Fitch has just cut Spain’s rating to ‘BBB’ from ‘A’… Outlook Negative. (That’s the same rating as Kazakhstan, for those keeping score).
And, in a seperate report also just released, Fitch estimated that the Spanish banking system will need require additional capital of between €50bn and €60bn to cover potential stress losses on their domestic loan portfolios. Under a more extreme scenario, based on what occurred in Ireland, these amounts rise to between €90bn and €100bn.
From Fitch:
The downgrade of Spain’s sovereign ratings by three notches reflects the following factors:
– The likely fiscal cost of restructuring and recapitalising the Spanish banking sector is now estimated by Fitch to be around EUR60bn (6% of GDP) and as high as EUR100bn (9% of GDP) in a more severe stress scenario compared to Fitch’s previous baseline estimate of around EUR30bn (3% of GDP);
– Gross general government debt (GGGD) is projected by Fitch to peak at 95% of GDP in 2015 assuming a EUR60bn bank recapitalisation, compared to Fitch’s forecast at the beginning of the year of 82% by the end of 2013;
– Spain is forecast to remain in recession through the remainder of this year and 2013 compared to Fitch’s previous expectation that the economy would benefit from a mild recovery in 2013;
–Spain’s high level of foreign indebtedness has rendered it especially vulnerable to contagion from the ongoing crisis in Greece; and
– The much reduced financing flexibility of the Spanish government is constraining its ability to intervene decisively in the restructuring of the banking sector and has increased the likelihood of external financial support.
The downgrade follows a series of recent steps taken by Fitch:
– The potential fiscal costs of the restructuring and recapitalisation of Spanish banks initiated in May (see ‘Fitch: Spanish Banking Reform Will Require State Assistance’ at www.fitchratings.com);
– Prospects for the Spanish economy in light of the latest episode of the systemic eurozone crisis triggered by the inconclusive 6 May Greek general elections result;
– The credit and funding profile of regional governments (see ‘Fitch Downgrades 8 Spanish Autonomous Communities; Negative Outlook’ dated 31 May at www.fitchratings.com); and
– The overall outlook for public finances following the announcement on 18 May of a second upward revision in the general government budget deficit in 2011 to 8.9% of GDP, compared to 8% estimated by Fitch in its last review of Spain in January.
And the rest of the report went thusly:
The dramatic erosion of Spain’s sovereign credit profile and ratings over the last year in part reflects policy missteps at the European level that in Fitch’s opinion have aggravated the economic and financial challenges facing Spain as it seeks to rebalance and restructure the economy. The intensification of the eurozone crisis in the latter half of last year pushed the region and Spain back into recession, exacerbating concerns over sovereign and bank solvency. The absence of a credible vision of a reformed EMU and financial ‘firewall’ has rendered Spain and other so-called peripheral nations vulnerable to capital flight and undercut their access to affordable fiscal funding. Spain has been especially vulnerable to a worsening of the eurozone crisis because of the high level of net foreign indebtedness (around 90% of GDP) and fragile confidence in its capacity to implement fiscal consolidation and bank restructuring in a timely fashion.
Spain’s investment grade status remains supported by a relatively high value-added and diverse economy as well as political and social stability despite very high unemployment. Competitiveness and export performance are improving and the trade balance on goods and services is expected to post a surplus this year. The rating is also supported by the Spanish government’s commitment to wide-ranging structural reform to improve the efficiency of public services and strengthen the budgetary and fiscal framework; enhance the flexibility of the labour market; and foster competitiveness and the growth potential of the economy. Moreover, securing public debt sustainability is within reach if the government is successful in reducing its budget deficit to 3% of GDP by 2014 and in light of the economy’s long-run growth potential of between 1.5% and 2% or higher if the structural reform agenda continues to be pursued.
Spain’s investment grade rating is premised on EMU remaining intact and Fitch’s judgment that the ECB, EFSF/ESM, and IMF, will, in extremis, provide financial support to prevent a fiscal funding crisis. Moreover, Spain’s ‘BBB’ rating incorporates Fitch’s expectation that Spain will secure financial support from its European partners for the restructuring and recapitalisation of the Spanish banking sector, though not necessarily a full-fledged policy-conditional external funding programme.
PUBLIC FINANCES
Since Fitch’s last formal review of Spain’s sovereign ratings in January, the 2011 outturn for the general government budget deficit has twice been revised upwards to 8.9% from 8% of GDP. Local and regional governments accounted for around two-thirds of the overshoot relative to the 2011 budget deficit target of 6% and remain a source of fiscal risk. Fitch recently downgraded eight regional governments in light of the expected increase in regional indebtedness and worsening economic and financing environment.
The settlement of outstanding payment arrears incurred by sub-national administrations and other ‘one-off’ operations will increase GGGD by 5.5% of GDP in 2012. Fitch expects that bank recapitalisation will add a further 6% of GDP to government debt during 2012 and 2013. Combined with a worsened outlook for the economy and higher interest payments, GGGD/GDP is projected by Fitch to peak at 95% in 2015 compared to the agency’s previous projection of a peak of 82% in 2013 (the latter broadly corresponds to the government’s current forecasts). Under a scenario whereby the recession is more severe than forecast (-2.7% and -1.5% contraction in real GDP in 2012 and 2013 respectively compared to -1.9% and -0.5% assumed in Fitch’s baseline projections), deficit reduction less rapid (3% primary budget deficit in 2013 compared to 1.4% assumed in the baseline) and bank recap costs are higher (9% of GDP rather than 6%), government debt would peak above 100% of GDP by 2014. Nonetheless, even under this negative scenario, government debt would stabilise reflecting Fitch’s analysis and judgment that public debt sustainability is within reach, albeit at a high level of indebtedness that offers very limited fiscal space to absorb further negative shocks.
The Spanish government is expected to retain access to market financing for fiscal purposes, albeit at an elevated cost. Resolution of the banking crisis, progress on deficit-reduction and on-going structural reform combined with steps at the European policy level towards resolution of the eurozone systemic crisis would support a normalisation of funding costs and enhance confidence in the sustainability of public debt.
FISCAL COSTS OF BANK RESTRUCTURING
Fitch initiated a review in May of its previous assessment that the recapitalisation of Spanish banks would incur a fiscal cost of around EUR30bn (3% of GDP). On 25 May, it was announced that Bankia/BFA faces a EUR19bn capital shortfall. Fitch now expects the fiscal cost of bank restructuring and recapitalisation to be in the range of EUR50bn to EUR60bn and in a negative stress scenario, the cost could rise to EUR90bn- EUR100bn. A detailed description of Fitch’s analysis of the potential capital requirements of the Spanish banking system is set out in an accompanying comment, “Fitch: New Base Case Indicates Spanish Banks Need EUR50bn to EUR60bn Capital”.
Fitch expects Spain to secure external financial support for the recapitalisation of medium-sized banks and savings banks which would help restore confidence in the banking sector as a whole. The core of the system – Santander, BBVA and La Caixa – will not require assistance in meeting more stringent provisioning and capital requirements and underpin Fitch’s confidence that the fiscal costs of restructuring the banking sector remain manageable from a sovereign credit and rating perspective.
Recourse to external funding for bank recapitalisation underscores the constrained financing flexibility of the sovereign to respond to adverse shocks. Nevertheless, securing low cost and long duration funding from European partners to assist in the restructuring of the Spanish banking sector is consistent with Spain’s current sovereign rating. If effective in restoring confidence in the banking sector and easing the fiscal burden of restructuring, such support would be credit positive.
NEGATIVE OUTLOOK
The Outlook on Spain’s sovereign ratings remains Negative, indicating a heightened risk of further downgrades. The Negative Outlook primarily reflects the risks associated with a further worsening of the eurozone crisis, notably contagion from the ongoing Greek crisis (see ‘Fitch: Re-Run Elections Would Be Critical for Greece, Eurozone’, dated 11 May atwww.fitchratings.com). Spain’s sovereign ratings at ‘BBB’ are robust to some further deterioration in the economic and fiscal outlook and somewhat greater than expected fiscal cost of bank restructuring, as well as to receipt of temporary external financial support for bank recapitalisation. However, Spain’s high level of foreign indebtedness and prolonged economic weakness as it deleverages and rebalances does render it vulnerable to negative economic and financial shocks. A loss of market access for budgetary funding and consequent reliance on external policy-conditional financial support would prompt a further review of Spain’s sovereign ratings.
Agreement on eurozone reforms that would strengthen confidence in the monetary union’s long-term viability and measures to ease the severe financial and economic strains currently evident across the region would be supportive of a stabilisation of Spain’s sovereign ratings. Along with the successful adjustment of the Spanish economy, supported by ongoing structural reform that enhances competitiveness and its growth potential, upward pressure on Spain’s sovereign ratings could emerge over the medium term.
———————————————————————————————————-
The second report, in which Fitch Indicates Spanish Banks Need €50bn to €60bn Capital
Fitch Ratings-London/Barcelona-07 June 2012: Fitch Ratings says that under its updated base case, the Spanish banking system will need additional capital requirements of between EUR50bn and EUR60bn to cover potential stressed losses on the domestic loan portfolio. Under a more extreme scenario, based on what occurred in Ireland, these amounts rise to between EUR90bn and EUR100bn. In both scenarios, this arises from the taking of upfront stressed losses, net of taxes, and without taking into account pre-impairment profits.
Over the past few years, Spanish banks have been increasing provisioning and improving capital levels. The Spanish government has passed legislation in 2012 imposing more demanding coverage levels on banks’ real estate (RE) exposures through income statement provisions and capital buffers (see “Higher Real Estate Coverage for Spanish Banks” dated 22 March 2012 on www.fitchratings.com.) This is in addition to the stricter capital requirements required in 2011 (see “More Stringent Capital Requirements for Spanish Banks” dated 1 March 2011 on www.fitchratings.com.). Fitch’s base case and Irish stress scenarios capture these same concepts by stressing asset quality and calculating stressed losses for the different asset classes while achieving higher capital ratios.
The front-loading of stressed losses is likely to be viewed by the markets as prudent and appropriate in order to address declining market confidence in the sector. In Fitch’s view, the probability of these severe losses materialising is growing and a near-term recapitalisation plan is increasingly likely to be needed for the more exposed banks in order to try to improve confidence.
The stress tests update previously published stress tests conducted in March 2011 and July 2010. While maintaining the same target equity-to-total assets ratio, Fitch has revised its stress scenarios to factor in the continued strained macro economic conditions in Spain, further asset quality deterioration (mainly in the RE sector), the ongoing eurozone crisis, which has contributed to heightened market risk aversion over Spanish debt, and the need for substantial support for a number of Spanish banks since July 2011. Of this support, the most important is the recent EUR19bn state rescue package requested by the Board of Directors of Banco Financiero y de Ahorros, S.A., the parent of Bankia, S.A.
In both the base case and the Irish stress case, Fitch estimates the amount of capital needed to reach a common equity-to-total assets ratio of 6.5% at end-2011 (equivalent to a core capital-to-risk-weighted assets ratio of 10% Fitch estimates), once stressed losses, net of tax and existing loan loss reserves, are deducted from equity (which includes mandatory convertible securities and EUR15bn of FROB funds already injected). The stresses assume probability of defaults (PDs) based on a multiple of non-performing loans (NPLs) and apply stressed loss given defaults (LGDs) to arrive at the stressed loss figure.
The stress tests are based on an aggregate loan portfolio of EUR1,783bn at year-end 2011 as reported by Bank of Spain statistics and EUR88bn in foreclosed assets. NPLs for the domestic loan portfolio grew by EUR32bn between end-2010 and end-2011 to EUR140bn. Given the sharp deterioration in asset quality and the worsening macro environment in Spain, Fitch has increased its NPL multipliers and its LGDs, particularly for the RE sector.
Fitch estimates that losses on the domestic loan portfolio would total EUR230bn under the base case and EUR295bn under the Irish case. Of these amounts, EUR160bn and EUR187bn, respectively related to the RE and construction sectors and included foreclosed property. A further EUR20bn and EUR40bn, respectively, related to residential loans (mainly mortgages) for individuals. The difference was corporate exposures, both large and small and medium-sized companies as well as consumer loans.
The multipliers and the LGDs applied are particularly severe on banks’ RE exposures as these assets already reported very high NPL ratios at end-2011. By type of RE loan, Fitch estimates that the average NPL at this date was: land (36%), unfinished property (29%) and finished property (23%).
Banco Santander, Banco Bilbao Vizcaya Argentaria (including soon to be merged Unnim) and Caja de Ahorros y Pensiones de Barcelona (including the soon to be merged Banca Civica) fare better under the stress tests that some of the medium-sized banks and savings banks with high exposure to RE. These three large Spanish banks have sufficient pre-impairment profit generation, reserves and capital to withstand Fitch’s stress scenarios and are therefore rated higher. However, they are not immune from negative ratings pressure due to the deteriorating economic situation and volatile market conditions in Spain. Fitch expects to publish a comment on its updated stress tests over the next few days and to review ratings in the near term where required.
