Why Spain Scares the Market

04/13/2012 9:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

By turning private debt into public debt, Spain has created a crisis that almost certainly will require a bailout. But unlike Ireland and Greece, it’s too big to bail out, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

What’s the big deal about Spain? Last year, the country’s government debt came to just 68.5% of its gross domestic product. That hardly puts Spain in the same class as Greece, right? The goal of the Greek rescue package is, after all, 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 US 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 ten-year bonds—which rise with the perceived risk of those bonds—climbed back within spitting distance of 6%? And why has that been enough to send the global financial markets into a bout of panic selling like the one we saw Tuesday?

How about because Spain’s debt represents a worse crisis than Greece’s, and a far worse problem than US debt. (Give us a few years, though.)

The Spanish debt crisis looks as if it has combined the worst of the Irish and Greek debt crises—and has wrapped the results in an economy too big for existing Eurozone funds and mechanisms to rescue. Spain looks as if it’s headed down the path that required a bailout in Greece and Ireland—and everyone knows that Spain is too big to bail out.

Let me start by laying out the shape of the Spanish crisis, and then suggest the likely outcome. And because I know many of you have questions about the two Spanish stocks you’re most likely to own—Banco Santander (STD) and Banco Bilbao Vizcaya (BBVA)—I’ll post in more detail on those Friday. (It’s kind of a Spanish theme to end the week.)

Why Spain Isn’t Greece
The first thing to understand about the Spanish debt crisis is that it doesn’t resemble the Greek debt crisis. Or it didn’t at the beginning, anyway.

The Greek crisis was a crisis in government debt. The Spanish crisis started off as a crisis in private debt. 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% when it peaks in 2013.

What happened? An Irish housing boom turned into a housing bust that 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 US 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, quadrupled from 1996 through 2007. That was twice the US 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 ($19.7 billion) worth of debt on international markets to fund their operations. By 2007, that had climbed to €100 billion ($131.4 billion). 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 couldn’t 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 Brothers 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, and the use of emergency liquidity from the central bank in 2010 when 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.

NEXT: How Private Debt Goes Public

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How Private Debt Goes Public
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.

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. For example, the government put €5.25 billion ($6.9 billon) from the fund into Caja de Ahorros del Mediterráneo 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 become 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 on into 2013.

But what did those banks do with that money? Well, what would you do if you were a banker borrowing at 1% in an economy sinking into recession—you don’t want to make a business loan in that environment, for sure—and 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 trillion in loan money, Spanish banks increased their holdings of Spanish government debt by €68 billion. (By the way, Italian banks have been doing exactly the same thing: They’ve bought €54 billion of Italian government debt in the same period.)

This hasn’t turned out to be the smartest play in the past month or so. As banks ran out of borrowed cash to buy government debt, yields started to move up and prices started to move down. (There were other reasons, too, for this price move, such as the attempt by the Spanish government to unilaterally rewrite its budget deficit target.)

In the past month, yields on the ten-year Spanish bond have moved up almost a percentage point, sticking the 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 to address skepticism about the soundness of the balance sheets of Spanish banks, by forcing them to recognize more of their real-estate losses.

Total real-estate exposure—including construction loans—adds up to €406 billion ($530 billion), according to Société Générale. And, according to the most recent 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 is counting on to keep buying Spanish debt (or at least to not sell it), and to make loans in the Spanish economy to keep the country from falling into an even deeper recession than the 1.7% drop in GDP in 2012 projected by the government (or the 2% drop projected by private economists).

The result? A half-measure designed to win back confidence in the banking system without crushing Spanish banks. The Spanish government is requiring banks to put an additional €50 billion aside against bad real-estate loans.

That’s certainly a splashy move. And 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 Société Générale. Banco Bilbao Vizcaya will likely see a 52% hit.

But the move hasn’t restored 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 according to Société Générale projections, those prices will fall an additional 15% through 2013.

Looking for Answers
Where does Spain’s 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—particularly 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 this week 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 even reduce the yields on Spanish and Italian debt. That would also reduce the losses at Spanish and Italian banks that have bought government bonds.

This new wave of bond buying would be linked to further acts of financial discipline by the Spanish government, in an attempt to further reassure the financial markets.

Would this work? Almost certainly not for long. The European Central Bank faces strong internal opposition to a lengthy program of bond buying, so any improvement in yields would 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.)

A second possibility is a third round of lending by the European Central Bank. This is politically viable only 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 fund doesn’t go into operation until July.) But I do think the odds are good that this crisis will get that bad.

Third, there could be 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 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 the reforms the Spanish (and Greeks and Italians and Irish and Portuguese) are using to try to improve the productivity of their economies are slowly making their effects felt, what Spain needs is some prospect 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 a special form of asset known as special drawing rights.

As you can see, most of the "solutions" I can think of involve running a printing press 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? As I said, I’ll post in detail on each of those stocks Friday.

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, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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