On the mend but testing times ahead

Transcription

1 On the mend but testing times ahead Recession is over, weak recovery ahead The Spanish economy has been improving in recent quarters, indicating to us that the bottom may have been reached in terms of GDP levels. Our outlook for Spain remains for small positive growth in the next 12 months, consistent with a slow recovery. We expect the economy to expand by 0.4% in 2014 (vs 0.5% consensus), from a 1.4% contraction this year. While we acknowledge that the worst of the recession may be behind us, our central case scenario implies a slow and fragile economic recovery. Nevertheless, the economy remains sensitive to adverse shocks and uncertainties, mainly on the fiscal side and the evolution of lending. Testing times ahead for banks The upcoming ECB BSA of which the AQR is just one part should ask what would I change to make a Spanish bank wanting to lend more to the real economy? We do not expect aggregate credit flows to turn positive any time soon as the economy deleverages, but the banking sector s ability to channel funds to profitable individual projects and avoid being a bottleneck to the recovery, particular in investment, is an important issue. Further provisioning on the refinanced loans, the conversion of (some) DTAs as loss absorbing capital and the ECB BSA to clarify (finally) the bank s sharecounts and BVs, are the upcoming events. and (still) a few pending challenges Our still prudent approach to the sector is related to the (still) pending issues that the system faces: (1) highly leveraged private sector which will not allow banks to resume (robust) loan growth, (2) not normalized (completely) access to funding markets, (3) 15% of domestic banks NII (half of their PBTs) being related to ALM portfolios, (4) SPGBs represent in some cases more than 2x their tangible equity, (4) the ECB BSA and its AQR process which could trigger some provisions/capital needs (see Table 2 for our estimates of potential provisions shortfall under our BofAML-AQR), and (5) challenging public deficit reduction, stabilization of the public debt and high unemployment, which lead us to think that the economic recovery will be a gradual process. More constructive on earnings but not value at current levels As the economic recession fades we increase some of our banks earnings estimates (mostly due to lower retail funding cost on the back of the Bank of Spain action in this regard) although this excludes potential bad debt hikes. We are also updating our banks expected fully loaded Basel III, by recognising the timing differences related deferred-tax assets. However even with our new estimates, and assuming no share count changes, we don t expect domestic banks to deliver more than ~8% RoNAV by the end of 2015 (10/13% in the case of BBVA/Santander). Therefore we struggle to see banks meeting cost of capital (at least) before 2016; hence, current multiples are already factoring in a blue-sky scenario, in our view. Price Objective Change Equity Europe Banks-Multinational/Universal 23 September 2013 Sergio Gamez >> Research Analyst MLI (UK) sergio.gamez@baml.com Ruben Segura-Cayuela Europe Economist MLI (UK) ruben.segura-cayuela@baml.com Tarik El Mejjad >> Research Analyst MLI (UK) tarik.el_mejjad@baml.com Table 1: Forecasts for Spain BofAML EC IMF GDP % -1.5% -1.6% GDP % 0.9% 0.0% Budget deficit % -6.5% -6.7% Budget deficit % -7.0% -5.9% General government debt % 91.3% 92% General government debt % 96.8% 98% Source: IMF, EC, Bloomberg, BofA Merrill Lynch Global Research. Budget Deficit and General debt as % of GDP. Table 2: Potential provisions needs ( bn) Due to more conservative provisions coverage and classification on refinanced loans 33.5 On non-real estate according to BofAML-AQR 18.8 On real estate assets and loans to house builders according to OW stress test adverse case 9.3 Source: BofA Merrill Lynch Global Research Table 3: POs and EPS. Old New EPS EPS Rating PO ( ) PO ( ) chg. 2013E chg 2014E Caixabank U/P % 3% Bankinter U/P % 11% Bankia U/P % 12% B. Popular U/P % 7% B Sabadell U/P % -23% BBVA Neutral % 9% Santander Neutral % 2% Source: BofA Merrill Lynch Global Research >> Employed by a non-us affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 70 to 72. Analyst Certification on Page 68. Price Objective Basis/Risk on page 66. Link to Definitions on page

2 Contents Executive summary 3 Recession over, weak growth ahead 7 Deleverage = downside risk to GDP 13 An update on system NPAs 16 Analysis of the refinanced loans 24 Non-legacy: 90% of loans, 60% of NPL 31 The (good) Spanish AQR 34 Overview of banks capital adequacy 37 Appendix 46 iqprofilesm Banco Popular 59 iqprofilesm Banco Sabadell 60 iqprofilesm BANKIA 61 iqprofilesm Bankinter 62 iqprofilesm BBVA 63 iqprofilesm CaixaBank 64 iqprofilesm Santander 65 2

3 Executive summary The Spanish economy has been improving in recent quarters, indicating to us that the bottom may have been reached in terms of GDP levels. Our outlook for Spain remains for small positive growth in the next 12 months, consistent with a slow recovery. We expect the economy to expand by 0.4% in 2014, from a 1.4% contraction this year (although we expect the second half of the year to be pretty much flat relative to the first six months). Nevertheless, the economy remains sensitive to adverse shocks. While we acknowledge that the worst of the recession may be behind us, our central case scenario implies a slow and fragile economic recovery. We expect a slow recovery of internal demand and a strong contribution from the external sector. Most of the difference in our central scenario from consensus relates to the fiscal outlook and the recovery of investment: We expect a stronger contraction of government consumption in 2014 than consensus, but our numbers are in line with those announced by the government in the stability programme and the presentation of the expenditure ceiling before summer. While our economic outlook and particularly that for the private sector does not differ much from others, we remain more conservative on the fiscal numbers. Looking at risks to our scenario, budget execution so far this year points to a deficit at least as large as in 2012 (7% excluding the impact of the banking recapitalization on the deficit), i.e., above the 6.5% target, and we see risks biased towards a larger number. Therefore we are still concerned about the potential rating implications of the fiscal performance. Table 4: Scenarios of potential provisions needs for banks under our coverage ( bn) Potential provision needs due to more conservative provisions coverage and 33.5 classification on refinanced/restructured loans Potential provision needs on non-real estate 18.8 exposure according to BofAML-AQR Potential provision needs on real estate assets and loans to housebuilders according 9.3 to Oliver Wyman stress test (adverse case) Source: BofA Merrill Lynch Global Research In addition, given the ongoing uncertainty in the Spanish banking sector (uncertain outcome of the ECB Balance Sheet Assessment BSA- and the EBA stress test next year), the pending deleveraging of the private sector, and the structural nature of the downturn, we expect a more subdued recovery of private investment than consensus. Additionally, we remain prudent on NPL formation and on the recovery of lending activity. This in turn also generates risks to the economic outlook. Although we would not expect aggregate credit flows to turn positive any time soon as the economy deleverages, the banking sector s ability to channel funds to profitable individual projects and avoid being a bottleneck to the recovery, particular in investment, is an important issue. We have previously argued that we do not expect a strong recovery in investment in the euro area ahead of the Asset Quality Review (AQR). This is incorporated in our central scenario but we also believe it constitutes one of the main downside risks to the economic outlook. In other words, all of the ongoing debates around Spanish banks add downside risks to an already subdued recovery scenario. We review the main open issues ahead and that are likely after the ECB s AQR, together with what level of provisions and capital would be needed to ensure a banking sector that supports the recovery (Table 4). 3

4 As of July, NPLs totalled 178.7bn according to Bank of Spain data but if we account for doubtful loans transferred to Sareb by Group 1+2 banks, the amount rises to 222bn, equivalent to c.21% of Spanish GDP, with the NPL ratio at c.14% (vs the published 11.97%). The banking system also has > 70bn of gross foreclosed real estate assets not included in the NPLs (in addition to 23bn at Sareb). If we adjust for the real estate assets (Sareb + banking system), the NPA ratio would be c.18% ( 315bn). Note that we do not include performing refinanced/restructured loans and so assume that (at least) 88bn of refinanced/restructured loans that are currently classified as performing could become doubtful and substandard at some point. If we consider that 40% of such exposure becomes problematic, the amount of potential NPAs would be 350bn, based on our estimates. Table 5: Breakdown of problematic assets ( bn) NPL ratio July (Bank of Spain) 11.97% NPLs July (Bank of Spain) NPL growth MoM (Bank of Spain) 1% NPLs on Sareb (transferred by banks 1+2 ) 44.0 Underlying NPLs NPL ratio proforma 13.7% Foreclosed real estate properties 93 NPAs NPA ratio proforma 17.9% Source: BofA Merrill Lynch Global Research estimates The Asset Quality Review (AQR) is now part of a broader BSA. We think that the BSA and the stress test are a clear opportunity to adopt a holistic approach to restoring investor confidence in the Spanish financial system and its balance sheet. Given the lack of information on the terms of the AQR, we are unable to determine specifically the potential impact of the review on Spanish banks capitalisation. However, we attempt to assess potential implications by assuming theoretical BofAML exercises on provisions for Spanish banks legacy assets as well as for the non-real estate related exposure. We therefore carry out an admittedly simplistic BofAML-AQR test of which Spanish banks should be targeting provisions coverage on their real estate loans book in order to comply with the adverse-case scenario in the stress test conducted by Oliver Wyman Management Consultant (OW) last year as well as provisions to cover expected losses half way between the base case and the adverse case scenario on the non- real estate loans book. Table 6: Potential provision shortfall under alternative scenario of AQR ( mn) Potential provision needs on legacy assets Potential provision needs on nonreal estate Total Potential provision needs Total as % of 1- yr PPP Total as % of current capital B. Popular 3,061 1,610 4, % 36% Santander 75 8,110 8,185 36% 9% Caixabank 1,970-1,970 60% 10% BBVA 1,581 7,193 8,774 80% 16% B. Sabadell 2,289 1,882 4, % 30% Bankia % 2% Total 9,340 18, % 13% Source: BofA Merrill Lynch Global Research. It includes write-offs loans otherwise the potential shortfall would be 4.6bn for B. Popular, 4.1bn for B. Sabadell, 8.1bn for Santander, 3.3bn for Caixabank and 8.7bn for BBVA. In total 29.5bn 4

5 23 September 2013 This exercise described above is more ambitious than just the consideration of higher provisions on the refinanced/restructured loans, and it would make banks balance sheets better adequate to support an economic recovery. If we focus our analysis only on the refinanced/restructured loans, we note that banks reclassified 7.2bn as impaired or substandard loans in Q2, equivalent to 8% of their total refinanced loans. We welcome the initiative but consider it not farreaching enough, and it raises doubts about the classification of such exposure ahead of the Pan-European AQR. Hence, we would expect further (more conservative) reclassification in the next two quarters. As the system has current provisions coverage of 19% on the refinanced/restructured loans (according to latest official data), we estimate that every 10ppt increase in provisions coverage on the non-real estate related refinanced/restructured loans may imply c. 14bn of incremental provisions for the system and c. 7bn for the real estate book. Table 7: Breakdown of refinanced/restructured loans Total Non real estate Real estate ( mn) mn as % of total mn as % of total B. Popular 14,363 6,607 46% 7,756 54% Santander 32,867 21,692 66% 11,175 34% Caixabank 26,000 17,940 69% 8,060 31% BBVA 24,100 11,086 46% 13,014 54% B. Sabadell 15,800 9,006 57% 6,794 43% Bankia 22,113 20,344 92% 1,769 8% Total86, ,243 64% 45,868 36% Source: BofA Merrill Lynch Global Research We also review in this note the banks capital adequacy based on Q2 numbers and assess the potential implication on the (partial or complete) DTA forbearance, which would imply its non-deductibility from the banks capital base under Basel III rules. In our view such potential conversion of the DTAs doesn't make the banks worth any more until they are under an insolvent position. We think that of the total DTAs, those classified as deferred tax on loss provisions (c.100bp of CT1) and, to a lesser extent, those classified as pensions related (c.30bp of CT1) could be under review by the government. We also analyse the implication of the bail-in buffer for Spanish banks. Our latest broad estimate of the size of the gap that needs to be closed in order to reach the 8% of own funds plus liabilities buffer for our Spanish coverage universe is c. 47bn (excluding banks senior debt). Table 8: Potential impact for banks on the P&L to comply with 8% bail-inable buffer ( mn) B.Popular B.Sabadell Bankia Bankinter BBVA Caixa Santander 1.5% RWAs (required) 1,314 1,201 1, ,966 2,266 7,849 Current T1 amortised as of , , ,631 Need of Tier 1 issuance , ,495 1,907 6,218 Cost due to new Tier 1 issuance (net) Tier 2 2,483 2,864 7, ,402 5,665 12,440 Cost due to new Tier 2 issuance (net) Total extra financial cost (T1+T2) as % of 2015 EPS (BofMLe) 14% 36% 52% 22% 3% 15% 8% Source: BofA Merrill Lynch Global Research estimates 5

6 Improvements but we see no value given current multiples We acknowledge that the worst of the economic recession seems to be over. We therefore have increased some of our banks earnings estimates (mostly due to lower retail funding cost on the back of the Bank of Spain action in this regard) although this excludes potential bad debt hikes or increasing sharecount as a consequence of the ECB BSA.. We are also updating our banks expected fully loaded Basel III capital ratios, by recognising the deferred-tax assets realised on the back of the generic provisions allocated by banks as loss-absorbing capital, as it seems that the Spanish government may guarantee such deferred-tax assets and therefore become lossabsorbing (as we detail later in this note). Our new POs reflect our revised estimates as well as our updated CoE, based on current government bond yields and new regulatory capital bases. Table 9: Spanish banks: earnings estimates EPS 2013E EPS 2014E EPS 2015E Old vs Old vs Old vs ( ) ( ) ( ) new 2013E new 2014E new 2015E Caixabank % 3% 3% Santander % 2% 1% BBVA % 9% 2% B. Popular % 7% 6% B. Sabadell % -23% -21% Bankinter % 11% 10% Bankia % 12% 12% Source: BofA Merrill Lynch Global Research estimates Table 10: Spanish banks: POs ( ) Old PO New PO Caixabank Santander BBVA B. Popular B. Sabadell Bankinter Bankia Source: BofA Merrill Lynch Global Research estimates However even with our new earnings estimates, and assuming no share count changes, we don t expect domestic banks to deliver more than ~8% RoNAV by the end of 2015 (10/13% in the case of BBVA/Santander). We think that the sector lacks value vs other jurisdictions in Europe given the current market multiples. Although we are factoring in the economic recovery in our estimates, we struggle to see banks meeting cost of capital (at least) before 2016; hence, current multiples are already factoring in a blue-sky scenario, in our view. Our still prudent approach to the sector is related (in addition to the current market multiples) to the (still) pending issues that the system faces: (1) highly leveraged private sector which will not allow banks to resume (robust) loan growth, (2) not normalized access to funding markets, (3) 15% of domestic banks NII (half of their PBTs) is related to ALM portfolios, (4) SPGBs represent in some cases more than 2x their tangible equity, and (4) the ECB balance sheet assessment and its asset quality review process which could trigger some provisions/capital needs. In addition, and as we address later on this note, we think that the economy faces some challenging tasks like the public deficit reduction, stabilization of the public debt and high unemployment. Table 11: Spanish banks market multiples Rating P/E2014E P/E2015E P/NAV 2014E P/NAV 2015E RoNAV 2014E RoNAV 2015E Caixabank Underperform % 7.9% Bankinter Underperform % 7.5% Bankia Underperform % 7.0% Banco Popular Underperform % 8.6% Banco Sabadell Underperform % 5.2% BBVA Neutral % 10.0% Santander Neutral % 13.6% Source: BofA Merrill Lynch Global Research estimates, DataStream. 6

7 Recession over, weak growth ahead We updated our macroeconomic projections recently to take stock of the positive surprise for Q2 across euro area economies. Q2 GDP was in line with the flash release, at -0.1% QoQ, after a revised -0.4% QoQ print in Q1 (from -0.5%). The breakdown showed that most of the surprise in the moderation of the contraction (we expected -0.3% QoQ at the beginning of Q2) came from stronger net exports (contributing 0.8ppt to the quarterly growth rate, while we had forecast 0.5ppt) and unexpectedly robust growth in government consumption at 0.9% QoQ, after a revised 0.0% QoQ in Q1 (previously -1.2%). The strong performance of exports in Q2 (+6.0% QoQ after -3.8% in Q1) helped investment in equipment recover (+2.9% QoQ), something that will persist into Q3. Despite this, the contraction in total investment accelerated to 2.1% QoQ (after -1.5% QoQ). Overall, we expect the economy to expand by 0.4% in 2014 (consensus expects 0.5%), up from a 1.4% contraction this year (although with a pretty much flat second half relative to the first). Upside risks include surprises on the export side as the global economy gains momentum and on the back of a strong tourism season, a faster recovery than we expect on SME lending, and further relaxation of fiscal adjustment. More particularly, we expect exports to moderate in H2 in terms of YoY rates on the back of base effects from 2012 and calendar effects that accelerated Q2 growth as in the rest of countries, while the pending fiscal adjustment contains consumption growth. We are constructive on the medium-term contribution of exports to growth. We have always argued that, in the case of goods, export behaviour in Spain was good before the crisis, and we have seen a convergence of export levels to the pre-crisis trend (Exhibit 1). But what we are unlikely to see happening is a structural shift in this trend without a stronger reform impetus that could lead to a larger exporter base as firms grow in size. Meanwhile, in the short run, most of the growth in exports will likely be driven by external demand. While export growth will remain strong over the next two years, it will not be enough to deliver strong GDP growth numbers in the context of subdued internal demand, in our view. As argued previously, these data do not change our general outlook on Spain of a slowly healing economy. In this context, we (and the government) are not expecting net employment creation before well into And even after then employment dynamics will be weak, in our view. Although employment has been behaving positively, unemployment figures overstate this slow improvement, that the active population that has been declining as people stop searching for work (and in some cases, even leave the country). Surprises in Q2 and base effects from data revisions in 2012 led to an improvement in the yearly numbers for Spain in 2013 (+0.3% in Spain relative to our previous forecasts, but our quarterly profile is barely unchanged. Our outlook for Spain remains for small positive growth in the next 12 months, and remains sensitive to adverse shocks (particularly on the fiscal side). 7

8 The fiscal stance has eased somewhat, as shown by budget execution so far this year (and, in our view, even beyond the relaxation of targets) and the behaviour of government consumption. In fact, government consumption expanded by 0.9% QoQ in Q2 and was flat in Q1. We do not expect these slippages to be corrected in the second half of the year, given the renewed European emphasis on structural adjustments (and hence, we expect Spain to miss its deficit target). However, we do not see any further relaxation that would add incrementally to quarterly growth during H2. We already warned at the beginning of the summer that the bottom in the economy could be reached before we (and consensus) expected, and that we expected macro data to support the message that a return to positive growth would be forthcoming over the summer. We also said that the summer would provide some positive headlines from Spain and allow some confidence momentum to build. But we also argued back then that we did not expect positive surprises to continue after the summer. In other words, Q3 data supports the view that the economy is reaching the bottom, and GDP growth could become positive, albeit at a low level. Overall, we expect a slowly healing economy that recovers very gradually. Recent data has been consistent with this message so far in Q3. Our GDP tracker for Spain is now indicating a flat quarter (0.0% QoQ in Q3 from -0.1% QoQ in Q2), in line with our forecast. The improvement so far has been driven primarily by soft data (see Chart 1), while hard data, although supportive of the fragile recovery, have not shown the same strength. Hence we feel comfortable with our forecasts. Chart 1: Impact of data on GDP Tracker relative to Q2 release - Spain Employed Large Firm Sales Consumer Indicator Services indicator Construction indicator Consumer Confidence Indicator PMI: Services PMI: Manufacturing IP excl. Construction Registered Unemployment Retail Trade Industrial Confidence Indicator Merchandise Imports Merchandise Exports Source: BofA Merrill Lynch Global Research 8

9 How are we positioned on the economic outlook? Our outlook for the economy is close to that of consensus, the IMF, the EC or the Spanish government. We remain only 0.2ppt below the Spanish government s forecasts for 2014 (although this will likely be revised upwards marginally), and of a similar magnitude for long-term growth. Table 12: GDP forecasts for Spain BofAMLe Consensus (Bloomberg, median) Spanish consensus GDP % -1.40% -1.30% -1.50% -1.60% GDP % 0.50% 0.70% 0.90% 0.00% Budget deficit 2013 (% of GDP) -7.00% -6.50% -6.70% -6.50% -6.70% Budget deficit 2014 (% of GDP) -6.30% -6.10% -5.90% -7.00% -5.90% Source: IMF, EC, Bloomberg, BofA Merrill Lynch Global Research. EC budget forecasts for Spain in 2014 do not include 1 ppt of GDP in measures announced right before the publication of the forecasts We do not have much information on any surprises for the 2014 budget and government revisions to the economic outlook. The main unknown at this point is what will happen with pensions, since the government has announced that they will increase between 0.25% and CPI+0.25%, although we assume the rise for 2014 to be in the lower bound since the ratio of affiliates to pensioners is close to 2 which has contributed to the widening of the social security deficit that will amount to 1.4% of GDP this year). We are also constructive on the medium-term contribution of exports to growth. We have always argued that, in the case of goods, export behaviour in Spain was good before the crisis, and we have seen a convergence of export levels to the pre-crisis trend (Exhibit 1). But what we are unlikely to see happening is a structural shift in this trend without a stronger reform impetus that could lead to a larger exporter base as firms grow in size. Meanwhile, in the short run, most of the growth in exports will likely be driven by external demand. While export growth will remain strong over the next two years, it will not be enough to deliver strong GDP growth numbers in the context of subdued internal demand, in our view. Exhibit 1: 12-month moving average for real exports of goods EC IMF Source: Haver, BofA Merrill Lynch Global Research. The trend line corresponds to the period

10 We are more conservative than consensus on fiscal numbers and debt sustainability, particularly for We will revise our budget deficit and debt dynamics once we receive the new budget at the end of September. In our current forecasts, Spain posts a deficit of 7.0% of GDP in 2013E and 6.3% in 2014E: We expect a contraction in government consumption of 2.9% in 2014, in line with its own figures, while consensus expects a contraction of around 2%. Despite this milder contraction, the consensus deficit forecast is smaller than ours, mainly driven by the differences in growth. But in our view, this reflects optimism of late regarding both the degree of contraction of government consumption and the deficit numbers. For example, the Spanish consensus was expecting a budget deficit of 5.7% six months ago (we were at 7.0% and the consensus has converged now to this number, at 6.7%). Budget execution so far this year is consistent with our forecast. In particular, the cumulative deficit until July was 5.3% of GDP (with a target for the whole year of 6.5%), excluding the local administration, with the central government posting a deficit of 4.3% of GDP (with a target of 3.7% of GDP for the year), and the regions posting 0.8% of GDP (1.3% of target). The social security administration showed a surplus of 0.1%, while it has a target for the year of - 1.4% of GDP. Since we would expect the social security fund (which has received already 89% of the transfers for the year from the central government until July) to widen in line with the target, and the local administration to post a small surplus, the regions and the central government would need to be close to budget balance for the rest of the year to satisfy the aggregate deficit target. In other words, numbers from the general government point to a deficit pretty much equivalent to that of 2012 up until July, suggesting that the government could miss this year s target. Indeed, the latter part of 2012 included close to 1ppt of GDP in one-off expenditure and revenue measures (among them some revenues from 2013 brought forward to 2012) that helped achieve the 7% of GDP at the end of 2012, which will not be available this year. This slippage could be partly corrected by the better economic outlook relative to Q In the absence of any new measures in the last part of the year, we could see a deficit even larger than 7% of GDP. The stability programme assumed an increase of tax revenues of 4.8%, which given the data until July, would require a 10% increase in tax revenues between July and December relative to the same period in This suggests to us that risks are more to the fiscal picture than to the economic recovery (although, as we address later on this note, the credit crunch is also a source of risk). In our most recent debt sustainability analysis, we highlighted that debt was expected to peak below 100% of GDP but this will significantly change after the recent revision in Spanish GDP numbers, the relaxation of deficit targets, and once we see the final fiscal data for 2012 (and before). In the meantime, we have incorporated the impact of GDP revisions to our short-term forecasts. Spanish GDP was revised lower in 2012 (0.2ppt) and 2011 (0.3ppt). More importantly, the GDP deflator was revised down significantly by 1.4ppt between 2009 and 2012, leaving GDP deflator growth at around 0% for the past four years. This has important implications for fiscal numbers (see Table on the appendix): 10

11 23 September 2013 The immediate impact has been to increase the debt level at the end of 2012 to 85.9% of GDP (from 84.2% of GDP previously), which would push the debt level to 100% of GDP at the end of 2014, in the absence of new measures and pending revisions of past deficit figures. The deficit number at the end of 2012 (excluding the impact of the bank recap) should increase by 0.1ppt, to 7.1% of GDP. Having said that, government consumption in 2012 has been revised lower by around 0.3ppt of GDP, which limits the risks of an upward revision of the 2012 figures. On the other hand, the fact that most of the downward revisions in nominal terms in previous years seem to have occurred in the gross operating surplus of the economy, we could see a possible downward revision of corporate tax collection (which represented close to 8% of tax revenues in 2012). When to turn more positive? As we argued previously (Groundhog day: new European semester, same demands) we would turn more optimistic on Spain if exports continue to surprise to the upside and/or the ECB managed to restore SME lending earlier than we expect. Also, our concerns regarding debt sustainability and trend growth would be lessened if Spain manages to come up with a clear, concise, well-defined consolidation plan for , with growth-friendly tax reforms and a major overhaul of the public administration, and renewed impetus for reform. Included, we think, should be a new round of labour market reforms dealing with duality (the introduction of a single contract), but also more ambitious reforms on the product and service markets. What can we expect from the budget? We have argued previously that measures announced up to now may not be enough. Our view is shared by the European Commission, which, after evaluating the stability programme and giving Spain two more years to reach a budget deficit of 3%, confirmed that the country would need to make savings of 1.5% of GDP pa on average over the next three years to reach the target based on the new path (starting 2014 see Table 13). Table 13: Budget deficit path going forward: Most of the adjustment still pending ( % of GDP) New path for the budget deficit Effort needed according to the EC* Source: BofA Merrill Lynch Global Research and European Commission. *This does not take into account the renewal of tax hikes expiring at the end of 2013, which amount to 1 ppt of GDP in This is net effort, in other words, it should take into account the impact on the economy and hence the total effort should be larger. We do not have much information on any surprises for the 2014 budget or on revisions to the economic outlook. Main unknown at this point is what will happen with pensions, since the government has announced a new reform that will lead to an increase between 0.25% and CPI+0.25%. Although we do not have the full details of the reform (still not approved) we would assume the increase for 2014 to be on the lower bound (which will help since the ratio of affiliates to pensioners is close to 2 which has contributed to the widening of the social security deficit that will amount to 1.4% of GDP this year). The press has also reported that the government is considering freezing wages in the public sector during

12 However, in our view this was implicitly incorporated in the numbers of the stability programme. Other than that, our concerns for the state budget are unchanged, as reflected in the approval of the expenditure ceiling. Although expected revenues are more conservative than in previous years they may prove challenging without further revenue measures (depending on where revenues end in 2012), while the evolution of expenditure may prove challenging without strong measures on pensions (pending the approval of the reform) and wages for public-sector employees. We will analyse this carefully when the budget is unveiled. March 2014 will be an important date for the future of fiscal adjustment in Spain. The government must detail its tax reform as requested by the European Commission (it has been announced that the advisory committee created would deliver a proposal by February) together with an ongoing expenditure review. We believe Spain needs a tax reform that reduces statutory rates, eliminates subsidies, tax credits and deductions, and shifts taxation towards a more growthfriendly system. This reform offers a good opportunity for the Spanish government to provide a credible medium-term fiscal adjustment as flagged in some of our notes (see our discussion on pending tax reform in Spain). 12

13 23 September 2013 Deleverage = downside risk to GDP Lending has remained extremely weak over the past year, with loans to the nonfinancial private sector contracting by 13% yoy in July (Chart 2). Adjusting for transfers to Sareb, the contraction of credit remains sizeable. While this is consistent with the needed (and not finished, particularly in the case of households, as we emphasised here) deleveraging process, we have underlined before that there is evidence of an ongoing credit crunch that restricts economic activity, as highlighted by the ECB s lending survey and recent academic papers 1. Chart 2:Total Loans MoM Evolution ( bn) Chart 3:Total Loans YoY Growth 2,000 1,900 1,800 1,700 1,600 1,500 1,400 1,300 1,200 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 20% 15% 10% 5% 0% -5% -10% -15% Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan % Jul-13 Source: Bank of Spain Source: Bank of Spain Chart 4:Loan Growth YoY by type of loan Chart 5:Loans Outstanding ( bn) by sector 40% 30% 20% 10% 0% -10% -20% -30% Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun % % Jun-12 Jun-13 1,200 1, Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun Jun-13 Corporates Individuals Agriculture Industry (ex-construction) Source: Bank of Spain Source: Bank of Spain As the IMF notes 2, one would have expected banks in the G0 group, according to the stress-test classification, to take over the broken healthy lending relationships that banks in other groups had to let go. This projected rebalancing of credit growth across banks does not appear to have materialised so far, as the pace of credit contraction to the private sector for the two groups of banks was essentially identical. 1 See for instance S. Bentolila, G. Jimenez, M. Jansen and S. Ruano, (2013): When Credit Dries Up: Job Losses in the Great Recession, mimeo

14 All in all, this suggests to us that G0 banks may be unable (or unwilling) to increase their market share as much as initially expected by the IMF, and credit to the economy could contract even further than anticipated. Table 14: Spanish banks lending evolution QoQ YoY Banco Popular -1% -8% Santander Spain -3% -8% Bankinter 0% -5% BBVA -2% -2% Bankia -4% -34% Source: BofA Merrill Lynch Global Research estimates, company report. Banco Sabadell not considered as it includes recent acquisitions In our view, there are several reasons for banks not increasing lending market share and, together with additional fiscal shocks in the future, represent a significant risk to our economic outlook. We are aware of the importance of developments in banking sector consolidation after the ECB s banks BSA, together with progress in the banking union to normalise credit flows in the euro area. In the case of Spain, additional factors reinforce our cautiousness on the evolution of lending, such as the (still) high private-sector indebtedness (charts below). Exhibit 2: Spanish private sector debt - split between households and non-financial corporates Exhibit 3: Spanish private sector debt to GDP Source: ECB, DataStream Source: ECB, DataStream We highlight in this note how the issues of the AQR, DTAs, leverage, restructured/refinanced loans and so forth generate large uncertainties regarding banks balance sheets ahead of the results of the banks BSA. For banks in Spain, we think that the BSA could prove to be a fundamental dislocation. The relationship between the Bank of Spain and its charges has been particularly close throughout the crisis, which will now change that the ECB is at the helm. We have very little visibility on the depth of the review. However, we think European regulators are aware that this is the last chance to return more credibility to the European financial system. This, in our view, could provide incentives to deleverage ahead of the AQR and to sell assets. 14

15 Additionally, Spanish banks continue to support SPGBs strongly, having increased their holdings up to June, to 38.5bn of the 44.5bn (net) issued. As we highlighted before, banks bias towards supporting SPGBs instead of lending is likely to continue for two reasons. First, the pretax margin available in taking government exposure is potentially equivalent to, or above, that of lending because there is almost no marginal cost, and credit losses are likely assumed to be zero (a prefunding margin on five-year government debt may be considered higher than the margin on lending). Second, a government bond position can be repo funded with a 5% or less haircut even for longer-dated exposures. This is a fraction of the discount required to repo fund mortgage or SME exposures, even when such finance is available. Additionally, if foreign investors fail to return to SPGBs more aggressively, we fear this process could lead to further tightening of existing restrictions, ahead of the AQR. Table 15: Loan book breakdown ( mn) B. Popular Santander Caixabank BBVA B. Sabadell Bankia Total Total loan book Spain 97, , , ,237 98, , ,120 as % of total 100% 100% 100% 100% 100% 100% 100% ow housebuilders 20,763 13,215 24,964 14,537 9,900 4,718 88,097 as % of total 21% 7% 11% 7% 10% 3% 9% ow individuals with mortgage collateral 27,767 51,000 90,321 85,100 36,000 79, ,934 as % of total 29% 27% 41% 41% 36% 58% 39% ow individuals others 3,270 12,000 32,627 22,400 4,000 5,981 80,278 as % of total 3% 6% 15% 11% 4% 4% 8% ow SMEs/Corporates 42,982 95,000 62,574 52,200 44,000 41, ,764 as % of total 44% 50% 28% 25% 44% 30% 36% ow public works+ others 2,303 18,000 10,481 31,000 5,000 6,263 73,047 as % of total 2% 10% 5% 15% 5% 5% 8% RE assets 11,491 7,845 12,081 12,570 6,300 5,326 55,613 Total loan book+re assets 108, , , , , ,042 1,004,733 Source: BofA Merrill Lynch Global Research estimates, company report 15

16 An update on system NPAs Regarding NPL formation, it is typically argued (and there is some evidence 3 ) that there is a 3-5-quarter lag between GDP bottoming and the peak in NPLs. However, we highlight the many reasons why this may not necessarily be the case for Spain, given that internal demand remains subdued despite the positive GDP improvement (driven by external demand) and that this is a reallocation cycle (with a large structural increase in unemployment) more than a cyclical movement and so the lag period could easily extend. We also highlight the following: Most of the evidence for the lag is framed in a cyclical downturn, but embedded in the current situation in Spain is a structural reduction of trend growth and an increase in structural unemployment (and, most importantly, long-term unemployment). In other words, while the recession could be over as soon as Q3, some of the more damaging elements of the crisis may persist. While the unemployment rate could start declining sooner than expected, this will likely be driven by a shrinking active population as people stop searching for work (and in some cases, even leave the country). We (and the government) are not expecting net employment creation before well into And, even after that, employment dynamics will be weak, in our view. Disposable income growth should be subdued in the next two years. The government expects wages to keep falling until 2015, when they are set to increase by only 0.7%. And this is assuming that current austerity in the stability programme is enough and that there is no need to announce new measures that may dent disposable income further. Bankruptcy proceedings in Spain are very costly, 4 which discourages companies from taking this route. This, coupled with the credit crunch, has kept the number of dissolved companies at high levels after four years of crisis. In July, the 12-month cumulative growth rate in the number of dissolved firms was still as high as 13%, from the peak of 16% in April The latest Bank of Spain data on non-performing loans (NPLs) showed a 1% MoM increase in July. This implies that the NPL ratio increased to 11.97% in July, up 188bp vs last year and up 35bp MoM (+ 2bn) Celentani, M., García-Posada, M. and F. Gómez (2010): The Spanish Business Bankruptcy Puzzle and the risis, FEDEA Working Paper

17 Chart 6:Total NPLs ( bn; LHS) & NPL Ratios Chart 7:Total NPL Ratios by Sector Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul % 179 Jan-13 Jul-13 14% 12% 10% 8% 6% 4% 2% 0% 35% 30% 25% 20% 15% 10% 5% 0% 29.0% 18.5% 11.8% 11.4% Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 NPLs NPL Ratio Agriculture Construction Industrials (ex-construction) Services Source: Bank of Spain Source: Bank of Spain Table 16: Spanish banks breakdown of NPLs ( mn) We estimate the breakdown of the NPL balance by segment. Table 16 shows that non-housebuilder NPLs represent c.61% of the total NPL balance for banks under our coverage (32% SMEs and 17% mortgages). Banco Popular Santander Caixabank BBVA Banco Sabadell Bankia Total Total NPLs 16,650 18,109 25,876 17,115 12,590 19, ,645 NPLs housebuilders 8,583 8,009 12,629 7,415 4,100 2,395 43,131 as % of total 52% 44% 49% 43% 33% 12% 39% NPLs rest of the loan book 8,067 10,100 13,247 9,700 8,490 16,910 66,514 as % of total 48% 56% 51% 57% 67% 88% 61% ow mortgages 1,998 1,811 3,105 1,883 3,399 6,178 18,374 as % of total 12% 10% 12% 11% 27% 32% 17% ow SMEs/Corporates 5,161 6,157 5,693 3,936 3,903 9,846 34,696 as % of total 31% 34% 22% 23% 31% 51% 32% ow other loans 832 2,173 4,399 3,936 1, ,439 as % of total 5% 12% 17% 23% 9% 5% 12% Source: BofA Merrill Lynch Global Research NPLs totalled 178.7bn as of July. If we account for doubtful loans transferred to Sareb by Group 1+2 banks, NPLs amount to 222bn, equivalent to c.21% of Spanish GDP, and the NPL ratio stands at c.14% (vs the published 11.97%). The banking system also has > 70bn of gross foreclosed real estate assets not included in the NPLs (in addition to 23bn at Sareb). If we adjust for the real estate assets (Sareb + banking system) the NPA ratio would stand at c.18% ( 315bn). 17

18 We are not including performing refinanced/restructured loans (which we detail later in this note). On 7 May, Bank of Spain published its Financial Stability Report (FSR), which states that the financial system has 208bn of refinanced/restructured loans, of which doubtful and substandard represent 58%. Hence, we assume that (at least) 88bn of refinanced/restructured loans that are currently classified as performing could become doubtful and substandard at some point. If we assume that 40% of such exposure becomes problematic, the amount of potential NPA would stand at 350bn. Table 17: Breakdown of problematic assets ( bn) NPL ratio July (Bank of Spain) 11.97% NPLs July (Bank of Spain) NPL growth MoM (Bank of Spain) 1% NPLs on Sareb (transferred by banks 1+2 ) 44.0 Underlying NPLs NPL ratio proforma 13.7% Foreclosed real estate properties 93 NPAs NPA ratio proforma 17.9% Source: BofA Merrill Lynch Global Research estimates Analysis of the real estate related NPAs for the system Of the total financial exposure to the construction and real estate sector ( 284bn), potentially troubled exposure (i.e., NPAs) amounted to 160bn, according to our estimate (of which banks under our coverage are exposed to 69%). Of the 284bn, we estimate that performing loans represent 43%, with the rest being real estate related NPAs (land accounts for 32% and unfinished developments/properties for 10%). We estimate that land represents 32% of the total exposure to construction and real estate and 41% of the problematic exposure, and that, respectively, unfinished properties make up 11% and 9%, and finished properties 50% and 50%. Table 18: Spanish financial system exposure to construction and real estate ( bn) Performing 123 Land 25 Work in Progress 16 Finished properties 61 Personal guarantees and second mortgage 18 Others 3 NPA 160 ow banks under our coverage 111 Land 65 Work in Progress 14 Rest (finished housing incl. foreclosed retail houses) 81 Total RE exposure 284 ow banks under our coverage 144 Source: BofA Merrill Lynch Global Research Of the 284bn, NPLs represent 57% ( 136bn), substandard loans account for 9% ( 25bn) and performing loans for 43% ( 123bn). According to our estimates, the coverage for NPAs will reach c.55% ( 87bn), with c.45% coverage of the total system s exposure to construction and real estate (assuming 30% general provisions). Table 19 shows NPAs and performing coverage by type of asset and the average coverage based on asset type. Land has 74% provisions coverage according to our estimate (regardless of its NPAs or whether it is being used as collateral in a performing loan). 18

19 Table 19: Spanish financial system exposure and coverage by type of assets ( bn) NPAs Performing exposure Total Coverage Land % Work in Progress % Finished properties % Total % Source: BofA Merrill Lynch Global Research. Total on performing exposure includes personal guarantees and second mortgages not considered previously In other words, we expect the system to have set aside 123bn of provisions related to construction and real estate exposure, of which 37bn would be general provisions and 87bn related to NPAs (of which c. 52bn for land, c. 10bn for unfinished properties and c. 28bn for the remainder). Therefore, the net exposure to construction and real estate should amount to 157bn, of which 86bn would be for performing exposure to construction and real estate. Of the 123bn performing exposure, we estimate that land represents 20%, unfinished properties make up 13%, performing exposure with finished properties as collateral accounts for 50% and performing exposure with personnel guarantee as collateral represents 15%. Sareb NPAs off-loading started With real estate assets worth c. 50bn (net value) transferred by Group 1 ( 36.5bn) and Group 2 ( 13.9bn) banks in December 2012 and February 2013, respectively, and with on average, the transfer price at 46% of the gross book value for loans to housebuilders and 63% on foreclosed properties, Sareb plays a crucial role in the unwinding of real estate in the system. Table 20: Sareb breakdown of asset transfer (net value) bn As % of total BFA-Bankia % BdV 1.9 4% Catalunya Banc % NCG % Total Group 1 banks % BMN % Caja % Liberbank 2.9 6% CEISS 3.1 6% Total Group 2 banks % Total % Source: BofA Merrill Lynch Global Research, FROB Sareb has made good progress recently and is on track to dispose (at least) 1bn of assets (2% of the total) before this year-end (see Table 21). However we would rather prefer to see straight disposal of assets rather than agreements in which Sareb keeps part of the risk (and potential return). 19

20 Table 21: Sareb projects Project Date Underlying asset Buyer Price ( mn) Bermudas M-13 Syndicated loans from Metrovacesa Sale - 35 Bermudas A-13 Syndicated loans from Colonial Sale Burlington Loan ML 245 Bull/Toro A-13 Residential properties FAB (49% Sareb) H.I.G Capital 120 Corona 7 offices properties (80% occupancy rate) In progress parking slots TBC Teide In progress Residential properties TBC Abacus In progress Parking slots, offices, TBC Blue In progress Hotels TBC - - Runner In progress 35% stake Parque Corredor among others TBC - 25 Harvest In progress 22 assets of rural land TBC - Source: Press, Sareb. FAB: Banking Assets Fund We think that an orderly unwinding of the Sareb assets is key to re-establishing a stable property market. The theme has three angles all linked though property prices. First, if Sareb does not dispose of assets in normalised circumstances within the next months, we expect private banks to proceed with the disposal of their own assets faster than initially expected, so that by the time Sareb is fully operational, the stock of units held by private banks would be lower than currently. Second, If the above plays out in a disorderly manner, there is a risk of accelerating property price declines, which may put the current (net) value of the Sareb assets at risk and therefore the current capital base of the private banks (57% of Sareb capital will be owned by the private sector). Third, in the event that Sareb becomes an institution that, once the asset disposal is in full swing, puts pressure on property prices in case the institutions needs positive cash flows, this could impact the private sector banks stock of real estate and eventually force them to increase provisions on real estate. Table 22: Sareb avg. impairment by asset class FROB OW Real estate developers 45.60% 42.30% ow finalised 32.40% 27.30% ow WIP 40.30% 39.40% ow urban land 53.60% 56.30% ow land 56.60% 56.30% ow other assets with RE collateral 33.80% 30.90% ow other assets with no RE collateral 67.60% 63.90% Foreclosed and acquired real estate assets 63.10% 62.00% ow finalised 54.20% 51.00% ow WIP 63.20% 61.40% ow land 79.50% 77.80% Source: BofA Merrill Lynch Global Research, FROB, Oliver Wyman Management Consultant In our view, if Sareb proceeds with a rapid unwinding of assets, and assuming disposals are made at no financial loss, we think the vehicle may see improving capital adequacy (on leverage metrics) assuming that transfer prices are adequate and there are no losses to impair the equity base. But the opposite also applies: (1) a larger-than-expected deterioration in the real estate market may render the transfer price of assets to Sareb unrealistic and put its capital at risk, and/or (2) a slow pace of asset disposals or a further deterioration in the quality of the loan book transferred to Sareb may raise cash flow issues. 20