Tags: EU, Euro, Europe, European Commission, Eurozone, Greece, Spain

Are Spain's Banks Better Off than Speculators Would Like to Believe?

By , Money Morning •

Somebody is bluffing.

Either Spain's financial system is on the verge of a breakdown, or hedge funds and speculators are exaggerating the vulnerability of Spain's banks to capitalize on short-selling Eurozone securities.

Investors will have a clearer picture of what's going on in Spain when the results of stress tests performed on the nation's banks are released. But until those results are known, rumors of a bailout of Spain will continue to circulate and liquidity will remain tight.

Borrowing costs in Spain and throughout Europe have been on the rise in recent months, as market observers fret over high levels of debt. At a closely watched auction for 12- and 18-month bills on Tuesday, the Spanish government raised $6.4 billion (5.2 billion euros). However, the 2.3% interest rate on the 12-month bills was 0.7 percentage points higher than what it paid last month. And t he yield on the country's benchmark 10-year bond rose 9 basis points to 4.823%, the highest in almost two years.

The higher yields investors are demanding to hold Spanish debt reflects speculation that Spain will follow Greece in needing a bailout.

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.

Savings banks have refused to price the mortgage-related assets on their books to accurately calculate their losses, but estimates put the banks' exposure as high as $408.4 billion (300 billion euros).

Spain's central bank last month was forced to bail out regional savings bank CajaSur with $621.75 million (500 million euros), and has advised other savings banks to merge to prevent company failures, spurring a wave of consolidation throughout the country's financial sector.

Banco de Sabadell SA last week said it would merge with Banco Guipuzcoano SA. And Caja Madrid announced just days before that it was conducting "virtual" merger with six small regional lenders to create Spain's third-biggest financial institution by assets.

The Bank of Spain last year established the Fund for Orderly Bank Restructuring (FROB) with the goal of recapitalizing banks. It is funded with 6.75 billion euros from the government and 2.25 billion euros from Spain's deposit guarantee fund. It can borrow another 90 billion euros in the debt markets with a state guarantee, but only 27 billion euros has been authorized and only 3 billion has been raised.

Some hedge funds and bank analysts have suggested that the FROB will need to raise tens of billions of euros to recapitalize the country's lenders - something Spanish financial officials adamantly deny.

Officials said yesterday (Wednesday) that the FROB has 12 billion euros available and is likely to put 11 billion euros towards loans to support mergers, including 4.5 billion euros for the Caja Madrid merger. The fund is expected to try to raise a few billion euros more after the summer to give it extra funds for emergencies.

Still, liquidity is drying up in Spain, making it more difficult for the government to pay its debts. Spanish banks borrowed a record $105.7 billion (85.6 billion euros) from the European Central Bank (ECB) last month. And t he extra yield investors demand to hold Spanish debt rather than German equivalents rose 13 basis points to 218.4 yesterday, the highest since before the implementation of the euro in 1999.

Spain's total debt equates to about 70.5% of the country's gross domestic product (GDP). That's about half the level of Greece but still worrisome with liquidity tight. Thus, rumors continue to circulate that the country will need help financing its debt.

Reports surfaced last week that said the European Union (EU) prepared to release funds from the $1 trillion (750 billion euros) rescue mechanism created to backstop Greece in May.

And Spanish daily El Economista reported yesterday, citing anonymous sources "close to the issuing entity," that the EU, the International Monetary Fund (IMF) and the U.S. Treasury have come up with a plan to extend a $355 billion (250 billion euros) line of credit to help Spain deal with its deficit issues.

Three German newspapers have run similar stories over recent days, citing German sources, but the EU, IMF, and United States have all denied the report. IMF chief Dominique Strauss-Kahn is due to arrive in Spain tomorrow (Friday).

"That story is rubbish," European Commission spokesman Amadeu Altafaj told reporters in Brussels.

The central bank also sought to stymie fears about Spain's banking system. In a speech published alongside its annual report, Bank of Spain Governor Miguel Angel Fernandez Ordonez said the central bank has conducted stress tests on all financial institutions and will publish the results.

"The Bank intends to make public the results of these stress tests, showing estimated loan losses, the consequent capital requirements and the contribution of promised balance sheet reinforcements, so that the markets have a perfect understanding of the circumstances of the Spanish banking system," he said, giving no further details of when the test results would be published.

Fernández Ordóñez and others insist that speculators, who are trying to profit by shorting the euro currency and other Eurozone securities, are what's really behind the bailout rumors and rising bond yields. Some analysts blamed such speculation for the soaring costs of Greek debt, which led to the country's bailout.

The cost of insuring $10 million of Greek bonds rose more than $400,000 in February, up from $282,000 in early January, as traders piled into credit default swaps (CDS) to bet against the country. Trading in credit-default swaps linked only to Greek debt has surged to $85 billion in February, up from $38 billion in the year prior, according to the Depository Trust and Clearing Corporation, which tracks swaps trading.

In an effort to crack down on such speculation, Germany last month banned the naked short-selling of European sovereign debt instruments. However, the European Commission (EC) on Monday suggested that any such ban should only be a temporary measure made in emergency situations. The EU has charged its executive arm with determining whether credit default swaps are "creating disorderly markets or systemic risks or are being used for abusive purposes."

After falling as low as $1.19 last week, the euro yesterday failed to break convincingly through the $1.2350 level.

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