Mortgage loans are the greatest risk as Spain’s government acts

As the Spanish government finally begins to act, could this be the end of the beginning of the madness we have already described in previous articles?

According to the Bank of Spain the total provisioning in Spanish banks is at Euro 166bn, which is an amount equal to 50 percent of the loans to property developers and construction firms. This represents losses occurring in a financial havoc scenario, as this credit tranche is relatively well examined.

This leaves no losses being accounted for in Spanish mortgage loans and corporate credits, which account for roughly Euro 1.4tr in total. When losses begin to be accounted for in this credit segment they could start a vicious circle of debt, figure 1. This dynamic needs to be halted with a credible solution likely involving EU rescue funds and the International Monetary Fund. The Cajas are by no surprise the most vulnerable victims in the short term.

In our hypothesis of an “Irish experience” worst-case scenario for Spanish banks, with total losses on housing and corporate loans totaling 20 percent, additional losses for the Spanish banking sector range from Euro 300-380bn. This amounts to roughly 3-4 times the Irish losses (in nominal terms) and approx. 30-40 percent of Spanish GDP, which the Spanish government is unable to be consumed by alone.

But the cash flow in some Spanish households and corporates must be under enormous pressure, as the current macroeconomic situation in Spain deteriorates. Unemployment is close to 25 percent and the Spanish economy is yet again in recession. So we can only expect substantial losses in these segments. I expect to see this in the banks reports sooner rather than later. Banks are trying to buy time, laxing the interest rate payments, but this can only go on for a limited period of time.

Furthermore, Spanish banks are holding Euro 231bn in Spanish sovereign debt, making the connection between state and banks even stronger. If their bonds decline in value the banks must post more collateral in the European Central Bank which takes capital that they might not have.

The solution is to avoid the “The vicious circle of debt” accelerating out of control, figure 1. The main task is to use ample determination to keep Spanish government yields down. The next step for the Spanish government is crucial. It needs to be firm and very credible and provide answers to how the whole banking system can be stabilised. It is likely that this will include both EU rescue funds, the IMF and perhaps a coordinated action by Mr. Draghi in the ECB. Sadly for equity investors, the capital needed will mean great losses for shareholders in Spanish banks.