Spain: Fear the worst

October 2, 2012: 11:52 AM ET

Inadequate stress tests of Spanish banks are just the first of the troubled country's myriad problems.

By Cyrus Sanati, contributor

FORTUNE -- It is becoming clear that Spain's stress test simply weren't stressful enough. The independent auditor's report on the nation's crippled banking sector released this past Friday made some rosy assumptions as to economic growth, mortgage losses and the quality of bank capital. Now Moody's and the Basel Commission are questioning the assessment directly and indirectly through two damning reports released this week on the state of the Spanish and European banking systems. Indeed, if the recent history of bank failures in the US is any guide, this could just be the beginning of a capital-raising death spiral, which could slowly and painfully consume Spain's banks from the inside out.

The revelation that Spanish banks would only need around 59 billion euros (54 billion euros after adjusting for pending deals and revisions), was no real surprise to the markets. It was actually a little less than what Oliver Wyman, the independent consultant tasked with auditing the Spanish banks for the study, had laid out in their preliminary report a few months ago. But as investors fully absorbed the study and its findings, it became increasingly clear that something was off.

The major concern is that the parameters by which the consulting firm stressed the banks seem a bit relaxed. For example, in what the study considers its worst case scenario, it estimates that property prices in Spain would end up bottoming out 37% below its 2007 peak. That sounds awfully high, but it actually isn't when you put it in context. Unlike most of its peers in the EU, Spain experienced excessive speculation in its housing market, driving property values up by as much as 200% and 250%, putting it on par with property bubbles that occurred during the same time in Ireland and in the worst-hit areas in the United States, like California, Arizona and Nevada.

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What's troubling is that property prices in Spain are already down 30% from its peak in December 2007. That means the "worst" case scenario envisioned by the report allows for Spain's property market to fall by just 7%. That might wash if that's where property values in California and Ireland bottomed out, but it's far off. Indeed, property prices in Ireland on average are down 50% peak to trough, while prices in California, Arizona and Nevada are down on average by 46%, 50% and 60%, respectively.

This scenario could work if Spain's economy was growing faster than either country and if unemployment numbers were going down. Of course, this is not the case, either. Unlike Ireland and California, Spain's economy is in recession and its unemployment rate is at a mind-boggling 25%. That's 10% higher than that of Ireland and 14% higher than that of California.

In a report out late yesterday, Moody's estimated that Spain's banks could need as much as 105 billion euros to meet bank capital standards, nearly double what the Oliver Wyman study called for. The Spanish government is now downplaying the reports saying that they will only need to request 40 billion from the promised 100 billion euros that the EU set aside to bailout the Spanish banking sector earlier this year, so that banks that do need to raise capital from other means than through the government. Banco Popular shocked the market yesterday after announcing that it was going to issue equity, diluting its current shareholders, in an effort to raise enough cash to fill the hole in its balance sheet (and avoid being beholden to the government).

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The Spanish government's decision to request far less money from the EU than what they may actually need to save their banks is a troubling development in this crisis as it could mean the markets may have to endure months of surprise capital raises from weak Spanish banks. Remember 2008 on Wall Street? Merrill Lynch would say they didn't need to raise capital, and they would announce a secondary offering the next week. Citi (C) would say the same thing and then comes word they were talking with sovereign wealth funds about investing billions. And we all remember what happened to Lehman.

But probably more disturbing than the weak stress tests is a report released yesterday by the Basel Committee on Banking Supervision, which oversees the implementation of many international banking standards. The most important thing they do is enforce international bank capital requirements, which is basically the amount of money a bank needs to park in the vault instead of lending it out to customers.

The report gave the green light to the US and Japan on their banks transition to the stricter Basel III regime, which is set to go into effect later this decade, but it gave the equivalent of a failing grade to banks operating in the EU. Apparently, the commission took fault with the banking regulators in the EU counting sovereign debt as risk free assets when assessing the strength of bank balance sheets. As we saw with Greece's soft default, sovereign debt isn't risk free, so to count it as such is a bit misleading.

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So how much sovereign debt are banks in Spain holding? When the European Central Bank initiated its LTRO program to help member states on the periphery that were struggling to sell bonds to skittish investors, it was decided to use the banks as a conduit for its scheme. The ECB would print cash and give it to the banks, which would then buy and hold the government bonds. The ECB chose this indirect approach because at the time it did not feel comfortable buying the bonds directly from the sovereign. It seemed like a great deal for the banks, though, as they got to borrow from the ECB at 1% and make 5% to 7% return on the interest on the sovereign debt.

While that might sound great, there is a reason why investors didn't feel comfortable buying Spanish sovereign debt and why it had such a high yield -- it's a risky asset. The last LTRO campaign printed 1 trillion euros which are now sitting in the form of sovereign bonds inside EU banks. In Spain roughly two-thirds of bank assets now consist purely of Spanish sovereign bonds -- bonds, like in Greece, could be devalued one day to give the government a break. Loading up Spain's banking sector with all this government debt, is like building a house on quicksand. If banks in Spain end up having to take 70% haircuts on the value of their supposedly "risk-free" Spanish sovereign bonds, as what happened in Greece, the results would be catastrophic -- multiple times over, worse than the "worst case" scenario in the bank stress tests.

The banking problems in Spain have finally been flushed out, but Europe is still far from solving the problem. Weak stress tests only serve to make the markets more anxious and volatile. The stress tests conducted in the US at the height of the banking scandal were successful in calming the markets, as the scenarios, while not super harsh, reflected the reality of the situation. So until Spain and the EU can recognize how bad things are at the moment, they will never realize how bad things could get in the future.

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