Why do I think crossholding is the present Bankia problem?

From El País

Banco Financiero y de Ahorros (BFA)

Well it is not divine insight, nor inside information: It is how the cookie crumbles!

The capital needed for a reconstruction of Bankia has gone up from the 5.4 bio. EUR that FROB (Fondo de Reestructuración Ordenada Bancaria = The Spanish dustbin bank company). First an additional 15 bio. EUR last Monday – if I recall correctly – and yet another 4 bio. EUR on Friday. We are now at? Is it 23 bio. EUR? Hard to tell – the figure changes faster than the date.

Finally a total figure of 60 bio. EUR is bantered around for the final capital injection need of the whole sector (I’ll return to why that figure is probably considerably underestimated)

Not impairments on real estate.

It is unlikely that we are talking new bad surprises from the real estate assessments – though there might be the odd billion – hardly counts between comrades in the gutter. The FROB estimates that to 5.3 bio. EUR (also a “freeze frame” figure), but that is probably arrived at from the tables agreed with the ECB – so that is as solid as we can hope for at the present time – it will go up if any attempt is made to sell off the property; but that can’t happen, so it won’t? Never mind.

The capital is to be injected directly into Banco Financiero y de Ahorros (BFA), which is the “Bad Bank” mother company of Bankia (that is supposed to be the “Good Bank” – some problem filling that part; but..).

Now BFA is a holding company for the distressed banks – distressed due to insolvency, not so much illiquidity. Into this holding company all the shares and stock held by the subordinate banks are transferred – that is what I would do. These shares come presumably partly investment shares of these regional banks and whatever there is happens to be on the shelves with intention to sell.

Crossholding eliminated

These shares are then in the BFA sorted into nice little boxes and consolidated. Then the boxes with shares in Bank A, Bank B etc. are now OWN shares and don’t count in the BFA (and how do you price a share in a failed bank?). One thing is the holding of own shares which shouldn’t influence the value of the outstanding shares in possession of investors – it would only mean the equity is split between fewer shares. Far worse is the fact that in the banks that have transferred these shares to the holding company – they are now an undeniable loss.

Chances are that those are the first 15 bio. EUR – but I might have gotten it the wrong way around.

Financing Developers

When a developer starts building the take a loan in the bank and leave shares for that loan as collateral. As the building nears completion the value of the property is supposed to take over from the shares as collateral.

Now the developer might buy more shares, as he might not need the entire loan all at once. This temporary placement will push up share prices. So – now all of a sudden the collateral is increased in value – which means they are security for an even bigger loan (to cover such nuisances as cost overruns, delays, Ferrari sports cars the odd bribe (though nearly legitimate afterthoughts as roads etc.). Eventually the block of flats is heavily overpriced and possible buyers broke. There is a limit to how much the bank can lend to home buyers to get the property off their hands.

And to make matters worse the nasty German chaps from the ECB goes over the banks books and find the collateral wanting. Thus the shares are seized by the bank (and much worse: The Ferrari is impounded).

Here I do assume the bank has been so much above board, that it has not accepted its own shares as collateral!

These seized shares are now to be sold and are put on the shelf with slightly shop soiled merchandise transferred to the holding company – here they are again sorted into the neat little boxes marked with each company’s name. And to the horror the collective number of own shares rises yet again.

It doesn’t affect the debt of the developer, as these shares cannot be sold. What is worse it doesn’t affect the impairments that should have been reduced with the proceeds from the sale of the shares. Again: We are not now talking reservation – we are talking impairment – that much closer to irredeemable loss.

The structure of the Bankia merger

The very structure of the merger of these seemingly unrelated regional banks could indicate that this crossholding pattern has been taken into consideration. If we look at the Danish mergers it is noteworthy that the mergers are of banks as widely geographically separated as possible – and to the largest possible extend maintaining a separate corporate identity if it is deliberate? I don’t know, but it certainly should reduce the crossholding problem.

In the case of Bankia in Spain these banks have spend that much more time in the freezer – with a pressure to raise capital – so they have presumably done it in the time honored way of Bank A selling 1 billion of their own shares to Bank B – and buy 1 bio. of Bank B shares from Bank B.

This ploy works fine – as long as a separate corporate identity can be maintained. But in the case of Bankia it seems like there has been a lot of “drip sales” to one another – to avoid a collapse of their shares on the stock market. Now crossholding is not illegal in most countries, but generally the annual report – as well as the stock exchange demands it – should inform about shareholders with over a set limit shall report their position.

Now again depending upon country and company the share must be registered in order to have a vote (a practicality so the company knows where the invitations for the annual assembly should be send). The problem is now not the shares in other banks that the bank owns – and votes with – but the shares that are in the trading stock which probably aren’t registered (and that has to be done some time before the annual general assembly for practical reasons). Furthermore those shares lying as collateral are formally the property of the debtor.

So the problem with crossholding is well neigh impossible to get a grip on before things go terribly wrong.

The capital need will probably be much higher.

As we have seen crossholding problems are liable to be much worse the more banks are consolidated. In some sense this equity has never really existed (You by Mine – I buy Yours), but in a distress situation when banks are forcefully merged they show up as losses additional to the losses/impairments/reservations from the primary reason to the insolvency.

This is a spiral that only very slowly comes to an end. For every further bank drawn into a “grand merger” will not only have the problem of possessing of owning shares in dead banks; but there is the problem of  long dead banks owning shares recently deceased banks. The problem is thus going to grow with the square of number of banks involved.

But we are far from finished: The more banks that are involved the more difficult it becomes to merger only banks with little crossholding. The figure of 60 bio. EUR seems to me to be a primitive extrapolation of the Bankia case.

Can the Spanish state cover?

Well we have a preliminary indication is that there are 3 more Caixas heading for the block, and the regional government of Cataluñia (population roughly the size of Greece) has thrown in the towel – so much for much self praised regional independence in Spain – and left the changeling in the care of the Spanish State.

Up to now the financial sectors problems have mainly been faced from below – in all European countries – except Greece that blew its own head off before more refined methods of passing into irrevocable subservience to the creditors could be devised.

Can Spain raise that sort of capital – as a State? Well …..

Probably yes. It will probably involve a haircut to the investors at some point, but it will end with the ECB under firm German hands financing eventually. It will end the southern European dream of a luxury cruise for the price of a bus fare.

The real issue is: Is the German economy strong enough to carry the load? Maybe.

Germany has rebuilt its own country three times in the course of the last century – with progressively better results. The one after WW1 was an unmitigated disaster as we all know. The one after WW2 took 40 years with a fair result and the latest – the integration of East Germany – has taken only 20 years with a splendid result. So by the Grace of God it just might be pulled off.