How Will the Spanish 'Bad Bank' Work?

European finance ministers signed off on Friday on conditions attached to the release of up to 100 billion euros ($123 billion) of aid for Spain's banks.

The plan aims to restore confidence in Spain's financial system and avert a full rescue for the euro zone's fourth largest economy.

One of the conditions involves the formation of a bad bank to take on foreclosed property, undeveloped land and bad loans to house-builders, in order to free up banks' balance sheets and get credit flowing once more.

Spain's banks are burdened with 184 billion euros of toxic real estate, equivalent to more than half of their total exposure to property after a housing bubble burst in 2008.

Here are some of the questions surrounding the bad bank, expected to be set up by November 2012:

1. How will the assets be priced?

Real estate assets will be transferred to an asset management company, the draft European Union document says, at a value established by a detailed independent audit whose results are expected at the end of September.

First to be transferred will be the loans to developers and foreclosed assets. Other assets may be transferred, depending on how quickly they sour, the document says. Losses must be booked by the banks at the time of transfer.

Spain, in consultation with the European Commission, the European Central Bank and the International Monetary Fund, will finalise the details of the structure by the end of August, with a view to the bad bank being up and running by November.

The big question is the price at which the assets will be transferred.

The draft document speaks of a 'real economic value', which analysts interpret as a price that is not rock-bottom but allows banks to access state aid while allowing the bad bank to sell on the assets at a profit for the tax payer at a later date, most likely within two or three years.

The difficulty is pricing the assets at a level low enough to attract private investors like hedge funds but high enough to allow banks a reasonable return.

2. How will the mechanism work?

Spain's bank restructuring fund, the FROB, will contribute cash or bonds from the European rescue funds to the asset management company related to a percentage of the value of the assets purchased, the document says.

Up to 25 billion euros has been earmarked to fund the bad bank, according to a working paper of the European Financial Stability Facility (EFSF).

But there are still a lot of questions around the capital structure and how asset values will be determined.

The FROB is likely to start hiring advisers to design the bad bank over the next few days, including auditors and law firms, one banker said.

In exchange for the assets, the banks will receive a small equity share in the bad bank plus state-guaranteed bonds issued by the bad bank or cash.

It is unclear whether the banks will then use the bonds at the European Central Bank as collateral, as happened in Ireland. Some say this will be seen as backdoor support from the ECB to finance the bad bank.

An alternative could be that the banks hold the bonds and receive a coupon payment from the bad bank, paid out of the functioning loans and asset sales.

3. Will all the banks participate?

Banks that receive state aid will be obliged to use the bad bank. The aid is directed at the four state-rescued banks -- Spain's fourth-largest lender Bankia and three smaller banks, Novagalicia, CatalunyaCaixa and Banco Valencia.

Independent auditors Oliver Wyman and Roland Berger identified in June a group of seven banks which could need to receive state aid or even be nationalised. They would then have to transfer their real estate assets into the new structure.

The Bank of Spain governor, Luis Maria Linde, said on Tuesday that assets would be transferred into one bad bank, although a government source said it was still not sure whether there would be individual bad banks for each entity and whether the assets would be divided according to type.

Another question is whether Spain's healthy banks like Santander and BBVA will use the facility. Again, this will depend on the price offered. If the bad bank offers to buy at a price higher than the lender provisioned for, it could be in the bank's interests to participate.

4. What is the time frame?

The document says a comprehensive blueprint and legislative framework for the scheme will be prepared by the end of August.

The Spanish authorities will adopt the legislation in the autumn so that the bad bank will be up and running by November.

The segregation and eventual transfer of assets would then start in December and be completed by June 2013.

-- To read the Memorandum of Understanding for the European aid to Spanish banks, please double click on https://www.rijksoverheid.nl/bestanden/documenten-en-publicaties/kamerstukken/2012/07/11/memorandum-of-understanding-on-financial-sector-policy-conditionality/memorandum-of-understanding-on-financial-sector-policy-conditionality.pdf

-- For a Q&A on the Spanish program, please double click on https://www.efsf.europa.eu/attachments/faq_en.pdf ($1 = 0.8156 euros)