A Growing Loan Knows no Losses

Around this time last year, the Eurogroup decided to give the periphery a hall-pass on fiscal targets for as long as the pandemic lasted. In return, the Eurogroup would make a number of demands on structural reforms. In the case of Spain, these include labour markets, public sector pensions, organization of internal markets, or VAT. Podemos became the largest obstacle to meet these pre-requisites to remain in the euro because of their social programs platform. Both Podemos and the socialists tried to ignore for as long as possible that these demands are the crux of the problem. There are many domestic theories on why Pablo Iglesias left the Government to run a politically suicidal campaign against a very popular candidate in Madrid. Perhaps he had no other options, as Spain’s EU partners may have asked for his head before disbursing the new Generation Funds.

Spain does not meet currently the most important requirements set forth in the Maastricht Treaty. Spain, alone among the Eurozone countries, did not once run a primary fiscal surplus in the recovery phase following the Banking and Sovereign debt crises. Unlike Italy, Spain has a very large debtor net international financial position. To square the circle of financial fragility, banks in Spain are still far from being profitable in spite of underproviding for bad loans as both the Bank of Spain and the Single Supervisor lament. With public sector debt running at twice the level of GDP set as a ceiling by the Treaty, the Sánchez Administration has very little room for manoeuvre.

How can the Eurogroup exact conditionality, you may ask, if the ECB is making sure that refinancing costs remain at the lowest levels in recorded history? Probably because they have made it clear that the Asset Purchase Program will go into taper soon. There are perhaps only two options for the errant countries: default or entering a comprehensive program. However, even if Spain were to apply to a program, in order to retain access to cheap funding, a large parliamentary majority would very likely be a requirement as was the case with Portugal. The current social-communist minority Government in Spain may not have the mandate nor the credibility to be the recipient of such largesse.

The four elections to regional parliaments since the COVID outbreak reveal a very low popularity for the Socialist Party and confirm the near disappearance of Podemos. Even when the socialists tie for a plurality of the votes, as was the case in Catalonia a few weeks ago, they are still shut out of the regional Government. The Socialist-Podemos coalition is probably paying the price for their shocking mishandling of the first wave of the pandemic, its uninformed complacency when it ran its course in May, and importantly for its retreat from leadership. Sánchez left the management of the second, third, and fourth waves as well as the vaccination drive in the hands of the regional governments while his Government was busy negotiating its survival. For many voters there is room for satisfaction in the recent debacle of Ciudadanos and the neutering of Podemos in Madrid, yet beware the baby faced Íñigo Errejón, who is positioning a splinter faction of Podemos as a Green Party option on the back of his success in Madrid. He is as dangerous as his formerly pony-tailed former friend is.

While most eyes are on the negotiations that have led to a new Government coalition of pro-independence parties in Catalonia, the usually pragmatic technocrats in the cabinet have joined the populist agenda. The Finance minister has been forced to react to a public relations fiasco on the part of several domestic banks. It is unclear who informs these decisions at such large organizations, but their tin ear to political developments and to their own status as twice rescued from financial ruin with taxpayers money is nothing short of shocking. In spite of the fluid political backdrop, the management of several of these banks could not wait any longer than the Q1 earnings call to announce large lay-offs.

While large layoffs at a bank should not normally even make the nightly news as Spanish banks employ 31% fewer people today than in 2010, the timing of the announcement could not have been worse. In the case of Caixabank, the mess was compounded by tabling to a shareholder vote the trebling from its current level of the compensation of its new Chairman. To complete the circle, some of these management teams also announced that they were ready and willing to propose dividend distributions as soon as their supervisor allows it.

Back in the world of reality, Mr Andrea Enria, the chair of the ECB’s Supervisory Board, will be in Madrid tomorrow hosting the eleven Spanish banks his department supervises. He will admonish his charges on two important topics: corporate governance and provisions for loan losses. He will describe in no uncertain terms his Board’s preference for the separation of functions between the chair and the CEO. In spite of their open embrace of ESG best practices, some of those in attendance may not like this part of the meeting, as they have yet to digest and internalise the G part of the ESG agenda. We would love to be a fly on the wall when Mr Enria starts the discussion on the need for higher provisions for loan losses. This reality check may shatter the dreams of generous dividend distributions that these management teams have promised their battered shareholders at the behest of bank analysts in the City. This meeting may well be the theatrical staging of the beginning of the European Sovereign and Banking Crisis Part II so we will pay close attention.

In the interim, let us not forget that the ECB has not banned dividends outright; rather they have forcefully suggested they are not a good idea at this point in the cycle. While some of these bank CEOs derive comfort from the fact that the rate of new NPL formation is very low, they should remember that this benign outcome is the result of Government programs and forbearance. The former will run its course eventually; the latter is not a solution for bad loans. The political backdrop in Spain as discussed does not give us much to go on. The outgoing deputy prime minister did everything within his power to undermine investor confidence especially when he singlehandedly started a crusade to undermine the value of billions invested by foreign private equity firms in residential real estate. A pandemic did not seem like the best of times to undermine the value of the collateral for most bank loans in the country. These CEOs’ mindset reminds us of Angelo Mozilo, the former chief executive of Countrywide Financial, who proudly displayed this motto on his office wall “A Growing Loan Knows no Losses”. The rest is history.