It was announced recently that Santander had acquired Banco Popular Español for €1, and that Santander intended to launch a rights issue and sell of half of the Real Estate loan book of Popular within 18 months.
This was announced in a bland way as good news, although clearly not for the shareholders of Popular or for the holders of mezzanine and subordinated debt issued by Popular: they have lost all their money. For €1 Santander acquires all the assets of Popular, and all the secured and senior unsecured liabilities. The difference between Total Assets and the Total of Secured/Senior Unsecured Liabilities is the Tier 1 plus Tier 2 equity, and all components comprising that equity have been expunged.
This deal, far from being good news, shows how weak the European banking sector is:
- Popular had passed all its European Banking Authority stress tests
- Its demise did not occur in generally stressed market conditions
- Popular was apparently compliant with all elements of the new EU framework for bank supervision: of capital adequacy, of liquidity and of leverage
But there was a run on the bank by retail depositors, concerned about the health of the bank and particularly for the health of its Real Estate loan book. In fact the fate of Popular is reminiscent of that of Northern Rock Building Society in the UK in 2007. In this case a "white knight" has been found in the shape of Santander to take it over, rather than the government having to step in directly, as the UK government did to rescue Northern Rock. Santander can only hope both that the loan book is of such quality that half of it can be sold off at an acceptable price and also that the rights issue proves to be adequate to replenish Santander's own capital levels.
The transaction was closed at such speed that Santander cannot have had time to perform detailed Due Diligence on the Popular loan book. It must simply hope for the best. Should things not turn out for the best there is another precedent in the UK and not a good one: Lloyds' acquisition of HBOS. In 2008 the UK authorities gave Lloyds – a large and solvent domestic bank - strong encouragement to acquire the ailing HBOS, waving aside Competition Law barriers. Then HBOS turned out to be too bad and too big for its "white knight" to digest: the "white knight" Lloyds became a "black knight" and the UK government had to step in and support it.
The Popular transaction sends out a lot of bad signals about the state of the Spanish banking sector and of the banking sector in Europe as a whole.
These can be summarised as follows:
- What other banks continue to have a poor book of Real Estate loans?
- If Popular – compliant with all of its EBA and ECB tests – turned out to be tottering, how many other banks are in the same position in Spain, and also in Italy, Portugal, Ireland, Cyprus and Greece?
- What is the inventory of domestic "white knights" in those countries, is it limited to BBVA in Spain and Intesa SanPaolo in Italy, and what happens if these knights refuse to fall on their swords?
- What happens if Santander "does a Lloyds" and turns into a "black knight"?
- Do the governments of Spain, Italy, Portugal, Ireland, Cyprus and Greece have the capacity to rescue ailing banks directly if no "white knights" are available, or to rescue the "white knights" when they become "black knights"?
The answer to the above is that there is a paucity of viable "white knights", support will have to come from an official level, and the several of the most threatened Member State governments do not have the capacity to render it. The support would then have to come from the EU level, meaning from the few solvent Member States in northern Europe.
The other side of this disaster is that it has shown up the inadequacy of the new EU framework for banking. Popular went down while compliant with all of it, and its bailout was not conducted strictly in accordance with the EU Bank Recovery & Resolution Directive, under which all senior unsecured creditors with over €100,000 should have been bailed in i.e. their holdings in excess of €100,000 should have been converted into equity-style instruments.
The questions around the adherence of the Popular transaction to this Directive bring us to more subtle outcome of the deal: that it was a disguised deliverance for major EU financial mechanisms themselves:
- The European Investment Bank is a senior unsecured creditor of Popular, through its SME loan programme: the outstanding is far in excess of €100,000, and the EIB's deposits into Popular to fund that programme are senior unsecured liabilities of Popular. The excess over €100,000 should have been converted into an equity-style instrument but this would have left EIB with a big hole in its accounts;
- The European Central Bank has allowed other EU banks to borrow against pledged bonds of Popular – including ones backed by real-estate loans. The ECB should have withdrawn Popular bonds from its list of eligible collateral and demanded that the borrowers either replace those bonds with others on the ECB list, or face the ECB seizing the Popular bonds and selling them to pay off the loan;
- The ECB also had loan outstandings to directly Popular itself: it should have defaulted the loans, seized whatever bonds Popular had lodged as collateral and sold them to pay off the loans.
However the ECB could not do that:
- The valuations it has assigned to the bonds on its collateral list are unrealistically high: the "haircut" on Popular bonds is as low as 1% in some cases
- The bonds may be legally tradeable but there would be no market for Popular bonds if it was known that the ECB had seized them and was selling them to pay off loans
- Similarly any collateral that Popular had lodged at the ECB might not be saleable within the "haircut" if it became known that the ECB had liquidated the positions of a major bank like Popular
- These problems of liquidating collateral within a small "haircut" would be exacerbated if Popular had lodged bonds issued by other banks, whilst other banks had lodged bonds issued by Popular: the ECB would find that it had a Correlation Risk on both sides, in that credit and market risks were the same on both (i) the Popular bonds pledged by other banks to secure their ECB loans and (ii) the bank bonds pledged by Popular to secure its ECB loans
In short, had the ECB tried to exercise its rights to either:
- I. request different collateral from banks that had pledged Popular bonds; or
II. default those banks loans and sell the Popular bonds to pay them off; or
III. default Popular's loans and sell the collateral that Popular had pledged...
The Popular situation has proved that, while the ECB mandate says that it can only lend against collateral, the reality of who it is lending to and in what size, combined with the extent of its list of eligible collateral, mean that its lending contains extreme Correlation Risk and that, in the circumstances in which the ECB might seek to realise its collateral, there would be no buyer in the secondary market:
- I. with the capacity to buy the security that the ECB might decide to liquidate in the size that the ECB would want to sell it; and also
II. with the willingness to buy at a price within the ECB's haircut for the size the ECB would be wanting to move.
The ECB would then just be driving the price of its collateral down, and putting the market into systemic meltdown since:
- I. all other participants would have to mark-to-market, downwards, their holdings of the same securities that the ECB was selling;
II. the ECB and all other participants would have to similarly reduce the value of their holdings in analogous bonds: if a 1.5% coupon 5-year Landesbank Hamburg bond had to be marked down to 95, then so would also a Landesbank Bremen 1.5% coupon 5-year bond have to be, even if the ECB was only in the market to sell the former
III. the ECB would then find that the value of the collateral pledged by more or less all its customers had fallen below the haircut level and the ECB should then either (i) ask the borrowers to top up their security or (ii) failing that, liquidate their positions
IV. if the ECB did that it would reinforce the downward spiral into meltdown
The "haircuts" prescribed by the ECB are very low compared to the values that might be realisable in such circumstances: some Popular bonds have a haircut of 1%. That level of haircut is commensurate with a AAA-rated sovereign, not a tottering mortgage bank.
So this whole cycle desperately needed to be forestalled in the case of Popular, and it was, by persuading Santander to act as a "white knight". The question is how many other Populars are there out there and where will the buck stop if the market runs out of "white knights"? It cannot stop at the Member State governments: it has to land at the EU level, and then we will be testing the willingness of the few solvent EU Member States to directly bail out the banking systems of the rest.
That is why the alarm bells should be ringing.
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