Significance: Moody's has downgraded its debt ratings for 30 Spanish banks on 23 March by one or more notches.

Implications: The Bank of Spain and government are placing significant pressure on Spanish banks to show their estimated loan losses after the abrupt end to the decade-long housing boom, and reveal their consequent capital requirements and the contribution of promised balance sheet requirements.

Outlook: The Bank of Spain calculates that the country's credit institutions need to raise EUR15.15 billion to satisfy the government and Bank of Spain's higher minimum core capital requirements. Moody's believes the overall cost could be nearer EUR40-50 billion, and warns that could even rise to EUR110-120 billion in a worst case scenario.

Moody's has downgraded its debt ratings for 30 Spanish banks by one or more notches. This followed its recent decision to downgrade Spain's sovereign credit rating by one notch from Aa1 to Aa2, citing concerns about the banking sector. The rating agency's decision to downgrade debt ratings for 30 banks reflects the "combination of heightened financial pressures on the country and its weakest banks, as well as a declining systemic importance of many smaller and regional banks." The downgrade did not affect Spain's largest listed banks, Santander and BBVA, or the large savings bank La Caixas. Moody's believe the final cost of the recapitalisation of the Spanish banking sector could be considerably higher than official estimates. Moody's believes the overall cost could be nearer EUR40-50 billion, and warns that could even rise to EUR110-120 billion in a worst-case scenario. This is significantly higher than the Bank of Spain's calculations that the country's credit institutions need to raise EUR15.15 billion to satisfy the government and Bank of Spain's higher minimum core capital requirements. Overall, the central bank has told 12 banks to increase their capital. The 12 credit institutions consist of two Spanish banks, two subsidiaries of foreign banks and eight saving banks.

Outlook and Implications

Spain's Achilles' heel continues to be parts of its still-traumatised banking sector. The Bank of Spain and government are placing significant pressure on Spanish banks to come clean about their estimated loan losses after the abrupt end to the decade long housing boom, and then reveal consequent capital requirements and the contribution of promised balance sheet requirements. The central bank governor Miguel Angel Fernandez Ordonez is hoping the whole process will help markets to have a "perfect understanding of the circumstances of the Spanish banking system."

It remains difficult to quantify the banks' capitalisation needs with confidence given the lack of a credible benchmark house price series to reveal the true fall in property prices since they peaked in early 2008. The official house price series appear to understate the weakness of the housing market during the crisis, given that they are calculated from valuations rather than final transaction prices. According to the National Statistical Office, house prices have slumped by 11.9% between the fourth quarter of 2010 and when they last peaked in mid-2007. Other housing market indicators suggest that the real-estate sector has been under greater pressure, and we believe that overall house prices have fallen by around 25% since they peaked in early 2008. However, others argue that house price falls have been lower than expected due to saving banks and several commercial banks hoarding large portfolios of repossessed properties and land which they have acquired to limit their exposure to the troubled construction and real estate sectors through debt-for-asset (property and land) and debt-equity-swaps. Importantly, this has helped to suppress their reported non-performing loans (NPL) ratio, camouflaging the true deterioration of their loan portfolio. The Bank of Spain is demanding that banks admit to potential losses on debt-for-property swaps. Consequently, the country's lenders have been asked to raise reserves from 10% to 20% on real estate assets they have held for more than a year, which increases to 30% on assets held for more than two years. The central bank hopes the new rule will force lenders to write down bad debts more rapidly than the current two to six years. The tougher provision rules are expected to coerce banks, particular the savings banks to sell their large property portfolios they have acquired as collateral from loan defaults, in an effort to improve solvency ratios, a move that risks further falls in property values that could impair the value of their asset books.

The final cost of recapitalising parts of the Spanish banking sector is likely to be a moving target in the near term. Worryingly, significant risks are threatening to prolong the housing market pain well into 2011 or even spill into 2012, resulting in a further degradation of real estate loans. The largest near-term risk is arising from central bank demanding that lending banks to put aside additional reserves of up to 30% on repossessed property holdings. This could force the over-extended savings banks to dump their repossessed property more rapidly onto a still deflating market. The prospect of a further fall in house prices in 2011 and possibly 2012 presents a considerable risk to the banking sector as whole, particularly with its existing loans to the construction sector and real estate services standing at a staggering EUR430.5 billion, or 41% of nominal GDP at the fourth quarter of 2010. Meanwhile, only 58.0 billion of this loan portfolio was classified as doubtful which seems low, suggesting it could climb notably with construction companies and property developers struggling to shift unwanted new properties, while real estate services continue to endure lower than normal house sales and still falling prices. The Bank of Spain defines a loan as doubtful when some instalment has not been paid for a period of more than 90 days, and those exposures in which there are reasonable doubts as to total repayment under the terms agreed.