Spain's banks, government co-dependent on debt

FILE-In this June 16, 2012, file photo, a demonstrator holds a life saver in front of the headquarters of Bankia bank during a protest against the Spanish bank in Madrid, Spain. Europe's finance ministers meeting Thursday will try to find common ground on whether to soften Greece's austerity terms, possibly clear a bank bailout request from Spain and discuss new ways to boost confidence in the 17-country eurozone. (AP Photo/Andres Kudacki)

FILE-In this June 16, 2012, file photo, a demonstrator holds a life saver in front of the headquarters of Bankia bank during a protest against the Spanish bank in Madrid, Spain. Europe's finance ministers meeting Thursday will try to find common ground on whether to soften Greece's austerity terms, possibly clear a bank bailout request from Spain and discuss new ways to boost confidence in the 17-country eurozone. (AP Photo/Andres Kudacki)

MADRID (AP) ? The Spanish government and Spanish banks are perilously co-dependent.

The financial strength of one hinges on the other, and right now both are struggling for survival.

The Spanish economy, the fourth-largest among the 17 countries that use the euro, is suffering from the aftershocks of a real estate bust that has devastated banks and families. Unemployment is nearly 25 percent and the economy is forecast to shrink 1.7 percent in 2012.

At the request of the Spanish government, euro countries offered up to ?100 billion ($125 billion) in rescue loans for Spanish banks on June 9.

Spain made the formal petition for the aid on Monday, but the terms of the loans ? including the size and interest rates ? have yet to be agreed. They are expected to be made public by July 9 and will likely be discussed at a key European leaders' summit that starts Thursday in Brussels.

The intentions of the bailout are good but the bank bailout has only made investors more nervous about the country's financial condition.

Although Spanish banks will agree to pay back the loans with interest, it is the Spanish government that is on the hook if they cannot. In effect, the bank loans will be treated as government debt. And as the country's debt load rises, so does the interest rate it pays to borrow money, a sign that the pool of investors hungry for Spanish bonds is shrinking.

One group of investors that isn't shying away from Spanish government bonds is Spain's banks. The amount of Spanish government debt owned by Spanish banks ? yes, the same banks that are about to receive billions in emergency loans ? is rising fast.

"It is as if the government were buying its own debt," says Alejandro Varela of Renta4, a Madrid-based brokerage. "It is like a dog chasing its own tail."

With Spain's economy enduring its second recession in just three years, analysts say the odds are rising that the government will need a bailout of its own. The yield on the country's 10-year bonds surpassed 7 percent last week, the level that pushed Ireland, Portugal and Greece to the breaking point, although it now has fallen back to a still alarming 6.5 percent or so.

Here are some questions and answers about the tight relationship between the Spanish government and its troubled banks:

HOW DEPENDENT IS THE SPANISH GOVERNMENT ON SPANISH BANKS?

Two-thirds of Spain's government bonds are owned by the country's banks, pension funds and insurance companies. That's up from 50 percent at the end of last year. By comparison, only 38 percent of French government bonds are held by domestic banks and other financial firms.

In Spain the sharp increase in such a short period signals that foreign demand is falling fast as the country's economic outlook worsens.

Spain has issued ?50 billion in bonds since the start of the year. It plans to issue another ?36 billion by the end of 2012, bringing its total debt to ?608 billion. The economy ministry notes that demand has been strong at recent bond auctions. However, the Treasury has been careful to issue debt in small increments ? about ?2 billion at each auction. And it knows the takers will include those trusty Spanish banks.

WHY ARE SPANISH BANKS BUYING SO MUCH GOVERNMENT DEBT?

They are attracted to the high interest rate on Spanish government bonds. The interest rate, or yield, on 10-year Spanish bonds has of late been the highest it has been since the country joined the euro in 1999. It means financial markets consider Spanish bonds to be a risky investment.

The European Central Bank is making Spanish bonds even more attractive for banks. To help ease the continent's financial crisis, the ECB has provided European banks ?1 trillion in three-year loans carrying an interest rate of 1 percent. Spanish banks, which have borrowed tens of billions of euros under the ECB program, can make a tidy profit simply by pocketing the spread between the interest rates on ECB loans and Spanish bonds.

Analysts say there is another reason Spanish banks keep buying their government's debt: survival. If Spanish banks were to stop buying Spain's bonds at a time when foreign money is fleeing, the government's borrowing costs would rise even higher and so would the threat of default ? on the very bonds held by the banks.

"If something does go wrong, it is Spanish banks that will be hardest hit by that," says Jennifer McKeown of Capital Economics in London.

HOW DOES THE BAILOUT OF SPANISH BANKS ALTER THE EQUATION?

The eurozone's $125 billion package of rescue loans for Spain's troubled banks is supposed to help them deal with huge losses on real estate investments and promote economic growth by making it easier for them to lend money to companies and individuals.

But the rescue package hasn't eased jitters about the country's financial system ? it's worsened them.

Bond investors have reacted to the deal by driving the (country's) government's borrowing rates higher. That increases the likelihood that the government itself will need help from the rest of Europe to get out from under its rising debt burden.

Spain's debt as a proportion of its annual economic output was forecast to be 80 percent this year before the bank bailout existed. With the bank bailout included, the country's debt-to-GDP ratio rises to 90 percent or more, according to some private analysts. When a country's debt burden exceeds 90 percent, it's generally considered bad for an economy's health.

Spain's total debt includes bonds issued by the central, regional and local governments, plus other liabilities, such as unpaid bills to state suppliers.

Spanish banks have also been hurt by the bailout. As the interest rate on government bonds rises, the value of the bonds already owned by banks falls.

HOW MUCH GOVERNMENT DEBT DO INDIVIDUAL BANKS OWN?

Banco Santander, the largest bank by market capitalization in the euro region, holds about ?35 billion in Spanish debt, or about 3 percent of its total assets. It is considered a relatively healthy bank that will not need to tap the $125 billion emergency loan package.

Bankia, SA, which crumbled under the weight of bad real estate loans and was recently nationalized, holds almost ?17 billion in state debt, or 5.5 percent of its total assets. It is one of several big banks that will need billions in rescue loans. CatalunyaCaixa, another bank that needs rescue loans, owns ?3.9 billion in Spanish bonds, or 5 percent of its total assets.

WHAT IS THE LIKELY OUTCOME FOR SPAIN?

The tight link between the Spanish government and its banks is sustainable, but just barely, says Varela of Renta4. The interest rates on Spanish government bonds are high but manageable ? for a short while longer, he says.

Spain's bond yields were even higher before it joined the euro, but back then the economy was growing and tax revenue was increasing. Today Spain's economy is lifeless.

But the government must keep selling bonds. It needs money to finance its budget deficit and repay maturing debt.

If confidence were to drop sharply, and borrowing costs went to 8 or 9 percent, then the appetite for Spanish bonds could evaporate, even among its loyal banks.

"At some point, if people stop financing you, you default," Varela says.

But Varela is betting on a different outcome. Because of Spain's size ? it is the fourth-largest economy in the euro zone ? he believes the ECB will eventually step in to buy Spanish bonds and break the co-dependency of banks and the government.

Associated Press

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