Investors dump Spanish bonds over renewed concerns over bad debt at banks

So long as Spain continues to protect bank book capital levels under the Japanese model for handling a bank solvency led financial crisis, the ongoing discovery of how much bad debt the banks hold will put pressure on the sovereign debt.

By following Iceland's lead and adopting the Swedish model, Spain could end the pressure on its debt.  Under the Swedish model, the banks are required to recognize all the losses hidden on and off their balance sheet today and use future retained earnings to restore their book capital levels.

A Bloomberg article discussed using ECB bond purchases as a way to take the pressure off the sovereign debt under the Japanese model.

Like all Japanese model related policies, this one has negative consequences.  As shown by Greece, the ECB doesn't take losses if a debt restructuring becomes necessary.  As a result, its purchasing Spain's debt increase the risk of the sovereign debt to private market investors.  They in turn require a higher yield to hold the debt.

To the extent that it is the banks that step up to buy the sovereign debt, private market investors see the quality of the banks' assets and the governmental deposit guarantee deteriorating.  This leads to more runs on the banks by both secured and unsecured depositors.

A Spanish minister called on the European Central Bank to do more to stem the sovereign debt crisis as the cost of insuring the country’s bonds against default surged to a record. 

“They should step up purchases of bonds,” Jaime Garcia- Legaz, a deputy minister in Luis de Guindos’s Economy Ministry, said yesterday in an interview. 

His comments came as ECB officials split over the steps to tame the crisis amid growing expectations that Spain will be the next euro member to seek a European bailout. Spanish banks’ borrowings from the ECB surged almost 50 percent in March, data showed yesterday, as they took almost a third of the longer-term lending offered to euro-region institutions.

A sign of the on-going run at the Spanish banks.

Prime Minister Mariano Rajoy is struggling to convince investors he can get Spain’s finances under control after last month refusing to meet deficit targets set by the European Commission and the previous government. While Rajoy said on April 12 Spain won’t need a rescue, credit-default swaps rose 17 basis points to 498 yesterday, surpassing the all-time high closing price of 493, according to CMA.... 

ECB officials are nevertheless struggling to present a united front over what to do next as investors dump Spanish bonds amid renewed concern about bad assets at the country’s banks....

Spanish yields surged above 6 percent in August, prompting the ECB to start buying bonds, and reached 6.78 percent in November before ECB President Mario Draghi said the bank would offer financial institutions unlimited three-year loans.

That measure helped tame Spanish borrowing costs, as institutions used ECB funds to pile up on the nation’s bonds. Spanish banks’ holdings of government debt jumped to 220 billion euros ($288 billion) in January from 178 billion euros in November, according to data from the Treasury. 

Average net borrowings from the ECB by Spanish banks climbed to 227.6 billion euros last month from 152.4 billion euros in February, the Bank of Spain said yesterday on its website. In net terms, they tapped more than 60 percent of the amount taken by euro-region lenders.