Spain Is The Next Lehman

“Where’s the next Lehman?”

--lead article in this week’s Economist

“We still view the Spanish banking system as weak given the ongoing deterioration in asset quality, and further capital injections will probably be required. It is also becoming more likely that any future capital injections would be achieved by bailing in bank creditors - particularly junior creditors - before resorting to the ESM support package.”

--Moody’s credit opinion for Spain

My answer to the Economist’s question is: Spain is the next Lehman. The ECB’s upcoming Asset Quality Review (this winter) will reveal a number of insolvent banks that will require recapitalization. Moody's already rates seven Spanish banks below investment grade . Now financing the recapitalizations shouldn’t pose a problem, because Spain still has a 50B euro credit line from the ESM. The ESM gives Spain the money, and they use it to recap the bad banks. Problem solved.

The problem would be solved were it not for the eurozone’s new “No Bailout Principle”, which requires “bailing in” creditors prior to the disbursement of ESM funds. In other words, banks must default before they can be recapitalized. The patient must die before he can be treated. Query: Once a bank has defaulted, why bother to resuscitate it? The damage is done, and the bank is taking up space.

It is conceivable that a bail-in of Spanish banks could be conducted in such a way that depositors, counterparties and interbank lenders would be protected. If so, it would be very helpful if the Troika could make such an announcement now, rather than waiting for the inevitable funding crisis this winter.

If no such reassurances are given, rational actors will further reduce their exposure to weak Spanish banks (correction: all Spanish banks). Presumably this funding could be replaced with funds from the ECB, but that is not a path to viability.

I would add that the Spanish government’s rating is teetering on the brink of junk status. It is now rated Baa3/Negative Outlook. Moody’s observes: “We would consider downgrading Spain in the event of an inability to implement the fiscal and structural reforms that are aimed at stabilising its debt burden, and/or in the event of a loss of access to private markets.”

Spain will stabilize its debt burden the same way that Greece and Cyprus did: default.