Beyond Greece: EU Banks May Be Next Focus of Markets

So far, Europe’s latest sovereign ills have not spread, but traders are watching the euro zone banks since they would be the first to carry the germs of financial contagion.

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Following several days of rumors, Spain late Wednesday moved to take state control of its fourth-largest bank, Bankia. The Bank of Spain would hold a 45 percent stake in BFA, the parent of Bankia, which it says is still solvent. The move requires clearance from the EU.

This comes as efforts to form a government in Greece among fractured political groups continue to flounder. The developments in Greece, since Sunday’s election, have set global markets on edge and amplified concerns that Greece could leave the euro zone.

Greece, it is feared, would be a catalyst for other weak sovereigns to follow.

Anti-austerity Greek politicians have rattled markets, particularly radical leftist Alexis Tsipras, who is attempting to form a governmentand says the bailout provisions would be nullified.

The European banks are “one focal point of the issue and because it’s a weakness it tends to get more attention at a time when there are broad-based concerns running around,” said Paul Christopher, chief international strategist at Wells Fargo Advisors. “I think it’s still a political problem.”

But another side show that traders have been watching intently has been unfolding in Spain. Besides taking steps to shore up Bankia, Spain is also expected to announce on Friday that it is requiring its banks to raise additional capital. Reuters reports 35 billion euros could be required, as provisions against property loans.

“This is a complete reversal of the new Spanish government’s policy, which was that they weren’t going to make any fresh funds available to the banks,” said George Magnus, UBS senior economic advisor.

The Spanish banks, which hold a significant amount of Spanish sovereign debt, have limited options for raising capital.

“They could either earn it or they can shrink their assets. If they shrink their assets, that becomes self-defeating,” Magnus said. “Somehow the Spanish government has to come up with a formula that incentivizes the banks to raise capital without forcing them to dump assets.

“One obvious way is for the Spanish government to pump equity onto the balance sheets of the banks, but that comes with a political price,” he said. Magnus said Spain has a comparatively low debt to GDP ratio, but adding funds to its banking system would affect its already problematic deficit.

“Nobody knows at this point how much the Spanish government could be on the hook for,” said Magnus.

Another cloud hanging over the markets is Moody’s review of the Western European banking sector and financial firms with global capital markets operations. Moody’s first announced the review in February, and it was expected to make its results public by June.

“It’s like a sword hanging over the market. Once we get it, we might factor in what the downgrade means,” said John Briggs, senior Treasury strategist at RBS.

“We seem to get market talk every morning that Moody’s downgrades are coming. The other day it was Italy. Then there was market talk today that it was Spanish banks that were getting downgraded. Once we receive the news, it might be buy the rumor, sell the fact,” in the bond market, he said.

Besides European banks, Morgan Stanley is also under review by Moody’s. Morgan Stanley reported Monday that it could have to put up $7.2 billion in collateral to counterparties if it gets hit by a credit downgrade of three notches. It would also have requirements of $2.4 billion to exchanges and clearing organizations.

Christopher said, while Moody’s actions could be end up being downgrades and could be meaningful for markets, the European LTRO bank liquidity program should help mitigate the situation.

Magnus, however, said the LTRO could have unintended consequences.

“The sovereigns and the banks are sort of locked into a nefarious interdependent relationship with is ruinous to them both. The ECB (European Central Bank) may have staved off a credit crisis in Europe at the end of the year by providing a trillion (euros) in loans to banks, which we know have been used in Italy and Spain to fund sovereign debt purchases. It intensifies the relationship to the banks,” he said.

But Magnus said Greece right now is the bigger threat to markets.

“I do think the most frightening thing, that pride of place still belongs to Greece. But Spanish yields have gone back over 6 percent and that has been the focus of the market,” he said.

Follow Patti Domm on Twitter: @pattidomm

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