Portugal Downgraded, Spain's Turn Again?

Spain's Finance Minister Salgado says the downgrade of Portugal earlier today does not put pressure on Spain. It is true as far as it goes, but of course Spain's problem transcends Portugal.

The ruling Socialists in Spain are seven seats shy of a majority and it has had to depend on smaller political parties for key votes. The economic austerity measures passed by a single vote in late May. The Catalan Party (CiU) has warned the Socialists that it will not support the 2011 budget proposals, which will be voted on in September and could threatened the viability of the government.

A greater sense of Spain's political climate may be seen in the coming days as state of the nation debate gets under way, with votes likely next week on various proposals.

Our proprietary models suggest the Spain's macro-economic situation is more consistent with a A rating than the AA S&P grants it, Aaa from Moody's and AA+ from Fitch. Spain's 10-year yield is 202 bp on top of Germany, widening 24 bp over the past month.

Earlier today Moody's placed Spain's bank rescue fund on watch for a possible downgrade. The fund, known by its Spanish acronym FROB is currently rated Aaa by Moody's. By putting it on watch, Moody's is signaling a likely downgrade in the next three months. Separately, Fitch has indicated that FROB has sufficient funds (max 99 bln euros), when coupled with existence of loan loss reserves and other reserves (est. 68 bln euros) to achieve a 6% common equity assets ratio for the overall Spanish banking system.

However, and this is why placing FROB on credit watch is so important: any funds in excess of 9 bln euros, FROB has to raise in the capital markets, as a sub-sovereign issuer.

Recall that FROB was initially to help facility consolidation among the cajas. Yet as Fitch notes, their ownership structure is not very clear. Of the 45 existing cajas, 37, Fitch says, are engaged in a dozen different processes, including 7 outright mergers and a number integrating mechanisms (Institutional Protection Scheme or SIP). Recent reforms in Spain ban politicians from owning cajas and this was seen as an effort to make it easier for them to raise capital, if/when necessary.

It is widely appreciated that Greece and Portugal are small compared with Spain. The 6% appreciation of the euro over the past several weeks has seen the talk of the imminent demise of EMU quiet down considerably. The EFSF mechanism and the stress tests due out in a little more than a week, fund managers are looking at the periphery of Europe to see if there is value.

Given Spain's size, some see European officials as having successfully built a fire wall around Spain. That said, investment in Spain has three risks that have been sketched here: the political situation is fragile; the sovereign rating is vulnerable to another downgrade, and the placing of FROB on credit watch ahead of next week's stress test results raises questions about Spanish bank support. The immediate risk is NOT that that Spain will default or restructure, rather the risk in the coming period is that bond yields will rise further.