Four Things that Keep Spain’s Senior Bankers Awake at Night.

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

Despite reporting reasonably solid-looking annual results last year, Spain’s banking sector continues to bleed on the benchmark index, the Ibex 35. In the last 12 months alone, it has lost over a fifth of its combined share value — €40 billion of stock value that just vanished into the ether!

In recent days the shares of Spain’s biggest bank and only “systemically important financial institution” (i.e. officially ordained Too-Big-to-Fail bank), Grupo Santander, have plumbed lows that have not been seen since the mid-nineties.

A not inconsiderable part of this ugly picture is owed to deteriorating global macroeconomic conditions, in particular the slowdown of China and key markets in Latin America as well as Italy’s recent bail-in/out of its financial sector [read: Who Gets to Pay for the Italian Banking Crisis?]. However, there are a number of key aggravating factors that are almost exclusively domestic in scope and which could pose a very serious threat to the long-term health of Spain’s already much debilitated banking sector.

Here are four of the biggest worries weighing on investors’ minds.

1) The Banks’ Exposure to Colossal Corporate Insolvency.

Ever since the renewable energy giant Abengoa announced, in late November, that it was seeking preliminary protection from creditors, fears have grown about the potential ripple effects of what could end up being Spain’s biggest ever corporate bankruptcy. Since then the company has closed its subsidiaries and stopped servicing its debt in key markets like Mexico, Chile and Brazil while in the U.S. creditors have asked a federal judge to put Abengoa Bioenergy of Nebraska LLC into bankruptcy over its outstanding debt.

Spain’s banks are owed approximately €4.3 billion by the Seville-based company. About 20% of that is unsecured and may get wiped out. Santander is at the top of the pile with €1.56 billion of exposure, followed by publicly owned Bankia (€582 million), Catalonia’s biggest bank, Caixabank (€570 million), Catalonia’s second biggest bank Banco Sabadell (€387 million), Banco Popular (€334 million), Bankinter (€210 million) and the state-owned Institute of Official Credit (ICO, €161 million).

Most of the banks have made no provisions to hedge their exposure – hence their alleged refusal to accept a haircut on any of Abengoa’s debt, which in the end could be unavoidable [read: Spain Braces for Its Biggest Corporate Solvency… Ever!].

2. Bankia’s Duped Shareholders Want Their Money Back.

A couple of years ago, thousands of victims of Spain’s biggest ever financial heist — Bankia’s IPO in 2011, which “allegedly” involved the participation of senior management, the bank’s auditor, Deloitte, Spain’s central bank and market regulators – launched litigation proceedings potentially worth billions of euros.

Last week, Spain’s Supreme Court shocked everyone by ruling that Bankia must refund two retail investors for intentionally misleading them over the state of its finances in the IPO brochure. Now the floodgates are wide open for thousands of fresh new claims. On the bright side (ha!), publicly owned Bankia says it has already provisioned up to €1.84 billion of mostly taxpayer-money to cover potential refunds to retail investors. But with institutional investors — including some of Spain’s other banks — also looking to recoup their funds, the damage might balloon.

3. The Mother of All Pay Outs.

If Bankia’s legal problems bode ill for Spain’s financial sector, imagine what could happen if many of the country’s banks were forced to pay back all the interest they’ve surreptitiously overcharged customers on residential mortgages — for years!

In October last year, Spain’s Supreme Court ruled that the floor clauses introduced by many banks, which set a minimum interest rate that clients have to pay the bank, even if the Euribor drops far below that figure, were abusive. It sentenced three banks — BBVA, Cajamar and Abanca — to return the difference to borrowers, but only on payments made since May 2013, arguing that the banks could not be made liable for all (or even much) of the money, since doing so would potentially cripple their finances.

The European Commission begs to disagree, saying that the refunds should extend all the way back to the first mortgage payments, the rationale being that if a clause is declared void, “it is so from its origin.” There are currently 2.5 million mortgages with floor clauses in Spain. If refunds were to be mandated retroactively, which could happen at any moment in the coming months, it would mean billions of euros in damages.

The toll is already being felt. At the end of last year, Banco Popular announced earnings of €105 million, 68% down from the previous year, after having provisioned €350 million to cover interest payment refunds for over 100,000 customers. Without the so-called floor clause in its mortgages with which to gouge its customers, the bank is expected to earn €80 million less per year, every year from now on – precisely at a time when its bad loan ratio just soared to a record 14.3%!

4. Prelude to a Sovereign Debt Nightmare.

Arguably the biggest threat to the balance sheets of Spain’s banks are plans currently being hatched in Brussels to set a limit on the sovereign bonds some banks can hold as eligible “risk-free” capital.

According to European Central Bank data, euro-area sovereign bonds accounted for just over 10% of banks’ assets in the Eurozone, or €2.73 trillion ($3 trillion), at the end of 2015 — over €300 billion more than at the end of 2014, on the eve of the ECB’s launch of its negative interest rate policy (NIRP). This trend is particularly acute in countries on the periphery, such as Portugal, Spain and Italy, where banks’ balance sheets are overflowing with bonds of their individual sovereigns — all considered “risk free” for regulatory reporting.

But that could all be about to change. Now fiscally hawkish euro-zone countries such as Germany, the Netherlands, and Finland want the system overhauled before forging ahead with closer banking union, to the barely concealed horror of southern European politicians and bankers.

Italian Finance Minister Pier Carlo Padoan has urged caution on introducing the new rules. “Let’s be very careful about translating into practice rules that look nice on paper,” he warned, adding that any such rules could lead to a sell-off and “instability”. Padoan’s sentiments were echoed by Santiago Fernandez de Liz, the chief economist for financial systems and regulation at Spain’s second biggest lender, BBVA, who cautioned that applying a proposal of this kind in the Eurozone would “reignite the fragmentation” of Europe’s financial markets.

The race is now on to get as much peripheral sovereign debt as possible off the balance sheets of peripheral banks and onto the ECB’s already bloated books. In January the central bank “invested” €6.1 billion in Spanish sovereign debt — 18.9% more than the previous month, raising the total amount it has spent on Spanish bonds since launching QE in March last year to €62.9 billion. Given the likely direction of EU policy, as well as the scale and scope of the risks, challenges and threats clouding the investment horizon in Spain, one can expect this trend to intensify. By Don Quijones, Raging Bull-Shit .

The scheme derailed. Read… Hedge Funds, Wall Street not Happy with the New Spain

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