European Credit Research

11 July 2012

Spanish burden-sharing a la Irish

Olivia Frieser, Ivan Zubo, Luba Fakhrutdinova European Credit Research We detail below the key points from the draft Memorandum of Understanding (MoU) for the Spanish bailout, although this may not be the final document.

A draft MoU for the Spanish bailout was leaked to the press yesterday evening. This may not be the final text, but it provides a good insight into the likely conditions of the package. The key conditions for banks requiring state aid are that distressed assets are transferred to a centralised bad bank and that there is burden-sharing for subordinated debt (including LT2) via voluntary or mandatory Subordinated Liability Exercises (SLEs). The legislation is to be completed by the end of August to allow the burden-sharing and mandatory SLEs, as well as a bad bank creation. We expect a similar process will be carried out as for the Irish banks, i.e. a voluntary LME followed by a more coercive approach. We do not expect BBVA and SANTAN to require state aid in order to recapitalise, hence, we do not expect coercive burden-sharing for these issuers. The first test case in our view will be the banks in FROB ownership, i.e. BFA/Bankia, Catalunya Caixa, NovaCaixaGalicia and Banco de Valencia. We do not exclude it for other banks such as Sabadell and Popular at a later stage. In terms of timing, a bank-by-bank stress test will be completed by the second half of September. Banks will need to submit restructuring plans to the EC by October 2012 and the first recapitalisations would take place by end October/November. The condition of sub debt burden-sharing in the case of a bank requiring state aid is in line with our views that we have expressed many times before, i.e. it would include LT2s, but there would be no burden-sharing of senior. This supports our trade recommendations of SUB/SEN decompression in index and for Santander (which could decompress in sentiment with concerns about other Spanish banks). The CDS implications for Bankia could be tricky given the rarity of both triggerable and deliverable bonds into the sub CDS.

Key principles: sector-wide and bankspecific conditions

There will be both horizontal conditionality (i.e. sectorwide) and bank-specific conditionality (for banks taking state aid) to the Spanish bailout. There will be three key elements: 1) Identification of individual bank capital needs through a comprehensive asset quality review of the banking sector (including a rigorous appraisal of the value of collateral and foreclosed assets) and a bank-bybank stress test. 2) Recapitalisation, restructuring and/or resolution of weak banks (i.e. the weakest banks should be wound down, and burden-sharing will be required). 3) Segregation of assets for banks receiving state aid into centralised bad bank (mainly for real estate assets and loans, but also potentially extended to other loans, with transfers at the long-term economic value of the assets established on the basis of the asset quality review). We expect it to be similar to NAMA, the Irish bad bank. The first tranche of 30bn will be prefunded and kept in reserve by the EFSF, to be mobilised in an emergency to restore confidence. As discussed after the Eurogroup meeting, this first loan would be transferred to the ESM when up and running, with no priority ranking. Ultimately, direct recapitalisation will be possible via the ESM, but this is to be finalised once a single supervisory mechanism is in place, with first discussions relating to this planned for September. Hence, we would not expect direct recapitalisation to be possible until next year.

Timing: most to be accomplished by yearend

In terms of timing, the bank-by-bank stress tests will be completed by the second half of September. Banks will need to submit restructuring plans to the EC by October 2012, and the first recapitalisations would take place by the end of October/November. Banks hoping to meet any capital shortfall internally or privately and planning a significant equity raise corresponding to more than 2% of RWAs will be required to issue cocos to the FROB by the end of December 2012 at the latest as a precautionary measure. Cocos will be redeemed by 30 June 2013, if they succeed in raising the necessary capital from private sources, or will be converted into equity otherwise. For banks raising capital privately, the deadline for raising capital is end of June 2013.

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Burden-sharing for subs, not senior

In terms of burden-sharing, the draft MoU states that after allocating losses to equity holders, the Spanish authorities will require burden-sharing measures from hybrid capital holders and subordinated debt holders in banks receiving public capital, including implementing both voluntary and, where necessary, mandatory Subordinated Liability Exercises (SLEs). Banks not in need of State aid will be outside the scope of any mandatory burden-sharing exercise. Legislation will be introduced by end-August 2012 to ensure the effectiveness of the SLEs. The Spanish authorities will adopt the necessary legislative amendments, to allow for mandatory SLEs if the required burden-sharing is not achieved on a voluntary basis. These amendments should also include provisions allowing that holders of hybrid capital instruments and subordinated debt fully participate in the SLEs. By end-July 2012, the Spanish authorities will identify the legal steps that are needed to establish this framework, so that its adoption can be completed by end-August 2012. The Banco de Espaa will immediately discourage any bank which may need to resort to State aid from conducting SLEs at a premium of more than 10% of par above market prices until December 2012. We have long said that we expected burden-sharing of subordinated debt including LT2 in the case of Spanish banks requiring state aid, and the news so far confirm this and our view that there will not be burden-sharing of senior for obvious reasons of potential contagion to other European banks. It supports our trade recommendations of sub/senior decompression in index and in peripheral banks (including more recently Santander, even though this is more in anticipation of a sentiment impact as we are not expecting an actual burden-sharing for this issuer). We remain Underweight peripheral banks sub debt.

value although there could be negative headlines for the time being, especially with a bad bank.

NAMA-style bad bank

The transfer of assets to a centralized (i.e. Irish NAMA like) bad bank will be a lengthy and complicated process. The estimates for losses could increase materially as part of this process. If we look at Ireland as an example, the initial haircut estimate of 30% turned out to be over 60% by the time the transfers of impaired assets were complete and the process took almost a year with many delays. In Spain we would argue this process may well take longer and be more complicated than in Ireland, given the much larger size of the banking system and distressed assets (NAMA was targeting 70bn of CRE assets which it ultimately paid for ~30bn, the figure could be several times that in Spain). Finally what impact is this going to have on the healthy banks, especially Santander and BBVA? Both banks have so far been steadfast in maintaining that they do not plan to participate in any sort of bad bank scheme. That said, for BBVA it could make sense to move some of Unnims assets into the bad bank, although it might be able to rely on the asset protection scheme it received as part of the package when it acquired Unnim.

Capital how much will be enough?

The MoU states that Spanish credit institutions will be required, as of 31 December 2012, to meet until at least end-2014 a CET1 ratio of at least 9% and that the definition of capital used will be based on that established in the ongoing EBA recapitalisation exercise. If this refers to the EBA capital definition used in the last stress test in December 2011, this is Basel 2.5 rather than full Basel 3 definition and hence more lenient. Most of the core European banks are aiming to have fully loaded Basel 3 CET1 of 9% by the end of 2013 at the latest, and we would argue that Spanish banks which want to regain market confidence will at the very least meet, if not exceed, this threshold. Ireland offers a useful precedent here as the policy makers have overcapitalized (to the tune of CET1 of around 20% right after the recapitalisation) in order to extinguish any doubts about capital adequacy for the foreseeable future.

Which banks will require state aid?

We do not expect Santander and BBVA to require state aid. While they will likely have to increase their capital, we think that they have internal and external resources to do so. However, the SUB/SEN ratio could decompress in sentiment with concerns about other Spanish banks. We would expect mid-sized banks such as Popular and Sabadell to require state aid. It is more uncertain in our view for CaixaBank, although we also view it as being at risk. The first test case for burden sharing will be the banks owned by the FROB, i.e. BFA/Bankia, Catalunya Caixa, NovaCaixaGalicia and Banco de Valencia. We imagine a similar process will be carried out as for the Irish banks, i.e. a "voluntary" LME followed by a more coercive approach. The CDS implications for Bankia could be tricky. There is only one triggerable bond in our view (the Bankia Tier 1) and little in terms of deliverable as well into the sub CDS. Senior Bankia bonds offer
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Further market implications

While we do not think that Santander and BBVA will need to resort to government aid anytime soon, we do believe that any coercive action against sub bondholders in Spain should probably have a bigger impact on BBVA than Santanders sub debt, given BBVAs larger exposure to Spain as a percentage of its overall business mix as compared to Santander. This differential thought seems to be somewhat priced in through the wider spreads on BBVA sub debt as compared to Santander, but in a stress scenario this differential could be extended further.

Santander vs. BBVA senior and sub CDS history

850 750 650 550 450 350 250 150 11/04/2012 18/04/2012 25/04/2012 02/05/2012 09/05/2012 16/05/2012 23/05/2012 30/05/2012 06/06/2012 13/06/2012 20/06/2012 27/06/2012
27/06/2012

BBVA SEN

BBVA SUB

SANTAN SEN

SANTAN SUB

Source: BNP Paribas

Santander vs. BBVA sub/senior ratio history

1.80 1.75 1.70 1.65 1.60 1.55 1.50 1.45 1.40 1.35 11/04/2012 18/04/2012 25/04/2012 02/05/2012 09/05/2012 16/05/2012 23/05/2012 30/05/2012 06/06/2012 13/06/2012 20/06/2012 04/07/2012

BBVA

SANTAN

Source: BNP Paribas

Separately, we do expect BBVA and Santander to benefit relative to other Spanish banks, i.e. burden-sharing of retail investors at other banks may drive depositors towards these two banks. For other peripheral banks, we see the risk of burdensharing where banks will need state aid in countries that have been or will be bailed out. Further analysis may be forthcoming on this topic and on CDS implications.

04/07/2012

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Contacts
Robert McAdie, Global Head of Fixed Income Markets Strategy and Research +44 20 7595 8885 robert.mcadie@uk.bnpparibas.com

European Credit Research

Olivia Frieser, Head of Investment Grade Research Jean-Yves Guibert, Head of High Yield and Leveraged Finance Research Cyril Benayoun, CFA, Senior Credit Analyst Business Services/ Transportation/Logistics Retail, Metals & Mining, Building Products Banks Covered Bonds +44 20 7595 8591 +44 20 7595 8308 olivia.frieser@uk.bnpparibas.com jean-yves.guibert@uk.bnpparibas.com

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