Spain at 7% Stresses Inadequacies of Rescue Options: Euro Credit

Money managers with more than $800 billion are betting European policy makers can only offer Spain a temporary respite from record borrowing costs.

Yields on Spain’s two-, five-, 10- and 30-year government securities climbed to euro-era highs this week amid speculation the nation will need a bailout to backstop its regions and banks. While the Organization for Economic Cooperation and Development called for the European Central Bank to buy Spanish debt, investors including AllianceBernstein Ltd. and M&G Group Plc said policy makers are hamstrung in how to rescue an economy twice the combined size of Greece, Ireland and Portugal.
“This crisis is unprecedented so the responses need to be unprecedented,” said Arif Husain, the London-based director of European fixed-income at AllianceBernstein, which oversees $407 billion. “Anything the ECB can do would prove temporary. The whole problem is that anything that’s happening at the moment is unconvincing, and markets hate uncertainty.”

Spain’s 10-year yield reached as much as 7.751 percent yesterday, and was at 7.05 percent as of 12:20 p.m. London time. Five- and 30-year yields also reached the most since the common currency was introduced in 1999 this week, while the cost of insuring against a default climbed to its highest ever.

The bond market rallied today after ECB President Mario Draghi signaled that officials are prepared to do whatever it takes to preserve the euro.

“To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate,” Draghi said during a speech in London.
Solvency Problem

“It’s difficult to see what the ECB can do because the problem is a solvency problem, not a liquidity problem,” said Ralf Ahrens, who helps manage about $19 billion as head of fixed income at Frankfurt Trust and owns fewer Spanish bonds than are in the benchmarks against which it measures performance. “It can’t be solved by printing money. The Spanish government needs to convince the market it can deal with the economic problems.”

The Frankfurt-based ECB supported the bond market in previous periods of turmoil by buying securities in the secondary market and by offering unlimited three-year loans under its Longer-Term Refinancing Operations, some of which banks reinvested in sovereign debt.

The central bank channelled 1 trillion euros ($1.2 trillion) to regional banks via two rounds of extraordinary lending in December and February, temporarily reversing a sell- off in Italian and Spanish bonds.
Temporary Fix

While the rate on Spain’s two-year note fell to as low as 2.15 percent following the second portion of the funding, they rose to as high as 7.147 percent yesterday. It fell 60 basis points to 5.81 percent today after Draghi’s comments.

“People are talking about the possibility of another LTRO, but this would surely prove even more temporary than before,” said Michael Riddell, a London-based fund manager at M&G, which oversees about $320 billion. “All the liquidity injection managed to achieve last time was to channel insolvent government debt down the throats of insolvent banks at prices where the banks are now even more underwater than they were at the beginning of this year.”

Spain requested 100 billion euros of international aid for its banks last month, becoming the fourth nation in the euro- region to seek assistance. The risk for Prime Minister Mariano Rajoy is that the additional burden of helping regional governments pushes bond yields to unaffordable levels.

European leaders agreeing that the Spanish bank aid doesn’t end up on the nation’s balance sheet may be an option to restore investor confidence, AllianceBernstein’s Husain said in a July 23 phone interview.
Burden Sharing

“Spain looks a completely different country if they can isolate the banking issues, and that problem is then put on the European balance sheet as opposed to Spain’s,” Husain said. That would prompt him to possibly buy the securities, he said.

A full-blown Spanish bailout can be averted if the ECB starts buying the nation’s bonds in large quantities, OECD Secretary General Angel Gurria said in a Bloomberg Television interview in London on July 24.

The bond-buying program should be reactivated “more decisively and with bigger numbers” as “you have to stabilize the yields,” Gurria said. “Just do it.”

The ECB bought more than 200 billion euros of debt from Greece, Ireland, Portugal, Italy and Spain using its Securities and Markets Program, which began in May 2010. While the initiative helped slow the ascent of yields, Greece, Ireland and Portugal all asked for official assistance.

The central bank said July 23 that it didn’t settle any government bond purchases for a 19th consecutive week.
Inefficient Market

“Draghi and his colleagues are aware that the SMP isn’t an efficient answer to the problems in the bond market,” Ahrens said. “The question is whether they start it again to buy some time. If the situation deteriorates and yields go up further, then there will be a temptation to restart bond buying.”

While Bank of Spain Governor Luis Maria Linde said June 17 that the ECB could restart its bond-buying program, the ECB ceased purchases in February amid concern from some officials that it was a form of monetary financing, which is prohibited under the institution’s founding treaty.

“Based on the way the ECB has conducted monetary policy to date, you would conclude that another LTRO is the most likely outcome,” said Alex Johnson, the London-based head of global fixed income at Fischer Francis Trees & Watts, which has $56 billion in assets. “That may be helpful in the shorter term, but it would appear that this is something that needs to be resolved at the political level.”