Eyes Wide Shut as Spain’s Banking System Collapses

As Spain collapses into depression, its banks are holed below the waterline and sinking rapidly, because they are the only remaining buyers of Spain’s sovereign debt. The government, unable to provide state aid to its banks, is desperately bending over backwards to hide the true state of Spain’s financial sector.

To that end it forced those cajas – the regional lending banks – which couldn’t meet a capital requirement of 8% equity to their risk-weighted assets, to merge with other banks, or be shifted onto the public’s balance sheet via partial nationalization.

However, spreading these toxic balance sheets around was never going to fool anyone, not least the markets. So the share prices of those Spanish banks which merged with cajas have continued to collapse.

In response, the Spanish government now plans to create a ‘bad bank’. The theory is that this would allow banks to clean up their balance sheets by selling toxic loans to the bad bank. Again, this amounts to obfuscation, as it is unclear how this will help banks trying to raise provisions for other loans and strengthen their capital.

The proportion of wobbly mortgages in Spain is still low when compared with those in Ireland – which is why many investors just don’t believe the numbers. Less than 3% of residential mortgages have started to wobble; surprising in a country where unemployment is close to 25%.

Incredulous investors think that Spain’s banks are hiding the true scale of bad loans by encouraging struggling customers to switch from normal mortgages to ones where they repay only the interest. The latest data show that terms are being modified on some 26,000 mortgages a month.

But this process can only defer a reckoning in Spain’s housing market – whose bubble, having dwarfed America’s, is nowhere near fully correcting. Mortgage defaults are likely to rise, especially as the banks’ ability to lend is being drained by the increased exposure to Spanish government debt.

The cheap money that the ECB’s Long Term Refinancing Operations have given the Spanish banking sector access to has only tied the solvency of the banks to that of Spain itself! Spanish banks have been far and away the biggest borrowers – drawing a record €316.3 billion from the ECB in March, up from €169.2 billion in February.

Spanish banks, the only buyers of Spanish sovereign debt, will soon own all of it!

But the markets have woken up to the fact that these banks are simply buying Spanish government bonds with the money, then offering those same bonds back to the ECB as collateral for the next round of LTRO money, which in turn will be spent on still more bond buying.

As Spain’s cost of borrowing rises, so the banking sector’s balance sheets are weakening. International investors are shunning European sovereign debt and non-resident European investors are bailing out of Europe debt, so domestic credit institutions are having to meet a growing share of their sovereigns’ financing demands. Spanish banks, which held around 16% of domestic debt at the end of 2011, held just short of 30% of it by March. Another LTRO would only accelerate this process.

Because there are simply not enough resources to bail out Spain, Europe’s policymaking elites are blind to where this all ends. Spanish citizens, however, know full well where their country’s downward spiral will lead. Capital is fleeing the country, as its citizens pull money out en masse: €65 billion left the Spanish banking system in March 2011 alone.

Annual rate of change in house prices. No sign of a deceleration in housing market collapse.

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