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Banks' debt lifeline for Spain starts to fray

Source: Reuters - Fri 6th Jul 2012
Banks' debt lifeline for Spain starts to fray

Domestic banks that have backed Spain's debt auctions with heavy buying could be reaching a limit for absorbing sovereign bonds, say financial analysts and 2 market makers, undermining the country's efforts to stave off a full-blown bailout.

If Spain had to cancel an auction due to lack of demand from big domestic banks, it could be forced to seek outside help for state finances on top of the up to 100 billion of aid already negotiated for its lenders, triggering a dangerous new phase in the euro zone debt crisis.

Spain's financing costs soared to euro-era highs in June as international investors dumped the country's debt, and on Friday its benchmark 10-year yields again breaching the 7% level that triggered an upward spiral in borrowing costs for Ireland and Portugal prior to their bailouts.

Until now, Spain's banks have filled the funding void, but the market makers say many of the lenders have reached or are close to limits on how much debt they are willing to buy of a country whose risk premiums are continuing to rise.

The limits vary from bank to bank, as they are based on internal risk controls rather than technical levels set by regulators.

But there are signs that a sector already burdened by billions of euros of underperforming loans is reaching a saturation point.

"Spanish banks were net sellers of Spanish debt over the last 2 months. That to me is a clear sign that banks have already reached a level where they feel uncomfortable holding more debt," said Luca Cazzulani, deputy head of fixed income for UniCredit.

One large Spanish bank and one mid-sized bank told Reuters they can still take on more Spanish sovereign debt, but one market maker warned that smaller Spanish banks are staying away from primary auctions.


Domestic banks held 28% of Spain's national debt in May, according to data from the Treasury, up from 17% at the end of 2011 as they spend funds tapped in 2 huge injections of cheap 3-year money by the ECB.

But they cut their exposure to national debt in April and May - and it wasn't international investors who picked up the slack.

Rather, Spanish institutions such as the public social security fund increased their holdings - bringing the state uncomfortably close to buying up its own debt.

The situation in Spain carries unwelcome echoes of events in Portugal last April, when the country's banks threatened to stop buying national debt as yields soared, which finally pushed the country to call for a bailout.

Spain as well as Italy last week won pledges from a European summit to let EU rescue funds step directly into the bond markets, temporarily easing pressure on their sovereign yields.

But details are patchy on how and under what conditions the rescue funds would be deployed or how a planned direct recapitalisation of Spain's ailing banks would work - giving int ernational investors little incentive to pile back into the country's debt.

"The summit result is positive and should encourage investors to buy Spanish debt. But the problem is that what is decided on will take time to implement," said one market maker.

"Spain is solvent. It's not a solvency problem, it's about liquidity. And my fear is that if markets don't adjust and there's no sign of international investors returning that eventually the liquidity will go," said the same market maker.

A second seller of Spanish debt said there was scant interest in the country's debt issues, and more commitment to end the crisis was needed from Germany, along with reform work at a national level to try and tempt investors back.


But according to Citi, there have been tentative signs of foreign investors returning to buy Spanish debt, and not just short-term issues.

That may encourage the Treasury, which on Thursday sold 3 billion of bonds, including a 10-year issue, after raising the target amount for the auction when yields eased temporarily after the European summit.

But major challenges lie ahead.

"There are a lot of hurdles both political and economic and it remains to be seen whether 100 billion is enough to finally draw a line under Spain's banking problems,," said Robert Crossley, head of European interest rate strategy at Citi.

"There are unresolved question around the ESM (permanent European rescue fund)... and the economic headwinds are very strong."

Even should a degree of stability return to Spanish debt markets, Citi's economist Willem Buiter expects S pain to be forced into an ai d programme that includes sovereign conditionality and oversight by the EU and IMF, possibly quite soon.

Further long-term funding injections by the ECB might help keep Spain's banks in the debt market a while longer.

But the central bank gave no indications on Thursday it was planning to revive either its LTRO programme or other non-standard stimulus measures any time soon.

And even if it did, such measures would not address the root causes of the debt crisis.

"Given the ECB is reluctant right now to come back to offer more longer-term operations it is right to think that domestic banks may be reaching a limit of how much debt they want to take on," said Harvinder Sian, strategist at RBS.

He said that banks probably had more capacity to take on debt to their balance sheets, but it was becoming more marginal.

"We need to see a return of international investors to stabilise the situation, and that is far from certain," he added.

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