· On Friday, April 26 Standard & Poor’s ratings agency cut their long term sovereign credit rating for Kingdom of Spain from A to BBB+. S&P analysts downgraded the nation because the economic contraction in Spain has been worse than previously projected. To visualize how severe the conditions are in Spain, observe the unemployment rate since 2005
· At the same time that tax revenues are dropping, the income support governments typically offer (unemployment insurance etc.) are increasing. In addition, Spanish regional governments are also undergoing financial strain, and are seeking help from the national central government. The central government’s reform agenda (e.g. higher medical copay’s, larger classroom sizes, centralized purchasing etc.) proposed will help, but will take time, and seem to only nibble at Spain’s deep problems with inflexible labor laws. And, similar to the US during 2008, numerous Spanish financial institutions are receiving governmental financial support. These have prevented a “bank run” by depositors, but the costs are still unfolding, as savings banks/cajas have been slow to recognize loan losses on their property portfolios. The combination of these burdens have developed into a perfect storm of increased sovereign obligations right when tax collections are down sharply. Here is how Spain compares to her regional peers
· The knock on effects of sovereign downgrades flow through to intertwined corporates, typically financials and state owned enterprises. So, one of the first effects of the Spanish downgrade is on her banking system, which was broadly downgraded on Monday, April 30, when 16 financials were cut. Most of these are not trading counterparties for CalPERS, but of the global trading banks, Banco Santander was dropped to A- and BBVA to BBB+. Generally, it is rare for corporates to enjoy ratings that are superior to their domicile, which Santander does.
· Note that since the ECB started their LTRO program, Spanish banks have boosted their holdings of Spanish sovereign debt by 38%. In general, “risky” debt issuers such as Spain (and Italy) are seeing their local bond auctions dominated by domestic purchasers. The renationalization of finance defeats many of the original synergies the common currency was supposed to provide. ECB haircuts depend on “best of four” ratings and will not change unless the other three rating agencies also downgrade Spain to below A-.
· Market signals, such as bond prices and credit default spreads, have been pointing toward a ratings cut. Here are implied ratings as of mid-April:
· Greek elections are on May 6, and if voters reject continuing with IMF/EU reform mandates that could set trigger another peripheral sovereign “risk off” cycle. The French 2nd round is also that day, and if the Socialist candidate Hollande delivers on his campaign statements (higher taxes, more govt spending, ECB focus on growth rather than inflation, etc.), the bond market could also have more volatility.
· The formal ratings are at risk of dropping further if debt/GDP ratios worsen, political support for reform agendas waver, or more obligations are moved from the private sector to the public burden. The investment implication is to be cautious in accepting uncompensated risks (such as counterparty exposure) to Spanish banks such as Banco Santander or BBVA.
Source material: Moodys, S&P, Bloomberg, Goldman Sachs, Deutsche Bank, BarCap, JPMorgan.
