Santander's takeover of Banco Popular Espanol: harbinger of ...

Santander's takeover of Banco Popular Espanol: harbinger of ...

Santanders takeover of Banco Popular Espanol: harbinger of the meltdown of the European banking system Briefing Paper written by Bob Lyddon London 30 June 2017 2017 Lyddon Consulting Contents Takeover of Banco Popular Espanol (BPE) by a white knight: Santander (SAN) Deviations from the EU Bank Recovery & Resolution Directive Parallels with Lloyds takeover of HBOS, when a white knight became a black one BPE as an example of the failure of the new EU regulatory framework Paucity of remaining white knights Inability of governments to step in European mechanisms as bankers of last resort Risks to the UK if SAN becomes a black knight Risks to the UK if the European mechanisms step in as bankers of last resort 2017 Lyddon Consulting Executive Summary The Red for Danger lights are flashing over the European banking system as BPE a bank in good standing had to be bailed out by a white knight, SAN BPEs demise points to the continued weakness of European banks Real Estate loan books, to the vulnerability of the ECB and EIB, and to the inefficacy of the new EU framework for dealing with banks The dangers for the UK are: 1. SAN UK is badly damaged if SAN as a whole becomes a black knight as Lloyds did when it bailed out HBOS;

2. The UK receives a demand for funds or has its guarantee liabilities increased at the EU level, because there is a paucity of other white knights to bail out further casualties, and because Member States lack the capacity to bail out their banking systems themselves. 2017 Lyddon Consulting What has happened between SAN and BPE SAN has acquired BPE for EUR1 SAN now needs to launch a rights issue in order to replenish its own Shareholders Equity Transaction claimed as a success of the new EU Single Supervisory Mechanism and of the operation of the EU Bank Recovery & Resolution Directive (BRRD) BPEs Shareholders Equity and all mezzanine and subordinated liabilities were expunged 2017 Lyddon Consulting SAN acquired all BPEs assets and liabilities (secured and senior unsecured) What did not happen at BPE Bail-in of unsecured creditors No bail-in of senior unsecured creditors for

their deposits above EUR100,000, as should have been required under BRRD 2017 Lyddon Consulting Other banks made to lodge alternative security at the ECB BPE is defaulted on its ECB loans and ECB sells BPEs collateral No requirement by the ECB for borrowers who have pledged BPE bonds as collateral to replace them with different eligible bonds, or to face a liquidation of their positions (see Appendix 2 for the 70 BPE bonds that were eligible as collateral at the ECB as per 3 March 2017) BPEs own loans from the ECB were not called in default, and the ECB did not have to liquidate the collateral it holds against BPEs loans Who was protected by that? The European Investment Bank: its SME loan programme through BPE is far in excess of EUR100,000, and the EIBs deposits into BPE to fund that programme are senior unsecured liabilities of BPE The European Central Bank: 1. It did not have to compel its other borrowers to come up with different collateral to the BPE bonds they had pledged; 2. It did not have to test the value of the BPE bonds pledged as collateral in

the open market compared to the haircuts it had specified for them; 3. It did not have to test the open-market value of the collateral pledged by BPE for its own ECB loans. 2017 Lyddon Consulting Santander has taken on major risks to benefit the ECB and EIB SAN cannot have carried out detailed Due Diligence on the BPE loan portfolio SAN has taken a punt on whether the assets it has acquired are worth more than, less than, or the same as the liabilities its has taken onto itself This is a shotgun wedding in which SAN has been forced by the Banco dEspana as an agent of the ECB to act as white knight for a failing bank SAN will stretch its own capital ratios. It must launch a rights issue. Even that will only be adequate if it succeeds in selling off half of BPEs Real Estate loans 2017 Lyddon Consulting The BPE assets are mainly Real Estate loans, and SAN aims to sell of half of them within 18 months Parallels with Lloyds takeover of HBOS in 2008 Parallels A big, solvent, domestic bank took over with strong official encouragement - another big domestic bank, one that had major problems in its Real Estate loan book The acquisition timeframe was very short so the white knight had no time to carry out detailed Due Diligence on the loan book of the other bank The white knight took a punt on the value of the assets it acquired

Risks and issues HBOS turned out to be too big and bad for Lloyds to swallow: BPE is a very large bank as well The white knight Lloyds became a black knight when HBOS caused Lloyds to fail in turn: then the UK government had to step in. Could BPE cause SAN to become a black knight and require the Spanish government to step in? Would it only be the Spanish government, or also UK, Poland, Brazil, Mexico, Portugal? 2017 Lyddon Consulting Parallels with JPMorgan takeover of Bear Stearns in 2008 What happened Bear Stearns was a major participant in the market for Residential Mortgage-Backed Securities (RMBS) Two of its funds defaulted and the fund trustee was about to liquidate the RMBS in the funds and sell them in the open market which would have taken the market down as there was a paucity of buyers The US authorities and other market participants appointed JPMorgan as white knight to take over Bear Stearns and prevent a firesale of the RMBS by the fund trustee (Bank of New York Mellon) Who benefited and who did not The market was spared the necessity of writing down the value of its RMBS to the same levels as the fund trustee would have achieved in its firesale, just as the ECB was spared similar necessities in BPEs case That write-down would have bankrupted many market participants, and BPE could have bankrupted the ECB, and caused a major loss at the EIB as well JPMorgan shareholders covered Bear Stearns losses and legal claims for RMBS mis-selling, via regular and large debits to the JPMorgan Profit-and-Loss account over an extended period, which it could afford 2017 Lyddon Consulting Summary of parallels with 2008 A major solvent, domestic bank is being used by the authorities to: 1. Bail out another large domestic player with problems in Real Estate loans 2. Avoid a systemic meltdown caused by the liquidation of very large amounts of collateral into an unreceptive market The only substantive difference is that, in the case of SAN/BPE, the loser out of the systemic meltdown would have been the ECB itself, because: 1. Its Quantitative Easing operations have allowed commercial banks to take out large loans 2. The loans are collateralised, but the collateral list runs to 30,000 bond issues 3. The list includes bonds issued by other banks, and includes RMBS 4. The loans and their security are therefore not independent of one another: the ECB runs a major Correlation Risk of a type that it forbids commercial banks from running

5. The ECBs security margin (haircut) is also inadequate, and does not reflect the credit and market risks of the bonds it has accepted as collateral 2017 Lyddon Consulting Worrying indicators from BPEs demise The new EU framework for EU banking supervision completely failed BPE passed its European Banking Authority stress tests BPE has never been identified as a bank requiring extra capital, or as non-compliant with the new EU banking tests of liquidity, leverage, net stable funding and so on 2017 Lyddon Consulting ECBs lending to commercial banks is in reality unsecured and its haircuts are inadequate The haircuts assigned to BPEs bonds by the ECB (see Appendix 2) are commensurate with a bank in good standing, not one in deep distress It has been proved that the ECBs loans are improperly collateralised, because the ECB could not exercise its supposed rights to either (i) request different collateral, or (ii) default a borrower and liquidate the pledged collateral, without triggering a systemic meltdown Bank restructurings proceeding in Italy Monte dei Paschi di Siena UniCredit Italian government supposedly to inject EUR20 billion But then the Italian government goes even further out of compliance

with the Fiscal Stability Treaty Completed a deepdiscount rights issue Proceeds entirely used up to write down bad loans Barely compliant with Basel III capital adequacy Has had to drop out of rendering assistance to other Italian banks 2017 Lyddon Consulting Veneto Banca and Banca Popolare di Vicenza Second round of bailout of these two banks, whose combined loss in 2016 was EUR3.4 billion Intesa is buying them by receiving EUR5 billion in cash and a promise of EUR12 billion of Republic of Italy guarantees on securitisations of toxic assets Failure of the new EU framework for European banking The only test that has really been passed is a test of the efficacy of the new EU framework of tests for avoiding the insolvency of banks The EU framework has passed the chocolate fireguard test: 1. It failed to give early warning of BPEs difficulties 2. Its provisions for how the resolve a bank like BPE would have caused a systemic meltdown on account of the eligibility of BPE bonds within the ECBs Qualitative Easing programme 3. The ECB actually increased taxpayer exposure on BPE by enabling other banks to borrow against pledged BPE bonds with a haircut of as little as 1%: commensurate with a government borrower, not a tottering mortgage bank

2017 Lyddon Consulting Where to go from here? It is absolutely clear that there is no political will to subject consumer and business depositors of banks to a bail-in of deposits above EUR100,000, as the BRRD requires Now we can also see that this provision would badly damage the European Investment Bank because it is a senior unsecured depositor into most large EU banks under its SME loan programmes If, instead of banks being equipped to resolve and recover themselves as BRRD intends, the template is for them to be bought out by large, domestic and solvent competitor banks, this raises a number of questions: 1. 2. 3. 4. How many other banks in Spain may need this support? How many banks in Italy, Portugal, Ireland, Cyprus and Greece may need it too? How many white knights are available? Who steps in when there are none, or when the white knights become black knights? 2017 Lyddon Consulting The UKs white knights and black knights in 2007-9 Original institution Bradford & Bingley Alliance & Leicester HBOS SAN SAN Lloyds Britannia Co-Operative Bank ABN-Amro RBS

Northern Rock Parts of Lehman Brothers None Barclays 2017 Lyddon Consulting White knight Outcome Digested by SAN UK over time Digested by SAN UK over time Too big and too bad to swallow Lloyds became a black knight and needed government support Co-Op has become a black knight, crippled by the Britannia bad loan book RBS became a black knight and needed government support Direct need for government support Barclays waited until Lehmans had gone down, did adequate Due Diligence, and bought healthy parts from the trustee European white knights now Country Spain White knights still available Banco Bilbao Vizcaya Argentaria Italy Intesa SanPaolo might manage one more on top of buying Veneto Banca and Banca Popolare di Vicenza Millenium BCP possibly Caixa Geral is state-owned Espirito Santo is #2 and already collapsed Santander Totta is #3

None Banking sector insolvent None Banking sector insolvent None Banking sector insolvent Portugal Ireland Greece Cyprus 2017 Lyddon Consulting Comments Bankia is #3 and in trouble itself #4 Sabadell is not big enough to take over a major player and is still digesting TSB Unicredit is #2 and is in the midst of its own recovery plan Monte dei Paschi is in a state bailout Very limited capacity to come up with white knights As with Northern Rock and RBS, the absence of white knights invokes the next fallback: direct government assistance This is the very outcome that that EUs new framework of tests was designed to avoid 2017 Lyddon Consulting The most likely outcome is the very one that that EUs new framework of tests was designed to

avoid Spain and Italy have one white knight each left: BBVA and Intesa The next fallback is direct government assistance The other countries under pressure have no white knights available at all White knights (and their shareholders) have to be willing to fall on their own swords After that the Spanish and Italian cupboards are bare Very limited capacity of governments to offer support In the case of all of Spain, Italy, Portugal, Ireland, Cyprus and Greece, though, the capacity of the government to render support is very limited: The country is insolvent or objectively in bail-out (Portugal and Ireland still have their bailout funding from the EU bailout mechanisms, even though they have exited bailout under its EU definition) The country is subject to the Fiscal Stability Treaty and has to direct any fiscal surplus it has to reducing its government debt If the country has no fiscal surplus, it will be in borrower mode but with its international borrowing capacity limited due to its poor credit rating, which is in turn attributable to its weak financial system and its lack of a fiscal surplus What happens then? The support has to come from the European mechanisms which means from the Member States, as the European mechanisms have very limited resources of their own 2017 Lyddon Consulting

Risks and issues for the UK Santander UK The UK needs first to consider the possible knock-on impact of the SAN/BPE deal on Santander UK, one of the UKs Big Five banks: What is the funding relationship between SAN UK and its parent as regards intercompany loans How much? In which direction? Are there plans for SAN UK to diminish its capital in favour of its parent: Via dividends? Via cost-cutting and job losses so as to increase remittable profits? What is the status of SAN UKs ring-fencing project? Is SAN UK completely self-sufficient as regards the funding of its assets from its own resources? Has it fully digested Bradford&Bingley and Alliance&Leicester? What is the quality of its Real Estate loan book? What would be the loss to the UK Financial Services Compensation Scheme if SAN UK went down? 2017 Lyddon Consulting Risks and issues for the UK European level The UK then needs to consider the likelihood of other European banks beyond BPE going down and the impact if they did This needs to start with an analysis of the likelihood of a need for support 2017 Lyddon Consulting Lists of substantial banks in each EU

Member State and their financial ratios as compared to BPEs Compilation of an At Risk list of the institutions with ratios the same or worse than BPEs Capacity and legality for government support if (i) no white knight is available or (ii) the white knight turns into a black knight and has to be rescued List of white knight candidates per country Risks and issues for the UK European level The second part of the analysis of the risk at a European level is what the UK could be asked to contribute and through what mechanism, if white knights and Member State governments cannot supply the required support There are seven mechanisms through which EU-level support could be furnished They are listed in Appendix 3 and the UK is currently subject to only five of them In each case there should be an analysis of the basis upon which UK funds could be demanded or UK guarantees increased, in what quantity, and what are the protections for the UK against the UK having the solution enforced upon it 2017 Lyddon Consulting

Summary The SAN/BPE transaction has many parallels with the Lloyds/HBOS and JPMorgan/Bear Stearns transactions in 2008, which were both milestones in the global financial crisis The SAN/BPE transaction is a harbinger of the meltdown of the European banking system, as the system continues to have high levels of bad loans many being Real Estate loans and there is very limited capacity to bring in white knights and government support to forestall a meltdown The support will have to come from the EU level, and, if support is furnished at that level, the UK can expect either (i) to receive a demand for funds, or (ii) to suffer an increase in its liabilities under guarantees, notwithstanding Article 50 having been triggered It is vital that those in authority charged with protecting the UKs financial interests take immediate steps to qualify and quantify the risk of a demand being forthcoming, and work out how to resist it 2017 Lyddon Consulting Appendix 1 profile of Bob Lyddon Independent international banking consultant 2000-present Author of the Brexit Papers: www.brexitpapers.uk Association of Corporate Treasurers tutor since 2007 PwC/implementation of the Euro 1997-1999 Transaction banker 1991-1997 Corporate and capital markets banker 1980-1991 2017 Lyddon Consulting Appendix 2 details of BPE bonds eligible as ECB collateral Summary of all Banco Popular bonds in the ECB database as of 3 March 2017 Maximum final maturity 41 years (as Residential Mortgage-Backed) Lowest haircut percentage 1% (not even adequate to account for a rise in interest rates) Highest haircut percentage 22.5% (where BPE acts as guarantor for debts of its finance company) Indicator

Many 1-year Certificates of Deposit are included BPE bonds feature more towards the end of the ECB series 2017 Lyddon Consulting Short-term funding of BPE Conclusion BPE became increasingly dependent upon short-term central bank funding, an indicator of its own weak credit and liquidity BPE became more reliant on this type of funding in the recent past Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon Haircut percentage 3% Notes 1% Maturity in years 5 1585 6851 0% 35 13% Residential Mortgage-Backed

10315 0% 41 13% Residential Mortgage-Backed 10677 2% 3 22.5% BPE is guarantor 17596 0.0875% 27 4% Residential Mortgage-Backed 18827 0% 0 13% Matured March 2017

19249 0% 29 4% Residential Mortgage-Backed 27275 2.939% 11 1% 27276 4.5% 3 4% 27277 2.084% 1 1% 2017 Lyddon Consulting Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 1.173%

Maturity in years 1 Haircut percentage 1% 27278 27430 4.125% 1 2% 27431 4.2% 2 2% 27432 1.983% 2 1% 27433 4.125% 0 1%

27434 3.956% 1 1% 27436 3.956% 1 1% 27437 3.75% 2 2% 27438 2.497% 4 1% 27439 1.422% 9 2

2017 Lyddon Consulting Notes Matured March 2017 Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 1.672% Maturity in years 10 Haircut percentage 1% 27440 27441 1.922% 11 1% 27442 3.5% 0 1% 27443 2.172%

9 1% 27444 2.125% 2 2% 27445 1% 8 6% 27446 0.75% 3 3% 27447 0.875% 4 3% 27583 0% 4

1% 27672 3.03% 3 1% 2017 Lyddon Consulting Notes Matures September 2017 Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 2.752% Maturity in years 6 Haircut percentage 1% 27676 27680 2.184% 4 1% 27682

1.402% 5 1% 27684 0.81% 5 1% 27685 0.549% 5 1% 27687 0.181% 6 1% 28130 0% 0 13% Matured March 2017

28132 0% 0 13% Matured March 2017 28133 0% 0 13% Matured March 2017 28135 0% 0 13% Matured March 2017 2017 Lyddon Consulting Notes Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 0% Maturity in

years 0 Haircut percentage 13% 28137 Matured April 2017 28138 0% 0 13% Matured April 2017 28140 0% 0 13% Matured May 2017 28141 0% 0 13% Matured May 2017

28142 0% 0 13% Matured May 2017 28143 0% 0 13% Matured May 2017 28144 0% 0 13% Matures June 2017 28145 0% 0 13% Matures July 2017 28146

0% 0 13% Matures July 2017 28147 0% 0 13% Matures July 2017 2017 Lyddon Consulting Notes Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 0% Maturity in years 0 Haircut percentage 13% 28475 Matures July 2017

28476 0% 0 13% Matures August 2017 28591 0% 0 13% Matures August 2017 28592 0% 0 13% Matures August 2017 28593 0% 0 13% Matures September 2017 28594

0% 0 13% Matures September 2017 28595 0% 0 13% Matures September 2017 28596 0% 0 13% Matures October 2017 28597 0% 0 13% Matures November 2017 28598

0% 0 13% Matures November 2017 2017 Lyddon Consulting Notes Appendix 2 details of BPE bonds eligible as ECB collateral Line # Interest coupon 0% Maturity in years 0 Haircut percentage 13% 28599 Matures December 2017 28600 0% 0 13% Matures January 2018 28601

0% 0 13% Matured March 2017 28602 0% 0 13% Matured April 2017 28603 0% 0 13% Matured May 2017 28604 0% 0 13% Matured March 2017 28605

0% 0 13% Matured March 2017 28773 0.708% 7 6% 28774 1.133% 7 6% 28873 5.28% 12 9% 2017 Lyddon Consulting Notes Appendix 3 the seven EU mechanisms The seven EU mechanisms through which Member States might be asked to render support The EU Budget via the Payments Appropriation, a simple demand for more cash The European Central Bank

The European Investment Bank (including the European Fund for Strategic Investments) The European Financial Stabilisation Mechanism (undrawn portion of 13.2 billion) European Financial Stability Facility (supposedly closed to further drawings and Eurozone-members only) European Stability Mechanism (Eurozone-members only) A newly-created mechanism using the Commitments Appropriation in the EU Budgets Multi-annual Financial Framework to create further funds and guarantees at Member States risk 2017 Lyddon Consulting Santanders takeover of Banco Popular Espaniol: harbinger of the meltdown of the European banking system Close of Briefing Paper written by Bob Lyddon London 30 June 2017 2017 Lyddon Consulting

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