Mark Hargraves, senior fund manager at Axa Framlington Investment Management, discusses the Spanish government's takeover of Bankia SA and the outlook for European banks. He speaks with Maryam Nemazee on Bloomberg Television's "The Pulse."

Spanish lenders are increasingly depending on the central bank and secured debt sales to lower funding costs after their return on equity in 2011 was the lowest in more than four decades following the country's real-estate crash. The ECB provides loans at rates of 1 percent against collateral such as covered bonds and mortgage-backed securities, which would be used to repay the debt in an event of a default, leaving fewer assets available to unsecured creditors, including depositors.

"Banks strongly relying on ECB funding and secured bonds are actually subordinating other creditors in the event of a bank insolvency, so recovery levels would be lower" said Helene Heberlein, managing director for covered bonds at Fitch Ratings. "The asset encumbrance is especially worrying from the point of view of banking authorities," when the "issuers are also deposit-taking institutions."

Return on Equity
The Spanish banking industry's interest margin, or the difference between what they earn on loans and the cost of funding, fell about 20 percent since July 2007 to 0.86 percentage points at the end of last year, the lowest since at least 1970 when the Bank of Spain started to compile the data.

Return on equity was negative at the end of 2011, the first time since at least 1985, as unemployment soared above 20 percent to the highest rate in the euro region and provisions against losses on real-estate debt rose.

The seven major banks, including Banco Santander SA (SAN), Banco Bilbao Vizcaya Argentaria SA (BBVA) and Bankia Group, which was formed in 2010 from a merger of seven savings banks to become the country's third-largest lender, will need 68 billion euros of additional capital as a buffer against bad loans and to comply with increasing regulatory requirements, according to a May 9 report from Royal Bank of Scotland Group Plc. (RBS)

Additional Provisions
Spain's government will make banks set aside more to cover property loans that are still being paid to bolster confidence in the financial industry. The rules, to be approved at a Cabinet meeting tomorrow, may create additional provisions of about 30 billion euros, said a person with knowledge of the situation, who declined to be identified because the new rules aren't public.

Spanish 10-year bond yields rose above 6 percent yesterday, boosting concern that borrowing costs may reach levels that prompted bailouts for Greece, Ireland and Portugal. Spain's Prime Minister Mariano Rajoy is fighting to rein in the euro- region's third-largest budget deficit and trying to shield public finances from the cost of cleaning up the banks.

"Spanish banks had turned to secured funding via bonds or ECB funding because it is the most optimal solution," said Arturo Bris, professor of finance at Lausanne, Switzerland-based business school IMD. "That is a social failure since it means the ultimate risks for taxpayers could be big in a scenario of an issuer failure."

Unsecured Creditors
The perceived risk of being an unsecured creditor is higher at firms that may be controlled by the government such as Bankia Group. It had 38 billion euros of real-estate assets at the end of 2011 and about half was classed as either "doubtful" or at risk of becoming so, according to the group's annual report.

Spain's bank-bailout fund will take control of Bankia with a 45 percent stake after nationalizing its parent, BFA. The group's new management must present "as soon as possible" a strengthened cleanup plan and the lender should "consider the contribution of public funds to accelerate and increase its cleanup," the regulator said.

Bankia fell as much as 3.8 percent to 2.05 euros, the lowest since the stock started trading in July, as of 9:55 a.m. in Madrid. The Ibex 35 stock index rose as much as 2.1 percent to 6,957.5 points.

Investors demand 312 basis points more to hold Bankia SA (BKIA)'s 500 million euros of 4.375 percent bonds due 2017 than covered bonds sold by the lender with a similar maturity, according to Bloomberg Bond Trader prices. That's the widest spread since Feb. 10, before the ECB carried out its second round of three- year loans in a bid to avoid a credit crunch.

Santander, BBVA Spreads
The difference between Santander's five-year-unsecured debt and its covered bonds is 89 basis points. For BBVA, the gap is 62 basis points for debt due in about four years.

The cost to protect Santander's debt against losses with credit-default swaps fell 8 basis points today to 410 basis points, after soaring from 232 on Feb. 7, according to data compiled by CMA. That means it costs 410,000 euros annually to protect 10 million euros of the debt for five years. Credit- default swaps on BBVA fell 6 basis points to 441, and Bankia's tightened 9 to 743, CMA data show.

Covered bonds are first guaranteed by a bank, and then by all its mortgage holdings in the event of a default. In contrast, buyers of securitized debt rely exclusively on the cash flows from a segregated pool of loans, so it doesn't affect recoveries for lenders' unsecured creditors. The difference between the two types of debt is diluted when banks retain their own bonds to be used as collateral for ECB loans, since those are obligations guaranteed by the lenders.

Rabobank Lending Willingness
Banks that encumber their balance sheets by tying up assets as collateral for securities such as covered bonds or repos with central banks have fewer available to meet claims if an institution fails. Any move to limit secured debt issuance risks hurting banks that have relied on record covered bond sales and the 1 trillion euros of three-year loans that the ECB has pumped into the system since December.

If asset encumbrance is "high it will automatically have an impact on the willingness on our side to lend money on a secured basis or unsecured basis, definitely," said Rabobank Groep Chief Financial Officer Bert Bruggink, whose bank is the only non-government controlled European lender with top credit ratings. "In Spain we see high levels" of asset encumbrance.

Protections are also being eroded for investors in 367.6 billion euros of Spanish mortgage covered bonds even as they're in a better position to recover from potential losses than unsecured creditors.

Home Prices
Asking prices for homes in Spain have dropped about 30 percent since the first quarter of 2008, according to a survey by real-estate website and IESE Business School. New mortgages awarded are at the lowest level since at least 2004, after total capital lent for all type of mortgages fell almost 50 percent from a year earlier, the government said April 24.

Under Spanish law, lenders can only issue covered bonds against home loans with loan-to-value ratios of 80 percent or less, or 60 percent if the loans are secured by other types of properties. Outstanding covered bonds shouldn't surpass 80 percent of banks' eligible mortgages, and a lenders whole book of mortgages can be called to repay the debt ahead of the rest of the creditors.

"The decline of house prices plus the negative net production of mortgages mean that if banks are updating their loan-to-value ratios they face shortages of eligible collateral," said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Merrill Lynch. "We think the asset encumbrance could be a serious issue in Spain."

Santander and BBVA, the country's two largest banks, have increased issuance of covered bonds to 80 percent of their eligible mortgages, the maximum allowed under the Spanish law.

Banco Santander has 27.81 billion euros of outstanding Spanish covered bonds, according to the prospectus of its 2 billion euros of 3.25 percent 2015 bonds due sold in February. That's up from 23.5 billion euros of the outstanding debt at the end of 2010, according to an Oct. 18 prospectus filed with the Spanish market regulator.

BBVA had 44.7 billion euros of covered bonds at the end of the year, according to the company's website. They account for 49 percent of the total 85 billion euros of the lender's wholesale funding, more than other type of debt, according to a company presentation.

Incentive to Pledge
Bankia Group's ability to increase mortgage covered bond issuance declined almost 40 percent to 6.5 billion euros at the end of 2011 down from 10.6 billion euros, a year earlier, according to a May 4 report from the company. That compares with 20.3 billion euros of maturing debt this year, including 9 billion euros of bonds that have the backing of the Spanish government.

The ECB applies a discount on top of the market valuation of as low as one percentage point on a covered bond, compared with at least 6.5 percentage points for an unsecured bank bond, or 16 percent for asset-backed securities, according to the central bank. The so-called haircut can be increased when banks pledge their own bonds.

"Banks in the euro region have the incentive to pledge covered bonds more than any other type of bank debt due to the lower haircuts the ECB applies to those instruments," Jose De Leon, a Madrid-based analyst at Moody's Investors Service said in a telephone interview. "That is prompting Spanish banks to issue, in some cases, close to the legal limits, which in practical terms means the erosion of protection for the covered bond investors, and for the rest of creditors including depositors and unsecured bondholders."

U.S. Subprime Collapse
Banks are also using their holdings of mortgage-backed securities for central bank loans after investor demand for debt pooling Spanish assets disappeared in 2007 following the collapse of the U.S. subprime-mortgage market that froze credit markets globally.

The Bank of Spain values senior bonds backed by residential mortgages issued by Madrid RMBS IV, created in 2007 by Caja Madrid, the largest lender integrated into Bankia, at 59.7 cents on the euro. That means the securities would yield 11.9 percentage points more than the euro interbank offered rate, according to data compiled by Bloomberg based on the repayment rate of the underlying mortgages in the last three months.

That compares with 90.9 cents net on the euro that the Bank of Spain is willing to provide against Bankia's 1.6 billion euros of mortgage covered bonds due 2019. The central bank valuation implies a spread of about 453 basis points more than the asset swaps rate, according to Bloomberg data.

Incentive to Pledge
Spanish banks have 167.5 billion euros of outstanding mortgage-backed securities, according to Spanish Mortgage Association data at the end of the year. Lenders in the country, which stopped selling the debt in 2007, had retained about 145 billion euros of the debt, which mostly are being used to build their reserves of assets potentially accepted by ECB as collateral to raise loans, according to JPMorgan Chase & Co (JPM) data.

Investors demand 565 basis points above the euro interbank offered rate, or euribor, to buy a senior bond backed by Spanish home loans compared with 25 basis points in July 2007, according JPMorgan Chase & Co. data. That's four times the spread for comparable debt backed by British home loans.

Mortgages are considered better collateral than other types of loans as arrears typically are lower than the average, and recovery levels in a default are higher than for consumer loans.

Spanish banks' non-performing loans as a proportion of total lending increased ten-fold since June 2007 to 7.8 percent at the end of last year, according to data compiled by the Spanish Mortgage Association. That compares with a six-fold increase to 2.7 percent for home loans, which account for 60 percent of collateral backing Spanish mortgage covered bond programs, according to Moody's data.

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