Solvency, recapitalization size haunt Spain, markets

Bad debt in Spanish banks is growing and as investors realize that these banks may need to be recapitalized, uncertainty over the size of recapitalization is also growing casting doubt whether Spanish government has enough money to handle this.

“One of our concerns in Spain is to what extent contingent liabilities could pass to the central government,” says Andrew Bosomworth, Pacific Investment Management Co.’s Munich-based head of portfolio management.

Most of the Spanish bad debt comes from bad mortgages but as the economy tanks other classes of loans are also contributing to Spain’s negative banking spiral.

Based on the bad mortgages, some 50 billion euros has been set aside to cover that, but as the other loan types deteriorate more money is needed but it is unclear how much.

“They’re going to need EFSF money to recapitalize the banking sector,” says Carsten Brzeski, a senior economist at ING in Brussels.

The uncertainty about the size of the recapitalization bill that the government has to pay has been pushing Spanish sovereign debt yields higher and this is deteriorating Spanish bank balance sheet even more.

Spanish banks and the government finances are joined at the hip because the banks used ECB loans to buy up lot of sovereign debt, so the negative loop goes both ways: as banks go bad so does the government, and as government deteriorates that is bad for the banks.

“The sovereign is affected by the view in the markets that the banks are in difficulties and in a circular loop the banks are affected by the market view that the sovereign is weak,” says Antonio Ramirez, a banking analyst at Keefe, Bruyette & Woods in London.

Meanwhile, Spanish banks exist on ever increasing ECB funding. ECB liquidity cash accounts for 8.6% of Spanish bank assets, a number that is not too far from the virtually bankrupt Greek, Irish and Portuguese banks which take in 10% to 12%.

By comparison, Italy’s ECB dependency is at 8.6% of its banking assets.

Some fear that all of this could spiral out of control affecting not just Italy but also France, considered too big to save. Some, like John Paulson, see an even grimmer outcome of Europe’s financial travails and are “shorting German government bonds [considered safe] in a wager that the euro zone debt crisis will significantly deepen in the coming months.”

Price charts of big US banks do not resemble their Spanish counterparts and we are yet to see whether that means that the US is immune to Spanish implosion.

For now, US banks, particularly BAC and C look set to go higher.