Madrid Leans on Its Troubled Banks to Buy Its Bonds

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.

Angel Navarrete/Bloomberg News

The Madrid stock exchange. The chief buyers of bonds sold by the government to finance its bailout of banks are the banks themselves.

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 it’s 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.