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Tuesday, February 19, 2008

The Spanish Banks' Growing War Chest

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.


Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.



During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?


Update

Geert asked me a question in comments, possibly reflecting some of the difficulties people may be having with this post.


"I must confess that I don't really fully understand this post."


Since I have tried to answer at length, I though it might be useful if I reproduced my explanation above the fold.

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think,though, that to get the background here you need to go through the posts on my Spanish blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

9 comments:

Anonymous said...

Hi Edward
I must confess that I don't really fully understand this post.
Aren't the banks simply speculating on the mortgage market? Banco Santander, Buffet and others, each with an own strategy (prior to 2002, municipal bonds, ...), smell money in a stressed market that is always accompanied by opportunities.
I wouldn't surprise me if they used CB money to speculate , though I've not seen the effect on the prices of ABO's.
An example I follow: http://www.belegger.nl/ASSBACK_B_____0!proc!11.koersen
If they buy securitized mortgages or don't sell theirs, and it's financed by the ECB, then they must expand liquidity in the market. No?

I'm suspicious about another action in the market too, but I'll put that in a different comment

geert

Anonymous said...

Recently Moody's published a report on Iceland
http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=5648
At the bottom of page 3 you can read that deposits held abroad are a contingent liability of the sovereign in cases of extreme stress (although the foreign banks need to meet the local regulations).

The last paragraph goes: "The first line of defense to the banks from a run on overseas branch deposits would come from liquid assets of
EUR 3.2 billion available to the Icelandic bank parent companies and branches. The banks then have alternative sources of funds available to them such as liquidity portfolios and back-up lines, amounting in aggregate to about EUR 17 billion (including those arranged by their subsidiaries), which could be tapped as the next line of defense. Assuming conservatively that EUR 4-6 billion of this could be mobilized by the parent banks for the overseas branches, the likely gap to be plugged by the sovereign falls, in a truly extreme stress
scenario, in the range of EUR 7-9 billion."

Is it a coincidence or not, but hte biggest Icelandic bank Kaupthing, promotes saving accounts agressively abroad?
http://www.kaupthing.com/
Its Kaupthing Edge account gives a very high 5 % in Belgium (6,86 % in the UK but I cannot compare)
Is this strategy only based on gaining market share or does it fit in a broader strategy of liquidity and profits?

Just guessing
geert

Edward Hugh said...

Hi there Geert,

"I must confess that I don't really fully understand this post."

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think,though, that to get the background here you need to go through the posts on my Spanish blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

Edward Hugh said...

"Recently Moody's published a report on Iceland
http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=5648"

Well I may be sticking my nexk out here, when I shouldn't be. But Iceland's medium term outlook seems much more positive to me than Spain's does, providing the price of aluminium stays above a certain level.

They have been investing in their future. In Spain people have been using an artificial inflation of house prices to consume more than they have been earning (the imported petrol, for all those houses with air conditioning and central heating). This inflation in house prices was made possible by a "financial innovation" (the cedulas) which now trun out not to be an interesting innovation at all, at least in the way they were done. Had the percentages on everything connected with the cedulas been much lower then the problem would probably have been handleable. But the cedulas were backed up to 90% with properties, and many of these properties had very high loan to valuation ratios (read circa) 100%, and the whole mortgage business became loaded towards recent mortgages given the strength of the boom, and the refi business. Which means there is not enough margin in the system to absorb a significant correction in prices, which means, watch out!

Iceland's problem is another one, and probably has more to do with confidence and the term structure of the debt. I mean basically Iceland has to have enoughb resources to stop a run on the kronur (like Turkey on the lira, or New Zealand on the kiwi dollar). Spain doesn't need to worry about a run on the euro, but it does need to worry about avoiding queues of depositors at the doors of the regional cajas should any of them start to go bust.

Edward Hugh said...

Some clarification perhaps. How might this work as it evolves?

Well I don't really go along with the Nouriel Roubini way of seeing things, and I certainly don't think the kind of picture he is painting is a likely scenario for the United States, but the FT did have an interview with him earlier in the week, and the some of the steps he outlines to full blown crisis could be very applicable to Spain, so I am reproducing an extract below. In particualr step 12:

"Step 12 would be "a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices"."

This is basically what happened in Japan in the 1990s, and Japan is the nearest role model I can find for what may now be about to happen in Spain.


*******************************

Prof Roubini is even fonder of lists than I am. Here are his 12 - yes, 12 - steps to financial disaster.

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had "reckless or toxic features", argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks' ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The "credit crunch" would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a "fat tail" of companies has low profitability and heavy debt. Such defaults would spread losses in "credit default swaps", which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the "shadow financial system". Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be "a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices".

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: "Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe." This, he suggests, is the "nightmare scenario" keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Edward Hugh said...

Incidentally the piece from Roubini I just cited comes from a much longer article by Martin Woolfe. I don't agree at all with the sentiment that Woolfe is expressing here, and indeed it raised something more than an eyebrow on my part. Basically, this I think shows what a mess you can get into if you don't take the demographic component in economic growth seriously. I think the US, like France, is standing on pretty solid ground here, so whatever short to medium term problems we may see in the financial sector, I wouldn't be expecting anything anywhere near "meltdown". My guess is they will handle the problem, but will need rather longer than usual to get back up to some sort of reasonable (2%) level of growth on a sustained basis.

Anonymous said...

Thank you for the extensive response, Edward.

I start to see some trees in the wood, but many doubts keep lingering. Well, we'll only know for sure when we will discuss this with hindsight.
I bet even the financial wizards cannot give us a satisifying answer today.

Thoughts that linger my mind are
- the regional banks have been the aggressive lenders in the market, but it are the big banks that borrow from the ECB, the cajas don't need it right now
- the banks are pooling the mortgages to make them liquid. I need to check the IFRS rules whether mortgages and securitised mortgages are bound to be valued the same way
- both Spain and Iceland have a deficit on the CA. I agree that the fundamentals for Iceland are better (personally I like its energy independence), but small independent currencies can face immense challenges (I compare with Belgium in the beginning of the eighties). And both will be / are struggling for liquidity on the international market.
- Spanish banks seem to have huge reserves 250 % of their deliquent loans)
....
My intuition tells me there's more than the eye can meet.

I certainly agree that as bond investors feel cheated, it'll take some time before the ASB market regains confidence on the international market, and as Spain relied heavily on that market, it's bound to meet liquidity challenges.

It is my practical experience that when someone exaggerated, he usually doesn't sweat it out, but looks for all means to keep the party going (or hide the ugly consequences), and ultimately makes it worse.

thanks again
geert

Detlev said...

Hi Edward. Fascinating article of yours. I've been looking for a way to 'short' the most exposed Spanish mortgage lenders. Any thoughts on that?

Detlev

Edward Hugh said...

Hi Detlev,

"I've been looking for a way to 'short' the most exposed Spanish mortgage lenders. Any thoughts on that?"

Sorry, this is really not my field. But my guess is that the Spanish banks are avoiding going to the wholesale money markets (and hence go to the ECB for money) precisely to try and avoid people doing exactly this. If you are interested in this topic I had another long, and I would say "fascinating" post on this topic on Spain Economy Watch at the end of last week.

Basically I myself am learning by doing here, since I am much more a "macro" than a financial markets and banking person. The thing is, with what is happening now in Spain it is hard to continue to maintain this distinction.