Why 100 bln euros for Spain Won't be Enough

Currency in Crisis

In the five sessions through today, the Greek stock market has rallied 25%. Equity traders seem to have anticipated the election outcome. A new government is not yet in place, but many are still confident it will be announced in the very near-term (today or tomorrow). At the same time, European officials seem to be much more supportive than they were prior to the vote. They seem more willing to modify Greece's program than if Syriza won, underscoring our sense that the bellicose rhetoric was simply the start of negotiations.

At the same time, it raises issues of the real meaning about sovereignty, that officials seem to determined to preserve. Recall that Italy's Berlusconi was pushed out not so much by the opposition in Italy as by European officials including Merkel. There has also been some intimation that European officials were more tolerant of the Greek excesses prior to the PASOK victory in late 2009 because of the government was center right. In the recent election, European officials as much as Samaras tried to portray it as a referendum on EMU itself, even though Syriza claimed to remain committed to EMU membership.

The hubris of small differences strikes with vengeance. The current memorandum of understanding--not the gravitas of a treaty or national law--is going to be reworked even if Syriza remains in opposition. Prior to the government being formed, an agreement between potential coalition partners is needed.

The first issue is the more than 11 bln euros in savings that the Troika is demanding over the next two years to pave the way for the next tranche of aid. This next tranche of aid is not going to go to the Greek people. It is so Greece can make its next debt payment to...wait for it....the ECB (and the official sector that holds more than 3/4 of Greece's outstanding debt). Greece wants to stretch out the pain for four years rather than two.

Spain trumps Greece. As frustrating as Greece may be for the Troika, in many ways Spain represents a larger and more intractable problem. Spain's bonds are enjoying a bit of a reprieve today, but this has more do with the general consolidative tone in the capital markets after yesterday's whiplash and ahead of the conclusion of the FOMC meeting tomorrow.

Spain's bill auction today saw a significant rise in rates and it still has a bonds to sell later this week. The news stream from Spain is poor and illustrates why the 100 bln euro line that the EU offered for Spanish banks will not be sufficient.  And this is even before Spain makes a formal request.

The Bank of Spain reported that "bad loans" rose to 8.72% in April, up from 8.37% in March and 6.36% a year ago. The euro value of these loans is estimated at almost 153 bln euro, with 4.8 bln souring in April alone. The percent of mortgages going bad rose to 3.01% in March from 2.74% at the end of last year. Spanish banks have over 600 bln euros in mortgages on their books.

The source of our continuing pessimism is that property and house prices have not yet completed their decline from the peak in 2007. That means more loans will turn bad. And given that nearly 1 in 4 Spaniards are unemployed and house prices continue to fall, (but are carried on the banks' books at full price, according to press reports)  the situation is worrisome.

The LTROs did not lead to new domestic loans. Bank of Spain data showed that lending in April was 3.5% below year ago levels and was off 1% in April alone. Deposits at Spanish banks were 5.4% lower in April than a year ago. The pace of depositor flight accelerated, falling 2.5% in April alone and that was before Bankia woes were acknowledged in May. Worse data then is likely next month from the central bank.

The IMF stress tests were predicated on a 4% contraction in the economy and another 20 percent decline in property prices. Under such conditions, Spanish banks would need another 37 bln euros. However, it is interesting to note that it also does not believe that Bankia needs 19 bln euros. The IMF's modus operandi has been to under-estimate the magnitude of the problem and it stays true to form in Spain.

Over the next day or two, addition stress tests from two private firms commissioned by the government will issue their report. Even then, however, it is not going to be clear the real condition of Spanish banks. News earlier today indicated that the Troika and Spain have agreed to delay the results of the audit being conducted by four accounting firms until September. This is disappointing and fuels speculation that the news is not going to be good. It also demonstrates that European officials are acting in an analog fashion while the world of finance has gone digital.

Prime Minister Rajoy continues to advocate ECB action. Some press reports suggest Italy is testing the waters for a proposal to make ECB support more automatic. There is also speculation that LCH Clearnet may soon raise the margin for trading Spanish bonds by 10-15%.

Do not be misled by the 2.6% rally in Spanish equities today or the 11 bp decline in 10-year bond yields. Spain's problems are still growing, not diminishing.