How To Play The Inevitable Spanish Restructuring

Includes: BBVA, SAN, SPY
by: Colin Lokey

By now, most people who follow the market are probably acutely aware of the laundry list of arguments that support the contention that stocks will likely continue to sell-off over the coming weeks. Nearly three quarters of the economic data released lately have come in below expectations, both the Dow and the S&P 500 dropped below their respective 50 day moving averages this week, the VIX broke above its 50 day moving average Monday, the VIX/VXV term structure is rapidly flattening out, and on and on.

What investors should really be watching, however, is the situation in Spain. The fact is, it is deteriorating faster than virtually anyone expected. Yields on Spanish 10-year bonds jumped nearly 20 basis points Tuesday and are now flirting with 6% - within shouting distance of 7% - the level at which the country is effectively priced-out of the market. As these yields rise, the underlying bonds lose value, causing bond holders to incur losses.

The problem for Spain is that its banks are the bond holders. Spanish banks increased their holdings of risky Spanish debt by 68 billion euros in the four months ended February. Spain's banks were able to make these purchases largely because the ECB loaned them money as part of the LTRO program. With no more LTROs on the horizon, Spain's banks will be unable to make further purchases. This is a problem because if the banks scale-back their bond-buying and no one else steps in (foreign investors are wary of Spanish government debt), the price of the bonds will likely fall amid the flagging demand.

If you're a Spanish bank then you face the following absurd predicament: buy more risky Spanish bonds or watch the price of the risky Spanish bonds you already own continue to decline because your purchases are the only thing supporting them. This is an untenable situation.

Foreign demand for the debt is likely the only thing that could save Spain, but the country's failure to meet deficit targets has largely scared-off investors. If Spain's banks fall it would be catastrophic for the country as "Spain's three biggest banks are nearly twice as big as the entire Spanish economy" according to Brian Sullivan of CNBC. Make no mistake, Spain will need a bailout this year or next.

In the worst case scenario (as put forth by Carmel Asset Managment) Spain's national debt will jump from 60% of GDP to 90%, housing prices in the country will fall by 35% causing GDP to contract by an extra 2% in 2013 and 2014, the country's banks will need to be recapitalized (a real problem considering the current bailout mechanisms aren't large enough to get the job done), and the economy will continue to deteriorate as the unemployment rate spikes.

The head of the Bank of Spain highlighted the vicious cycle the country is caught in Tuesday when he noted that if the economy contracts further, the country's banks will likely need more capital - of course, implementation of the austerity measures which are a de facto precondition for attracting foreign investment in the country's bonds will almost ensure that the economy does contract further, thus necessitating the need for more capital. It is clear then how all the negatives are beginning to reinforce each other.

Before you think about 'buying the dip' in U.S. stocks then, consider the implications on world markets of a Spanish restructuring. If you have no idea what the scope of such an event might be, consider this: Spain is five times the size of Greece in economic terms. Bet against Banco Santander (STD) and BBVA (BBVA). Long puts on the S&P 500 (SPY).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.