The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (36 page)

Some of Spain’s most senior officials are frustrated and irritated by the attitude subsequently shown by Germany and the Troika. ‘One of the problems we have,’ one official told me, ‘is the long, long list of moral judgements. The problem was economic not moral. Germans are depicted as sensible savers, hardworking people. We “pigs” don’t work, we spent much too much, and enjoy our fiestas and siestas lying on the beach, with a German and a Dutch guy giving us free beers. But this really is all about monetary policy and incentives.’

He traces the root cause of the problem to German reunification in 1990, when a 1:1 exchange rate was agreed for the West German and East German mark. This generated a very deep real-estate recession in Germany that lasted a decade. And then the euro arrived with super-low interest rates and a relaxed monetary policy, matching those of the USA. Eurozone interest rates were naturally focused on helping the depressed German economy, by far the biggest economy in the zone, without much heed being paid to the consequences elsewhere within the monetary union. The end result for countries such as Spain was very low interest rates for a very long time – so low, that taking the still-elevated level of inflation into account, such peripheral countries in fact experienced an extended period of negative interest rates.

‘With negative interest rates the rational thing is to grow debts,’ the Spanish official told me. ‘It’s not lazy. It’s the direct outcome of negative interest rates, year after year after year. The whole time we were saying we have a huge problem. In the meantime German banks were desperate to escape very low interest rates in low-yield Germany, so they looked outside to the USA and Spain. German banks were buying the high yield that they could not provide domestically.’

After this conversation, the official said he would deny ever having met me if the quotes were attributed. Such are the sensitivities in a nation-state where sovereignty is not absolute, but shared with its partners. The former minister Campa puts it like this: ‘The side effect of real negative rates is that people and companies want to leverage. A single monetary policy for the whole euro area has these side effects. At the time monetary policy was focused on German weak growth. Is there a domestic financial policy that could have dented that boom? There’s no real effective policy. It’s very difficult in general to stop a build-up of a bubble of this kind, when everybody is benefiting.’

Actually, Spain did have a go at halting the growth of its bubbles, using bank buffer funds and government deficits, and did better than most. It managed to rein in the very worst excesses of the credit cycle through a Bank of Spain tool known as ‘dynamic provisioning’. From 2000, banks and cajas were obliged to put 20 per cent of their income aside as a buffer in the good times. At the time it was bitterly opposed by Spain’s big banks, international accounting regulators and foreign regulators. The profits of Spain’s big banks were certainly hurt by the policy. ‘You’re crazy,’ a Bank of Spain official recalls a caja lobbyist telling him in 2000. ‘You’re conservative, you’re harming us internationally, you are mad.’ Half a decade on, as the cajas found themselves using these provisions at the onset of the crisis, the same lobbyist said they were not so bad. A full decade on, the lobbyist told him that the Bank of Spain should have been even tougher. In the same way, the major international Spanish banks, such as Santander and BBVA, complained about dynamic provisioning during the boom, but by the time the crisis hit they were boasting about it. All of which goes to confirm that over the medium term a banker cannot be relied on to know what is good, even for themselves.

Obviously a crucial flaw of such a plan is that in a severe double-dip recession, the buffer is depleted without being replenished. That is precisely what happened in 2011/12. A more subtle flaw was that it created opaqueness around the true state of the caja balance sheets. More fundamentally, it allowed the regulator to take its eyes off the ball with the cajas. But Santander and BBVA did remain in strong health relative to other European competitors, particularly considering the ill-health of their domestic market. The more bullish proponents of the policy say that €30 billion of taxpayers’ money was saved. There was no bailout of the private banks. Dynamic provisioning helped smooth the wave, but did not prevent it from breaking.

Spain is also justified in feeling a little hard done by, given that, like Ireland, it kept to the rules of the game on deficits. Berlin and Brussels designed the so-called ‘Stability and Growth Pact’ to limit government deficits within the Eurozone. Unlike Germany and France, Spain stuck to the strictures of the pact until the crisis. The best performers were Finland and Luxembourg, followed by Spain and Ireland. The worst performers were Italy and Greece, then Germany and France. Whether you were a fiscal fiend or a fiscal saint turned out to have very little bearing on whether or not you needed a bailout. Spain and Ireland showed the best predictor of euro-crisis pain was a country’s net financial position – basically those huge international inflows of hot money into domestic credit markets.

The entire economy of Spain turned out to be a giant mortgage: an epic one-way bet on property, estate agents and construction. When the Lehman Brothers crisis of 2008 put a stop to those international inflows of cash, the Spanish property market collapsed, homes were left unsold, construction companies went bankrupt, millions of workers were laid off, property taxes collapsed, and regional-government deficits spiralled as welfare payments to people and banks surged, as more and more cajas needed to be bailed out. ‘Throughout the period,’ says Campa, the former minister, ‘we were always under pressure, but never at the front line of the threat. Another country was always seen as more vulnerable, and we had the ability to react with significant policies sufficient to restore confidence – but at a very high political cost.’

Zapatero’s government saw the Greek sovereign-debt crisis emerging in 2010. In May of that year it responded with an austerity package, reversing social policies and freezing pensions. It prompted massive protests and was seen as political suicide. Zapatero left office without contesting the election in 2011, and the centre-right Partido Popular won a landslide. The new prime minister, Mariano Rajoy, doubled up on the austerity, with brutal cuts to government spending. Spain always benefited from the fact that Italy looked much worse. After the technocrat Mario Monti was appointed Italian prime minister, the bond markets switched their attentions from Rome to Madrid. Rajoy’s efforts were made more difficult because some of the toughest cuts he wanted were actually not his to make, but in the hands of Spain’s strong regional governments. The protests were huge. Rajoy was anxious to avoid the humiliation of a Greek-style bailout. But the ‘doom loop’ – in which rotten banks created market fears about governments, which in turn worsened funding for banks – was in full flow. The problems in Spain’s cajas proved overwhelming. The final trigger was the slow-motion run on Bankia.

The palatial offices of the Bank of Spain in Madrid have a regal air: there are Royal Steps, there are vaults full of gold (though nearly three-quarters of the original gold reserves were shipped to Moscow in 1936, after the outbreak of the Spanish Civil War), and there are rooms hung with priceless Goya paintings. Goya was paid in share certificates for these portraits of senior Bank officials, and so became a shareholder in the original Bank of Spain. By 2011 there were various other curious additions to the Bank’s asset base. The Bank of Spain was increasingly finding the country’s debts ending up on its own balance sheet – and, as the Bank of Spain is part of the eurosystem, these debts ultimately ended up on the balance sheet of the European Central Bank. In fact, Spanish banks were creating packages of mortgage loans and corporate loans specifically to use as collateral for ECB cash. The bulk of those mortgage-covered bonds were now effectively funded by the ECB, after the funding from German and other foreign institutions dried up.
Cédula
issuance for mortgages reached record levels in 2010 and 2011, after the collapses of the cajas and the property market, and in the wake of fears about the future of the euro itself.

In the summer of 2011 Bankia cashed in a €773 million portfolio of loans called Madrid Active Corporations 5 (MAC 5). This portfolio included tram lines, the metro station at Barcelona Airport, some wind farms – and the world’s most expensive footballer, Cristiano Ronaldo. Caja Madrid had lent Real Madrid €76.5 million to buy Ronaldo from Manchester United. It was the second largest single loan in MAC 5. Unusually, the transfer fee was paid up-front and in full. Originally the loan for Ronaldo had garnered an AAA rating. But by 2012 that had been cut, just after the team and the footballer had become Spanish champions. Still, Real Madrid were good for their money.

At the same time, a large quantity of Spanish property junk was being parked on the ECB’s balance sheet, for a time the only form of funding available to weak Spanish banks. During March 2012, Spanish transactions of this type doubled in a month to €315 billion, which in practice meant large chunks of the Iberian Peninsula’s decaying property assets were being cashed in at the Frankfurt pawnshop (alongside some government debts). At the height of Spain’s banking crisis the rate of issuance of mortgage
cédulas
actually accelerated, reaching record levels – but this was essentially funded by the ECB, rather than by north European banks.

The Spanish banks were running out of assets to underpin the existing
cédulas
for mortgages and public-project borrowing. So they scoured their balance sheets for other assets that could be transformed into a
cédula
and therefore traded in for ECB cash. Spain even issued a Royal Decree Law in July 2012 to create an entirely new type of
cédula
, backed by loans for exports. The Madrid office of the credit agency Moody’s said that it showed the banks were running out of conventional mortgage assets to parcel up.

By August 2012 more than a third of all the ECB’s emergency funding was in Spain. It had increased by eightfold over a year. The assets were being quality-controlled at the Bank of Spain. The more toxic ones were given a ‘haircut’, their value slashed to protect the central bank. In Germany, newspapers conducted investigations into the quality of Spanish quality control. Developments echoed what had happened in Ireland in autumn 2010. Spanish government borrowing costs shot up at the same time, making it impossible for the government to inject the funds necessary to stabilise the Spanish banks. With deposits fleeing, Prime Minister Mariano Rajoy had to do what he had promised he would not: ask Europe for the funds.

I sit in the large office of one of the Spanish financial officials who deals with the Troika. Spain avoids using the word ‘bailout’ to describe the programme. Officially the IMF is merely an adviser, rather than a lender. Spain is not Greece, after all. But sovereignty has sapped away from this nation. The official describes the first meeting with the Troika: ‘Do you have a plan?’ they asked in relation to Spain’s cajas. ‘OK, this is your plan,’ they said, presenting a paper. My official offers a personal opinion. ‘The external presence is extremely helpful,’ he says. ‘I never imagined we would have done what we have done in financial reform in the past few months without their presence. We have done in six months what would have taken a decade.’

A Spanish minister does not like to have bureaucrats from Frankfurt, Brussels and Washington sitting on his office sofa, telling him what to do. But ultimately he accepts the predicament. ‘There is useful pressure,’ my official says. ‘Sometimes you have to do things that it’s better to blame on other forces. It’s tough, there is some loss of sovereignty, but we negotiate with partners what to do.’ I ask him if he is enjoying his job. ‘No,’ he replies.

The precise course followed by the torrent of credit from northern Europe en route to Spain weighs on minds in Madrid. In their search for yield, German banks (memorably described as ‘stupid Germans in Düsseldorf’ by the writer Michael Lewis in
The Big Short
) had also been investing in toxic US subprime mortgage debts at the very top of the market. When German loans to Americans went sour in 2007–08, the German banks lost, and required massive bailouts from the German taxpayer. When German loans to Spaniards soured in 2010–11, the Spanish lost out, assuming the credit risk, and the German banks got paid off in full. The mechanics of the covered-bond market and the insistence from the ECB that Spain bail out its banks meant, in the first instance, that Spanish taxpayers were left with the bill.

At the heart of Spain’s bailout is the FROB – the Fondo de Reestructuración Ordenada Bancaria (‘fund for orderly bank restructuring’). The FROB was set up by the Zapatero government to deal with the rotting cajas. By June 2012, under Rajoy’s government, it was the receptacle for a financial bailout of €100 billion. The FROB can be seen as an undertaker preparing an entire part of Spain’s financial system for burial. Or perhaps it is more like a matador planning one clean, forensic blow to finish off the weakened, bleeding bull of the banking industry. The day I dropped in, the FROB’s staff were moving to offices near Real Madrid’s Bernabéu stadium, not far from the HQ of Sareb. ‘The new government couldn’t trust the cajas,’ a senior official told me, ‘because behind the cajas with some exceptions were politicians. Perhaps not in the retail business, but in the case of corporate business there was a lot of mistakes.’ He pointed the finger at regional, rather than national, politicians.

FROB’s initial attempts to sort out the cajas failed horrifically in the case of Bankia, which it created out of the merger of seven cajas – three of which, including Caja Madrid, were in a bad state. It turned out to be a monster worthy of Dr Frankenstein, a monster that increased, concentrated and made systemic the financial problem, rather than reducing or even solving it. In Bankia, Spain had created a too-big-to-fail institution, two years after the 2008 crisis had shown the dangers presented by such vast financial organisations. In December 2010 Rodrigo Rato, ex-managing director of the IMF, was brought in on a multi-million-pound salary to run Bankia – seemingly at a profit. But weeks after he resigned in May 2012 it became apparent that Bankia was making multibillion-pound losses. A few months later the leaning tower of Bankia lodged the largest loss in Spanish corporate history, principally caused by the rotten legacy of Caja Madrid and Bancaja, a similar institution from Valencia. The controversy was politically charged because Caja Madrid had been officially owned by the local Madrid government run by the Partido Popular (PP), the centre-right party that came to power nationally in 2011 under Mariano Rajoy. Bancaja’s board in Valencia had been similarly close to the PP.