Caja Madrid Chairman Rodrigo Rato (center) in March 2011 with the chiefs of the six other savings banks which made up Bankia. Just over a year after it would be nationalized CARLES FRANCESC

Just two years after it was born out of the merger of seven of the country's biggest savings banks, among them Caja Madrid and Bancaja, Banco Financiero y de Ahorros (BFA) was taken over by the Bank of Spain at the end of May after posting a record 3.3-billion-euro loss. The thinking behind BFA was to use it to store the seven lenders' toxic assets, while Bankia would hold the supposedly healthy assets. With 11.5 million customers, 4,000 branches nationwide and a 10-percent share of the market, what could go wrong? Last July, 48 percent of Bankia was floated on the stock exchange at 3.75 euro a share. That price has plummeted to around a euro.

It was the Socialist Party, backed by the Bank of Spain along with the approval of the Popular Party-run regional governments of Valencia and Madrid, as well as that of the respective boards of the cajas in question, who decided that merging savings banks left crippled by years of property market speculation was better than letting them sink under the weight of their toxic assets.

Now, following the de facto nationalization of Bankia, the Attorney General's Office has begun an investigation into whether its management, headed by former economy minister and managing director of the IMF Rodrigo Rato, hid the truth about the parlous state of its situation. The government says that BFA and Bankia will need at least 19 billion euros to stay afloat.

In 2007, Caja Madrid reported a net profit of 2.9 billion euros, and Bancaja, 491 million. So what went wrong?

For a start, the economic crisis that erupted at the end of 2007 has put more than three million Spaniards out of work, setting off a chain reaction of insolvency that has hit the banks hard. Those with the biggest number of mortgages on their books, among them Caja Madrid, have suffered most. Then, when the property market collapsed, it soon became clear that the banks had overextended their loans and investments.

Merging savings banks with the same liquidity problems due to their unwise investments in the property market can now be seen as a less than wise approach. And then there are the accumulated errors made by the directors of savings banks as the crisis bit deeper.

EL PAÍS has talked to board members (past and present) of Bankia, BFA and Caja Madrid, as well as asking the opinion of politicians involved in setting up the new bank. It has also sounded out academics and financial experts on the decisions taken over the last five years by the government in merging the country's savings banks.

1. THE CURRENT SITUATION

Bankia is the sum total of the healthy assets of seven savings banks. The new entity has around one in every 10 euros of Spain's 190 billion euros' worth of loans, along with a tenth of the 139 billion euros kept in savings accounts. Mortgages make up around 45 percent of its portfolio, of which around 5.7 percent are not being repaid at the moment. Loans to property developers added up to 33 billion euros in 2011, of which 16 percent are not being repaid; a sum that is five times higher than mortgage defaults.

Bankia's size means that its problems are now a national problem. Its creation at the end of 2010 by bringing together the country's biggest and oldest savings banks was meant to make it unsinkable: comparisons with the Titanic are odious, but inevitable.

2. FORCED RESTRUCTURING

In 2009, the Socialist government of José Luis Rodríguez Zapatero decided to restructure the banking system, encouraging the almost-bankrupt cajas to merge by offering huge amounts of taxpayers' money. Caja Madrid's chairman, Miguel Blesa, who had been in the post since 1996 after being pushed forward by former Prime Minister José María Aznar, wanted to merge with the Caja de Ahorros del Mediterráneo (CAM) and one of Galicia's savings banks. "We were told at informal meetings that Francisco Camps and Alberto Núñez Feijoo

[the respective regional premiers of Valencia and Galicia] were opposed to the idea. Blesa knew that the CAM was in a bad way, but it was small, and he thought it had potential in the long term," says one board member. "Even then," says another, "Blesa knew that Bancaja was the wrong choice to merge with because it was a bottomless pit." By the end of 2009, no partners had yet been found for Caja Madrid. A year lost in finding it a way to survive the long march to come of the economic crisis. But worse was yet to come.

3. THE POWER STRUGGLE

The cajas were originally set up to provide loans to people suffering in the aftermath of the Peninsular War with Napoleonic France in the early 19th century. Often founded by the Catholic Church, they aimed to give farmers loans at reasonable interest rates during times of poor harvest. However, having a savings bank in fiercely regional Spain became a sign of autonomy. Many got hijacked by local governments who put politicians on their boards and hived off funds to pay for grandiose construction projects.

Toward the end of 2009, Esperanza Aguirre, the head of the Madrid regional government, launched a concerted effort to take control of Caja Madrid. Her first objective was to remove Blesa, arguing that he had been in the post longer than the rules allowed. She wanted to replace him with her right-hand man, Ignacio González, despite the fact that he had no experience of running a bank and that the PP and the Socialists had both agreed that the longstanding practice of the parties naming the directors of savings banks so that they could control them had to end. Even now, after all that has happened, there are a great many wives of politicians from all parties with absolutely no business experience occupying seats on the boards of companies owned by Caja Madrid. Rodrigo Rato gave a seat on the board of Bankia to Carmen Cavero, Ignacio González's sister-in-law and his wife's co-partner in a Madrid art gallery.

But Aguirre set off a power struggle in her own party, and would soon come up against her archrival, Alberto Ruiz-Gallardón, now justice minister, but then still the mayor of Madrid, and who was determined to protect Blesa at all costs. The infighting soon span out of control, spawning tons of headlines and prompting PP leader Mariano Rajoy to intervene. To Aguirre's annoyance and Ruiz-Gallardón's satisfaction, he appointed Rato to the top post in Bankia.

4. A POISONED CHALICE

In January 2010, still with no suitor in the offing for Caja Madrid, Rato took up his post and set about peacemaking on the board in a bid to guarantee a stable mandate. He also steeled himself for the coming rollercoaster ride at the head of a bank that had been driven almost to the point of collapse.

"Blesa had rebuilt Caja Madrid, making it into the fourth-biggest financial entity in Spain. In 2006, it was making a profit of one billion euros a year. In 2007, it reported record profits of 2.9 billion after selling 10 percent of its stake in Endesa for twice the price it had paid. Suddenly, the financial situation was very good, and the bank let its guard down," says a former board member.

"Why did we lend so much money to property developers and grant so many mortgages to families to buy houses?" asks another who lived through the golden years. "Because we were simply following what the productive model had been in Spain up until that time, a model based on the construction sector," he answers. "We were in the vanguard of that model. We lent more money and we undertook more projects than anybody else," adds another insider. Between 2004 and 2006 there were more than 600,000 housing starts. In 2010, the figure had fallen to less than 100,000.

Spain's politicians insist that they are not to blame for the property bubble that brought Caja Madrid down when it popped, pointing out that every major loan was approved by the bank's board, who would receive a report on each proposal put together by the caja's financial committee. The reports would explain each proposal, the guarantees involved, a profile of the client and an evaluation of the viability of the project. According to one of the politicians who sat on the boards, they never questioned the committee's evaluation. This was how Caja Madrid came to lend one billion euros to the soon-to-be-bankrupt Martinsa-Fadesa to buy land throughout Spain, and how it joined in a syndicate to lend four billion euros to Metrovacesa for a doomed office building construction, and that saw Caja Madrid end up with nine percent of the company. The bank also funded ambitious infrastructure projects carried out by the Madrid government that have so far been underused and thus unprofitable.

5. THE MERGER

With the help of the Bank of Spain, Rato looked for allies to help face Bankia's uncertain future. "We were all expecting a merger with five small cajas

[Caja Insular de Ahorros de Canarias, Caja de Ávila, Caixa Laietana, Caja Segovia y Caja Rioja]," recalls a Caja Madrid board member. "Then one day Rato turned up to tell us that the Bank of Spain was prepared to allow a merger with Bancaja. It was something of a surprise," he adds. But nobody on the board raised any objections.

"The merger of Caja Madrid and Bancaja was a shotgun wedding." That was how Esperanza Aguirre described the operation, speaking on May 17, as the full extent of the BFA-Bankia crisis became apparent. Two years earlier, when the merger took place, with the blessing of her regional government, Aguirre's tone was somewhat different: "This is good news for the entire Spanish financial system, but especially for the region of Madrid, given that this new caja will be the biggest financial entity in Spain. This is good news, and something that Spain needs right now, and something that the people of Madrid need."

The day the board of Caja Madrid approved the merger, in late July 2010, at least two directors asked for detailed breakdowns of the state of the individual savings banks involved. "We were given global data, and Rato said that he could not give us information on what was going on within each of the cajas that we were to merge with."

The global data was supposedly underwritten by auditors Deloitte and backed by the Bank of Spain, the FROB bank restructuring fund, and the Economy Ministry. "We weren't really the driving force behind the merger," says a member of the government at the time. "It was Rajoy who wanted to create a bank that the PP could control."

A Socialist Party board member has a different version of events, saying that Virgilio Zapatero, a former minister and deputy president of Caja Madrid, defended the merger tooth and nail because the governor of the Bank of Spain and the government itself wanted it to go ahead. It was no shotgun wedding, but neither were all the parties involved fully aware of the issues and risks involved. Nevertheless, the board passed the merger unanimously.

Five months later, at the customary planning meeting, held in Toledo's Parador hotel, Rato and Caja Madrid's management revealed some of the problems that Bancaja faced.

"We saw that it was half the size of Caja Madrid, but had twice as much bad debt. Rato listed some of the property companies that Bancaja had a stake in, and he even went so far as to say that we might have to bring somebody in from the construction industry to manage the property portfolio," recalls one of those present. But even the best salespeople in the real estate business were unable to find anything of worth in the vast array of land purchases and construction projects that the assorted cajas had invested in.

A senior member of Bankia's board explains the situation at the time: "When we asked for details of the best land in Valencia so that we could either sell it or develop it, we were told about land on the beach front; when we went to look at the land we found that in reality it was 500 meters away from the beach, behind the A7 highway. In another case we found that a caja had invested in a gated community of 1,000 houses in a village of 800 people. When we learned about the true state of Bancaja at the Toledo meeting, we began to worry that these other savings banks were going to contaminate Caja Madrid. Bancaja had some good industrial investments, such as its stake in Iberdrola, but we soon realized that this in no way counterbalanced its overexposure to the property sector."

Despite the bad news, Rato continued to push ahead blindly, putting together teams and paying them handsomely for their efforts. Some non-executive directors who had sat on the board during the Blesa period say that their earnings rose fourfold during the Rato mandate. "They were paid between 80,000 and 120,000 euros a year under Blesa. But Rato, who himself was earning 2.4 million, appointed some board members at pay scales of up to 500,000 euros. Nobody ever brought up the subject of recompense at the meetings, or suggested that our remuneration be cut." These were unprecedentedly high rates of pay in return for unprecedentedly poor results.

6. THE BAILOUT

While Rodrigo Rato was putting together a viability plan with the Bank of Spain in May that would require some 6.3 billion euros - his last-ditch defense against collapse - the government stepped in to nationalize BFA, and removed him from his post in the process. He was replaced by José Ignacio Gorigolzarri, whose first task was to oversee the publication of the bank's true results: a loss of 3.3 billion euros, as opposed to the 300-million-euro profits that had been reported, while at the same time revealing a need for a 23-billion-euro injection. When the new reality was made public, board members reacted angrily to the public's hostility, some feeling the need to say: "We're not crooks."

7. WHERE NOW?

Bankia, along with at least six other former savings banks, already patched up with state aid, will be first in line to tap the European rescue funds agreed over the weekend. But the IMF said in a report on Friday that six other old cajas, accounting for around 22 percent of the financial system, face similar challenges to Bankia due to their high real estate exposure. The other banks likely to be asking for cash are Catalunya Caixa; Unnim - now part of BBVA; España-Duero - merged with Unicaja; NovaCaixaGalicia; Banco Mare Nostrum; and Banca Civica - which belongs to CaixaBank. Spain now has around 10 savings banks, less than a quarter of their number two years ago after the government forced a programme of consolidation.

NovaCaixaGalicia and CatalunyaCaixa were created by combining savings banks in two regions - Galicia and Catalonia - partly to placate local politicians. The state took them over last year when it became clear they could not handle their losses. These two lenders require around nine billion euros to cover the latest government demands for capital to cushion against real estate loan defaults, the Bank of Spain told a closed-door parliamentary committee hearing, according to a political source present at the briefing.

Small listed lender Banco de Valencia is another potential black spot. It was also taken over by the government with the intention of auctioning it off with guarantees against future losses. Valencia is also home to CAM, which was called the "worst of the worst" by a former central bank governor after losses began to soar when exposure to real estate at the bank was properly recognized.

CAM, Bancaja and Banco de Valencia lent unsustainably to property developers, often connected to the political elite, who threw up block after block of holiday apartments along Spain's Mediterranean coast. Ultimately, it was the brashest side of the building boom which brought about disaster.