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Spain's banks, government co-dependent on debt

Monday - 6/25/2012, 7:10pm  ET

DANIEL WOOLLS and HAROLD HECKLE
Associated Press

MADRID (AP) - The Spanish government and Spanish banks are perilously co-dependent.

The financial strength of one hinges on the other, and right now both are struggling for survival.

The Spanish economy, the fourth-largest among the 17 countries that use the euro, is suffering from the aftershocks of a real estate bust that has devastated banks and families. Unemployment is nearly 25 percent and the economy is forecast to shrink 1.7 percent in 2012.

At the request of the Spanish government, euro countries offered up to (EURO)100 billion ($125 billion) in rescue loans for Spanish banks on June 9.

Spain made the formal petition for the aid on Monday, but the terms of the loans _ including the size and interest rates _ have yet to be agreed. They are expected to be made public by July 9 and will likely be discussed at a European Union leaders' summit that starts Thursday in Brussels.

The bank bailout, however, has only made investors more nervous about Spain's financial condition.

Although Spanish banks will agree to pay back the loans with interest, it is the Spanish government that is on the hook if they cannot. In effect, the bank loans will be treated as government debt. And as the country's debt load rises, so does the interest rate it pays to borrow money, a sign that the pool of investors hungry for Spanish bonds is shrinking.

Moody's Investor Service late Monday downgraded its credit ratings on 28 Spanish banks. Moody's said the weakening condition of the country's finances is making it more difficult for the government to support the country's lenders. The rating agency also said the banks are vulnerable to losses from Spain's busted real estate bubble.

One group of investors that isn't shying away from Spanish government bonds is Spain's banks. The amount of Spanish government debt owned by Spanish banks _ yes, the same banks that are about to receive billions in emergency loans _ is rising fast.

"It is as if the government were buying its own debt," says Alejandro Varela of Renta4, a Madrid-based brokerage. "It is like a dog chasing its own tail."

With Spain's economy enduring its second recession in just three years, analysts say the odds are rising that the government will need a bailout of its own. The yield on the country's 10-year bonds surpassed 7 percent last week, the level that pushed Ireland, Portugal and Greece to the breaking point. On Monday, the yield was 6.57 percent.

Here are some questions and answers about the tight relationship between the Spanish government and its troubled banks:

HOW DEPENDENT IS THE SPANISH GOVERNMENT ON SPANISH BANKS?

Two-thirds of Spain's government bonds are owned by the country's banks, pension funds and insurance companies. That's up from 50 percent at the end of last year. By comparison, only 38 percent of French government bonds are held by domestic banks and other financial firms.

In Spain the sharp increase in such a short period signals that foreign demand is falling fast as the country's economic outlook worsens.

Spain has issued (EURO)50 billion in bonds since the start of the year. It plans to issue another (EURO)36 billion by the end of 2012, bringing its total debt to (EURO)608 billion. The economy ministry notes that demand has been strong at recent bond auctions. However, the Treasury has been careful to issue debt in small increments _ about (EURO)2 billion at each auction. And it knows the takers will include those trusty Spanish banks.

WHY ARE SPANISH BANKS BUYING SO MUCH GOVERNMENT DEBT?

They are attracted to the high interest rate on Spanish government bonds. The interest rate, or yield, on 10-year Spanish bonds has of late been the highest it has been since the country joined the euro in 1999. It means financial markets consider Spanish bonds to be a risky investment.

The European Central Bank is making Spanish bonds even more attractive for banks. To help ease the continent's financial crisis, the ECB has provided European banks (EURO)1 trillion in three-year loans carrying an interest rate of 1 percent. Spanish banks, which have borrowed tens of billions of euros under the ECB program, can make a tidy profit simply by pocketing the spread between the interest rates on ECB loans and Spanish bonds.

Analysts say there is another reason Spanish banks keep buying their government's debt: survival. If Spanish banks were to stop buying Spain's bonds at a time when foreign money is fleeing, the government's borrowing costs would rise even higher and so would the threat of default _ on the very bonds held by the banks.

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