Spain part 1:
Contagion very much one of the buzz words of the day as details of the Irish Bailout get released and the market likely moves its attention to Portugal and Spain. The outlook for Spain remains the most important in terms of the wider European economy and the EUR as any bailout would test the limits of available resources in the EU/IMF. We continue to believe Spain will develop along a path where debt dynamics remain sustainable over the medium term, though I fully acknowledge the market has little confidence in this outcome (and has the ability to make this situation self-perpetuating!).
So what is really going on in Spain and why is it important?
Why is Spain important?
* Its economy is substantially bigger than Greece, Ireland and Portugal combined.
* A bailout of Spain would require essentially full use of resources available from EU/, IMF and other sources, putting the back-stop infrastructure to the test.
* The potential losses involved in a restructuring of Spanish debt could trigger a eurozone-wide banking crisis.
But it is not a question of liquidity in Spain......
* The underlying issue is whether the Kingdom of Spain is solvent.
* It is not a question of liquidity given that Spain does not have any large pending bond debt maturities and given that the ECB has an obligation to provide liquidity to solvent Spanish banks (and has proven willing to do so earlier this year).
* But the market is currently pricing in an increasing probability that the Kingdom of Spain will ultimately have to default on its debts in some form. Using a standard recovery rate assumption of 40%, the 10Y CDS for Spain is now pricing a default probability of 42% for Spain, up from 27% in the beginning of August and 20% at the beginning of this year.
* This deterioration is understandable in the context of contagion from Ireland, but it is not immediately logical in the context of domestic developments in Spain - aggressive fiscal tightening measures over the last six months, somewhat better than expected growth, and robust earnings among the biggest Spanish banks.
Are the debt dynamics in Spain sustainable?
There are three key elements of uncertainty in the outlook for Spain and its debt sustainability:
1. Costs linked to banking system recapitalization;
2. Risk of further significant declines in house prices;
3. Underlying fiscal dynamics.
1) The Banking System
* Investors fear that the cost of contingent liabilities in Spain could be of a similar magnitude to Ireland. This view is based on the fact Spain has seen comparable increases in house prices and domestic credit as well as a similar construction booms. There has also been a comparable spikes in unemployment in Ireland and Spain since 2007.
* But there are also some big differences :
- The Irish banking system was much bigger, with banking assets to GDP in excess of 1,000%, compared to less than 500% for Spain.
- Lending standards appear to have been better in Spain.
- Spanish banks (unlike Irish banks) did not have large problematic external exposure to the UK and US markets. Instead they had soundly performing assets in Latin America.
* Total risk weighted assets of Spanish banks (all major institutions) amounts to €1,914bn (179% of GDP), based on end 2009 numbers from the bank stress test from June. Santander and BBVA, the two biggest banks in Spain, account for 47.6% of total risk weighted assets. The remaining 52.4% of risk weighted assets in the Spanish banking system, or €1,002bn are held by a combination of other commercial banks, and the savings banks (Cajas).
* Separating Santander and BBVA from the overall asset pool makes sense, because it is hard to construct scenarios where Santander and BBVA are likely to need new capital. The basic reason being that both institutions are generating strong pre-provision profits, including from their business outside Spain. Consistent with this, Santander and BBVA have consistently been able to access wholesale funding markets, even during May this year. That said, CDS spreads for Santander and BBVA have widened out last week to levels similar to what we saw during the panic of May, illustrating that even the most robust institutions are not immune to current sentiment.
* In the stress test, the ‘worst bank' was DIADA, which according to the stress test would see losses of 10% of risk-weighted assets. If we apply this percentage to the entire risk weighted assets outside of Santander and BBVA, then we get losses of €100bn (10% of €1,002bn). Some of this will be absorbed in profits and existing provisions, leaving a smaller amount left for recapitalization. Importantly, the stress test's growth assumptions of -1.4 in 2010 and -1.2% in 2011, do not look overly optimistic, with 2010 GDP likely to come in close to flat y-o-y.
* Another way to look at the potential for loan losses is to focus on exposures linked to the housing market and real estate more broadly. Whilst delinquencies on residential mortgages remain below 3%, the total exposure to real estate development and construction is €445bn, of which €250bn are held within the savings banks (Cajas). The Bank of Spain has argued that only €165bn of this exposure is troubled, as other parts are to sound projects (such as airports, utilities, as well as developments outside Spain). Moreover, provisions of €42bn have already been made for the troubled part of the loan portfolio. In terms of exposures, which have not been provisioned for Cajas may have €225bn and commercial banks around €180bn (of which Santander and BBVA account for around €80bn). In any case, if we assume losses of 40% on the entire portfolio of real estate development and construction loans, we get to a loss figure of €178bn, for which at least €42bn of provisions has been made. A part of this gap of around €130bn in additional potential losses would be absorbed in profits, but could see a need for recapitalization of perhaps €75-95bn.
* With nominal GDP at €1,066bn, it is hard to argue that a recapitalization need of around €80-120bn (or around 8-12% of GDP) would by itself alter the debt dynamics (as has been the case in Ireland). It would be important to pin down what could be ‘too optimistic' about these calculations. Clearly, a restructuring of sovereign debt in the eurozone is one such risk. Another risk would be a significant rise in delinquencies on residential mortgages, linked to significant further declines in housing prices and continued rises in unemployment.
Contagion very much one of the buzz words of the day as details of the Irish Bailout get released and the market likely moves its attention to Portugal and Spain. The outlook for Spain remains the most important in terms of the wider European economy and the EUR as any bailout would test the limits of available resources in the EU/IMF. We continue to believe Spain will develop along a path where debt dynamics remain sustainable over the medium term, though I fully acknowledge the market has little confidence in this outcome (and has the ability to make this situation self-perpetuating!).
So what is really going on in Spain and why is it important?
Why is Spain important?
* Its economy is substantially bigger than Greece, Ireland and Portugal combined.
* A bailout of Spain would require essentially full use of resources available from EU/, IMF and other sources, putting the back-stop infrastructure to the test.
* The potential losses involved in a restructuring of Spanish debt could trigger a eurozone-wide banking crisis.
But it is not a question of liquidity in Spain......
* The underlying issue is whether the Kingdom of Spain is solvent.
* It is not a question of liquidity given that Spain does not have any large pending bond debt maturities and given that the ECB has an obligation to provide liquidity to solvent Spanish banks (and has proven willing to do so earlier this year).
* But the market is currently pricing in an increasing probability that the Kingdom of Spain will ultimately have to default on its debts in some form. Using a standard recovery rate assumption of 40%, the 10Y CDS for Spain is now pricing a default probability of 42% for Spain, up from 27% in the beginning of August and 20% at the beginning of this year.
* This deterioration is understandable in the context of contagion from Ireland, but it is not immediately logical in the context of domestic developments in Spain - aggressive fiscal tightening measures over the last six months, somewhat better than expected growth, and robust earnings among the biggest Spanish banks.
Are the debt dynamics in Spain sustainable?
There are three key elements of uncertainty in the outlook for Spain and its debt sustainability:
1. Costs linked to banking system recapitalization;
2. Risk of further significant declines in house prices;
3. Underlying fiscal dynamics.
1) The Banking System
* Investors fear that the cost of contingent liabilities in Spain could be of a similar magnitude to Ireland. This view is based on the fact Spain has seen comparable increases in house prices and domestic credit as well as a similar construction booms. There has also been a comparable spikes in unemployment in Ireland and Spain since 2007.
* But there are also some big differences :
- The Irish banking system was much bigger, with banking assets to GDP in excess of 1,000%, compared to less than 500% for Spain.
- Lending standards appear to have been better in Spain.
- Spanish banks (unlike Irish banks) did not have large problematic external exposure to the UK and US markets. Instead they had soundly performing assets in Latin America.
* Total risk weighted assets of Spanish banks (all major institutions) amounts to €1,914bn (179% of GDP), based on end 2009 numbers from the bank stress test from June. Santander and BBVA, the two biggest banks in Spain, account for 47.6% of total risk weighted assets. The remaining 52.4% of risk weighted assets in the Spanish banking system, or €1,002bn are held by a combination of other commercial banks, and the savings banks (Cajas).
* Separating Santander and BBVA from the overall asset pool makes sense, because it is hard to construct scenarios where Santander and BBVA are likely to need new capital. The basic reason being that both institutions are generating strong pre-provision profits, including from their business outside Spain. Consistent with this, Santander and BBVA have consistently been able to access wholesale funding markets, even during May this year. That said, CDS spreads for Santander and BBVA have widened out last week to levels similar to what we saw during the panic of May, illustrating that even the most robust institutions are not immune to current sentiment.
* In the stress test, the ‘worst bank' was DIADA, which according to the stress test would see losses of 10% of risk-weighted assets. If we apply this percentage to the entire risk weighted assets outside of Santander and BBVA, then we get losses of €100bn (10% of €1,002bn). Some of this will be absorbed in profits and existing provisions, leaving a smaller amount left for recapitalization. Importantly, the stress test's growth assumptions of -1.4 in 2010 and -1.2% in 2011, do not look overly optimistic, with 2010 GDP likely to come in close to flat y-o-y.
* Another way to look at the potential for loan losses is to focus on exposures linked to the housing market and real estate more broadly. Whilst delinquencies on residential mortgages remain below 3%, the total exposure to real estate development and construction is €445bn, of which €250bn are held within the savings banks (Cajas). The Bank of Spain has argued that only €165bn of this exposure is troubled, as other parts are to sound projects (such as airports, utilities, as well as developments outside Spain). Moreover, provisions of €42bn have already been made for the troubled part of the loan portfolio. In terms of exposures, which have not been provisioned for Cajas may have €225bn and commercial banks around €180bn (of which Santander and BBVA account for around €80bn). In any case, if we assume losses of 40% on the entire portfolio of real estate development and construction loans, we get to a loss figure of €178bn, for which at least €42bn of provisions has been made. A part of this gap of around €130bn in additional potential losses would be absorbed in profits, but could see a need for recapitalization of perhaps €75-95bn.
* With nominal GDP at €1,066bn, it is hard to argue that a recapitalization need of around €80-120bn (or around 8-12% of GDP) would by itself alter the debt dynamics (as has been the case in Ireland). It would be important to pin down what could be ‘too optimistic' about these calculations. Clearly, a restructuring of sovereign debt in the eurozone is one such risk. Another risk would be a significant rise in delinquencies on residential mortgages, linked to significant further declines in housing prices and continued rises in unemployment.
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