Spain: Another Pain

Pressure is mounting on Spain. The 10-year yield today is essentially back to where it was when the ECB broadened its sovereign bond purchase scheme to include Spanish and Italian bonds. On Oct 27, the 10-year yield was near 5.33%. Today it is 100 bp higher. This is not a very conducive environment for tomorrow's new benchmark offering (up to 4 bln euros of bonds that mature in 2022).

Spain has elections on Sunday and there is little doubt over the outcome. The Popular Party (PP) is going to win handily. It may garner around 200 seats and the PP also governs most of the regions. It will have a strong political mandate.

The mandate will be used to enforce greater austerity on the country. Rajoy, the next prime minister, seems to have been a bit vague on the extent of public sector spending cuts and how he will rein in regional spending. Measures to increase labor market flexibility may first result in higher unemployment before the pro-growth benefits are realized.

Rajoy has promised to cut corporate taxes, but this may be a difficult campaign pledge to keep as the risk of under-shooting growth means larger deficit, requiring more austerity to hit the target.

The challenge for Spanish banks is not peripheral exposure as it is for some other euro zone countries, like France for example. Recent reports suggest Spanish banks exposure to Italy, Portugal and Greece sovereign bonds is "only" about 15 bln euros. Exposure to the private sectors, including banks, in those countries is less accessible.

Instead the challenge is exposure to the real estate and housing markets. Spanish banks have reportedly set aside more than 100 bln euros over the last three years to cover losses arising from this sector. More is needed. The Bank of Spain classifies about 52% of the 300 bln euros of bank exposure to property developers as "troubled". The risk is the this understates the case and the depth of the losses that may have to be incurred.

While Spain's largest banks have diversified out of Spain, their exposure to Spain's real estate market is still substantial, with 25-33% of that exposure in trouble. In addition, to tweaking their risk weighted optimization models, Spanish banks have also reduced their loan book in Spain. According to the central bank figures, the domestic loans have fallen at a 5.6% annualized pace through September.

Rajoy will be inheriting a financially vulnerable and economically weak economy. The economy stagnated in Q3. The details indicate domestic demand is contracting sharply with a rise in the net exports suggesting foreign demand may have picked up the slack (5.4% rise quarter/quarter of goods exports). Private consumption slipped 0.1% on the quarter, but public sector spending was slashed 1.1% in Q3. Final private domestic demand fell 0.3% and is the second consecutive quarterly decline.

S&P downgraded the regional government of Andalusia yesterday to A+ from AA- and kept a negative outlook. We suspect other regions are susceptible to downgrades as is the Spanish sovereign. In fact, our proprietary assessment is that there is scope for more a more than one notch move. We believe it is an A- credit, compared with the current AA assessment from S&P and Aa2 by Moody's and AA+ at Fitch.

If Spanish bonds remain under pressure, the next shoe to drop may be for the clearers to increase margins. With the ECB reluctant to completely fill in the vacuum left by fleeing investors, pressure on Spanish bond will likely persist after a new government is in place. In fact, the risk is that the new government reveals greater fiscal straits than the outgoing government, if that is not too cynical to suggest.

Spain's challenge is not just its real estate market and the linkages between private and public debt, but the way European officials have dealt with and are dealing with the other periphery, especially Greece and Italy,makes investors wary. The efficacy of hedges in the form of sovereign credit default swaps has been questioned. This leaves only a few options, including reducing exposure outright. A stabilization of the European debt crisis will aid Spain even if it wouldn't resolve the hang over from the housing market bubble. The ECB's rate hikes in April and July did no favors for Spanish mortgages, which the lion's share are at variable rates.

We expect the ECB to cut rates again in December. On the margin this is helpful, but may be too little too late to provide significant help.