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The Spanish debt crisis combines the worst of the Greek and Irish crises in a too-big-to-fail package
04/13/2012 8:30 am EST
Last year the country’s government debt came to just 68.5% of GDP. That hardly puts Spain in the same class as Greece, right? The goal of the Greek rescue package, after all, is to REDUCE that country’s debt to 130% of GDP. Gosh, Spain isn’t even in the same debtor class as the United States. The U.S. debt to GDP ratio passed 100% in 2011 and is forecast to hit 112% by the end of 2013.
So why have yields on Spanish 10-year bonds climbed back within spitting range of 6%? And why has that been enough to send the global financial markets into a bout of panic selling like investors saw on Tuesday, April 10?
How about because Spain is a worse crisis than Greece and far worse than the United States. (Give us a few years, though.) The Spanish debt crisis looks like it has combined the worst of the Irish debt crisis and the Greek debt crisis and has then wrapped it in an economy big enough to make existing EuroZone facilities and mechanisms totally inadequate for a rescue. Spain looks like it’s headed down the path that required a bailout in Greece and Ireland—while everyone knows that the country is too big to bailout.
Let me start by laying out the shape of the Spanish crisis and then suggest the likely outcome. I know many of you have questions about the two Spanish stocks you’re most likely to own if you own any at all—Banco Santander (STD) and Banco Bilbao Vizcaya (BBVA). I’ll post in more detail on those later today. (Kind of a Spanish theme-day Friday. Banco Santander is a member of my Dividend Income Portfolio http://jubakpicks.com/ and Banco Bilbao Vizcaya is a member of my Jubak’s Picks portfolio http://jubakpicks.com/ )
The first thing to understand about the Spanish debt crisis is that it doesn’t resemble the Greek debt crisis. Not at the beginning, anyway. The Greek crisis was a crisis in government debt. The Spanish crisis started off as a crisis in private debt. And it has only gradually become a crisis in government debt.
Spain’s public debt may have ended 2011 at a relatively manageable 68.5% of GDP, but the Spanish private sector is awash in debt to the tune of 300% of GDP. And as the Irish debt crisis shows, if a country winds up turning unsustainable private debt into public debt, the deterioration of public finances can be stunningly fast.
In 2007 Irish public debt was a low 25% of GDP. The country finished 2011 with a public debt to GDP ratio of 112%. And it’s forecast to hit 120% by the time it peaks in 2013.
What happened? An Irish housing boom turned into a housing bust turned into a financial crisis at the banks that issued the mortgages. And when the Irish government stepped in to rescue the banks, the private debt became a public burden.
The Irish housing bubble was astonishing even by U.S. standards. The country started 1997 with a housing stock of 1.2 million homes. By 2008 that was up to 1.9 million homes. Housing prices, meanwhile, rose four times from 1996 through 2007. That was twice the U.S. appreciation during that period.
Housing prices started to fall in early 2007—even before the global financial crisis. But with the financial crisis, the big Irish banks that had borrowed in the global financial markets to fund their mortgage binge couldn’t find financing. In 2003 Irish banks issued 15 billion euros worth of debt on international markets to fund their operations. By 2007 that had climbed to 100 billion euros. Ireland is a small country: that bank borrowing came to half of GDP. When international financial markets stopped lending to pretty much everybody in the financial crisis, Ireland’s banks had no way to refinance that debt as it matured. And with the value of the mortgages on their books plunging, the banks were in deep trouble. Two weeks after the Lehman bankruptcy in September 2008, the banks turned to the Irish government for rescue.
The steps that the Irish government took beginning in 2008—a blanket two-year guarantee to the banks, the use of government money to recapitalize the banks, the use of emergency liquidity from the central bank in 2010 once the Irish banks ran out of collateral for loans from the European Central Bank—effectively turned the private debt into public debt. In 2010 the government’s budget deficit for the year hit 32% of GDP. That locked the Irish government itself out of the financial markets and the country had to turn to the European Central Bank, the International Monetary Fund, and the European Union for a rescue.
With the example of Ireland before it, Spain has done everything it can to fix its private debt problem while moving as little of it as possible to the public balance sheet. For example, the country has, so far, used a guarantee fund, underwritten by payments from the country’s banks, to help finance the sale of weak or failing banks. Using that method, the government put 5.25 billion euros ($6.9 billon) from the fund into Caja de Ahorros del Mediterraneo before selling the bank to Banco Sabadell. This arrangement has the advantage that the fund and its disbursements don’t count as part of the government’s budget or budget deficit.
But the firewall between public and private debt exemplified by that fund is increasingly ineffective. The balance sheets of Spain’s banks and Spain’s government have been growing even more entwined in recent months. The 1 trillion in 3-year loans offered by the European Central Bank to European banks in December and February was supposed to solve the liquidity problem for banks that couldn’t access the financial markets to refinance maturing debt. Those banks could borrow at 1% from the central bank. Many banks were able to borrow enough to meet their refinancing needs for 2012 and into 2013.
But what did those banks then do with that money? Well, what would you do if you were a banker borrowing at 1% in an economy sinking into recession—don’t want to make a business loan in that environment, for sure—but where Spanish government debt is paying 3.5% or 4% or even 5%, depending on the maturity? You take your European Central Bank money and buy Spanish government bonds, of course. (UBS estimates that only 4% of that 1 trillion wound up going into new lending in the real economies of the EuroZone.) From November 2011 to February 2012, the time when the European Central Bank was dishing out that 1 trillion in loan money, Spanish banks increased their holdings of Spanish government debt by 68 billion euros ($88 billion.) By the way, Italian banks have been doing exactly the same thing: they’ve bought 54 billion euros of Italian government debt in the period.
This hasn’t turned out to be the smartest play in the last month or so. As banks ran out of borrowed cash to buy government debt, yields on that debt started to move up and prices started to move down. (There were other reasons too for this price move like the attempt by the Spanish government to unilaterally rewrite its budget deficit target.) In the last month yields on the 10-year Spanish bond have moved up almost one percentage point, sticking the Spanish banks that bought Spanish government bonds with big losses.
You can see how this has put the Spanish government in a bit of a spot. It needs to reassure outside investors that the Spanish banking system is sound. To do that it needs to consolidate the banking sector by selling off or closing down weak or failing banks. And it has address skepticism about the soundness of the balance sheets of Spanish banks by forcing them to recognize more of their losses, especially real estate losses. Total real estate exposure—including construction loans--adds up to 406 billion euros ($530 billion), according to Societe Generale. And according to the last report from the Bank of Spain, more than 40% of Spanish bank loans tied to property and construction are “problematic.” (Those “problematic” loans add up to about 18% of Spain’s GDP.)
But these are the very banks that the government needs to keep buying Spanish debt (or at least not to sell it) and to make loans in the Spanish economy if the country isn’t going to fall into an even deeper recession than the 1.7% drop in GDP in 2012 projected by the government (or the 2.0% drop projected by private economists.)
What’s the result? Half-measures that, the government hopes, will be enough to win back confidence in the banking system without crushing Spanish banks. That’s why the Spanish government has forced banks to put an additional 50 billion euros aside against bad real estate loans.
That’s certainly a splashy move. For example, it has killed profits for 2012 at the strongest Spanish banks. Banco Santander will see a 42% hit to profits in 2012 as a result of the increase in provisions against bad loans, according to Societe Generale. Banco Bilbao Vizcaya will see a 52% hit.
But it hasn’t been enough to restore confidence in Spanish banks. At Banco Santander the increased provision brought reserves against foreclosed real estate in Spain to 50%. That’s a big improvement from 30% in 2010 and 10% in 2008. But the estimate among bank analysts is that across the Spanish banking industry, the required increase in provisions is only about half as large as it needs to be. The Spanish real estate market is by no means finished working its way through the bust from its bubble. Home prices are down 25% from the peak of the bubble but, projects Societe Generale, home prices will fall another 15% in 2012-2013.
So where does this crisis go from here?
There are no good or straightforward solutions. The obvious one—to put Spain into a Greek or Irish-style rescue plan—is politically impossible. The countries that would have to cough up the cash—and especially Germany—won’t.
In the absence of any good plan, I think the EuroZone and Spain fall back on a series of increasingly desperate kludges by the European Central Bank, other global central banks, and finally the International Monetary Fund.
First, as intimated on Wenesday by bank executive committee member Benoit Coeure, the central bank will go back into the business of buying Spanish and Italian government debt. The hope is that this will stabilize or actually reduce the yields on Spanish and Italian debt. That would also reduce the losses at Spanish and Italian banks that have bought their government bonds. This new wave of bond buying would be linked with new acts of financial discipline by the Spanish government in an attempt to further reassure the financial markets.
Will this work? Almost certainly not for any length of time. The European Central Bank faces strong internal opposition to a lengthy program of bond buying so any improvement in yields will be temporary. And the plan also faces the problem that if European Central Bank buying reduces yields, what, exactly, will bring other buyers into the market for these bonds? (And more austerity from the Spanish government is just going to make the Spanish recession deeper and the Spanish budget deficit larger.)
Second possibility, a third round of lending by the European Central Bank. This is only politically viable if the crisis in Spain gets so bad that the German Bundesbank and Chancellor can be convinced that the alternative is blowing the entire European Stability Mechanism on rescuing Spain. (And, of course, that 500 billion euro fund doesn’t actually go into operation until July.) But I do think the odds are good that this crisis will get that bad.
Third, a coordinated round of growth-promising stimulus from the central banks of the United States, Japan, and China. (Sorry but I don’t see the politics of the EuroZone or the United Kingdom letting them play.) These moves have the advantage that they can all be portrayed as driven by domestic needs—for example, China needs to push growth higher and moves to stimulate growth in China would have nothing to do with the EuroZone crisis.) The fact is that while whatever reforms the Spanish (and Greeks, and Italians, and Irish, and Portuguese) are making in order to improve the productivity of their economy are slowly making their effects felt, what Spain needs is some prospects for growth. A world economy growing by an extra percentage point or two would be more likely to buy more from Spain than one growing more slowly.
Fourth, the last resort would be to drag the Spanish government kicking and screaming into a rescue program designed and run by the International Monetary Fund. (How to finance that? The IMF could run its own printing press to produce Special Drawing Rights. As you can see, most of the “solutions” I can think of involve running one printing press or another to add to the money supply. I’m not saying I think this is a good thing; just that it’s more likely politically. )
And where does this leave Spain’s two biggest banks? Banco Santander and Banco Bilbao Vizcaya? I’ll post in detail on each of those stocks later today.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Santander and Banco Bilbao Vizcaya as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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