and Manresa; and Cajas Duero and España. In May 2010 it bailed out Cajasur and in June that year funded three further integrations: Caja Granada, Murcia, Penedes and Sa Nostra; Cajas Madrid, Bancaja, Insular de Canarias, de Avila, Laietana, Segovia and Rioja to form Bankia; and Cajas del Mediterraneo, Cajastur, Extremadura and Cantabria.

In September this year it approved three further recapitalization exercises, injecting €2.47 billion into Novacaixagalicia (93.2% of capital needed), €1.72 billion into Catalunyacaixa (90%) and €568 million into Unnim (100%). It has also injected €2.8 billion into CAM, which is up for sale.

In late November Banco de Valencia became the seventh bank to be taken into state hands. The total bill to Frob will now be €20 billion.

The merger of the cajas is much needed in one of the most over-banked countries in Europe. According to EBF data for 2010, Spain had 337 banks and 43,164 bank branches. By comparison Italy has 760 banks but 33,640 branches and France 305 banks and 28,633 branches. Spain has the lowest number of employees per branch – just 6.1, roughly half that of France with 13.3. Thus consolidation seems much needed and long overdue. It is gathering pace both within Frob’s mandate and outside it – for example Spain’s fifth-largest bank, Banco Popular, announced a €6 billion merger with struggling Banco Pastor in early October.

But in tackling the problem by merging entities what is also being merged is lending practices. While the larger Spanish banks extended developer loans to plots that had maybe two to three years’ planning permission attached to them, some cajas were lending to sites with around five to seven years. Planning permission on these loans has often been extended to up to 10 years or more while building permits are unsurprisingly hard to come by. Sites such as these in developments far from city centres or away from the coast have become all but impossible to sell.

Experts suggest that this type of loan could make up as much as 50% of the total €176 billion bad debt that needs to be dealt with. "Every bank has this type of exposure," says a banker in Madrid. "It is not just the problem banks – even the biggest banks are exposed, although to a lesser degree. Some of this land might take 20 or 30 years to be developed – there is almost no demand for it." And as the weaker entities with these loans on their books are forced to merge with the stronger, their weaker lending practices merge with them.

This is a central worry for the rest of the banking sector. "A good percentage of the Spanish banking sector has problems but is fundamentally healthy," explains Gonzalo Gortazar, chief financial officer at CaixaBank.

CaixaBank was formed earlier this year when La Caixa was split into the bank and an unlisted holding company into which a portfolio of bad real estate assets was placed.

"The banking industry in Spain has been efficient, profitable and innovative," says Gortazar. "The large Spanish banks have been seen as models of retail banking excellence in many markets."

Speaking at his office in the bank’s Barcelona headquarters he emphasizes that the inherited problem of bad real estate lending is the key issue for the financial system and the main threat to the Spanish economy.

"If we don’t fix it the whole economy will be affected. We need a solution to the land problem," he tells Euromoney. "If there is a new initiative that is done with common sense and will help financial institutions deal with potential losses it would allow them to deal with that part of the problem that does not have a private sector solution."

Financing of households and NPISHs
Annual percentage change
Source: Bank of Spain


It is no surprise that the large banks want to see the problem of bad assets fixed – and fast. The tide of losses that it represents is already lapping at their door. In October the government merged three separate deposit guarantee funds, which were separately targeted at the banks and the savings banks into a single €6.6 billion fund to assume losses from the state takeover of the cajas. So the good banks are now directly paying for the failed banks’ mistakes.

This was graphically illustrated last month by the collapse of Banco de Valencia – brought down by soured lending to property developers, primarily in the Levante region, which has been particularly badly hit by the property crash.

Will Banco de Valencia’s real estate portfolio be a big problem for new owner Bankia?Will Banco de Valencia’s real estate portfolio be a big problem for new owner Bankia?
Shares in the lender were suspended on November 7 after it was revealed that a full 74% of its €3 billion of loans to real estate and developers was deemed doubtful and it faced a €800 million shortfall in loan-loss reserves. The bank, which has assets of €24 billion, became part of Bankia when its parent, Bancaja Inversiones, was merged with Caja Madrid to form Banco Financiero de Ahorros (BFA) – the holding company for Bankia – earlier this year. "The problem is far worse than they were anticipating," reckons one source in Madrid. "This is a real problem for Bankia."

Bankia itself owns only 27% of Banco de Valencia, however, and BFA claimed that the Frob takeover of Banco de Valencia would not have a "significant" impact on its solvency in a filing to regulators on November 21. Deutsche Bank and Guggenheim Capital are also exposed to Banco de Valencia through their holdings in Bancaja.

Frob will now inject €1 billion into the failed lender and provide it with a €2 billion credit line. The book value of Bankia’s stake in Banco de Valencia is around €150 million, so writing this off could be the worst-case scenario for the former. But the episode demonstrates the risks that could face large, healthy Spanish banks if they are put under pressure to buy out smaller struggling lenders.

Frob is trying to sell another seized caja, Alicante-based Caja de Ahorros del Mediterraneo (CAM), which disclosed a nine-month loss of €1.73 billion last month. All the large lenders are expected to bid for the bank. When asked about potential acquisitions, CaixaBank’s Gortazar is guarded. "We are in a unique position," he says. "Our funding requirement for 2012 is just €2.5 billion and we have over €20 billion liquidity. We have the ability to undertake acquisitions but we will be careful. Liquidity is a precious asset."

Spain’s plans to deal with its ailing cajas have been injected with a new urgency after the intensification of the eurozone sovereign debt crisis since July. Only the largest institutions still have access to the capital markets. Even Banco Santander did not exactly endear itself to investors when it indicated that it may not call a jumbo lower tier 2 issue that is part of a senior exchange announced in November.

Many of Spain’s banks are cut off from the funding markets, something that, together with the capital requirements of the most recent EBA stress tests, will only intensify the problems they now face (UNNIM, CAM, Catalunya Caixa, Banco Pastor and Caja 3 all failed the tests).

Wholesale debt issuance by Spanish banks was just €5 billion for the third quarter this year – its lowest level since the fourth quarter of 2008 in the immediate wake of the Lehman collapse. Two banks, Bankia and Banca Civica, have gone to the IPO market to fund themselves but had to do so at rock-bottom prices. Both issues were 80% sold to domestic buyers.

The larger banks, such as Santander and BBVA, have been at pains to emphasize their limited exposure to Spain and the extent of their international operations. But these are operations that they are now being forced to sell to raise sufficient capital to shore up their balance sheets, as Santander’s sale of a 7.8% stake in Santander Chile brutally demonstrates.

For the smaller players there is a risk that the damaging deposit wars of earlier this year will be reactivated. Before a clampdown by the Bank of Spain in June some of the smaller savings banks were offering 12-month rates as high as 5.5% to attract deposits – a dangerous zero-sum game with a finite volume of deposits but unlimited potential for losses. Ignacio Moreno, bank analyst at Citi in London, warns that until wholesale markets reopen there is a risk that deposit-rate hostilities will surface again. Worryingly, some of the most aggressive loans are being offered by banks that are already under Frob control.

While sovereign risk remains so acute, it is hard to see how Spain’s smaller banks will get access to the wholesale markets without some sort of government guarantee for funding. Lobbying of the new administration for such a move must be intense. "In the short term we need the capital markets to reopen for Spanish and other European banks," says Gortazar. "There is a major need for this. We need policy tools to break the vicious cycle and negative feedback loop. We need bravepolitical decisions at European level."

By merging the cajas the Bank of Spain is hoping that their sum is greater than their parts – certainly when it comes to dealing with bad debts. "You need bigger institutions," says Moreno. "Big banks know how to manage this exposure better. They know the market well and have the expertise that the smaller players do not have."

NPL formation Spanish banking system
Contributions to the annual percentage change
Source: Bank of Spain, Barclays Capital

In Spain just four institutions have total assets greater than €200 billion (Santander, BBVA, Bankia and La Caixa) so fewer, larger lenders makes a lot of sense. By general consensus there will be a second or third round of bank restructuring in Spain before the real estate problem is solved, so instead of ending up with 15 cajas it might end up with closer to five.

The alternative approach, and one that was mooted quietly by the Partido Popular when in opposition, is that of a state-owned bad bank. The concept is understandably divisive, and there is likely to be limited popular support for any taxpayer-funded alleviation of the banks’ problems. "Rajoy floated the idea of a bad bank as an exploratory balloon before the election," reckons one commentator. "It is not a serious proposal."

It could become one as the situation deteriorates. Any discussion of a bad bank in Spain begs comparison with Ireland’s National Asset Management Agency (Nama), which was set up in 2009 and has so far acquired assets with a face value of €71.2 billion from Irish banks. During two days of meetings in Madrid for this article, Euromoney spoke to just one banker who was supportive of a Nama-style proposition for Spain. Most believed that Nama destroyed the Irish banking system, forcing the nationalization of virtually the entire sector.

"The problem with a bad bank is that if you pay a par price for the assets you are subsidizing the banks, which is not acceptable to the Partido Popular," says one observer. "But if you buy at a fair price the banks simply can’t take it. Even buying at net value would not be bearable for many savings banks." Despite acquiring assets at aggressively low prices, Nama reported a loss of €1.2 billion for 2010.

It is no surprise that bankers don’t want to see the establishment of a bad bank. But it may be only this kind of incentivized scheme that will get the real estate backlog moving. "Entities need to be forced to move these exposures off their balance sheets quickly," says Kingsley Greenland, chief executive at Boston-based loan sale adviser DebtX, which has been advising on loan sales in Spain. "Banks react faster when there is a profit motive to get the loans out of the door. The cost of a bad bank to the system may be high but the expense of having these assets stuck on the books of an institution is higher."

Certainly the consolidation of the banking sector would be a far easier and cheaper proposition if the bad assets were not part of the equation. The management of any such bad bank would, however, be crucial to its success and many in the market are sceptical, believing that it would be staffed with civil servants rather than managers that have true real estate expertise.

That expertise seems to be amassing in the private sector in the ranks of distressed debt funds, hedge funds and private equity firms sizing up the opportunity in Spain. Cerberus, Fortress, LoneStar, Blackstone and Morgan Stanley have all been linked with potential activity, but this part of the market is long on speculation and short on deals.

There is activity at the smaller end of the market from domestic Spanish buyers often purchasing foreclosed second homes along the coast, though quantifying exactly how many sales have taken place and at what price is tricky. "There are a lot of difficult assets to be sold over the next 10 years but the sale of first residences is possible – it is a matter of being aggressive in adjusting the price," says a Deutsche Bank source. "Second residences and condos in the middle of nowhere remain very difficult to sell."

Assets at risk as a percentage of total assets
September 2011 
Source: Company data, Barclays Capital 

Deals that have been done have, however, often involved brutal markdowns, with loans often changing hands at just 10% of face value. Greenland at DebtX argues that what the market needs is a large benchmark distressed sale. "When prices get this low for investors it becomes a country bet," he says. "We saw this in Germany with the sale of portfolios from eastern Germany and with the Resolution Trust Corp in the US. There needs to be a mega deal involving the poorest assets so that the market can set a floor."

But there is still no sign of such a deal, and Greenland believes that interest from international buyers in Spanish distressed debt might wane as a result. "There has not been a demonstration that there is a return on the due diligence investment in Spain because a significant deal has yet to be done. Investors will come back when someone proves that this is possible."

RBS hired Morgan Stanley in 2010 to advise it on the sale of a €1 billion Spanish portfolio, a deal that was expected to attract interest from large buyers such as Goldman Sachs or LoneStar. The UK bank eventually managed to sell a portfolio of Spanish mortgage loans with a face value of around €290 million to US private equity firm Perella Weinberg in March this year. RBS reportedly took a 45% hit on the loans.

There is now much discussion of a €3 billion portfolio that is believed to be on the block from Banco Santander. The situation is unclear to say the least as Santander denies the existence of the deal while everyone else that Euromoney speaks to in Madrid knows about it, with some claiming to have seen the documentation. Santander chief executive Alfredo Sáenz was asked about the deal at the presentation of results in October but declined to comment.

"Santander intends to sell over time the real estate that has come on its books through acquisitions and adjudications during the crisis (€8.3 billion-worth before provisions, €5.7 billion after provisions) but any large sale would not be for anything like €3 billion, however," a Santander spokesman tells us.

Sources that claim knowledge of the deal explain that a mixed portfolio of roughly 60% land, 20% commercial and 20% residential might be being hawked and that two large distressed buyers – reportedly Cerberus and a Morgan Stanley real estate fund – offered a 57% haircut on the loans. Santander has provisioned 32% against its real estate assets – ranging from 25% for the best and 42% for the worst – so apparently rejected the deal. Cerberus is now understood to have pulled out of negotiations.

This highlights the yawning credibility gap that Spanish banks face in trying to sell off distressed real estate to private buyers – they simply don’t believe the numbers. "Spain has a GDP of €1 trillion and banking assets of €3.2 trillion," says one observer. "The big problem for the banks is that investors simply don’t believe the asset valuations on the books. There are huge questions over the credibility of book values."

A report from Boston Consulting Group in June claimed that Spain’s banks were sitting on €50 billion of "hidden" real estate related losses. There is thus a pressing need for potential buyers and Spain’s banks to meet in the middle when it comes to establishing a market price for legacy real estate assets. "A distressed value fund would value land under IFRS rules and sites for which there is no bid would be valued at close to zero," sources at Deutsche Bank in Madrid explain. "Local banks would be valuing the same assets under local GAAP and under increased Bank of Spain pressure are probably now provisioning between 40% and 50%."

More clarity from the Bank of Spain on exactly how damaged some of the problem banks are would certainly help to clarify just how much further the programme of forced mergers has to run. There is almost universal praise for the central bank’s information gathering and its intimate knowledge of the position of every bank.

But this has also prompted criticism that it is acting as a data provider rather than a regulator. "The Bank of Spain should have been much more severe with the savings banks in 2007 and acted much more quickly – this was a huge error," says one financier. "It now needs to clearly classify which savings banks will survive and which will not."

All eyes are now on Caixa Catalunya, which merged with Caixa Tarragona and Caixa Manresa last year but for which a further buyer might now need to be found.

Spain’s real estate problem is large and worrying but it is not insurmountable. "The situation in the country is very different from that of Ireland," says Enrique Diaz-Barcelo, senior banker at BNP Paribas in Madrid. "The real estate stock can be absorbed over time. The demand for real estate over a long cycle is greater – even the excess coastal homes can be sold. It is just a matter of time."

But there are too many banks in the country sitting on too much of this real estate for which they have not realized losses. How this situation is rectified depends on the extent to which the private sector is prepared to get involved or whether it is left to the state to intervene and establish a bad bank.

“This is going to be painful in terms of jobs losses but required in order to add transparency for the market to distinguish between good and bad banks”

Manuel San Salvador
Manuel San Salvador, who was chief executive of Banco Urquijo, part of the Banco Sabadell group, from 2006 to 2010
"The government would have the mechanisms to be proactive in restructuring and intervene through the Bank of Spain facilitating the restructuring of the sector as the government did in the past with other sectors," says Manuel San Salvador, who was chief executive of Banco Urquijo, part of the Banco Sabadell group, from 2006 to 2010.

"This is going to be painful in terms of jobs losses but required in order to add transparency for the market to distinguish between good and bad banks. The process will accelerate the concentration of the banking industry in Spain," he tells Euromoney.

The process will, however, be less painful if the banks can be mobilized to sell off their bad loans and distressed buyers can find a price level that does not destroy them. This is more likely to be achieved through smaller sales than larger ones, which means that the process will take much longer than it would with jumbo portfolio sales. "Local capital pools together very quickly once you reach pricing equilibrium," Greenland believes. "Selling the assets via small sales to domestic buyers means that it could take as much as three times longer to complete the process than it would with jumbo sales to international buyers but the price achieved for the loans will probably be better."

So if international investors are dissuaded from persevering in Spain by wider eurozone debt concerns, a local solution will mean that the problem will dog the banking industry for years to come.

As the tumbleweed blows across the deserted four-kilometre runway at Aeropuerto Central Ciudad Real it is sobering to reflect that, immediately before Spain’s property collapse, regional governments were planning similar airport projects in Cataluña, Aragón, Valencia, Murcia and Andalucía. Things could have been a lot worse.