Investors See Caution Flags as Spain Bails Out Struggling Savings Banks

Spain's central bank has decided to bail out regional savings bank CajaSur with $621.75 million (500 million euros), causing investors to worry that Spain's savings banks are in more trouble than the country can handle.

Spain's savings banks drastically increased lending when the economy was booming, leaving them highly exposed to a precipitous decline in housing prices. The unlisted banks have granted about $341 billion (243 billion euros) in real estate/construction loans.

Now savings banks - often criticized for their lack of accountability - are refusing to price the mortgage-related assets on their books to accurately calculate their losses. Estimates put the banks' exposure as high as $408.4 billion (300 billion euros). The savings banks' ownership models make it difficult to raise money as they are controlled by local politicians and cannot easily sell shares.

[mm-toolbar]"Banks and those that run them have no incentive to come clean over the scale of losses within the housing market, Spain is currently a kind of anti-market," Jonathan Tepper, chief editor at an economic research and analysis company, told CNBC.

Now the Bank of Spain is encouraging savings banks to merge to prevent company failures. This bailout is seen as a warning to other banks that they could face a takeover by the central bank if they do not follow through on acquisition opportunities.

CajaSur, formerly run by the Catholic Church, voted earlier Saturday against a merger with the larger savings bank Unicaja. CajaSur's board of directors consisted mostly of priests who wanted to avoid a decision resulting in heavy lay offs.

But CajaSur lost $748 million (596 million euros) last year, and its dire financial position prompted the Bank of Spain to step in hours after the board's vote.

"All the regional governments should be aware that decisions have to be made quickly," said Spain's Finance Minister Elena Salgado. She said the central bank has shown "firmness, control and solvency."

This is the first seizure financed by the Fund for Orderly Restructuring of the Spanish Banking System (FROB). The government's policy gives banks until June 30 to apply for the fund's support. The state's cost for propping up the failing banks is estimated to grow to $43 billion (35 billion euros), at a time when Spain just announced an $18.76 billion (15 billion euro) austerity package.

There are 45 savings banks in Spain and the government wants to see that number cut to around 20. At least 16 are currently in merger talks.

CajaSur represents just 0.6% of Spain's banking industry assets, prompting some to think this takeover will not hurt Spain's economy and could trigger the much-needed merger activity among small savings banks.

"There are foreign investors who are negative on Spain for whatever reason, but this is a relatively small bank," Alberto Espelosin of Spain's Ibercaja Gestion, told Bloomberg. "I prefer to see it as something positive because it is the start of a process of restructuring of the banking industry which is very necessary."

But others say the government's policies are not good enough to stabilize the banking industry.

"Current policy is to take one good bank and merge it with a bad bank in the hoping of getting an average bank," said Tepper.

The lending abilities of these "average banks" coupled with the added bailout expense to Spain's government are making investors nervous.

"It has refocused people's attention on the bigger picture question of whether or not this is merely a sovereign debt issue or something more systemic across Europe and potentially across the broader financial system," Craig Peckham, equity trading strategist at Jefferies & Co., told Reuters.

Spain's banks were all down Monday on the bailout news. Banco Bilbao Vizcaya Argentaria SA (NYSE ADR: BBVA) slipped 5.36% to $10.42 and Banco Santander, S.A. (NYSE ADR: STD) fell 5.19% to $10.41.

Goldman Sachs Group, Inc. (NYSE: GS) announced it was cautious on Spanish banks and Credit Suisse cut earnings per share estimates 2%-4% for the industry.

Analysts say investors have yet another reason to pull out of Europe and head for the United States.

"[T]he U.S. offers a better destination for capital than the EU at the moment," David Miller, head of alternatives at Cheviot Asset Management, told CNBC. "The growth dynamic in the U.S. is favorable and America also has a history of tackling big deficits. Europe, since the launch of the euro, does not."

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