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Who’s afraid of the big bad bank?

18 November 2011 By Fiona Maharg-Bravo

Spain is suffering from a real estate hangover. One of the biggest problems facing Spanish banks is what to do with the real estate loans and foreclosed properties left over from the construction boom and bust. Now the opposition People’s party, which is expected to decisively win elections on Nov. 20, is said to be mulling the creation of a state-backed bad bank. Such an approach has been tried in Ireland with mixed success. It would be a high-risk strategy for Spain.

Spanish lenders are sitting on 338 billion euros of real estate exposure, half of which is in arrears or foreclosed, according to the Bank of Spain. Setting up a bad bank would free up balance sheets and allow management to focus on making new loans. By exchanging dud loans for government-guaranteed bonds, lenders would also gain extra collateral they could use to borrow from the European Central Bank.

The problem, however, is accurately valuing property loans amid a dearth of transactions, particularly in land. Taking a conservative approach to valuations protects taxpayers, but forces banks to crystallise big losses. This creates a big capital hole that needs to be filled. If valuations are too high, however, taxpayers will be on the hook for future losses.

Moreover, the bad bank would use up Spain’s scarce resources. Assume, for example, that the 176 billion euros of impaired property assets have to be written down by a hefty 60 percent. Subtract existing provisions, and banks would have to absorb 33 billion euros of losses, after tax. The state would be on the hook for some that. And it would still have to spend another 70 billion euros, roughly equivalent to 7 percent of GDP, to buy the toxic loans.

A different approach might be for the state to force banks to recognize big losses on toxic assets up front, but stop short of buying them. True, the government would still have to wholly or partly nationalise some lenders. However, it could then carve out the bad assets on a case by case basis, and return the cleaned-up banks to the private sector. That may not be as neat a solution as the clean sweep the bad bank would provide. But it would minimise the risk for the beleaguered Spanish taxpayer.


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