Investment bank Mediobanca warns of “clear risk of contagion.”

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

“The Cover of La la Land with a Potential Horror Story” is the title of a report about Spanish banks, authored by analysts at Italian investment bank Mediobanca. The shares of many Spanish banks have surged in recent months, some as much as 50%, hence La La Land. “Banco Popular [the teetering bank we’ve written so much about] seems to be the only exception to a truly happy world, but the current situation could take a nosedive with clear risk of contagion for the rest of the sector.”

Spain’s sixth biggest bank, Banco Popular, remains on the verge of either collapsing or being gobbled up by a bigger bank before it collapses. The bank lost over 60% of its market cap last year and it’s already 30% down so far this year. Popular has become a favorite target of short-selling hedge funds. Moody’s has just downgraded its senior debt two notches to B1 (junk), with negative outlook due to the bank’s “weak solvency levels” and worsening capital position.

For Popular to remain a going concern beyond 2017, it must pull off another capital expansion, this time of around €4 billion. That’s a big ask for a bank with a market cap of just €2.9 billion, and that has already burnt through the lion’s share of the €5.4 billion it raised in its three previous rights issues. Popular’s long-term investors are smarting. Some are even threatening to sue Popular for intentionally misleading them in last year’s rights sale.

It’s not just investors who are unhappy. So, too, are the bank’s depositors, many of whom are voting with their feet by moving their money elsewhere. Last year the bank lost 6.5% of its deposit base. According to a report by the financial daily El Confidencial, the deposit outflow is swelling from a trickle into a deluge.

The bank is responding by doing the only thing it can: make its deposits more attractive than everyone else’s. A fix that’s virtually guaranteed to backfire. Popular’s deposit rates now range between 0.75% and 4%. It may be enough to hold on to just enough of its deposit base for a little while longer, but with the eurobor sticking steadfastly to 0%, offering such enticing rates will obliterate Popular’s wafer-thin margins.

The more the situation at Popular worsens, the more likely it is to affect other banks in the sector. As Mediobanca points out, “23% of Spain’s banks are lining up for an IPO or rights issue.” If a bank the size of Popular begins to collapse in a disorderly fashion, it’s likely to drag down valuations for potential newcomers such as Unicaja. Some might even postpone their public launch indefinitely.

Erdogan’s Big Squeeze

Small banks are not the only ones with big problems. Spain’s second largest bank, BBVA, racked up gross operating losses of €608 million in the domestic market last year. This is the same bank whose chairman, Francisco González, warned last year that the ECB’s negative interest rate policy is “killing us.”

The bank has carved out a sizable presence in more lucrative albeit high-risk markets, such as Turkey, where it owns a majority stake in one of the country’s largest banks, Garanti. In 2016 BBVA’s Turkish operations produced gross operating profits of €1.76 billion — just over a quarter of the group’s total global profits of €6.39 billion.

Such fortunes may not last. The Turkish Lira is among the most volatile currencies this year and margins are getting squeezed across Turkey’s mortgage market. In August last year, President Recep Tayyip Erdogan called on private banks to slash their rates. The banks, including Garanti, obliged. Since then, their borrowing costs have risen sharply, a move they’re not passing on to home buyers.

Some banks are even taking direct losses on their real estate lending. It’s a problem that’s likely to get worse, not better, as Erdogan strengthens his hold over Turskish institutions.

Betting the Bank on Emerging Markets

It’s not just Turkey that BBVA needs to worry about. The bank’s most profitable national market, by a long shot, is Mexico, which last year contributed €2.67 billion (just under 45%) to the group’s global profits. Like Turkey, Mexico is a fertile land of opportunity for those who can stomach the risks. But things could turn sour at any moment, especially with public debt spiraling out of control and relations with its biggest trading partner, the U.S., balanced on a knife edge.

According to a new report by JP Morgan Chase, if Trump pushes on with plans to impose a border adjustment tax of 20% on imports coming into the US, it could end up shaving as much as 2.7% off Mexico’s annual GDP.

Mexico and Turkey accounted for over two-thirds of BBVA’s global operating profits in 2016. Emerging markets as a whole (with Peru, Colombia, Chile, and Argentina also at the fore) represented just over 90% of the group’s pretax profits last year. That’s a hell of lot of risk exposure for one bank to have, especially given recent warnings about the scale of emerging market debt.

Spain’s biggest bank, Santander, is officially too big to fail, and it’s embarking on the mother of all debt binges. In the coming months, it faces headaches in two of its biggest markets: the potential complications posed by Brexit to its UK operations, and the exposure of its subsidiary, Santander Consumer USA, to the now deflating US subprime auto bubble, though neither headache is big enough to topple the bank.

Investors remain remarkably sanguine about the risks posed both to and by Spain’s banking sector, presumably on the assumptions that Spanish banks were already bailed out and cleaned up once and, if that wasn’t enough, that the ECB has their back. By Don Quijones.

From the Doom Loop to the Black Hole. Read… Three More Reasons to Worry about the Euro’s Future

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