4/12/2012 7:40 PM ET|
Why Spain scares the market
By turning private debt into public debt, Spain has created a crisis that almost certainly will require a bailout. But unlike Ireland and Greece, it's too big to bail out.
What's the big deal about Spain? Last year the country's government debt came to just 68.5% of its gross domestic product. That hardly puts Spain in the same class as Greece, right?
The goal of the Greek rescue package is, after all, to reduce that country's debt to 130% of GDP. Gosh, Spain isn't even in the same debtor class as the United States. The U.S. debt-to-GDP ratio passed 100% in 2011 and is forecast to hit 112% by the end of 2013.
So why have yields on Spanish 10-year bonds -- which rise with the perceived risk of those bonds -- climbed back within spitting distance of 6%? And why has that been enough to send the global financial markets into a bout of panic selling like the one we saw Tuesday?
How about because Spain's debt represents a worse crisis than Greece's and a far worse problem than U.S. debt. (Give us a few years, though.)
The Spanish debt crisis looks as if it has combined the worst of the Irish and Greek debt crises -- and has wrapped the results in an economy too big for existing eurozone funds and mechanisms to rescue. Spain looks as if it's headed down the path that required a bailout in Greece and Ireland -- and everyone knows that Spain is is too big to bail out.
Let me start by laying out the shape of the Spanish crisis, and then suggest the likely outcome. And because I know many of you have questions about the two Spanish stocks you're most likely to own -- Banco Santander (STD) and Banco Bilbao Vizcaya (BBVA) -- I'll post in more detail on those on Friday in the Top Stocks blog (kind of a Spanish theme to end the week).
Why Spain isn't Greece
The first thing to understand about the Spanish debt crisis is that it doesn't resemble the Greek debt crisis. Or it didn't at the beginning, anyway. The Greek crisis was a crisis in government debt. The Spanish crisis started off as a crisis in private debt. It has only gradually become a crisis in government debt.
Spain's public debt may have ended 2011 at a relatively manageable 68.5% of GDP, but the Spanish private sector is awash in debt -- to the tune of 300% of GDP. And as the Irish debt crisis shows, if a country winds up turning unsustainable private debt into public debt, the deterioration of public finances can be stunningly fast.
In 2007, Irish public debt was a low 25% of GDP. The country finished 2011 with a public debt-to-GDP ratio of 112%. And it's forecast to hit 120% when it peaks in 2013.
What happened? An Irish housing boom turned into a housing bust that turned into a financial crisis at the banks that issued the mortgages. And when the Irish government stepped in to rescue the banks, the private debt became a public burden.
The Irish housing bubble was astonishing, even by U.S. standards. The country started 1997 with a housing stock of 1.2 million homes. By 2008 that was up to 1.9 million homes. Housing prices, meanwhile, quadrupled from 1996 through 2007. That was twice the U.S. appreciation during that period.
Housing prices started to fall in early 2007 -- even before the global financial crisis. But with the financial crisis, the big Irish banks that had borrowed in the global financial markets to fund their mortgage binge couldn't find financing. In 2003, Irish banks issued 15 billion euros ($19.7 billion) worth of debt on international markets to fund their operations. By 2007, that had climbed to 100 billion euros ($131.4 billion). Ireland is a small country; that bank borrowing came to half of GDP.
When international financial markets stopped lending to pretty much everybody in the financial crisis, Ireland's banks couldn't refinance that debt as it matured. And with the value of the mortgages on their books plunging, the banks were in deep trouble. Two weeks after the Lehman Brothers bankruptcy in September 2008, the banks turned to the Irish government for rescue.
The steps that the Irish government took, beginning in 2008 -- a blanket two-year guarantee to the banks, the use of government money to recapitalize the banks, and the use of emergency liquidity from the central bank in 2010 when the Irish banks ran out of collateral for loans from the European Central Bank -- effectively turned the private debt into public debt. In 2010, the government's budget deficit for the year hit 32% of GDP. That locked the Irish government itself out of the financial markets, and the country had to turn to the European Central Bank, the International Monetary Fund and the European Union for a rescue.
How private debt goes public
With the example of Ireland before it, Spain has done everything it can to fix its private debt problem while moving as little of it as possible to the public balance sheet. The country has, so far, used a guarantee fund, underwritten by payments from the country's banks, to help finance the sale of weak or failing banks. For example, the government put 5.25 billion euros ($6.9 billon) from the fund into Caja de Ahorros del Mediterráneo before selling the bank to Banco Sabadell. This arrangement has the advantage that the fund and its disbursements don't count as part of the government's budget or budget deficit.
But the firewall between public and private debt exemplified by that fund is increasingly ineffective. The balance sheets of Spain's banks and Spain's government have become more entwined in recent months. The 1 trillion euros in 3-year loans offered by the European Central Bank to European banks in December and February was supposed to solve the liquidity problem for banks that couldn't access the financial markets to refinance maturing debt. Those banks could borrow at 1% from the central bank. Many banks were able to borrow enough to meet their refinancing needs for 2012 and on into 2013.
But what did those banks do with that money? Well, what would you do if you were a banker borrowing at 1% in an economy sinking into recession -- you don't want to make a business loan in that environment, for sure -- and where Spanish government debt is paying 3.5% or 4% or even 5%, depending on the maturity? You take your European Central Bank money and buy Spanish government bonds, of course. (UBS estimates that only 4% of that 1 trillion euros wound up going into new lending in the real economies of the eurozone.)
From November 2011 to February 2012, the time when the European Central Bank was dishing out that trillion in loan money, Spanish banks increased their holdings of Spanish government debt by 68 billion euros. (By the way, Italian banks have been doing exactly the same thing: They've bought 54 billion euros of Italian government debt in the same period.)
This hasn't turned out to be the smartest play in the past month or so. As banks ran out of borrowed cash to buy government debt, yields started to move up and prices started to move down. (There were other reasons, too, for this price move, such as the attempt by the Spanish government to unilaterally rewrite its budget deficit target.) In the past month, yields on the 10-year Spanish bond have moved up almost a percentage point, sticking the banks that bought Spanish government bonds with big losses.
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Great article JJ. We frequently hear client investors say "why should we worry about the PIIGS over in the EZ?" They have absolutely zero comprehension as to the complexity and inter-connectedness and size of the problem.
All will be well until some event or miscue causes this process to be seen as "hey everybody the emperor has no clothes!" Then it will be like rats fleeing a sinking ship.
They keep eating and eating and ordering more without noticing that the restaurant owner has hired the hell's angels to collect the bill before they leave. Making them wash dishes just won't do as heads will roll and countries will implode.
I hope some of these policy-makers read your article and wake up .....
The 5, 000 year cliche, is about to be become relevant to the nanny staters, "ain't no such thing as a free lunch.
So European banks get themselves into trouble gambling on bad subprime mortgages, turn to their governments for a bailout, who need to then go to the EU for a larger bailout, who then loan a bunch of cheap money to the banks, who buy risky European gov't bonds. Talk about rearranging deck chairs on the Titanic. It's all a giant, meaningless, circular accounting exercise...
pha q 123
you fall victim to stereotypes, you blame all your problems on illegals, and others, but you have to look at your self, am sure you supported the war in afghanistan and iraq, and am sure you are a christian. we are an entitled society, we feel we deserve everything we want, we have forgotten how to work, and we want 20.00 an hr to tighten bolts and nuts. we have become a society of hollywood dreams and lack of reality. the truth is most of you are stupid, most of you live in lala land. and most of you are lazy. hence our society has gotten off track, we no longer take chances, we support a gov, that imposes severe restrictions on people in the name of safety, and we have become too scared. other words are crumbling super power, and has been
Hit the reset button.
All private and public debts are here by null and void.
It is not the Politician's fault. It is the voter's fault.
The people alive now that turn on the light in the bathroom in the morning see the face of who destroyed our society. You people with your Government Union pensions, Social Security, Medicare, Medicaid, buying houses stupidly, not saving, smoking hash, blaming "corporations", blaming others, etc.
What ever happened to the Americans in America? Bunch of 5th century "Romans"
Hows how incompetent bankers and finance professionals are.
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