Spain banks at heart of eurozone chaos

MADRID -- Spain is under increasing pressure to find a quick way to save its troubled banking sector from collapse.

Politicians and investors around Europe are worried that the recession-hit country will not find the money to cover the toxic property loans weighing its banks down. The expectation now is that Spain's government will have no choice but to seek an international bailout to help it bolster its lenders.

The concerns have sent Spain's borrowing costs on the international bond markets to worrying levels -- close to the points where most market-watchers say a country cannot maintain its debt. Spain, previously rated A, may need as much as $126 billion to bolster its banking system, compared with an earlier estimate of about $38 billion, U.S. credit rating agency Fitch said Thursday. Fitch went on to downgrade the country to BBB, two notches above junk, and warned that the country faced further downgrades. In its most recent debt auction Thursday Spain managed to raise $2.52 billion -- but at much higher rates than in previous bond sales.

Earlier this week, the country's finance minister, Cristobal Montoro, warned that the country was rapidly running out of ways to finance itself and that the "the door to the markets is not open for Spain." In his most explicit plea for Europe to come to Spain's aid, Prime Minister Mariano Rajoy told a Senate session the next day that Europe "needs to support those that are in difficulty."

On Thursday, Rajoy for the first time didn't stick to his standard line that Spain has no intention of seeking outside help. And Germany, without mentioning Spain by name, gave its clearest hint so far that it thinks the county should tap the European rescue fund before its banks become too hot to handle.

Spain's financial problems are not due to Greek-style government overspending, but because its banks got caught up in the collapse of a property bubble.

Following Spain's entry into the euro -- and joining currency forces with more stable economies such as Germany -- the country's banks gained unprecedented access to international loans at rock-bottom rates, which they passed on to their customers.

Spanish construction firms, property speculators and homebuyers snapped up the cash in expectation that the housing boom would go on forever. And the government did nothing to slow or regulate the manic building as it collected a tax bonanza and record budget surpluses.

In 2008 the real estate bubble that supercharged the economy for more than a decade burst. Banks, particularly Spain's savings banks or "cajas," have been saddled with enormous amounts of bad loans. As the second recession in three years hits Spain with more economic gloom predicted, the amount of bad loans are expected to surge while plunging house prices will lower the value of the huge stock of repossessed homes the banks already own. Making matters worse, Spain's unemployment has risen to nearly 25 percent -- making it increasingly difficult for many Spaniards to pay their mortgages.

The country's central bank, the Bank of Spain, says the sector is still burdened with about $220 billion in "problematic" real estate holdings.

While Portugal and Greece got bailouts because of high public debt, Spain's debt stood at a relatively low 68.5 percent of its gross domestic product at the end of 2011, and is predicted to hit 78 percent by the end of the year. That higher figure would still be lower than the 2011 debt percentage of GDP of countries like Italy, Belgium, France and even Germany.

WHY IS IT IMPORTANT THAT THEY FIND A SOLUTION?

Spain's trillion-euro economy is much larger than the three countries that have already received bailouts, making its problems much more worrisome for European leaders. Bailing out Spain itself would likely stretch the eurozone's finances to the breaking point because the Spanish economy is the fourth largest in the 17-country eurozone, behind Germany, France and Italy.

A full-blown Spanish bailout including its public finances would hurt growth in Europe, the United States and Asia by creating losses and fear among banks, which are key to the functioning of the global economy, and by hurting trade. Many U.S. companies get a sizable part of their sales and profits from Europe so a recession there would impact companies and economies around the world. Even U.S. mutual funds have an average 3.6 percent of their assets invested in European stocks.

Because many European governments are already overburdened with debts, rescuing their failed banks risks bankrupting some of them. The banks, in turn, own huge amounts of their governments' bonds. The result is that any fall in confidence in either the banks or the government tends to create a downward spiral requiring more foreign financial aid.

The fear is that once Spain is forced into a bailout, other countries such as Italy would follow suit, adding further pressure on the eurozone.

HOW MUCH WILL IT COST?

The latest storm to hit Spain's financial markets was caused by Bankia S.A., the country's most stricken lender. At the end of May, the lender -- itself the result of a merger of failing cajas -- announced that it needed (euro) 19 billion ($23.63 billion) in government aid. Spain only has (euro) 5 billion left in a (euro) 19 billion fund that it established in 2009 to help banks. The government has promised to help Bankia but has not mapped out a plan.

There are at least four other banks, all smaller than Bankia, that probably also need help.

Estimates put the overall cost of bailing out Spain's troubled banks at between (euro) 40 billion and (euro) 100 billion, but no one knows the real price tag. The International Monetary Fund may be able to shed some light on the true total when it issues an evaluation of the banking industry next week. The government has also commissioned independent audits of the sector also to determine the banks' recapitalization needs. No decision will be made on how to recapitalize the sector until after the audits, Rajoy said Thursday.

The government has also pushed lenders to strengthen their finances by merging, and has told banks to set aside (euro) 84 billion more in provisions by the end of 2012 to cover their toxic real estate assets. Spain's two largest banks -- Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA -- are expected to meet the stiffer requirements. However, investors are fearful about the ability of the capability of smaller banks and the true extent of their liabilities.

WHERE COULD THE BAILOUT MONEY COME FROM?

Spain has so far failed to set out a clear road map on how its banks -- in particular Bankia -- will be saved. At first, government officials floated an idea of injecting government debt into the lender so that the bank itself could go to the European Central Bank using the bonds as collateral to receive recapitalization cash. European leaders ruled out that option.

Spain also said it could fund the bank bailout by selling more debt on international markets. But the interest rate investors force Spain to pay on 10-year bonds shot up to 6.7 percent, matching a record high and perilously close to the 7 percent level that forced Greece, Ireland and Portugal to accept bailouts and harsh conditions on government finances. While Spain passed a key market test Thursday by selling bonds with 6 percent interest, the cost to shell out those sort of returns over the long-term are prohibitively high.

Spain would like to get European aid for its banks but is reluctant to ask for it because under current rules the aid would have to be given to the government. That would allow Brussels to dictate policies to Madrid, something the Spanish government is keen to avoid. It would also further hit investor confidence, sending interest rates on its bonds even higher -- and into bailout territory.

WILL THERE BE STRINGS ATTACHED -- LIKE THE GREEK BAILOUT?

Spain is trying to convince European leaders -- and especially the eurozone's paymaster Germany -- to let it have a "light" form of a bailout without directly asking for it. EU leaders last July approved a measure allowing the continent's bailout funds to lend money to recapitalize banks in countries not already receiving bailouts -- such as Spain.

The money would have to be funneled through the Spain's government. But because the money is meant to help troubled financial institutions rather than the government, the conditions attached to the bailout loan would not have to be as overarching as those attached to government bailouts, such as in Greece and Ireland. However, the country in question would be ultimately responsible for repaying the loan, and would have to show that its economic policies are sound enough to allow it do to that.

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Associated Press writers Daniel Woolls, Ciaran Giles, David McHugh and Shawn Pogatchnik contributed from Madrid, Berlin and Dublin.