Tuesday, May 20, 2014

Spanish Banks; A Reality Check

Santiago López Díaz, CFA Exane BNP Paribas, European Equity Research

Bank of Spain published yesterday a EUR2.5bn decline in NPLs during the month of March to EUR193bn (-1.3% m/m). This is the first time since 2006 in which NPLs decline during two consecutive months. It seems we have already reached (or we are even past) the proverbial NPL peak. It is important to keep in mind, however, that banks usually wait until the last quarter of the year to book the “recurrent extraordinary” portfolio clean up….which happens consistently every year and has nothing extraordinary about it.

Reported NPL numbers need to be analysed in the context of the assets transferred to Sareb and in the context of the EUR211bn of restructured loans existing in the system (15% of total loans). In our view, the reported BoS NPL figure lacks: 1) NPLs transferred to Sareb (EUR38bn, according to our estimates); 2) foreclosed assets both in Sareb and in the private sector, which by definition are NPLs reclassified as other assets (EUR90bn, according to our figures); and 3) part of the restructured loan book still considered to be performing (an additional EUR51bn, according to our estimates).

When we add these figures to the BoS NPL figure, we reach a total adjusted stock of NPAs of EUR372bn (almost twice the reported figure) and an adjusted NPA ratio approaching 22%, which highlights the order of magnitude of the credit mismanagement during the crisis.

The most interesting data, however, was released last week in BoS’ Financial Stability Report. Total restructured loans in Spain increased by almost EUR30bn during the last quarter of the year (+16% q/q increase!). Banks are not just transferring assets from one category to the other but continue to aggressively restructure operations. We don’t have Q1 14 data at the nationwide level but we suspect (and we have the data for certain banks) that restructured loans continue to rise.

Last year BoS introduced new rules forcing the banks to reassess their restructured loans which led to a significant increase in NPLs (and provisions) by year end 2014. The new rules forced banks to consider a restructured loan as a NPL if the loan had been restructured more than once or if the restructuring conditions allowed the debtor not to pay interest and principal for more than 30 months. Both requirements were followed by a “except if the bank considers the debtor can pay” comment.

We think the rules allow banks a significant degree of discretion. In fact, the larger the company the more likely it is to be considered viable in the long term (because not doing so would imply heavy losses for the lenders). We know several companies which have been restructured more than once which we suspect are not considered to be NPLs.

Were companies still considered to be performing even if they were not supposed to pay interest or principal for more than two years? What restructuring conditions are we talking about here? 1% interest for 30 years? There is, in our opinion, a big conflict of interest because the banks are the ones assessing their own potentially problematic loans (and the track record in terms of credit quality is not really something to brag about).

The new Royal Decree allowing banks to exchange debt for equity in troubled companies (mainly SMEs) which “could be viable if not for an excessive debt burden” makes the Spanish Chapter 11 procedures more flexible from a legal point of view and it is a welcome development. Beyond the more flexible legal procedures this is quite tricky. To begin with, who decides whether a company is viable or not? We guess it is the banks. There is a clear incentive for them to label anybody as viable.

More interestingly, if the remaining debt is exchanged for equity, banks could be able to free provisions allocated to the debtor because they will no longer be lenders but equity holders (not to mention that NPLs will decline).

Good, if companies might be labelled as viable “except for an excessive debt burden” we are happy to announce that Real Madrid won its 33rd La Liga Championship during the weekend…”except for Atlético...and Barca”.

Maybe “this time is different” (although these words are the four most dangerous in investing). As Warren Buffett usually says; “if past history was all there was to the game, the richest people would be librarians”. Having said that, if past history is any indication of what we can expect in the future we would be cautious about what the companies label as viable (especially considering that, in our view, a widespread inefficient credit culture is the main reason behind the Spanish banking crisis).

Let us use a recent analogy used by Seth Klarman. It seems we are under the Truman Show Restructured Loan Dome. Everything looks fine under the artificially manufactured Sun… but it is an illusion (understanding we are already close to or even past the NPL cycle peak).

According to our estimates NPLs among the listed banks we cover declined by 1.9% q/q at the end of March 2014 (-EUR3.5bn) but the decline was just 0.6% once we include foreclosed assets in the picture. In the case of BBVA, CABK and BKIA (the companies who provided Q1 14 data) once we include performing restructured loans the total stock of NPAs has barely moved during the quarter.

Going forward the cost of risk should go down quite materially considering that; a) provisions seem to be adequate (albeit not excessive) in some areas, b) we are close (or even past) the NPL peak, c) some companies are partly front-loading future credit costs (although we do not expect material write backs) and d) provisions should be much lower than normal in the early stages of a new economic cycle. We struggle to understand, however, how the cost of risk is going to be close to (or even better than) the all-time low when most of the (theoretical) growth will be focused on SMEs. More importantly we do not consider the all-time low is a “normalised” level. All-time low = “normal level” is an oxymoron.

The key driver of future results will be (beyond the decline in the cost of risk) revenue generation. NII should benefit from the increase in retail deposit spreads and from the reduction in wholesale funding costs thanks to the recent debt issuances. That said, total revenues will also be negatively affected by the gradual reduction in unusually high trading gains. In SAB’s case, for example, trading gains in Q1 14 represented 57% of total revenues and were almost twice as high as NII.

From a regulatory point of view all these bonds (rated BBB- when they were acquired by the institutions) carry zero risk weighting. Yet we believe that anybody thinking these bonds carry zero risk from an economic perspective is fooling themselves. Note that during August 2013 the amount of sovereign paper on the banks’ books was equivalent, on our estimates, to 2.3x the tangible equity of the institutions we cover, leaving the companies quite vulnerable to a sovereign shock.

In an oligopolistic banking market with no loan growth, banking theory dictates that banks raise prices but clients might not be that willing (or able) to accept much higher prices with a sustained unemployment rate above 25% and a low savings rate. Spreads of new loans are in fact, according to our calculations based on bank of Spain data, falling already. CABK’s CEO recently mentioned during a press conference that “There is a price war going on although some companies might acknowledge it and some others might not". Like Yogi Berra used to say “In theory there is no difference between theory and practice. But in practice, there is”.

All factors considered we would have expected to see an improvement of the earnings outlook for the companies we cover but that has not been the case. 2014 and 2015 adjusted EPS have been in fact downgraded (Bloomberg consensus) by an average of 6% and 1% respectively since the beginning of the year with double-digit cuts in companies like BBVA or POP. Over the last month, according to our estimates based on Bloomberg data, all the companies we cover but BKIA (from a very low base) have seen their 2014e estimates cut and five out of seven institutions have seen their 2015e estimates cut too. Multiple expansion (and unlimited free money) seems to be the driving force behind the share price performance. With the stocks trading, on our estimates, at 14.0x 2015e P/E we maintain our Underperform rating across the board.

In situations like this the oldest trick in the book to justify higher share prices is to lower the cost of capital. Money is free and the Treasury is issuing debt at the lowest cost in history after all! Fair point.

Old fashioned as we are we continue to use a double-digit cost of risk for Spain (around 10%). We understand that the Spanish Treasury is issuing debt at the lowest cost in history. We also understand that; 1) the Spanish debt / GDP is at the highest level in history, 2) the different Spanish governments have systematically run large deficits (something unlikely to change, in our opinion, considering national elections in 2015) and 3) the black economy could be as high as 30% of the total.

We are reluctant to materially reduce our cost of capital in a country in which a third of the economy does not pay taxes (not to mention corruption). Regarding the banking industry if we talk about a “normalised” environment we guess we should also use a “normalised” cost of equity (not the theoretical one we would get using the current ultra-low interest rates).

Ah, yup, we forgot one small detail. Under no circumstance are we going to materially reduce the cost of capital in a bank in which the arbitrage and trading of BBB rated securities represents one of the main (if not the main) business activities.