|Madrid Leans on Its Troubled Banks to Buy Its Bonds By LANDON THOMAS Jr. Published: June 7, 2012 |
LONDON — While the Spanish government was able to sell all the bonds it wanted to on Thursday, it mostly sold to the usual buyers: Spain’s increasingly fragile banks.
And so, as Madrid tries to come up with the money to bail out its banks, its main lenders are increasingly becoming many of those same institutions.
If it sounds like the most vicious of circles, it is.
Economists warn that over the long term, Spain will have trouble meeting its substantial financial requirements until foreign investors return to the market as regular buyers, injecting new money into the system. Until late last year, foreign investors were doing just that. But lately, much of the foreign money has been staying away.
Foreign investors are leery of the high risks involved in holding the debt of a government facing the twin challenges of persistent budget deficits and a banking industry, hobbled by bad real estate loans, that may soon require a bailout costing as much as 100 billion euros, or $126 billion.
On Thursday, after the financial markets closed in Europe, Fitch Ratings raised red flags over Spain’s creditworthiness by downgrading the country’s debt by three notches, to BBB from A, leaving it just above junk status.
For Fitch and others, the fear is not only that Spanish banks will need a bailout, but that Spain itself might — in which case holders of its bonds would take significant losses.
“We think Spain will require a full bailout package,” said Phoenix Kalen, a bond strategist in London for Royal Bank of Scotland. “Over the long run, Spain would be unable to issue bonds at sustainable yields and would need a full package to restore economic fundamentals.”
On the face of it, the auction Thursday was a success: Spain was able to sell 2.1 billion euros ($2.63 billion) worth of bonds, and demand was much higher than expected. And while the interest rate on the closely watched 10-year note jumped to 6.04 percent from 5.74 percent at the previous auction of similar securities in April — and a potential unsustainable borrowing cost for the government — it was lower than last week’s high of 6.63 percent.
Traders said, too, that for the first time in months a number of hedge funds in London bought the bonds. They are evidently calculating that, at above 6 percent, Spanish bonds are a pretty good bet, especially with talk building that Europe is close to extending some form of a rescue to the country’s banks.
But skeptics point out that the government may have won an easy battle by setting a relatively low target of money to be raised in the auction. They say it remains decidedly unclear whether Spain can raise the substantial amounts it will need to survive by relying so much on its local banks to pay the bill. Ms. Kalen estimates that Spain will require 276 billion euros ($347 billion) to finance its budget deficit and pay off bonds maturing through 2014.
Spain’s banks now own 67 percent of the country’s bonds, the largest such proportion in the euro zone. Despite the perils to both the banks and the government, the incentives are still in place for lending institutions to keep accumulating these high-risk securities.
As long as the Spanish government does not default and demand for loans in the recession-mired economy remains negligible, lending to the government remains in many respects the only game in town for banks. Moreover, they can borrow cheaply from the European Central Bank and make a nice return lending the money to their own government.
“If you are a Spanish bank its very profitable to borrow at 1 percent and lend at 6 percent,” said Santiago Lopez, a banking analyst in Madrid for Exane BNP Paribas. “The risk is that Spain defaults on its bonds, and if that happens you are bust anyway.”
While Spain’s banks are especially weighed down by their government’s debt, they are by no means unique in that regard.
“Spanish banks are buying Spanish bonds, Italian banks are buying Italian bonds and British banks are buying British bonds — this home bias is escalating and it is unlikely to abate anytime soon,” said Carmen M. Reinhart, an expert on international finance and sovereign debt at the Peterson Institute for International Economics in Washington.
Ms. Reinhart has just published a paper titled “The Return of Financial Repression” — the academic term of art for this phenomenon — arguing that the debt needs of many countries, combined with risk aversion on the part of foreign investors, are pushing countries to take extraordinary steps to create a captive audience for their bonds.
Aside from the immediate effect of diverting banks from their primary charge of making loans to businesses and individuals, Ms. Reinhart points out that this practice backfires if the country reaches the default point, as was the case with Greece. “Then you are doomed,” she said.
In her paper, Ms. Reinhart points to numerous steps that European governments have taken to induce their banks and other domestic investors to buy state bonds.
These include France’s efforts to make it more attractive for pension funds to buy government bonds. One of the tactics in Spain has been for the government to put a cap on the interest rates bank depositors can earn, making it that much more attractive to buy higher-yield government bonds.
Italy, with a much larger and sophisticated bond market, has been more blunt in this respect. Last year, banks and businesses organized a “buy Italian bonds” day in which commissions on bond purchases were temporarily waived to get individuals to buy more bonds.
And while specific examples of the government talking banks into buying their bonds are hard to find publicly, analysts in Spain say that in light of the close ties between banks and the public sector there, it is fair to assume that bankers have gotten the message that now more than ever is the time to buy Spanish.
Still, a powerful incentive has been the low-cost loan program the European Central Bank put in place this year. Spanish and Italian banks have been the most aggressive borrowers from this lending window, and they have funneled much of this money back into the coffers of their home governments.
But analysts at Citigroup argue that the even more powerful incentive has been European banking regulations. Government bonds in Europe carry a zero-risk weighting, according to global standards on how much money banks must set aside to insure against losses.
That means that in contrast to the treatment of mortgages or corporate loans, banks need not set aside more capital if they buy additional government bonds, even though these assets in reality may be among the riskiest that the banks own.
While European banks may see these bonds as free from risk, foreign investors certainly do not.
The Abu Dhabi Investment Authority, one of the largest sovereign wealth funds, recently removed Spain from its benchmark bond index for Europe. That means it need not allocate any portion of its assets to Spanish bonds.