Like a zombie in a horror movie, the Eurozone crisis just won’t die. Instead, it keeps lurching at investors from different shadows on the European continent. This same zombie that has been terrorizing the Greeks for months is now terrorizing the Spanish…and all of Europe is shuddering with fear.
Spanish government bond yields are soaring again…as are Italian bond yields. The chart below shows the spread between 10-year Spanish and Italian government bond yields and 10-year US Treasury yields. The Spanish 10-year, for example, is yielding 6.56%, which is a whopping 5% more than the measly 1.56% yield on 10-year Treasurys. Meanwhile, the price of insuring Spanish bonds against a default keeps climbing from one all-time high to another.
When the European Central Bank (ECB) launched its long-term refinancing operation (LTRO) earlier this year and began providing three-year loans to European banks, it literally bought time for the most financially distressed members of the Eurozone. The Bank of Spain, for example, recently announced that during the month of March, Spanish bank borrowings from the ECB soared from €152 billion to €227 billion.
But the Eurozone’s “bought time” is ending.
Spanish banks are in big trouble. Not only are they sitting on a mountain of distressed real estate loans, but their depositors are fleeing in droves. The only place Spanish banks can turn to replace this lost funding is the ECB. Spanish banks have taken up 30% of the LTRO loans issued thus far.
The Spanish banks, in turn, are propping up the Spanish government by purchasing Spanish government bonds.
“Weaker lenders are merely parking the ECB’s ultra-cheap funds in [Spanish government] bonds until they need the money to roll over their own debts,” writes Ambrose Evans-Pritchard in his latest Telegraph column. “That [moment is fast approaching] since European banks have €600 billion in redemptions over the rest of the year.”
Considering the turmoil we’ll surely see in the Spanish economy, €600 billion in maturing debt is going to be a huge challenge for the banks.
Meanwhile, the Spanish economy is fraying at the edges. It has many unresolved issues. A backlog of mortgage-related losses lurks unrecognized on the balance sheets of Spanish banks. The restructuring of the Spanish housing bubble has yet to begin. Housing prices remain at levels far above what would be justified by Spanish incomes.
I’ll highlight a shocking figure: 80% of Spanish household wealth is in real estate. And 24% of households own second homes. So when (not if) housing prices fall further, this decline will crush the rest of the economy.
There are no identifiable demand-side catalysts to prevent the Spanish housing market from falling. Spain’s population is aging, and its youth, living with a 50% unemployment rate, is in no position to buy houses — especially at today’s asking prices. The “bid” side of the market is well aware that it’s a buyer’s market. Buyers know that there are plenty of excess vacant housing units.
The new government can make heroic efforts to cut spending. It can also push to reform the highly rigid labor markets. But these efforts will fail to get the country out of its hole. Support from the European Central Bank is the only force propping up Spain’s teetering tower of debt.
Carmel Asset Management estimates Spanish banks are undercapitalized by €200 billion, or 20% of Spanish GDP. To give you a frame of reference, this sum would be equivalent to US banks being undercapitalized by $3 trillion (or four times the amount of money that Treasury Secretary Hank Paulson requested from Congress for TARP in late 2008).
Spain will need “four TARPs” to recapitalize its banks…if nothing changed! But both sides of the Spanish balance sheet are deteriorating. On the asset side, real estate loans continue to go bad, and on the liabilities side, depositors are fleeing Spanish banks. Meanwhile, investors are also fleeing the scene by dumping Spanish government bonds.
This situation is screaming for a bankruptcy and restructuring. Delaying this inevitability will only result in larger losses in the future. The Spanish economy will not rebound until its debt is restructured.
The deficit targets that Spanish politicians are promising to EU paymasters are unreachable. The layers of bureaucracy are thick. Each level of government in Spain — central, regional, provincial and municipal — will fight for its turf and its budget. Bureaucracy has made the labor market very inflexible. According to a Word Bank index of wage rigidity, the Spanish work force ranks as the least flexible among developed economies — worse than even France, with its legendary socialist labor policies.
Furthermore, austerity measures in a country so reliant on government spending and employment would be self-defeating, as it was in Greece. Even if government spending falls, GDP would fall as fast, or even faster. Business lobbying group Circulo de Empresarios points out that since 1996, the number of Spanish public employees has grown from 2.2 million to 3.2 million.
What does this mountain of evidence mean for the future twists and turns of the Euro crisis? It means that the EU, if it’s going to have a chance of holding things together, is “going to need a bigger boat,” as Roy Scheider’s Chief Martin Brody says in Jaws…or else toss a few passengers overboard.
The European Financial Stability Fund (EFSF) EFSF is not a viable solution for this mess. The political will of countries like Germany to increase their funded financial commitments to the EFSF is fading. More European politicians will wake to the fact that Spain’s official 60% debt-to-GDP ratio rises closer to 90% if you adjust for regional government debts, loan guarantees and state-run businesses. The picture gets much worse if you project how insolvent the banks will be when they finally deal with their backlog of mortgage and construction loan losses.
The sugar rush from the ECB’s LTRO is wearing off. More pressure will fall on the ECB to resume its direct purchases of PIIGS debt. More than likely, the ECB will respond to the challenge in the only way it knows how: Print euros.
Considering the explosive nature of this situation, gold’s sluggishness is puzzling. Gold and other tangible stores of value have been rather dormant over the past six months. Perhaps most investors will wait to act until the gravity of this situation in Spain is hitting them squarely between the eyes…rather than merely staring them in the face. But I think it’s only a matter of time before gold awakens from its slumber.
By Dan Amoss