Seeking Alpha
Long/short equity, special situations, contrarian, research analyst
Profile| Send Message| ()  

Recently, German Finance Minister Wolfgang Schaeuble told the Welt am Sonntag newspaper that Spain's short-term financing needs were "not so big," and that it wouldn't be the end of the world if Spain was to "pay a few percent more at a few bond auctions."

Herr Schaeuble knows better.

Checkmate Is Checkmate

It's true that Spain could finance itself at 7% for some months, but the reason it won't is the same reason behind early capitulation in chess. It doesn't matter if you're checkmated in two moves or in 20; checkmate is checkmate.

Modern countries don't actually pay the principal on their debt. They pay the interest, or "coupon," on their debt, and if they've been running serious deficits, attempt to run more balanced deficits going forward until the cumulative effect of mild inflation reduces the real debt burden.

Italy's problem is that there is so much legacy debt that has to be rolled over, mostly through the issuance of new debt, that paying out a 7% yield on that new debt is tantamount to paying off a credit card with 7% interest using a credit card with 12% interest. In that case, how do you pay off the card with the 12% interest rate? Italy's credit rating would only crumble further, because in the absence of inflation, its debt load would be increased. Checkmate in 20.

For Spain, the 7% threshold on 10-year sovereign debt is considered to be a psychological threshold; important, but survivable nonetheless. The purpose of this article is to disabuse investors of that notion.

The only way to cut through the spin that people like Herr Schaeuble and Mario Draghi depend on is to look at the numbers. Unfortunately, there are a lot of numbers to be taken into consideration, due to the sheer scale of the subject -- far more than most investors have time to pore over. Add to that diverging forecasts and political spin, and the real macro picture becomes increasingly obscured. This article, therefore, depends heavily on visual aids for clarity.

Forecasting Generosity

Click to enlarge images.

The BdE is, of course, the Banco de España -- the national central bank of Spain and supervisor of the Spanish banking system. Note how its adverse scenario projections are consistently rosier than the IMF's, despite the fact that they source the same data. The IMF itself has consistently low-balled projections from 2009 and has revised the European outlook lower yet again, which means that the adverse-scenario projections given in the above table are far too optimistic. Consider the following Table:

Out of a steady decline in GDP, Private Consumption, Public Consumption, Gross-Fixed Investment, and Construction Investment comes ... growth. Magical thinking at its finest, courtesy of the IMF.

This is why 7% yields matter.

Interest rate shock = profit shock, and due to the massive reallocation of Spanish lending from the property sector to the corporate sector, additional shocks to corporate profits will devastate the balance sheets of Spanish banks. As Herr Schaeuble is the German Finance Minister and not a bartender working a counter in Kreuzberg, I assume his "trust me, Spain is just fine" comments above are relying on domestic complacence, international illiteracy, or both. Observe what has happened to Spanish household finances even under the most optimistic of projections below:

Note that these figures are based on a Household Survey done in 2008. To account for both 2009 contraction and the onset of the European Sovereign Debt Crisis, we have to expand our survey. Here are the revised figures.

This table doesn't factor in the multiplier effects due cuts by the Spanish government when calculating the share of distressed households. What is the share of debt-at-risk at now? Pick a number.

The impairment loss quoted here is 73 billion euros -- in order for banks to recapitalize to a Tier 1 ratio of 4%. To put this in perspective, Bankia had a Tier 1 ratio of 4.1%. The recommendation of the European Banking Authority courtesy of 2011 EU Stress Tests is 9%, or 15.75% of Spanish GDP. The IMF is whistling past a graveyard.

That amount is increased by the decline in residential and corporate real estate prices:

What does the Spanish Property Sector look like?

Spanish banks are heavily exposed to the Property Sector (Real Estate plus Construction). How are those loans performing? The following table is included in the IMF's "Selected Financial Soundness Indicators." Spanish banks are unwinding as many of their Property Sector loans as possible, as quickly as possible, which the IMF naturally finds to be an indicator of sound banking.

However, the Spanish banks appear incapable of divesting themselves of these toxic loans quickly enough to keep up with the rate of default.

Meanwhile, provisioning for losses on these loans has collapsed, along with both credit and deposits, further lowering Tier 1 capital ratios.

If Spanish bank funding isn't going to Consumer Credit or the Property Sector, and isn't being used to improve Tier 1 capital ratios, where is it going? The first place is, of course, the Corporate Sector.

As we saw in Box Table 2, those loans are at risk due to the increase in 10-year sovereign bond spreads. Where did the rest of the money go? Those selfsame government bonds.

Checkmate in 7

Higher spreads = lower corporate profits = an increase in non-performing loans issued to the Corporate Sector = higher unemployment = lower tax revenues = missed targets = increased government cuts to reduce deficit = higher spreads. Checkmate in 7.

How much more money does Madrid need to finance itself? More than you think, in an imploding economy.

Is the death spiral even making an impact on the cost of government? If you've got five years or so to wait. Yet, as we can see here, government debt isn't Spain's problem.

According to Credit Suisse, the Spanish government must borrow €385 billion until the end of 2014 to cover its budget deficit and other needs such as bond redemptions. That is highly unlikely to happen, given the fact that Spain is about to be ejected from the bond markets.

Austerity in these circumstances is self-defeating. The problem is that Spanish banks are several multiples of Spanish GDP and that credit was lent badly at every turn. The Spanish banking sector cannot survive 7% yields for any length of time due to the composition of its balance sheets.

Conclusion

I would advise all but the shortest-term traders to be wary of financials, especially those with high exposures to Spain, such as Barclays (BCS) and Deutsche Bank (DB). U.S. banks with significant exposure to Spain include Bank of America (BAC), Morgan Stanley (MS), Goldman Sachs (GS), JPMorgan (JPM), and Citigroup (C). Investors may also want to initiate short positions in the iShares MSCI Spain Index (EWP).

Source: Why Is 7% Such A Scary Number?