Spain Bombs World Markets: A Special Report (EWP, EWG, SPY)

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spain flag 300x200 Spain Bombs World Markets: A Special Report (EWP, EWG, SPY)

Spain roils world markets as borrowing costs increase and stock market plunges

Spain is back on the front pages of global financial media as worries mount over the health of the country’s banking sector and the possibility of a Greek-style default happening again, only this time on a much larger scale.

The IBEX 35 Index plunged 3.58% today and the 10 year bond spiked to nearly 6%, close to the psychologically important and “unsustainable” 7% level.

The costs of Spanish credit default swaps rose to record highs as bondholders display less faith in the country’s long term fiscal outlook as the country struggles with higher borrowing costs and a slowing economy made worse by recently imposed

A brief look at Spain’s fiscal history

Spain’s economic problems began in 2008 when its housing market collapsed.  The fact that most of Spain’s unregulated savings banks had significant investments in the real estate market led to these banks losing substantial sums of money.  As a result, public benefits needed to be increased, which forced higher amounts of government spending.  This led to Spain’s government debt skyrocketing over the last several years. 

Spain experienced an economic boom around 2005, posting budget surpluses.  Much of this was due to the booming housing market.  The Maastricht Treaty, which is the Treaty that essentially created the European Union and the euro, required Spain to reduce its long-term interest rates.  This led many Spaniards to take out loans to purchase homes which caused the construction industry to experience an economic boom.  In fact, the construction industry accounted for 13% of the total employment in Spain by 2007.  Plus, the Spanish economy accounted for over one-third of all employment within the Eurozone between 1999 to 2007.

However, housing pricing and demand began falling in 2008, which led to a 10% jump in unemployment levels.  This led to an increase in the need for unemployment benefits.  Spain’s unemployment benefits are quite generous and these payouts led to a massive drain on the country’s economic resources, as well as a significant decline in the country’s tax revenue, as much of it was dependent upon real estate.  The budget surpluses that Spain was enjoying circa 2005 at the rate of 2% of GDP had now turned into budget deficits of roughly 4% of GDP, which violated the Stability and Growth Pact’s mandate that no European Union country could carry a government budget deficit of more than 3% of GDP.  The Stability and Growth Pact ensured fiscal discipline after the euro was introduced as the European Union’s official currency. 

What made matters even worse for Spain was the fact that its regional savings and loan banks, known as cajas, were largely unregulated, keeping Spain’s government in the dark when it came to their true financial condition.  Cajas were responsible for serving 46 million residents throughout Spain, and most of the clients served by cajas included families, non-governmental organizations, and small- to medium-sized businesses that larger banks did not want to loan to due to the higher likelihood that these clients would not successfully pay back the loans.  In addition, cajas did not have to reveal such important information as loan-to-value ratios, repayment history, and the collateral on loans, nor did they have to reveal how much investment they had in the Spanish real estate market.  As a result, the Spanish government was largely unaware of the real financial danger cajas were actually in.

Further complicating this financial situation was when Santander and BBVA, Spain’s two largest banks, slowed their financial lending in 2007.  Cajas picked up the slack and made loans available to those clients who couldn’t obtain loans from the two largest banks.  Cajas owned 56% of Spain’s mortgages by 2009, with 20% of the cajas’ assets being made up of loan payments from property developers. 

In 2009, Spain’s housing market crashed which led to today’s economic problems.  It started with the cajas being unable to obtain payment on their loans as construction companies fell into bankruptcy and many loans defaulted.  This led to construction companies owing billions of euros to the Spanish banking system, with estimates running as high as 180.8 billion euros by mid-2010.  

In March, 2009, Spain’s government announced that it had provided its first bailout of a caja.  While cajas and major banks differed to an extent, global investors saw this as the first sign that the Spanish financial sector was in serious economic trouble.  This led to investors losing confidence in the Spanish banks, which caused bank shares to quickly lose value.  This led to a cycle where the banks needed more cash to pay the investors who wanted to withdraw their deposits from the banks.  From January through April 2010, investors pulled out a total of 21.6 billion euros.  This led to more bailouts being offered by the Spanish government, which only further eroded investor confidence in the Spanish economy.

It is important to note that Spanish loans are usually recourse loans.  Recourse loans allow a creditor to pursue not just the collateral for recovery of the loan, but also to pursue the borrower’s other assets as well.  This differs from the United States, where a creditor can only foreclose on the collateral (such as a residence) and not go after the borrower’s other assets.  Due to the fact that Spanish banks can go after borrowers’ other assets, most Spanish citizens attempt to continue paying off their loans each month, thereby sacrificing investment in any other sectors of the economy.  

Making matters even worse is the fact that Spain’s current unemployment rate is more than 20% which is the highest rate in the industrialized world.  When you are considering Spaniards under 25-years old, that unemployment rate rises to an unbelievable 40%.  Even those Spaniards with university degrees do not escape the unemployment tidal wave, as this group of Spaniards is experiencing 9.4% unemployment, which is twice as high as the rest of the European Union. 

Why Spain Matters

Spain is especially important to the survival of the Eurozone for two main reasons.

The first reason is that Spain serves as a model for weaker countries in the European Union.  Spain is often talked about along with Greece, Ireland, Italy, and Portugal.  Except for Italy, all of those aforementioned countries have requested bailouts from the European Union, and Italy’s last bond auction resulted in higher yields, signifying growing concerns among investors regarding Italy’s ability to pay down its debt.

Most analysts believe Spain is in a better financial position as compared to the other four countries mentioned due to its larger economy and its smaller public debt (63.4% of GDP, a percentage that is smaller than both the United Kingdom and Germany’s debt percentage).  If Spain does falter on paying back its sovereign bonds and requests a bailout, global investors will lose even more confidence in Italy, Ireland, Portugal, and Greece, which could make their economic situations even worse.  This could lead to a greater chance of Italy requesting a bailout while further hindering the recovery efforts in Greece, Portugal, and Ireland.

The second reason why Spain is considered a special case worth watching by global investors is that Spain was a founding member of the Eurozone and is also often associated with France and Germany, two of the more powerful countries in the Eurozone.  If Spain falters on the payback of its sovereign bonds, analysts fear the economic situation throughout the Eurozone could become dire, thereby causing a tremendous strain on the global economy and adversely affecting the economies of the United States, China, and emerging economies.

Furthermore, Spain is the world’s 12th largest economy by GDP and 5th in the European Union, so problems here will reverberate around the world and be substantially more significant than those seen so far in Greece or Ireland.

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