Last month, analysts pegged the worst case scenario for Banco Espirito Santo SA (ELI:BES), huge losses necessitating a government bailout, at about 5%. Today, the worst case has come true as Portugal’s central bank announced that it would break up BES into a good and bad bank, extend billions in euros to stabilize the former and start winding down the latter.

Banco Espirito Santo SA (ELI:BES) will receive €4.9 billion ($6.6 billion) and depositors and senior bondholders are expected to remain whole, while subordinated debt holders and shareholders (which likely includes Seth Klarman’s Baupost Group) can expect to take a serious haircut.

Banco Espirito Santo SA
Banco Espirito Santo

Banco Espirito Santo SA shareholders will stay with the bad bank

“It became imperative and urgent that a solution was implemented to guarantee deposits and safeguard the financial system,” said Bank of Portugal Governor Carlos Costa, reports Patricia Kowsmann for The Wall Street Journal.

Costa explained that the bad bank would include toxic assets like the loans to the Banco Espirito Santo SA (ELI:BES) parent company that are probably unrecoverable, and a host of other non-performing assets. Shareholders and subordinated debt holders will stay with the bad bank and will have to make due with whatever assets are recovered during its dissolution.

As for the good bank, Portugal set aside €12 billion of the €78 billion bailout it received in 2011 to help capitalize its banks, and still has about €6 billion remaining in the fund, €4.4 billion of which is going to be used to stabilize a rebranded Banco Espirito Santo SA (ELI:BES), including deposit accounts, performing assets, and obligations to senior bondholders.

Banco Espirito Santo SA – Hedge funds built up stakes on what looked like a value stock

Trouble has been brewing at Banco Espirito Santo SA (ELI:BES) for more than a month after the bank missed interest payments in early July and had its stock briefly suspended amidst a sell-off. Former CEO Ricardo Espirto Santo Salgado was detained and questioned as part of a money laundering and tax evasion investigation, and we learned last week that BES lost an incredible €3.49 billion ($4.68 billion) in the second quarter, far worse than had been expected.

During that time Baupost, D.E. Shaw, and Goldman Sachs have all built up positions of more than 2%, and there are probably plenty of other funds and investment banks with smaller positions in Banco Espirito Santo SA (ELI:BES), attracted by what could have been a bargain if the bank survived.