Spain May Suffer From ECB Lending Curbs as Expansion Falters

By Ben Sills and Esteban Duarte

Aug. 28 (Bloomberg) -- Spain's economy, brought to the brink of a recession by surging global credit costs, may find money even harder to come by when the European Central Bank tightens its lending practices.

Spain's banks have stored up 89 billion euros of their own asset-backed securities, more than any euro-region country, because the ECB accepts them as collateral in auctions, according to UniCredit SpA. Now the central bank wants to change the rules, ECB council member Yves Mersch said in an interview on Aug. 23, a move that may leave Spain holding the bag.

``This may affect negatively the profitability of Spanish banks and their ability to lend,'' said Willem Buiter, a professor at London School of Economics and a former Bank of England policy maker. ``It could lead to slower growth.''

Spain's banks have relied on cheap money from the ECB to help provide credit to consumers and companies even as the economy is buffeted by a real-estate downturn. Without the ECB, the country would be more dependent on foreign investors, who are demanding higher returns before committing funds.

ECB officials have agreed to adjust collateral rules in response to some banks' attempts at ``gaming the system,'' Mersch told Bloomberg News at the Federal Reserve's annual retreat in Jackson Hole, Wyoming. Axel Weber, another council member, said in an interview published yesterday in Frankfurt that the ECB must ensure its rules are ``not abused.''

Fitch Warning

The share of asset-backed bonds in the collateral deposited with the ECB jumped by a third last year. What's more, the quality of the assets underlying those bonds has deteriorated, Fitch Ratings said in a report in May. Spanish banks are pooling ``higher risk'' mortgages and consumer loans to back the bonds, Fitch said.

``We see bonds being issued just to forward them directly to the ECB,'' said Kornelius Purps, a fixed-income strategist in Munich at UniCredit, Europe's fourth-largest bank.

Holders of asset-backed securities can get money 39 percent cheaper at central-bank auctions than through investors. A Spanish mortgage-backed bond rated at the highest credit rating trades with a spread of about 2.8 percentage points to the euro interbank offered rate, or Euribor. The resulting rate of 7.76 percent compares with an average rate of 4.74 percent at yesterday's ECB auction for three-month money.

Since the credit squeeze began a year ago, Spanish institutions raised their monthly borrowing from the ECB by 31 billion euros to a record 49.4 billion euros, according to data compiled by Bloomberg based on central-bank figures. The increase is three times the size of Prime Minister Jose Luis Rodriguez Zapatero's fiscal stimulus package aimed at averting a recession.

`Delicate Situation'

``The economy is in a very delicate situation,'' said Jose Luis Martinez, a strategist at Citigroup Inc. in Madrid, who predicts a recession in Spain in the second half of the year. ``One reason for that is the tighter credit conditions and anything which exacerbates that is bad news.''

Spain's economy grew 0.1 percent in the second quarter, the slowest in 15 years. The euro region's gross domestic product shrank for the first time since the introduction of the single currency in 1999.

One option for ECB policy makers is to reduce the amount of money that can be borrowed for every euro of asset-backed collateral, Natacha Valla, chief economist of Goldman Sachs Group Inc. in Paris, said in a report after Mersch's comments.

Spanish Debt

Buiter said the ECB may make it harder for banks to use as collateral bonds backed by loans they themselves granted. Banco Popular Espanol SA, Spain's no. 3 lender, tripled its holdings of assets eligible in ECB auctions to 15.2 billion euros since December 2006. The bank faces 7 billion euros of debt maturities over the next 18 months.

Spain's economy doubled in size over the past decade as the decline in borrowing costs brought by euro membership spurred construction and consumer spending. That spree saw Spain run up the world's second-biggest current-account deficit after the U.S., leaving businesses and consumers reliant on foreign lenders.

With household debt reaching 130 percent of incomes, consumption was already slowing when the global credit crunch began. The turbulence triggered a collapse in the housing market as investors became more reluctant to provide financing to Spanish lenders. Home sales fell by a third in May from a year earlier.

``If the ECB restricts the possibilities for using asset- backed bonds in refinancing operations, the market spread will widen again,'' said Sylvain Broyer, an economist at Natixis in Frankfurt. ``Such a tightening will hurt the part of the euro-zone economy which is weakest right now.''

To contact the reporters on this story: Ben Sills in Madrid at bsills@bloomberg.netEsteban Duarte in Madrid at eduarterubia@bloomberg.net;