Bubble

Last year, in this space, I warned that the Spanish banks could run into serious trouble if the European recession deepens. The cajas were particularly vulnerable being dependent on state subsidies brokered by politicians.

I recall the Spanish Embassy wrote a rejoinder to that piece, saying basically that their banking system was fine. I hope they write a rejoinder to this piece, too.

Over the weekend, Europe’s financial managers worked through the night. Spain asked for about $100 billion in the form of a “credit line” to its banks, particularly the largest Bankia. Spain’s partners in the Eurozone quickly made the money available.

Everyone else, apart from the official spokesmen of the Spanish government, called this a “bailout.” Indeed it is, except that the money is not coursed through government but injected directly into the banks.

The size of the bailout makes the Spanish financial predicament many times larger than Lehman Brothers. Recall that when US authorities balked at bailing out Lehman, a financial tsunami swept across the globe. A deep recession hit most economies.

As in the case of the “toxic assets” carried by US investment banks like Lehman, the Spanish banking system reflects the bursting of the asset bubble that Madrid tolerated because, for years, it was politically profitable to do so. For years, the Spanish economy appeared to grow because asset prices were sharply rising.

 The rise in asset price allowed the banks to inflate the size of their portfolios. They lent out money on overpriced collateral because of rising asset prices. When the bubble burst, so to speak, assets prices dropped like a heavy stone. Banks found themselves absorbing properties whose prices were rapidly falling.

 Individual Spaniards who borrowed on the basis of inflated asset prices could no longer service mortgages on property worth very much less at present. It does not help that years of recession caused the 25 percent unemployment rate dragging down Spain’s economic prospects. For young Spaniards below 24 years old, the unemployment rate is a whopping 51 percent.

The high unemployment rate forces down domestic consumption. Lower domestic demand discourages investment in Spain. Less investments mean less borrowing, and then less profits for the banks.

 The recession, at the same instance, increases the volume of defaults by bank borrowers — across the whole range from credit card holders to large enterprises investing in property development. The more defaults by borrowers, the more banks are compelled to acquire properties submitted as collateral. As the banks accumulate properties, the real values of these decline sharply.

The situation in Spain is different from the situation prevailing in Greece. It is important to note that difference.

In Greece, it is the government that basically accumulated debt until these debts could no longer be serviced. On the verge of defaulting on public debt, it is the Greek government that had to be bailed out. If Greece defaulted, the entire European banking system will be in danger of collapse since they hold debt papers that are basically worthless.

In Spain, the government was quite adept at putting the fiscal crisis under control by embarking on an austerity program soon enough. But bank credit was basically frozen and the economy was at a standstill because bank assets shrunk at each passing day.

As in the case of Greece, the rest of the Eurozone had no viable option except to bail out the problematic Spanish banks. If these banks folded because they were holding on to toxic assets, the rest of Europe’s banks will be in serious jeopardy.

 This is the reason why, over the weekend, after frantic conference calls, European financial authorities rushed a bailout package to favor Madrid. The package will prop up the Spanish banking system for the time being. The financial system, resembling the circulatory system in human anatomy, will not freeze up and cause a wave of bankruptcies to happen.

The bailout, however, will not cure the recession. It will simply buy time and hold off a massive default whose ripple effects will be more severe that what we saw in 2008 after the Lehman episode. This is the particular dilemma confronting the deepening crisis in Europe.

 To cure the recession, domestic demand and investments should both rise. However, the austerity program made necessary to avert a deepening of the financial crisis militates against economic expansion.

There can be no growth while governments struggle to restore stability to the financial system. Firefighters cannot be builders at the same instance.

While the dimensions of the Spanish crisis are awesome on their own, we must remember that this is happening while the Greek crisis simmers without a clear path to resolution. The lingering problem with Greece magnifies the peril posed by the Spanish crisis.

 Things, in a way, are teetering on the edge. If any of the major European banks buckle under the crisis, there will be a generalized financial contagion. US banks cannot escape the effects since they are exposed in the billions to the European banks.

If the recession in Europe deepens, US growth prospects will be compromised. If the US slides back into recession, the Asian economies will feel the pain.

A year ago, many expected that the giant economies of Brazil, Russia, India, China and South Africa (the so-called BRICS), supported by a second tier of emerging economies composed of Turkey, Indonesia and Colombia, might provide the growth drivers to prop up global expansion. All of these economies, however, had to scale down their own growth projections because of the recession in Europe and weak US data.

This is a challenging time for everyone.