Running out of time to deal with Spain’s banks’ losses

AS THE one-time American defence secretary Donald Rumsfeld once so famously observed, it is not enough to say that we don’t know everything. In fact, we can break down the things we don’t know into categories. Some things we know we don’t know: known unknowns. Others, we don’t know we don’t know: unknown unknowns.

From the perspective of financial markets, the ones that matter are the first ones. Things the markets don’t know they don’t know about tend not to have much effect. But things they know they don’t know about they hate.

High on the list at the moment is the solvency of Spanish banks. EU finance ministers began meetings last night to negotiate the details about how to use (and whether to extend) the €750bn bailout facility. As they prepare to bail out, how should contract for difference (CFD) traders prepare to cash in?

Unlike some smaller countries in the European periphery, Spain on paper looks relatively well placed. Decisive action earlier in the year by the Socialist government helped to cut the deficit from 11.1 per cent of GDP in 2009 to an expected 9.3 per cent for 2010.

Last week, the Spanish Prime Minister Jose Luis Rodriguez Zapatero reaffirmed that the deficit would fall to 6 per cent of GDP next year and keep falling. A bond auction last Thursday was considered a success as €3.5bn of new debt was issued at an interest rate of 4.55 per cent. As a result, the Ibex 35 index, which tracks the share price of the top 35 most liquid Spanish stocks, leapt up by close to 10 per cent.

But while investors in bonds were relatively comfortable putting money into Spain, CFD traders would seem wise to be a little less optimistic. The sword of Damocles hanging over the Spanish economy is undisclosed banking sector losses. Since 2008, the Spanish housing market has lost 20.3 per cent of its value; according to Nomura, prices will continue to fall until 2013.

So far, after guaranteeing banking losses in 2008, the Spanish government has only injected Spanish “cajas” – unlisted savings banks – with €15bn of new capital. Given the extent of the possible losses, as much as another €100bn could be needed, around 8 per cent of Spain’s GDP. As Michael Hewson, a market analyst at CMC Markets, put it: “No one knows how much exposure the banks have, because there’s no disclosure”. He argues that without transparency, markets will always fear the worst, and so confidence in Spain will drop away.

HIGHER FINANCING REQUIREMENTS
Just as banking losses extended Ireland’s deficit to 32 per cent of GDP, the fear is that they will impose much higher financing requirements on Spain – already due to expand enormously in March as old debt reaches maturity.

If Portugal is forced into accepting a bailout, then Spain will be seen as the next obvious victim. According to RBS, the current fund falls short by €124bn of the amount Spain would need in the case of a bailout, while the European Central Bank is unlikely to take up the slack by buying many more distressed bonds. Consequently, it seems likely that fear about the Spanish banking sector will continue.

RBS believes that Santander could lose about 4 per cent of its value, Banco Popular 13 per cent and Bankinter – Spain’s sixth largest listed bank – around 18 per cent. That in turn is likely to drive down the Ibex 35 as investors flee to safer havens. Traders would seem well advised to go short then, and reap the profits of uncertainty.

But they should also watch out. Another researcher, AlphaValue, estimates that the Spanish banking sector is already under priced significantly. Its analysts believe that Santander’s share price could increase by 59.2 per cent. If policymakers discover a “silver bullet” for Europe’s debt problems, valuations could well rocket.

That doesn’t look very likely at the monent – in fact, at this moment of relative calm, it would seem things can only get worse. One way or another, known unknowns are becoming known knowns.

POSSIBLE OUTCOMES

NO MORE BAILOUTS
If Portugal presents a credible deficit reduction plan, and the markets accept it over the next year, then it may avoid a bailout entirely. An EU wide solution such as e-bonds or massive European Central Bank buying might also prevent a bailout.

SPAIN AVOIDS BAILOUT
If Portugal is successfully bailed out, market turbulence would turn to Spain next – and its banks. If Spain then offers a credible plan to recapitalise banks and to cut long run borrowing, a bailout may be avoided.

SPAIN BAILED OUT, CRISIS STOPPED
If Spain is bailed out, attention may then turn to Belgium, Austria and other vulnerable nations. If that is stopped with a credible (undoubtedly German led) plan, then crisis may be averted, but years of austerity assured.

SPAIN BAILED OUT, CRISIS ONGOING
If Spain is bailed out and contagion spreads to Italy or France, or if a bailout or other solution is not agreed, then a disorderly exit from the euro, default and economic collapse may follow. This remains unlikely.