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The situation in Spain is looking worse every day. I believe Spain is following the path of Greece into bankruptcy.

Let's take a look at the Spanish bond yields. At the end of 2011 we got the massive ECB bailout package named Long Term Refinancing Operation (LTRO). This relieved the bonds of certain peripheral governments like Italy, Greece and Spain. Lately though, with many Spanish regions on the verge of bankruptcy, Spanish bond yields are rising again and as a consequence I urge investors to avoid financials. You can consult my previous article about bank exposure to Spain here.

Let's take a quick look at the Spanish bonds. The best way to look at stress in the bond yields is to look at the bond spread between long term maturities (Chart 1) versus short term maturities (Chart 2). If the spread narrows, it means there is stress, because the shorter maturity is about to rise above the longer maturity bond yield. Normally in a healthy economy, longer maturities always have higher yields than shorter maturities. If this is not the case, this means that defaults are looming (see Greece bond yields: shorter maturities have higher yields than longer maturities).


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Chart 1: Spanish 10 year bonds


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Chart 2: Spanish 2 year bonds

If we put these two Spanish bond maturities together we get Chart 3.


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Chart 3: Spanish 2 and 10 year bonds

As you can see we got a low spread between 2 year bonds and 10 year bonds in following periods. Late 2008 (economic crisis), end of 2011 (LTRO package) and last but not least "today".

So what is happening today in Spain? According to Mike Shedlock's research, 6 autonomous Spanish communities have applied for aid from Spain, which is bankrupt on its own. The revenue of these regions has been plunging and he expects all communities to seek for aid eventually. Today, one of the Spanish regions Murcia has asked for aid from the federal government of Spain. They are asking for 300 million euro by September 2012. Murcia is the second Spanish region asking for aid after Valencia. The other 4 regions who are expected to ask for aid are: Castile-La Mancha, Andalusia, the Canary Islands and the Balearic Islands. As these Spanish regions are on the verge of bankruptcy, Spain is in need for a bailout. This brings me to the Spanish bailout package.

Just recently, the Eurozone finance ministers approved the bailout of Spanish banks:

The Eurogroup of euro zone finance ministers today formally accepted a memorandum of understanding with Spain, which will allow Madrid to borrow up to 100 billion euros to recapitalise its banks, Luxembourg's Finance Minister Luc Frieden said.

We are talking about 100 billion euros, which is not nearly enough to give any significant support to the Spanish housing market. According to Danny Esposito Spanish banks hold 400 billion euro in mortgage backed securities (MBS) which decline very rapidly in value as bond yields spike upwards. This is because the value of mortgage backed securities have negative convexity in relation to interest rates. I already pointed out the negative convexity of mortgage backed securities relating to yields in this article. As longer term Spanish bond yields go upwards (Chart 1), the price of MBS will decline rapidly.

The average maturity of Spanish real estates is 28 years (2007). Let's take this number for further calculations. For example: 30 year Spanish bond yields are 7% now, and will likely go to 8% the next month. We can calculate the loss from Nomura's bond price vs. yield graph:

Chart 2: Nomura Bond Price VS. Yield
(Click to enlarge)

For a rise in yield from 7% to 8%, the decline in price of the MBS is approximately 10%. Similarly, a rise in yield from 7% to 10% is a decline in price of 20%. For the 400 billion euro in MBS, this is a decline of 80 billion euro (20% of 400 billion is 80 billion).

This means that a 3%-4% uptick in Spanish bond yields is enough to render the 100 billion euro bailout useless. Imagine what would happen when 30 year Spanish bond yields were to go through the roof with let's say 25% for 30 year bond yields, like in Greece right now. The losses would be immense.

To make matters even worse, Spanish' neighbour Greece has been declined any further help from the IMF on 22 July 2012, Der Spiegel magazine said. This will add additional pressure on all the PIIGS countries including Spain.

Conclusion:

The situation in the peripheral countries of the eurozone is rapidly deteriorating and this will have its implications on the financial industry as a whole. I would advise investors not to invest too much money in the financials, especially Spanish banks. German banks have high exposure to Spain, so I would avoid those too, for example Deutsche Bank (DB). As for the UK banks, Barclays (BCS) has a high exposure to Spain and is not a good investment in my view. You might think the U.S. banks are safer, but the five banks: JPMorgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Bank of America Corp. (BAC) and Citigroup Inc. (C) had a total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy. So I would avoid those too. As the Spanish economy is on the verge of collapse you could try to short the iShares MSCI Spain Index (EWP).

Source: Spain Is Following Greece In Its Path To Bankruptcy: Avoid Financials