“This sales process is atypical, as the seller itself cannot at this point make a rough calculation of what the value of the entity is, and if they can’t, neither can we.” The current share price of Spain’s sixth biggest bank, Banco Popular, at €0.67, is just pennies above its lowest point ever. According to analysts at 20 different investment banks consulted by Bloomberg, the “objective” value of those shares could be anything from €1.50 (Oddo & Cie) to €0.25 (Kepler Cheuvreux). There’s good reason for this uncertainty: Popular’s books are filled with impaired real estate assets that date back to before the collapse of Spain’s gargantuan real estate bubble. They are now in varying stages of decomposition. And the prices at which they’ve been valued on the bank’s books appear to have little relation with today’s reality. It now turns out that not even Popular’s management knows what’s really going on on Popular’s books.
Representatives of Banco Santander and majority state-owned Bankia, the two banks studying Popular’s books to decide whether or not to submit a binding offer for the bank before the deadline of June 10, are having serious difficulties trying to understand Popular’s accounts, according to Spain’s financial daily Expansión. Although there is “total collaboration” from the struggling entity, Popular’s management has not yet completed its own review of the impaired assets on the bank’s balance sheets and therefore cannot offer a precise valuation of the bank.
“A bank sells out of necessity, not voluntarily,” said a senior official of one of the entities that is carefully analyzing Popular accounts. “The problem,” he adds, “is that this sales process is atypical, as the seller itself cannot at this point make a rough calculation of what the value of the entity is, and if they can’t, neither can we.”
This heightened uncertainty has apparently exacerbated the run on the bank’s deposits as well as triggering further declines in Popular’s contingent convertible bonds, the infamous Co-Co bonds. Co-Cos have no maturity date and are designed to be “bailed in” before taxpayers get to foot the bill. Thus, they’re a measure of how likely investors think a bail-in is.
Popular has two batches of Co-Cos. Those issued in October 2013 are currently trading at 78 cents on the euro. That’s below the previous lowest level registered in February last year, when Deutsche Bank’s troubles sparked a broad, albeit short-lived, sell off of Co-Cos across Europe’s financial markets.
The second issuance, from 2015, is in even worse straits, trading at 68 cents on the euro.
The difference between the two positions is mainly due to the fact that the bank chose to raise the capital threshold at which the bonds would be bailed-in from 5.125% (for the first issuance) to 7% (for the second issuance). In other words, if Popular’s capital ratio, which, according to its latest results is just above the ECB’s minimal threshold, falls below 7% the bank won’t make the coupon payment on the second batch of bonds.
In such an event, investors would end up being stuck with bonds that have plunged in value and pay no coupon. Then, if regulators deem that the bank is failing, the Co-Cos get “bailed in,” either by getting converted into increasingly worthless shares or by getting canceled altogether.
So far, no bank has defaulted on their Co-Co bonds. But that could be about to change, according to Expansión. The current levels of Popular’s Co-Cos imply that investors believe there is a very real possibility that Popular will end up converting the bonds into shares. At the height of Deutsche’s Co-Co crisis, when investors feared that the capital threshold would be breached, the bonds fell to 69 cents on the euro, at the time the lowest point for any major financial institution.
Popular’s second batch of Co-Cos just crossed that line. To reassure spooked investors, an official spokesperson of the bank has stated that the payment of the next scheduled coupon in June is not at risk. Deutsche Bank has already shown that this sort of situation can be turned around and its Co-Cos have recovered. But Deutsche Bank was still able to raise new capital, a luxury that Popular no longer has. According to Expansión, some of Popular’s investors have already begun to calculate how their accounts would be affected if, as feared, the Co-Co bonds were converted into shares.
If that were to happen, it could send a very dangerous signal to the markets: despite all the restructuring, forced mergers and acquisitions, and the €300 billion taxpayer- funded bailout of the country’s savings banks (if you include all of the government guarantees), Spain’s banking system is not nearly as fixed as the authorities, both political and monetary, claim. More to the point, some investors may even begin wondering if Popular is the only bank in Spain to have massively inflated the value of the “assets” on its books.
As Francisco González, the president of Spain’s second biggest bank, BBVA, said during testimony in the Bankia Case, accounting in the banking sector is so elastic that it’s like chewing gum. The difference between a profit and a loss, a valuable or non-performing asset, on a bank balance sheet invariably depends on who’s doing the counting and what methods they’re using.
It’s only when a bank’s accounting methods come unstuck, as is happening now with Popular, that the true condition of its financial health can be revealed. But by then, for many investors, it’s already too late....