Analysis: S&P throws Spanish banking crisis into sharp relief

MADRID/BRUSSELS (Reuters) - Spain's latest credit rating downgrade has thrown into sharp relief the need to revive a banking sector that could need another 100 billion euros to cover bad debts in order to avoid exposing another weak flank in the euro zone crisis,

The options are clear: Spain's troubled banks seek fresh capital themselves, the government comes to their aid or euro zone funds are somehow pushed in their direction.

But while the need for new funds is pressing, policymakers have no clear idea how to proceed.

The problem is the banks are in no shape to attract investment, Madrid cannot offer much more help since a domestic bailout would worsen Spain's already parlous debt position, while Brussels rules out direct euro zone aid to banks.

Something will have to give.

Standard & Poor's cut Spain's rating by two notches to BBB+ late on Thursday, citing a budget deficit which is not falling as fast as planned and "the increasing likelihood that the government will need to provide further fiscal support to the banking sector".

A burst property bubble and a deepening recession have made it likely Spanish banks will need more money than previously thought to recapitalize. Left unchecked, the hole could push Spain towards a Greek-style bailout which the euro zone can barely afford.

Latest data show Spanish banks are carrying their biggest burden of bad loans since 1994. As the economy deteriorates, compounding households' problems in repaying debt, they are expected to need more than the extra 53.8 billion euros ($71 billion) the Bank of Spain has predicted.

Just how much is difficult to gauge.

"It's evident they are short of capital," said Andrew Lim, analyst at Espirito Santo in London.

Lim said the 53.8 billion euros buffer covers real estate loans alone, and estimated more than 100 billion euros more could be needed to provide for other loans on its books that could go bad.

Banks have already taken enormous writedowns on property holdings. The new concern is they are refinancing too many business and consumer loans which will inevitably turn sour, in order to avoid taking a hit in the near-term.

"It's a moving target as the economy contracts, but any guesstimate probably shows losses will rise," said Hank Calenti, credit analyst at Societe Generale, which sees a need for 70 billion euros in provisions, and that assumes no acceleration of the economic downturn.

The Spanish government is not burying its head in the sand.

Government and financial sources told Reuters this week that Madrid will force banks to move all their real estate assets into a special holding company within weeks, although details of the scheme are still being worked on.

It also has a deposit guarantee fund though that is now almost bare and Spain needs at least 20 billion euros to secure the sale of three bailed-out banks.

Buyers will not be tempted unless they get guarantees to cover future losses from rotten real estate assets and the government wants the banks to replenish the fund.

One option would be to issue bonds against future bank contributions but that would be putting further burdens on a financial sector that can ill afford them.

Tristan Cooper, Sovereign Debt Analyst at Fidelity Worldwide Investment, contrasted Madrid's approach with that of Ireland, which took a huge hit up front, although Madrid has pumped something like 18 billion euros into its banks.

"Spain has chosen a softer approach, asking the banks to clear up their own mess before the government pumps in cash. We may have reached the end of the road on that one," he said. "A decision point on bank support is approaching fast and this could involve asking the EU for help."

Ratings downgrades could accelerate that process by pushing up the cost of funding, for the government and the banks. Spanish 10-year yields broke above the pivotal six percent level again on Friday, following S&P's action.

"The rating matters. That can be a factor that may push Spain closer to external help," said Antonio Garcia Pascual at Barclays Capital.

Economy Secretary Fernando Jimenez Latorre stuck to the script, ruling out any use of EU funds to bail out the sector, saying Spain had enough capacity of its own and that any call on public funds would be "very limited".

WHAT GIVES?

The option which would save most face - allowing the Spanish government to avoid the stigma of seeking outside assistance as Greece, Ireland and Portugal have - would be for the currency zone's rescue funds to directly recapitalize banks.

However, euro zone officials say the currency bloc is unlikely to allow the ESM, the permanent 500 billion euro bailout fund that is to come online in July, to do so.

"Some people have this bee in their bonnet, but only on a personal basis. It will not happen," a senior euro zone official said, a refusal echoed by EU Economic and Monetary Affairs Commissioner Olli Rehn in a Reuters interview last week.

The ESM's treaty states it can lend to banks, but only via a government. Any change to the treaty would require a new round of ratifications by national parliaments.

The European Commission will present a plan to deal with failing banks in Europe before the June 18-19 summit of leaders of the world's 20 biggest economies in Mexico.

But that is a mechanism to thwart future, not existing, crises as it will require banks to pay into it, taking time to build up to a critical mass. Spain's needs are more pressing.

All that leads some analysts to think the Spanish government will have to prop up its banks, regardless of the impact on its debt-cutting drive.

"The government must come out soon to say how they will address them," said Gilles Moec, an economist with Deutsche Bank.

The creation of more than a trillion euros of three-year money by the European Central Bank, a chunk of which was devoured by Spanish banks, has bought time. Spain's central bank says their funding needs are met for this year and probably well into next, averting the prospect of a credit crunch.

That, though, is not a solution.

"Although liquidity positions have improved and ECB long-term funding brings a reprieve, Spanish banks need to continue to build their capital buffers so that they can freely access private funding markets," the International Monetary Fund said this week.

There is also, if ECB policymakers are to be believed, little prospect of them launching a new round of money creation.

Spain's banks themselves are taking different approaches. Santander took $1.3 billion of further losses on property assets this week while BBVA, said it would write down property investments later in the year.

Either way, investors are increasingly nervous. The cost of buying protection against a default on bonds issued by Spain's biggest two banks has risen.

As ever with the euro zone debt crisis, doing nothing is not an option. But it may take a while yet for policymakers to get there.

"Given the harsh austerity measures being imposed, the likelihood of a further bursting of the property bubble and the precarious situation of the country's overleveraged banks, it seems unlikely that the end of Spain's woes is anywhere near," said Stefan Angele, Head of Investment Management, Swiss & Global Asset Management.

"It may ultimately require a euro zone solution that is much bigger and more wrenching than the process in Greece." ($1 = 0.7559 euros)

(Additional reporting by Julien Toyer, Fiona Ortiz, Steve Slater, Chris Velacott and Sinead Cruise; Writing by Mike Peacock; Editing by Giles Elgood)

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