Mystery Behind Spanish Banks' Extend-And-Pretend "Bad Debt Miracle" Revealed

One of the mysteries surrounding the insolvent, and already once bailed out Spanish banking sector, has been the question why reported bad loans - sharply rising as they may be - are still as relatively low as they are currently, considering the nation's near highest in the Eurozone unemployment rate, and in comparison to such even more insolvent European nations as Greece, Cyprus and Slovenia.

Courtesy of the just completed bank earnings season, and a WSJ report, we now know why: it turns out that for the past several years, instead of accurately designating non-performing loans, banks would constantly "refinance" bad loans making them appear viable even though banks have known full well there would be zero recoveries on those loans. In fact, as the story below describes, banks would even go so far as making additional loans whose proceeds would be just to pay interest on the existing NPLs - a morbid debt pyramid scheme, which when it collapses, no amount of EFSF, ESM or any other acronym-based bailout, will be able to make the country's irreparably damaged banks appear even remotely viable.

WSJ has more:

It has puzzled Spanish bank analysts for years: Why did the country's mortgage delinquency rate rise so slowly even as unemployment soared above 26%?

 

A big part of the answer—revealed by a spate of bank earnings reports in recent days—is that Spanish lenders had been making their loan books look healthier than they really were by refinancing big numbers of loans to struggling homeowners and businesses.

 

The lower interest rates and easier terms of refinancing helped hundreds of thousands of Spaniards like Juan Carlos Díaz, who stopped making mortgage payments more than a year ago, remain in their homes and keep their businesses afloat longer than otherwise would have been possible. It has also helped banks bury a growing risk in their credit portfolios and avoid recognizing losses on debts they are unlikely to recover.

Yet even with this ridiculous "extend and pretend" gimmick, NPLs just hit a new record high as a % of all loans according to the Bank of Spain.

One dreads to even contemplate just how worse this ratio would be if banks were honest in marking loans anywhere close to realistic recovery prospects. One may however soon find out, because new "more stringent disclosure guidelines from Spanish banking authorities are bringing these risks into the open. Partly as a result, mortgage delinquency is rising fast—a trend that could damp recent investor enthusiasm for a bailed-out banking industry rebounding from a property-market crash."

The Bank of Spain, the country's central bank, began forcing banks in April to re-evaluate and disclose their refinanced loan books out of concern that some lenders had been taking advantage of relatively loose guidelines to mask the deteriorating creditworthiness of their clients. As Spain's economic slump deepened, the Bank of Spain said at the time, "Difficulties considered to be temporary in many cases have become structural."

Which is the story of the New Normal in a nutshell: temporary issues revealed to be structural, and in fact worsened by ongoing, relentless central bank intervention which prevents the liquidation and cleansing of tens of trillions in bad debt from the global system. What is worse is that alongside that revelation, it is also about to be revealed that, surprise, Spain is not even close to recovery. Which will kill the only thing that matters in that insolvent continent: the latest dose of confidence.

It does, however, explain why the ECB shocked 98% of economists with its rate cut - recall that it was the soaring NPLs in Cyprus that led to the wholesale confiscation of uninsured deposits in order to preserve the domestic banking sector.

So back to Spain, and the clash of reality with can kicking:

For years following the real estate crash in 2008, analysts say, lenders applied an "extend-and-pretend" approach by refinancing ailing real-estate developers. Ultimately, banks were forced to recognize those losses, spurring last year's €41 billion European Union bailout of Spain's banking system....  It also raises questions about whether banks have continued to sweep under the rug loan losses lurking on their balance sheets, a concern that has dogged the sector since the start of Spain's economic crisis.

The answer, incidentally, is a resounding yes. Continuing:

Refinancing struggling homeowners "only pushes the problem forward without finding long-lasting solutions because in the end, the debts only grow while the borrower's capacity to repay doesn't improve," said Carlos Baños, chairman of AFES, an association that advises mortgage holders who have trouble paying their debts. "These days it's hard to see things getting better unless you win the lottery."

So how exactly have banks been sweeping reality under the rug for over 5 years? Meet Mr. Diaz:

For Mr. Díaz, a 49-year-old account manager at a company that makes chemical pumps, the extend-and-pretend approach worked for a while. In 2007, he took out a €600,000 mortgage on a suburban Madrid home. At the time, his wife's fast-food restaurant in southeastern Madrid was going gangbusters, selling roasted chicken whole and in sandwiches to construction workers during a big housing bubble.

 

In 2008, the bubble burst, leaving her business with few customers. Her take-home pay dwindled, and paying the mortgage starting eating up most of the household's monthly income.

 

In 2010, Mr. Díaz asked his bank, Caixabank SA, CABK.MC for help. The bank agreed to refinance the mortgage, allowing him to lower his monthly payments by paying only interest during four years. The lender also furnished him with a second mortgage, for €32,000, to pay off credit card and other bills.

 

By 2012, the family's finances were stretched so thin that Mr. Díaz began drawing from savings to keep his wife, two children and himself in their home.

 

In July last year, he stopped paying the mortgages, rebuffing his bank's offer for an additional grace period that would further lower his monthly payments.

 

Mr. Díaz said he has few good options. "I realized paying the mortgage was like having bread for today and going hungry tomorrow." He said: "Whatever happens now, let it come."

Which is ironic, and funny, because ever more people are saying exactly the same thing about the entire global economy and capital markets.

The reason: everyone - from the lowliest unemployed worker to some of the most respected fund managers - is so tired of the central banks' only remaining scam of asset price manipulating "extend and pretend" that they would rather take the pain now, and force "whatever happens now", instead of live with the reality that "going hungry tomorrow" is an assured outcome for the members of what was once the now extinct global middle class.