The ties that bind the Eurozone’s tottering banking system to its weakest governments are growing ever-tighter. That’s because the Spanish government is attempting to give Bankia, its third largest bank, EUR19bn in government bonds to help shore up its capital base. Spanish banks tumbled on Monday, the 10-year Spanish government bond yield gave up +16bps to 6.42% (for fear of missing their fiscal targets) while the EUR-USD fell back too. It is clear that the region would be clearly better off if its banks owned no government debt however.
But they do. In fact, the banks are the biggest owners of government debt (accentuated by the ECB’s LTRO) and governments are slowly becoming the biggest owners of the banks.
Spanish PM Rajoy claims that Spain is not like Greece. And it is not. At this stage, Spain is still in a position where it can give its banks its own debt in an effort to restore confidence. Greece is currently locked out of debt markets and has to rely on the rest of the Eurozone and bonds issued by the European Financial Stability Fund. But with Spanish sovereigns yielding ~6.42% (record spread of ~514bps over German Bunds) and edging perilously close to the 7% danger level, it may only be a matter of time before Spain follows suit.
• We see a lot of similarities between Ireland and Spain where banking insolvency becomes a government one as the latter agrees to bail out the former. Initially, their problems were not one of government debt but one of household debt. Since Ireland joined the Eurozone and its monetary union, household debt to income ratio has risen dramatically from 93% to 220% (there are similar trends in Spain too). But it was only when we saw government intervened in a heavily indebted banking system (the Irish government kept Anglo Irish bank from insolvency by giving it a promissory note) did the situation turn south for the sovereign. Bond investors largely shut off Ireland’s access to markets, not because it threatened to default but because it was determined not to. Spain and its banks seem to be in a similar position today to what Ireland was in a couple of years ago. The deteriorating environment for residential mortgages in Spain is somethings which still needs to be – first – acknowledged and then – secondly - addressed. Recall that Bankia was given a clean bill of health only three weeks ago.
But they do. In fact, the banks are the biggest owners of government debt (accentuated by the ECB’s LTRO) and governments are slowly becoming the biggest owners of the banks.
Spanish PM Rajoy claims that Spain is not like Greece. And it is not. At this stage, Spain is still in a position where it can give its banks its own debt in an effort to restore confidence. Greece is currently locked out of debt markets and has to rely on the rest of the Eurozone and bonds issued by the European Financial Stability Fund. But with Spanish sovereigns yielding ~6.42% (record spread of ~514bps over German Bunds) and edging perilously close to the 7% danger level, it may only be a matter of time before Spain follows suit.
• We see a lot of similarities between Ireland and Spain where banking insolvency becomes a government one as the latter agrees to bail out the former. Initially, their problems were not one of government debt but one of household debt. Since Ireland joined the Eurozone and its monetary union, household debt to income ratio has risen dramatically from 93% to 220% (there are similar trends in Spain too). But it was only when we saw government intervened in a heavily indebted banking system (the Irish government kept Anglo Irish bank from insolvency by giving it a promissory note) did the situation turn south for the sovereign. Bond investors largely shut off Ireland’s access to markets, not because it threatened to default but because it was determined not to. Spain and its banks seem to be in a similar position today to what Ireland was in a couple of years ago. The deteriorating environment for residential mortgages in Spain is somethings which still needs to be – first – acknowledged and then – secondly - addressed. Recall that Bankia was given a clean bill of health only three weeks ago.
Delinquencies on Spanish mortgages are still less than 3% and well below the peak in Ireland or the USA. This is a remarkable outcome for a country which has more than 25% of its workers out of work (although part of this may be due to Spain’s relatively large underground economy where the official jobless may still be earning an income). So there is clear denial amongst the Spanish banks and no doubt, why the government has asked them to increase provisioning against those mortgages which are underwater. Banks are reluctant to do so given that they need additional recapitalisation, which is next to impossible under current market conditions……and reason why the government is now providing capital….and reason why the government debt-to-GDP ratio is heading for 100%.
What happens now? Well, we understand there is enough money from IMF, EFSF and ESM (European Stability Mechanism) to bail-out Spain if need be. But there is currently not enough firepower to bail out both Italy and Spain should contagion take effect. That’s why we believe the ECB will react with a -50bps rate cut. The market will rise initially but will soon realise this is lame before demanding something more meaningful; that might include buying EU peripheral sovereign bonds in the secondary market but until the ECB explicitly targets a cap of say 6%, will equity investors begin to breathe a little easier.
• The Irish voters will vote (Thursday) on whether to accept the EU’s new ‘fiscal compact‘. There is a critical article of current EU policy of austerity and why voting ‘yes ’ will condemn Ireland to more economic hardship. This is the fourth year of austerity in Ireland and it is clear the economy is weakening further, says economist, David McWilliams (source: FT). Albert Einstein once said, ‘the definition of insanity is doing the same thing over and over again and expecting different results.’ Austerity does not work in restoring public finances to more sustainable levels without growth to counter-balance.
Irish balance sheets are broken; they own houses, land and apartments on the asset side and debts on the other - the former is falling in value and the debt side is fixed. So while incomes fall, the debt burden becomes more problematic for Irish households, the banks they borrow from and ultimately the government, who keeps them alive. Maybe EU policy-makers will work something out before it reaches Spain (if it has not done already). Still, it begs the question; if Ireland is often seen as the poster boy of EU austerity, why are Irish CDS spreads trading where they are and why are the sovereign bonds still at ~7%? EU leaders might be impressed with themselves but the bond market thinks austerity is a dumb deal.
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