Spanish Yields Blow Out Amid Italy Contagion As Italian Banks Scramble For Dollar Funding

Contagion from the recent surge in Italian yields has spread, and is hitting Spanish 10Y yields which over the past 3 days have blown out from 1.65% to as high as 1.82% this morning, before paring some of the move, printing at 1.77% last which is still the highest level since October 2017.

There are also Spain-specific news that have pushed yields wider, to wit yesterday's ruling by the nation’s Supreme Court they must pay a one-time tax of about 1% on mortgage loans that traditionally was passed to their clients. The report sent Spanish banks tumbling as much as 6.3% at Banco de Sabadell while banking giant BBVA dropped 1.8%, thanks to its larger international business that cushions the impact of the ruling.

The Supreme Court revised an earlier ruling, deciding now that the levy on documenting mortgage loans must be paid by the lenders, and since mortgages are one of the biggest businesses for domestic banks, analysts have been grappling with how big the hit to income would be. As Bloomberg notes, the sentence is one of a string from Spanish and European Union courts in recent years in favor of home buyers and at the expense of banks.

“The decision implies a severe setback for the Spanish financial system and joy for every mortgage-payer, who might get back a significant amount” of money, said Fernando Encinar, head of research at property website Idealista. In the short term, banks will likely raise their mortgage arrangement fees to compensate for their new cost, he said.

The levy is applied to the mortgage guarantee - the loan amount plus possible foreclosure costs - and could be roughly 1,500 euros ($1,728) on a 180,000-euro loan in Madrid, according to Angel Mejias, an attorney at M de Santiago Abogados in the capital.

“This is one more negative piece of news for banks, but the market is over-reacting as it is very difficult to calculate the real impact the ruling will have,” Renta 4 banking analyst Nuria Alvarez said by phone. “Margins are already under pressure from low interest rates and this adds to all the negative sentiment toward banks.”

That said, on Friday Spanish banks rebounded, erasing earlier losses after the Supreme Court announced it would call a plenary session to decide whether Thursday’s mortgage-documentation taxes ruling should be confirmed, adding that the new ruling is a U-tern from previous legislation, with "huge economic and social impact."

Whatever the outcome, attention will remain focused on Italy where earlier today yields continued to drift wider, hitting a new of 3.808% before paring the move to 3.73%, still 5bps higher on the day.

And while the Italian deficit showdown with the EU as well as the "Doom loop" have both been extensively discussed, and are widely seen as the reason behind the recent weakness in Italian assets, in a concerning development, on Thursday there was anecdotal reports that a reason behind yesterday's sharp spike in 3-month USD Libor, which jumped 2.4bps to 2.469% - the sharpest move since March - was a scramble by Italian banks to secure dollar funding, as Italy's redenomination risk has started drifting wider once again.

As Bloomberg's Vincent Cignarella wrote on Thursday, citing a fixed-income trader, Italian banks "banged the basis swap vs euros to fund dollar-denominated debt. Not so much paying up, but reducing BTP holdings to create liquidity." He explains below:

The banks are flipping high-quality liquid assets (HQLA BTPs), which they are required to hold to satisfy capital ratios under Basel rules. They pledge the BTPs into the repo market then swap euros for dollars to avoid paying up in the straight depo markets. The BTPs remain HQLA and will continue to be high quality even if both S&P and Moody's downgrade Italian sovereign debt later this month (S&P rates on the 26th). That is because DBRS currently rates Italy as investment grade BBB.

As a reminder, there is some risk that either S&P or Moody's or both rating agencies can further downgrade Italy's credit rating later today, although if DBRS retains its BBB anchor investment grade until 2019, at least Italian collateral will remain eligible for ECB purposes. So while BTP/Bund spreads will likely widen in the event of a downgrade, Cignarella notes not to expect any haircut from the ECB. That said, watch Italian bank CDS: "holding falling securities will likely weigh on the banks' credit quality, raising their borrowing costs."

Ultimately, it all boils down to the cabinet's standoff with Brussels: should the war of words escalate between the EU commission and the populist government, Italian assets will get (much) worse before they get better.