Why Rato Smiles After Spanish Banks Proved No Amusing Failure

To shore up the Spanish banking system, Caja Madrid Chairman Rodrigo Rato may offload a stake in a water ride inspired by the Greek god Triton, a restaurant modeled after a Roman villa and an Egyptian-themed fun house called the Piramide del Terror.

The attractions are part of a seaside amusement park called Terra Mitica that lost more than 203 million euros ($283 million) since it opened in 2000 with financing from local savings banks.

Today, the park on the Mediterranean coast outside Benidorm stands as a roller coaster-filled monument to the politically driven lending spree that helped push some of Spain’s savings banks to require government bailouts -- and that now threatens the whole country’s economy, Bloomberg Markets magazine reports in its January 2011 issue.

The savings banks, known as cajas, have been largely controlled by representatives of regional governments, who funded construction projects to boost local economies. When Spain’s real-estate bubble burst in 2008, property values dropped by more than 20 percent. As of August, the country’s bad bank debt had reached 102.5 billion euros, more than Italy or Greece.

Bad loans as a proportion of total loans were 5.62 percent in August compared with a median of 3.2 percent for 22 of Europe’s biggest banks, according to New York-based research firm CreditSights Inc.

Rato, 61, was the economy minister who paved the way for Spain’s adoption of the euro in 1999 -- helping to create some of the economic problems he’s now trying to tackle.

Rioja to Canaries

As Spain adapted to the euro zone’s requirements in the mid-1990s, it was able to cut interest rates to be in line with those of other future euro nations. Average mortgage rates plunged to 3.5 percent in 2003 from 11 percent in 1995, sparking a real-estate boom.

Spending on construction -- particularly along the Mediterranean and in Madrid -- fueled Spain’s average annual growth of 3.75 percent from 1999 to 2007, compared with 2.24 percent for the euro area as a whole. After leaving the Spanish government, Rato headed the International Monetary Fund in Washington from 2004 to 2007, returning to Spain before global financial markets seized up.

Now he’s managing Caja Madrid’s transformation into the third-largest lender based in Spain via a merger with six smaller rivals. As part of the merger, which was encouraged by the Bank of Spain, the government is lending the bank 4.5 billion euros of capital. The sprawling group includes Valencia- based Bancaja, which owns 24 percent of Terra Mitica, and lenders that stretch from the Rioja wine region to the Canary Islands off the coast of Africa.

Possible Downgrade

“This is an emblematic merger because of its size, and its success is of key importance to the entire financial system’s health and future competitiveness,” says Elena Iparraguirre, an analyst at Standard & Poor’s in Madrid. In June, S&P put Caja Madrid’s long-term debt rating under review for a possible downgrade from A, five steps above non-investment grade.

The merged bank will be Spain’s No. 3 based on its assets of 339 billion euros, behind Madrid-based Banco Santander, with 1.24 trillion euros, and Banco Bilbao Vizcaya Argentaria SA, with 557.8 billion euros.

Spain, one of the 16-country euro zone’s fastest-growing nations as recently as 2006, is now a laggard. After creating more than half of the 5 million new jobs in the euro area from 2001 through 2006, Spain has lost more jobs than any other euro nation. Unemployment surged to 20.8 percent in September as the economy shrank for two years in a row.

Mythical Land

Spanish lenders now pay the biggest premium ever on their Debt relative to other banks in Europe. Spreads on Spanish bank bonds in euros rose to a record 166 basis points more than the average for all lender debt denominated in the currency on Nov. 30, up from a gap of 63 basis points on Oct. 31, according to Bank of America data.

The government projected a budget deficit of 9.3 percent of GDP in 2010, more than three times the euro zone ceiling, and growth of 1.3 percent in 2011. Spain is trying to trim that in part by slicing state workers’ wages -- and potentially slowing the economy.

The Bank of Spain, concerned about mounting bad debts at the savings banks, has been urging lenders to combine. The country’s 45 savings banks will be reduced to 18 through 13 different mergers, according to the central bank.

‘How Is It Possible?’

“It’s clearly very necessary to repair the savings banks but the process raises some doubts in my mind,” says Eduardo Martinez-Abascal, a professor of financial management at IESE business school in Barcelona. “How is it possible to merge three, four or even seven bad cajas and come up with one healthy one?”

Risky loans and investments are among the hidden dangers that could undo a recovery. Terra Mitica -- which translates as Mythical Land -- is just one money loser. (In 2010, the park’s owners contracted with a new management company that has an option to buy it.)

Of Caja Madrid’s 235.8 billion euros of loans and property investments, the bank estimates 18 percent of that total could default, resulting in a 16 billion euro loss.

The bank says the new capital lent by the government and the 1.1 billion euros the bank set aside in 2010 to cover losses should enable Caja Madrid to withstand the defaults.

Job cuts and other cost savings will bring the bank back to health and enable it to repay the government, Rato says.

‘Pushed Ahead’

“We clearly know what problems we have, we are tackling them and we have pushed ahead,” Rato said in a Nov. 16 speech in Madrid.

Caja Madrid may need even more bailout money before Rato can turn it around, says Lorenzo Bernaldo de Quiros, a Spanish economist who served from 1996 through 2004 on a panel that advised Rato as economy minister.

“It’s not a merger of one healthy company with a sick one; it’s a merger of a very sick company with another that’s critical,” he says, referring to Caja Madrid and Bancaja, the two largest banks in the merger.

Bancaja’s profit tumbled 32 percent to 170.1 million euros in the first nine months of 2010, while Caja Madrid’s profit plunged 63 percent to 231.6 million euros.

Ownership Structure

One obstacle to job cuts and asset sales is the ownership structure of the cajas. The banks are controlled by general assemblies that include representatives of local government, employees and depositors rather than stockholders. After the merger is completed in January, Caja Madrid will control 52 percent of the bank’s voting rights while the other cajas will control the rest.

These boards elect the bank’s top managers, who have to balance the goals of profitability with serving local interests, says Alberto Recarte, who was a board member of Caja Madrid for 18 years through 2009.

Throughout the boom years, Caja Madrid lent heavily to construction firms. “It was one of the cajas that took least care with lending to real-estate developers,” says Recarte, 63, who worked as an economist for Rato’s conservative People’s Party from 1992 through 1996.

In 2008, Caja Madrid set aside 271 million euros to cover losses on about 1 billion euros in loans to Martinsa-Fadesa SA, a Madrid-based developer that sought bankruptcy protection in July of that year.

Local Interests

Caja Madrid supported other local interests. In 2007, it invested about 460 million euros in Iberia Lineas Aereas de Espana SA, which was the target of a takeover by British Airways Plc and U.S. buyout firm TPG Capital, formerly known as Texas Pacific Group. A spokesman for Caja Madrid said at the time that the bank wanted the carrier to remain “in Spanish hands.”

Iberia is based at Madrid’s Barajas Airport, which provides jobs directly and indirectly to 170,000 people and generates about 10 billion euros in economic activity for the region annually.

The pattern was repeated across Spain. Bancaja has lost money on investments in a local Formula 1 auto-racing venture and loaned money to the Valencia CF soccer team, which has had to sell players to stay afloat.

Rato’s political pedigree makes him well suited to navigate the challenges of running the merged bank, Recarte says. “He is above all a politician,” Recarte says. “It’s Rato’s political authority that can make this merger happen.”

‘Cajas Can Change’

Rato himself says his new job isn’t about politics, but banks. “This is a chance to show that cajas can change,” he says in his Madrid office.

From a young age, Rato saw that banking success can be fleeting.

His father, Ramon, who owned two banks, was convicted in 1967 of making unauthorized transfers of Spanish currency to Switzerland and sentenced to three years in prison, according to “Rodrigo Rato: The Political and Personal Biography of the Mastermind of Economic Change in Spain,” (La Esfera del los Libros, 2003) by Amador G. Ayora. The book says the verdict led to the seizure of family assets and the failure of the banks: Banco Murciano and Banco de Siero.

In 1971, Ramon was pardoned under an amnesty that allowed the family to recover assets, including radio stations, according to the book.

Berkeley MBA

Rato earned a law degree from the Complutense University of Madrid in 1971. He moved to the U.S. to attend the University of California, Berkeley, where he earned an MBA in 1974.

In 1975, a year after Rato returned to Spain, dictator Francisco Franco died, ending one-party rule.

Rato jumped into the democratic fray, joining the People’s Alliance, a grouping of social and political conservatives founded by former members of Franco’s last government. It was the precursor to today’s People’s Party, currently in opposition to the ruling Socialists. Rato won election to parliament in 1982.

The People’s Party came to power after 20 years in opposition, in 1996, when it made a deal with the Catalan nationalist party Convergencia i Unio to obtain a ruling majority. Over a dinner of shrimp, lobster and crema catalana dessert at the Majestic Hotel in Barcelona, Rato and party leader Jose Maria Aznar agreed to concessions on autonomy, including handing over more powers to the Catalan police.

Rato became economy minister in Aznar’s government and embarked on a campaign to get Spain into the euro zone.

Wages Frozen

To reduce the budget deficit below the 3 percent required, Aznar’s government froze civil servants’ wages and cut public works spending. By 1999, the deficit had fallen to 1.4 percent of GDP from 4.8 percent when Aznar became prime minister.

Once Spain adopted the currency, the economy took off. Rates plunged, and construction boomed.

In 2000, Terra Mitica opened its gates on the coast south of Valencia, aiming to attract a clientele of Britons, Germans and other Northern Europeans who had rushed to buy vacation homes along the Mediterranean coast with their euros and pounds. Rato also cut the highest income tax rate to 48 percent from 56 percent, giving the wealthy more disposable income.

With hindsight, some economists blame Rato for failing to use the good times to make lasting changes in the country’s economy.

‘Partly His Fault’

“He didn’t do enough to improve competitiveness,” says Xavier Sala-i-Martin, a Columbia University economics professor who served with Rato on a Spanish industry commission for pension reform. “When the crisis came, the country didn’t have a substitute for construction and tourism, and that is at least partly his fault.”

Rato, like his predecessors, wasn’t able to change labor laws that make it hard to hire and fire workers or develop industries that could create new jobs when the construction and tourism boom ended, Sala-i-Martin adds.

In March 2004, Rato’s People’s Party was poised to win another majority. Then, three days before the general election, a series of terrorist bombings in Madrid railway stations and commuter trains killed 191 people. An electorate stunned by the tragedy voted for change, ejecting Rato’s People’s Party from power in favor of the Socialists.

In June 2004, Rato became chief of the IMF. Riding his reputation for overseeing 32 straight quarters of growth in Spain, and supported by the EU, he beat out Mohamed A. El-Erian, who at the time was a money manager at Pacific Investment Management Co., for the post of IMF managing director.

(El-Erian, a former IMF deputy director, moved to Cambridge, Massachusetts, to manage Harvard University’s endowment and later returned to Newport Beach, California-based Pimco, where he’s now chief executive officer.)

‘Completely Bored’

Rato presided over the Washington-based organization during a period when global economic meltdowns were few and far between.

By June 2007, the international lender’s worldwide portfolio had shriveled to $11.8 billion from a peak of $81 billion in 2004, and a single nation, Turkey, accounted for about 75 percent of its loans. Rato’s main contribution was insisting in June 2007 that members reject currency policies that create instability for other countries.

“He was completely bored by the IMF,” Recarte says.

In October 2007, two years before his term was to end, Rato quit, citing family reasons and saying he was concerned about his children’s education.

Investment Banking

Back in Spain in 2008, Rato worked as an investment banking adviser to Banco Santander and as a senior managing director at Lazard Ltd., helping the firm win Spanish clients.

In January 2010, the local politicians who control Caja Madrid, acting on orders from the People’s Party’s national leadership, elected Rato to run the bank. Five months later, as the economic crisis crested, the Bank of Spain coaxed savings banks to combine.

Even before the Caja Madrid merger is finalized, Rato has been working to streamline the group.

In October, he raised 157 million euros with the sale of a 3.4 percent stake in Casablanca, Morocco, lender Attijariwafa Bank. He will close some of the 1,380 branches in cities where the merged banks have overlap.

He also plans to save 500 million euros annually in part by cutting as many as 4,000 positions -- or 15 percent of the work force of 26,000. To achieve his goals, Rato will have to negotiate with Spain’s powerful trade unions.

Comisiones Obreras, one of the country’s biggest labor unions, opposes Rato’s plan to offer 2,500 employees early retirement to reach his goal of cutting 4,000 jobs. It wants to increase the number of those taking early retirement.

Rato has won over union chiefs in the past.

“He is a person I always felt I could trust,” says Jose Maria Fidalgo, former head of Comisiones Obreras.

‘Lost Coins’

He recalls that after visiting Rato in his Economy Ministry office on Cuzco Square in Madrid around 2001, he received by courier an envelope containing a few coins and a handwritten note.

“Jose Maria, so that you can see I’m a good person, I’m returning these coins” that had fallen out of Fidalgo’s pocket during the chat, he recalls the note saying.

Rato now has to build his reputation as a banker who can modernize an institution that dates back to 1702.

“Caja Madrid is a company with more than 300 years of life behind it,” Rato said in his Nov. 16 speech. “With great effort we will guide it toward a positive outcome.”

A monument to the bank’s long history is on view from Rato’s office: architect Santiago Calatrava’s 92-meter (302- foot) golden obelisk, Caja Madrid’s gift to the city to mark the anniversary of the bank’s founding.

After watching the work he did bringing Spain into the euro fall apart amid the credit crunch, Rato’s new role gives him a chance to repair the damage, one investment at a time.

To contact the reporters on this story: Vernon Silver in Rome at vtsilver@bloomberg.net Charles Penty in Madrid at cpenty@bloomberg.net

To contact the editor responsible for this story: Frank Connelly at fconnelly@bloomberg.net Or Michael Serrill at mserrill@bloomberg.net

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