Saddling Spain With Bank Burden Repeats Irish Error: Euro Credit

Spain’s surging borrowing costs suggest the nation is hurtling toward a full sovereign bailout as the same aid policies that doomed Ireland to pariah status on the capital markets are repeated in southern Europe.

Spain’s 10-year bond yields jumped 76 basis points since the government agreed June 9 to seek 100 billion euros ($126 billion) from the European Union to recapitalize its banks, reaching 7.09 percent today after yesterday’s euro-era record of 7.29 percent.

Germany is reluctant to sanction disbursements directly to the region’s banks. Channelling payments via governments, however, increases their debt burdens, undermining their creditworthiness and stoking investor concern about ranking behind official creditors for repayment.

“Germany still refuses to recognize its mistakes,” said Ray Kinsella, a lecturer in banking and finance at University College Dublin. “It is wrong that the burden of adjustment should be borne by these peripheral countries, which are in effect acting as the insurers,” of German and French banks which benefited most from euro-region trade, he said.

Ireland’s banks needed 63 billion euros after a decade-long real estate boom ground to a halt in 2008. In Spain, the government is awaiting the results of an audit of the financial industry by consultants Roland Berger and Oliver Wyman.

Split Opinion

“There is significant support for the idea of funding the banks directly in manner that would go off the sovereign balance, but that support wouldn’t be very strong among the AAA countries,” Irish Finance Minister Michael Noonan told lawmakers in Dublin on June 14. “The people who pay the piper have a stronger say.”

Germany, which has AAA grades from all of the major rating companies, is the biggest contributor to Europe’s bailouts, with commitments to the European Financial Stability Facility worth 211 billion euros, which is 27 percent of the total.

EU leaders should commit to starting the European Stability Mechanism, the 17-nation euro zone’s 500 billion-euro ($632 billion) firewall, by July 9, according to draft conclusions prepared for a June 28-29 summit in Brussels obtained yesterday by Bloomberg News. Lawmakers across the 17-nation currency union must ratify the fund.

Toxic Link

Ireland’s October 2020 bonds, regarded as the nation’s debt benchmark, yield about 7.41 percent, within about 35 basis points of where Spain’s benchmark yields are. The cost of insurance against Ireland defaulting using credit-default swaps was unchanged at 683 yesterday, according to prices from data provider CMA. In Spain, the figure is 624, implying a 41 percent probability of the nation failing to meet its obligations within five years.

Spain’s borrowing costs surged at its first auction since becoming the fourth euro member to seek a bailout, with the Treasury paying the most since at least 2004 to sell debt repayable in one year. The Treasury sold 2.4 billion euros of bills at 5.074 percent, up from 2.985 percent at a previous auction on May 14.

The “toxic” link between the banks and sovereign is “evident in Spain,” said Alan Ahearne, former economic adviser to Irish Finance Minister Brian Lenihan. “The only thing that might have changed that was if the 100 billion euros being earmarked for Spanish banks came from the ESM. That could have been a game-changer” by funding the banks directly, he said.

Iceland pursued a different path to ease its economic crisis, allowing its three biggest banks to default in 2008. Now, even as the Europe’s debt crisis escalates, Iceland is growing again and unemployment is falling. Much of Iceland’s recovery results from its “unorthodox” crisis management, according to Fitch Ratings, which restored the island to investment grade in February.

Burden Sharing

The Icelandic route is not available to euro members, Ahearne said. Ireland took control of five of its six biggest domestic lenders in 2008 after the European Central Bank told the government to save its banks, and committed 34.7 billion euros to rescue Anglo Irish Bank Corp.

“Ireland tried to share the burden with senior Anglo bondholders, which would have reduced the burden on the sovereign,” he said. “It was not allowed.”

Including the costs of the bank recapitalization, Ireland’s debt to gross domestic product ratio will peak at about 120 percent, according to International Monetary Fund forecasts. That’s up from 25 percent in 2007. Spain’s debt will peak at about 95 percent, Fitch said on June 7, as it cut the country’s credit rating to ‘BBB’ from A.

As Spain’s creditworthiness deteriorates, bondholders are wary of being subordinated to the EU agencies that might demand priority repayment for supplying aid to the nation. Lenders to Greece lost more than 70 percent of their investments when the nation restructured its debts, while the ECB and other official lenders were exempt from the discounts.

If EU leaders “wanted to be really radical they would subordinate themselves to anyone buying primary debt from this juncture onwards for a couple of years,” according to Gary Jenkins, director of Swordfish Research Ltd. in Amersham, England. “That might actually encourage investors to buy alongside them which is what they need to do if the euro zone is going to continue. Lending money is all about confidence and that is shot to bits right now.”

To contact the reporters on this story: Dara Doyle at ddoyle1@bloomberg.net

To contact the reporter on this story: Joe Brennan in Dublin at jbrennan29@bloomberg.net

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