Ireland has this banking advice for Spain: imagine the worst and double it.
Like Ireland, Spain sought a bank bailout after being felled by a real-estate crash. Now, just as the Irish did, the Spanish are awaiting the results of outside stress tests gauging the size of the hole in the banking system.
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"Think of the worst possible scenario on banking losses: then double it," said Eoin Fahy, an economist at Kleinwort Benson Investors in Dublin. "Adopt the most conservative assumptions."
Nine hundred miles northwest of Madrid, Irish analysts wring three lessons from its own banking crisis, among the worst in history. First, quickly present an accurate estimate of the bad loans. Second, force banks to face up to losses, possibly through the creation of a so-called bad bank. Third, share as much of the loss as possible with bank bondholders.
"Spain should face the economic reality, even if they have to value property loans at discounts of 40, 60 or even 80 percent," said Alan Ahearne, former economic adviser to Brian Lenihan, the finance minister who presided over Ireland's response to the near-collapse of its financial system. "If the real losses aren't faced up to, who's that going to fool?"
Spain's government already ordered banks to set aside provisions equivalent to 45 percent on the nation's 307 billion- euro ($387 billion) book of loans linked to real-estate developers, Economy Minister Luis de Guindos said May 11.
By bringing in outside experts to examine the banks, signs are that Spain is drawing some lessons from Ireland's mistakes. After agreeing to a bailout of as much as 100 billion euros for its lenders, the Spanish government is awaiting the results of an audit of the banks by international firms Roland Berger Strategy Consultants and Oliver Wyman Ltd.
The International Monetary Fund, in a report released last week, said that Spain's banks need at least 37 billion euros to weather a contracting economy.
It took Ireland 2 1/2 years after guaranteeing the financial system in 2008 to bring in outside experts to comb through the banks' books.
In October of 2008, Lenihan called the Irish guarantee the cheapest bailout in the world, as the state had injected nothing into its lenders at that point. Two months later, he said the banks may need much as 10 billion euros. Two years later, the central bank ordered lenders to raise a further 29.2 billion euros. In September 2010, they needed a further 12.1 billion euros, as loans were sold to the country's bad bank.
With bank costs escalating, investors shunned Irish sovereign debt and forced the nation into a bailout. As part of the rescue agreement, the central bank hired BlackRock Inc. to assess the capital shortage at the banks. Based on those tests, the banks needed an additional 24 billion euros.
"Spain has learned one key lesson," Fahy at Kleinwort Benson Investors said. "Bring in outside, completely independent people to assess the losses."
Once the losses are quantified, Spain must consider how to deal with those bad loans. For now, Spain is sticking to propping up and restructuring failing lenders, defying some pressure from its aid partners to take more radical action.
Finnish Prime Minister Jyrki Katainen said on June 11 that Spain should split up some lenders, with some loans dispatched to a bad bank, as Ireland did.
On the advice of economist Peter Bacon, Lenihan decided to set up the National Asset Management Agency to purge its banks of about 74 billion euros of toxic real estate assets.
The agency paid about 32 billion euros for the commercial real-estate loans, crystallizing massive losses in the Irish financial system.
While the then-government originally estimated that banks would suffer an average 30 percent discount on the loans, by the time the final loans were transferred in 2010 the discount had risen to 57 percent. The capital holes were then mostly filled by the state.
"Conceptually, it's still the best way of cleaning up the banks," said Bacon in an interview. "I'm not sure about the Spanish banks, but if there is a credibility issue over their ability to manage risky property loans, than it's probably better to remove them from their balance sheets."
In theory, the removal of risky real estate loans freed the Irish banks to restart lending. In reality, that hasn't happened, as banks hoard capital to guard against future losses on their souring mortgage loans and public funding markets remain closed.
NAMA's operations are also drawing criticism. Bacon said this week that the agency may be doomed to losses as the agency sells assets in a falling market. Irish commercial property prices have declined about 65 percent since their peak in 2007, according to Investment Property Databank Ltd.
"I'd advise that Spain tread carefully," said Michael McGrath, finance spokesman with Ireland's Fianna Fail, which was the main ruling party when NAMA was created. "If they set up a NAMA-type company, they may find a black hole that is much worse than they ever imagined, as was the case in Ireland."
Once the losses and capital needs are known, the state needs to figure how to fill the holes. While the European Central Bank has ruled out imposing any losses on senior bank bondholders, the Irish playbook suggests junior bondholders may be at risk. In 2010, Ireland introduced emergency laws allowing the state to secure court orders to change the terms of junior bonds.
In all, subordinated bondholders suffered about 15 billion euros of losses in Ireland, helped by the direct or threatened use of the new laws, due to expire this year.
Spain may be reluctant to impose losses on holders of junior debt. Bankia Group is among Spanish lenders that sold 22.4 billion euros of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor.
Because of capital structure rules, these investors should be wiped out before losses are imposed on junior debt holders, a move Spanish Prime Minister Mariano Rajoy's government may shy away from unless he introduces laws to protect them.
Other key differences between Ireland and Spain's banking crisis are emerging, said Philip Lane, head of economics at Trinity College Dublin. Writing on the irisheconomy.ie website, he noted that real estate loans peaked at 77 percent of the Irish economy, compared with 29 percent in Spain. The Spanish bailout is also 9 percent of their economy, compared with 63 billion euros, or 43 percent, in Ireland.
Yet the core issues are the same, according to Irish analysts, who expect Spanish banking woes to push the nation into a full bailout. Spain's 10-year bond yield rose to a euro- era record of 6.998 percent yesterday. Ireland sought a full bailout when yields reached 7.99 percent on Nov. 19, 2010.
"Spain, like Ireland, has over the last few years been pushing through fiscal and financial reforms," said Ray Kinsella, a professor of finance at University College Dublin. "But, like Ireland, it continues to chase a receding horizon in terms of banking stability. The situation continues to move ahead of the Spanish authorities."