On Spain's "Self-Reinforcing" Collapse And Why It Will Get Much Worse Soon
With bond spreads in Europe refusing to slow down for the Thanksgiving holiday (unlike the US, Europe will be open through the end of the week), and both Portuguese and Spanish spreads jumping to fresh records, with Spain nearly approaching the bailout threshold of 5%, it appears that the market has now pretty much skipped Portugal whose insolvency is a given, and has commenced the "pack of wolves" thing on Madrid. Expect to hear many accusations that CDS traders, and their naked shorting, is the spawn of satan any minute now, and for CDS trading limits to be imposed imminently (not to mention LCH hiking Portuguese and Spanish margins as early as today), even though as we have demonstrated repeatedly in the past, it is all cash bond sellers who are driving the price down. Nonetheless, it is a fact that "price action is now self-reinforcing" - what this means for Spain and for Europe is explained by Goldman's Francesco Garzarelli. Note that this is only a small part of the story. As Zero Hedge discussed first in early July, a far biggest systemic threat is what is happening (or rather, not happening) in the mortgage space, where just like in the US, Spanish Cajas continue to misrepresent the "phantom" bad debt on a national level, however unlike the US and the nationalized GSEs, there is no sovereign backstop to a nation full of delinquent mortgages. Back then the Stress Test farce brushed this biggest risk under the rug. Now that reality is back, this topic will soon come back with a vengeance.
Spain in the Spotlight
With no specific new local macro information, the market’s focus has turned to Spain, where 5-yr CDS broke above 300bp, taking out the highs reached in June. As we highlighted in our note this Sunday commenting on the Irish rescue package, this was fairly predictable. Investors have long been concerned about the potential unrecognized property market losses in the Spanish non-listed banks, and the resulting contingent liabilities for the public sector, and the latest twist of events in Ireland has promoted comparisons.
Undoubtedly, there are several areas of weakness in Spain to point to. Unlike in the ‘core’ countries, Spanish industrial activity has slowed in September, and the improvement in the trade balance appears to have stalled. The EUR 99bn scheme for voluntary recapitalization of banks (FROB) remains largely un-tapped, and its eventual activation will weigh on public sector issuance (2011 gross government bond supply is in the ballpark of EUR 130bn). Finally, the European mutual support framework continues to appear to us as inadequately capitalized to deal with potential credit problems of the size of the Spain.
Against this background, one cannot rule out the possibility of a further escalation of tensions as the price action becomes self-reinforcing. The fact that we are approaching year-end does not help, as the appetite to bear risk is gradually declining. Nevertheless, our view remains that the support offered to Ireland (which will possibly be extended to Portugal), goes a long way towards addressing the source of EMU credit tensions. We also continue to believe that the price of Spanish sovereign risk is increasingly diverging from its fundamental value. In support of this stance, we note the following.
- The Spanish economy is large and diversified, with relatively deep capital markets. Purchasing managers indices for November point to ongoing recovery in the core economies, and Spain should also be a beneficiary given its integration with its main trading partners (for reference, around 60% of Spain’s exports goes to the rest of the Euro-zone and one third of the total to Germany and France alone). The household savings ratio in Spain is one of the highest among the OECD countries.
- On a cash basis, the central government’s deficit has fallen by 40% in the first 10-months of 2010, compared to the same period in 2009. Last Friday, the government proposed a series of structural reforms in addition to those already implemented throughout the summer, including public sector wage cuts and initial labour market reforms.
- As a whole, the two largest domestic banks are profitable (their ROEs are in excess of 20%), have raised equity recently, and have an internationally diversified balance sheet. Moreover, the banking sector has seen inflows into deposits, and their reliance on the ECB funding has diminished. The exposure vs. general government sector is lower than in the average of Germany, France and Italy.
- Finally, Spain is of much greater systemic relevance to the Euro-area than Greece, Ireland or Portugal. According to BIS data from March, the country’s largest external creditors are Germany, France and the Netherlands, and the risk is mostly with the private financial and non-financial sector (updated figures for June should be available in early December). Should tensions escalate (not our baseline) the prospect of a heavier response by policymakers, including a shift in ECB’s stance regarding the provision of term liquidity, is a distinct possibility