The Bernanke Put – Euro Style

The Spanish debt auction proceeded in an orderly fashion
even as yields crept higher. The general consensus appears to be that Spain is
too big to fail. I would suggest that Spain might be too big to save. Spain is
the European Union’s fourth largest economy and 14th largest in the
world. Last week, their credit rating was lowered to BBB+ by the Standard &
Poor’s rating agency. This week, they announced that their GDP had contracted
by 0.3%. This quarter’s decline marked the beginning of Spain’s second recession
since 2009. Finally, the composition of their debt makes any positive economic
headway in the next few years nearly impossible.

The interest rate benchmark is the 10-year bond or note.
Spain saw full participation at yields of 5.82%. There are two important points
to be made here. First, the participation rate is measured by the bid to cover
ratio. It was quite a bit stronger than the last auction in March, coming in at
2.9 compared to 2.4 for the last auction. The second point is the yield of
5.82%. The alarm bells sound when Spanish debt yields hit 6% on the 10-year
note. That’s the magic number at which Spain can no longer afford to refinance
or, rollover the financing of their budget. Spanish yields have solid
resistance between 6.125% and 6.25%. They peaked at 6.625% in November 2011.

The International Monetary fund released a report on the
European Union and the global debt issues entitled, “Global Financial Stability
Report.” Spain’s BBB+ credit rating is three notches above junk status. According
to the IMF the probability of default on BBB+ credit has risen from 0.734% in
2007 to 6.05% at the end of 2011. I believe that the recent pitches by the
BRIC’s (Brazil, Russia, India and China) to contribute to the bailout funds and
push the total available reserves to $430 billion has been received by the
markets as restoring confidence, rather than preparing for financial
Armageddon.

Spain’s primary source of trouble is the bursting of a
housing boom bubble. Sound familiar? Here in America we struggled through the
economic crisis as unemployment peaked at 10%. Meanwhile, the number of homes
in foreclosure peaked at 8.12 million in January of 2010 and drove home values
here down approximately 25%. Spain’s unemployment rate is nearly 25% and close
to 50% for people under 25. The Spanish real estate boom put 80% of the
population in home ownership. Foreclosure rates are now topping 10% at some
banks and the unemployment situation is creating a death spiral. This is
leading to marked to market values on repossessed homes as much as 60% below
their peak. Marked to market values leave the repossessing bank with an
over leveraged asset and reduces their capital base further constricting their
economy.

Spanish banks packaged their loans for resale on the
commercial credit market as mortgage backed securities. These securities were
prime at the time of origination. However, as their economy has declined the
nonperformance of these loans has placed more of them in the default category.
Some of these mortgage pools now contain up to 14% of mortgages more than 90
days over due. The obvious conclusion is that many Spanish banks are in
trouble.

The European Central Bank and the IMF have teamed up to try
and save Spain from themselves. The Troubled Asset Relief Program (TARP)
committed $470 billion to U.S. banks and the auto industry in order to keep
people in their homes and on the job. The $430 billion that has been pledged to
save Spain will not be enough to cover the mortgage losses. Furthermore, the
average Spaniard’s primary asset is their home, which accounts for
approximately 80% of their net worth. The Spanish debt will be hard to spread
around.

This leads to the IMF report on national household
deleveraging within the constructs of a banking crisis, which found that the
deleveraging process trims an average of 1.45% of GDP. European corporations
are already hurting. The lowest levels of corporate credit have skyrocketed
from 2% of total corporate credit to almost 16% of total corporate credit in
the last 5yrs. How will the ECB decide which ones are worth saving and how will
Spain feel about relinquishing their sovereignty to the decisions of the ECB
and the IMF? Government has never been very successful at manipulating markets
over the long haul. I believe the bond auction was palliative only because
investors are certain the ECB will backstop their purchases just as we have
grown accustomed to the Bernanke Put here in the U.S. Finally, when government’s
lose control of the markets they have been manipulating, the disaster is
spectacular.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.


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