Why Moody's downgraded Spain's debt rating

Investors aren't yet convinced of Europe’s ability to recover from its deep financial woes.

In fact, market activity over the past several days suggests investors think Greece will inevitably default on its debt payments without robust additional aid, that Portugal will soon have to resort to a European Union-International Monetary Fund bailout, and that Spain’s financial system is in peril.

EU leaders met Friday in an informal summit to discuss terms to additional rescue mechanisms. While final agreements won’t come until the next summit on March 24, Germany suggested it’s willing to budge on its terms to help ailing economies, under certain conditions.

But on everyone’s mind is Spain. While its finances are not nearly at risk as their smaller peers, lenders have to account for a worst-case scenario not shared by policy-makers that could eventually involve a rescue of Europe’s fifth-largest economy, an impossible task with current available funds.

The source of uncertainty is the savings banks, known as cajas, which were the most exposed when the construction and real estate bubbles burst. Almost two-thirds have disappeared in a series of supported mergers and those remaining were given a deadline to raise enough capital or face a partial government takeover, much like in the US.

But Moody’s downgraded the Spanish economy over how much money savings banks need to meet strict new regulations designed precisely to soothe investor jitters. The agency said between $55 and $70 billion are needed, twice more than the $27 billion the government expected, but similar to most analyst estimates.

Hours after the downgrade, the well-respected and comparatively fiscally conservative Bank of Spain contradicted Moody’s estimates, saying the cajas would need $21 billion, in line with government estimates.

The difference though could be purely one of definitions.

“The messages are extremely different and depend on the starting point that you use,” explained London-based Deutsche Bank senior economist Gilles Moec.

Moody’s and most financial analysts use “the adverse scenario, the worst outcome universe, the capital buffer that should be in place if things get hairy, and work from there,” while the Bank of Spain makes its estimates based on current capital needs, which are a lot better.

“We think Spain is quite strong to fend for itself because it has a low level of public debt and it could recapitalize its banks without risking its public debt. It’s a lean government, closer to the US and the UK, more than Europe,” Mr. Moec said.

“But banks have lent too much and have too much exposure to property markets and the way to address it is to increase buffer. This is ultimately what would reassure the market,” Moec said, citing the US government bank bailouts as an example.

“After the second rescue was in place, the US government forced banks to take the money, even if they didn’t need it," he said. "It had a shock and awe effect. You want to go a step further than what is absolutely needed.”