Pain in Spain Falls Mainly on Trichet as ECB Accepts Toxic Debt

By Esteban Duarte and Neil Unmack

July 29 (Bloomberg) -- Spain's housing collapse is becoming European Central Bank President Jean-Claude Trichet's economic crisis as delinquent home-loans rise amid a slowing economy.

Spanish lenders, once the most prudent on the Continent, have almost tripled borrowings from the Frankfurt-based ECB in the past year to 47 billion euros ($74 billion), pledging bonds backed by assets, including mortgages, as collateral. That's the fastest increase in Europe, overtaking Italy, Ireland and the Netherlands, according to data from the countries' central banks.

``There are some worrying parallels between the Spanish and U.S. mortgage markets, including their rapid growth in recent years,'' said Rui Pereira, head of Spanish structured finance at Fitch Ratings in Madrid. ``Banks had relaxed lending standards in recent years due in large part to the booming housing market and abundant liquidity.''

Trichet, 65, faces the slowest-growing economy for two years, the European Union's statistics office in Luxembourg said this month, while inflation rose to a 16-year high in June amid record oil prices.

``Given the scary amounts of public-sector funds siphoned through the money market by the ECB since last August, financial instability carries large economic costs,'' said Lena Komileva, head of Group of Seven market economics in London at Tullet Prebon Ltd. ``The longer it persists the greater the risk.''

Growth will pick up in the fourth quarter after a ``trough'' in the second and third, Trichet said on July 18. The ECB raised Europe's key interest rate to 4.25 percent on July 3.

Housing Slump

Spanish lenders' bad debts more than doubled as the housing slump that began with subprime mortgages in Florida and California crossed the Atlantic, infected Europe's hottest vacation-home market and more than halved economic growth to 1.8 percent in 2008, according to an International Monetary Fund forecast last week. Mortgage arrears in Spain are the highest in six years, according to Standard & Poor's.

Banks in the euro region can raise cash by handing over assets, including mortgage-backed securities, to the ECB, either agreeing to buy them back later or pledging them as collateral.

The ECB values the assets at a discount from face value and the borrowing bank keeps the debt on its balance sheet. While most of the loans mature in one week or three months, the central bank has also provided some lasting for six months since the credit crunch struck.

For the ECB to lose money, both the bank that's borrowing and the loans comprising the collateral must default.

The ECB'S list of eligible securities for loans includes bonds from from Banco Santander SA, Spain's biggest lender, according to the central bank's Web site. The bonds are backed by mortgages that exceed property values by as much as 24 percent.

Eligible for Collateral

The debt, part of an issue called Santander Hipotecario 4, is eligible for use as collateral, but has been kept in reserve and not pledged, said Madrid-based spokesman Peter Greiff.

``Santander has not used the ECB's liquidity facilities in any significant way,'' he said.

Bonds backed by mortgages and other assets accounted for 18 percent of the ECB's loan collateral at the end of 2007, up from 4 percent in 2004, Fitch data show.

Spanish lenders increased their use of three- and six-month ECB loans to 27.5 billion euros as of June 30, from 2.4 billion euros a year earlier, according to the country's central bank.

That accounts for 10 percent of the ECB's three- and six- month lending, more than any country except Germany, France and Ireland.

Spanish loan defaults rose in May to 27.76 billion euros or 1.5 percent, from 12.05 billion euros or 0.77 percent a year earlier, the Bank of Spain said.

Cheaper Way

Sending asset-backed bonds to the ECB in exchange for loans is a cheaper way to obtain cash than selling debt to investors. The central bank charged an average of 4.36 percent for three-and six-month liquidity loans this year, 60 basis points less than the three-month euro interbank offered rate, or Euribor, a benchmark for borrowing, and about 3 percentage points less than the cost of selling mortgage-backed securities.

Spanish AAA rated mortgage debt is judged to be the riskiest on the continent, with investors demanding as much as 240 basis points above Euribor, up from 85 basis points at the end of 2007, according to Dresdner Kleinwort prices. That's more than twice the interest margin on equivalent securities in the Netherlands. Only bonds secured by home loans to U.K. borrowers with poor credit histories trade at higher spreads, Dresdner data show.

Less Costly

Borrowing from the ECB by pledging asset-backed bonds also costs less than taking savings deposits from consumers, who receive an average 4.5 percent interest rate, according to the Bank of Spain.

``Spain's banking sector appears not to be able to match its lending with the deposits it takes and that's another reason for banks to go to the ECB,'' said David Owen, chief economist for developed markets at Dresdner Kleinwort in London.

The ECB's lending program ``has served us well'' and the bank is ``continuously examining'' its rules, Trichet said at a press conference in Frankfurt July 3 after raising euro interest rates. Raphael Anspach, a spokesman for the bank, declined further comment.

``The ECB is aware that banks are pledging more securities at the low end of the accepted quality range,'' said Natacha Valla, economist at Goldman Sachs in Paris. ``The ECB can't accept too massive a pledging of asset-backed securities.''

The ECB can take A rated bonds for collateral while the Bank of England will accept only AAA rated securities. The U.S. Federal Reserve's Term Securities Lending Facility requires that any bonds not issued by Fannie Mae or Freddie Mac must carry top rankings to qualify.

More Reliant

Spain's lenders may become more reliant on the ECB for cash as the housing slump worsens. Caja Madrid SA, the second-biggest savings bank, had three Aaa rated bonds backed by mortgages placed on review for possible downgrade by Moody's Investors Service last week. Mariano Utrilla, a spokesman at Caja Madrid, didn't comment when asked in an e-mail about the central bank liquidity program.

Banco Popular Espanol SA, Spain's third-biggest lender, scrapped its earnings forecast last week as bad loans more than tripled to 1.15 billion euros, or 1.89 percent of total debt.

The company has 15 billion euros of bonds to use as collateral for central-bank borrowing but plans to tap the facility only ``in a moderate way,'' said Juan Echano, an investor-relations official.

Biggest Deficit

Spain created half of all new jobs in the euro area between 2001 and 2006, more than any other country, according to Eurostat data. Its $146 billion current-account deficit at the end of 2007 was the world's largest after the U.S.

As the real-estate boom ended, La Coruna, Spain-based developer Martinsa-Fadesa SA this month sought bankruptcy protection on 5.2 billion euros of debt. Luis Gonzalez, a spokesman for Martinsa in Madrid, declined to comment.

``Spain is more at risk than any other market in Europe'' because of ``the decline in demand from Europeans who bought vacation homes over the past 10 years,'' said Gilles Moec, senior economist at Bank of America Corp. in London.

To contact the reporters on this story: Esteban Duarte in Madrid eduarterubia@bloomberg.net; Neil Unmack in London nunmack@bloomberg.net