•    HOME   
•    NEWS   
•    BUSINESS   
•    INTERNATIONAL   
•    TECH   
•    SPORTS   
•    LIFE & TIMES   
•    OPINION   
•    MY JAKARTA   
•    BLOGS   

Spain’s banking system, which avoided the worst of the financial maelstrom, is rapidly evolving from a source of pride to a source of concern despite strong profits. It is faced with massive bad real estate loans and uncomfortably large holding of government debt.

There is real potential for three Spanish vulnerabilities — its banks, its real estate and development industry and its own government debt — to act on one another and amplify any weakness.

Activist regulation in the good times meant that Spain’s commercial and savings banks went into the crisis comparatively well capitalized. Crucially, they were less likely to play at regulatory arbitrage by creating off-balance-sheet entities to eat dubious loans. That, as well as more conservative funding profiles, led to better performance during the sharp sell-offs in global securities markets over the course of 2008.

The long sell-off in Spanish real estate, however, is taking an increasing toll on the banks.

Residential real estate is now down about 25 percent from the peak. Amazingly, Spanish builders were at it even as sales plummeted, finishing 50 percent more houses in 2009 then they were able to sell.

That leaves Spain with a glut of unsold houses, and, like in the United States, a large amount of shadow inventory which is bank owned, or soon will be.

Spanish banks, like their US peers, have been relatively slow to play hardball with developers, to whom they have lent the equivalent of a third of gross domestic product, partly because throwing loans into default would only force them to reserve more money against the debts. Nonetheless, bad debts available for sale held by Spanish banks and savings banks have tripled in the year to September, the latest data released, to more than 25 billion euros ($34.4 billion). The Bank of Spain is reportedly mulling new steps to force banks to increase the amount of capital they hold against doubtful real estate loans.

To be sure, on a reported basis Spanish banks are still highly profitable. What is at issue is how those profits are calculated and the outlook for the banks’ underlying assets.

While keeping existing borrowers on life support, Spanish banks have cut back viciously on credit to everyone else.

Lending is down 38 percent to corporations and 32 percent to households in the year to January.

This has doubtless contributed to a jobless rate that the government sees hitting 19 percent this year.

Spain and its banks also face growing pressure because of what amounts to an arbitrage gone bad. The European Central Bank has made plentiful cheap funds available to banks in the euro zone, and Spanish ones have been in the forefront in borrowing cheaply from the it and using the funds to buy higher-yielding and longer-dated government debt, thus pocketing the spread and supposedly rebuilding capital.

The amounts involved are huge; Spanish banks bought government bonds in the fourth quarter equal to 63 percent of all net issuance by the Spanish government, and, according to UBS, have bought more of their government’s bonds in the past 20 months than their peers in any other euro area country.

Like so many other strategies, this one worked well until it didn’t.

Sparked by events in Greece, concerns have grown about Spain’s credit-worthiness, forcing a sell-off in Spanish bonds relative to benchmark German ones. Spreads on Spanish debt have recovered from February lows, but banks will have been facing large paper losses and may find themselves less eager to hold government debt. According to Spanish news reports, the nation was concerned enough about trading in its debt and derivatives that it asked its intelligence service to probe “speculative attacks.”

Spain’s banks have made liberal use of ECB funding to park real estate loans in securitizations that were created to be retained by banks rather than sold on to unsuspecting investors. More than 61 billion euros of asset-backed securities were issued in Spain last year, the vast majority of which are still sitting on issuers books.

Meanwhile the ECB is mulling steps to encourage banks to retain less, making noises about tightening collateral requirements. This could have a negative impact on retained asset-backed deals as well as lower-rated government debt. Some of this may well be self-correcting. Neither the ECB nor Spain will shoot themselves, or the banks, in the foot.

It is fair to say that Spain has been a giant “extend-and-pretend” exercise for the past two years. The strategy, where possible, was to put off issues and hope for an improvement in the macro environment.

That improvement hasn’t really arrived, Spain faces new pressures and the banks sit uncomfortably at the center.

James Saft is a Reuters columnist