Spain to seek bank aid as borrowing costs soar

Spain's medium-term borrowing costs spiraled to a euro-era record on Thursday and independent auditors said Spanish banks may need up to 62 billion euros in extra capital, to be filled mostly by a euro zone bailout.

Euro zone finance ministers met in Luxembourg to discuss how to channel up to 100 billion euros ($126 billion) in aid to Spanish lenders weighed down by bad debts from a burst property bubble. The bailout was first agreed two weeks ago, but details of exactly how much is needed and how it will be distributed are still being hammered out.

Many in the markets see the package as a mere prelude to a full program for the Spanish state, which Madrid vehemently denies it will need.

"We have already started working on the design of the aid with the Commission, the European Central Bank and the International Monetary Fund," Spanish Economy Minister Luis de Guindos told reporters as he arrived for the talks. "We will present the request in the next few days."

Spain's financial plight took centre stage a week before a European Union summit tackles long-term plans for closer fiscal and banking union in a bid to strengthen the euro's foundations, after bailouts for Greece, Ireland and Portugal failed to end a 2-1/2-year old debt crisis.

To pave the way, the leaders of Germany, Italy, France and Spain will meet in Rome on Friday.

Two independent audits by consultants Roland Berger and Oliver Wyman found that Spanish banks would need between 51 and 62 billion euros in extra capital in extra capital to weather a serious downturn in the economy and new losses on their books.

The Bank of Spain said the 100 billion euros offered to Madrid gave a wide margin to correct these capital needs. Spain's three biggest banks would not need extra capital even in a stressed scenario, it said.

The government said it did not expect to shut down any banks and preferred to restructure those in difficulty. European Competition Commissioner Joaquin Almunia has said at least one bank may have to be wound down.

In Luxembourg, officials said the finance ministers decided Spain could initially apply to the euro zone's temporary rescue fund, the European Financial Stability Facility, for the money, with the loan taken over by the permanent bailout fund the European Stability Mechanism (ESM) once it is up and running after July 9.

"This was decided informally, because there is no formal request from Spain yet," one euro zone official said.

Such a solution avoids a problem which had scared investors. Debt issued by the ESM must be paid back first in case of a Spanish default, relegating private creditors down the pecking order. Because the new bailout debt will originate from the EFSF it will be issued without the ESM's seniority requirement.

Threatening Yields

Earlier on Thursday, Madrid sold 2.2 billion euros in medium-term bonds, drawing strong demand almost entirely from domestic banks. Yields on 5-year paper rose to a 15-year high of 6.07 percent, a level regarded by analysts as unaffordable for any prolonged period.

The runaway Spanish yields contrasted with a French auction at which the yield on 5-year benchmark paper hit an all-time low of 1.43 percent.

"The first worry is can they (Spain) fund from the markets? They raised 2.2 billion versus a 2 billion target, so they can raise the money," said Achilleas Georgolopoulos, a strategist at Lloyds in London.

"Then the (question is), are the yields threatening for the medium term? And yes, clearly they are much higher than the previous auction ... But still they can continue for a few months to fund at these levels."

The ministers were also expected to ponder the next steps with Greece, following the formation of a coalition of mainstream parties committed to the country's 130 billion euro EU/IMF bailout but determined to renegotiate some of its terms.

Athens will ask lenders for two more years to hit fiscal targets and an extension to unemployment benefits as it seeks to soften the punishing terms of the bailout that saved the country from bankruptcy, a party official said.

Greek officials have said this would entail an extra 16-20 billion euros in foreign funding. It sets up a showdown with Greece's euro zone partners, in particular paymaster Germany, which have offered modifications but no radical re-write of the conditions attached to the lifeline agreed in March.

"We can always discuss conditions of the loan. But let us not forget one thing: This is not one-way development aid," Luxembourg Finance Minister Luc Frieden told Reuters Insider television.

Rescue Fund to the Rescue?

The German government and opposition reached a deal that will allow parliament to approve the ESM next week, but Germany's top court may delay the rescue fund's start date, saying it needed time to study the treaty.

The ESM cannot come into effect without approval by Europe's biggest economy. Ratification also requires the signature of the president and a nod from the constitutional court in Karlsruhe.

The parliamentary floor leader of Merkel's conservatives appeared to dash French and southern European hopes of nudging Berlin towards common euro area debt issuance, saying there would be no mutualisation of debt in Europe.

Italian Prime Minister Mario Monti suggested, on the sidelines of this week's G20 summit, using the euro zone's rescue funds to buy the bonds of Spain and Italy in the secondary market to bring down their borrowing costs.

Monti hosts Spanish premier Mariano Rajoy, German Chancellor Angela Merkel and French President Francois Hollande in Rome on Friday and is also expected to raise the idea there.

Merkel has played down the proposal, which investors said might be counter-productive unless the ECB stepped in decisively in support.

A day before the four-way meeting, Italy disclosed that it is missing its target to lower the budget deficit to 1.7 percent of gross domestic product and will have to cut spending by a further four billion euros to meet the goal.

Any European bond-buying would come with strings attached, equivalent to the sort of bailout programs that Rome and Madrid are trying to avoid because of the stigma attached.

Given the limited capacity of the temporary EFSF and planned permanent ESM rescue funds, with at most 500 billion euros available, a senior EU source said such intervention would make sense only if the ESM had a banking license enabling it to borrow from the ECB. Germany has so far opposed that idea.

[Source: By Jan Strupczewski and Julien Toyer, Reuters, Luxembourg and Madrid, 21Jun12]

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