Investors worried about the viability of Spain's banks sent its borrowing costs into the danger zone and shares sliding Wednesday, spooked about whether the government can pay for a bailout of a banking sector saddled with toxic loans fueled by a decade-long property frenzy.
Doubts over how recession-hit Spain will handle a (EURO)19 billion ($23.63 billion) injection into troubled lender Bankia helped drive the interest rate on Spanish 10-year bonds _ a gauge of investor confidence over how well the country can handle its debts _ up to 6.67 per cent. This was the same euro-era high it reached last November _ just after elections ousted the Socialists blamed for failing to manage the financial crisis and brought in a new conservative administration.
There is a growing concern that more Spanish banks may need saving amid mountains of loans gone bad and foreclosures of property now worth far less than the loans paid out to build it. Some estimates put a complete sector bailout cost at between (EURO)50 billion and (EURO)150 billion. But Spain only has (EURO)5 billion left in the (EURO)19 billion bank bailout fund it established in 2009. This means that Spain will have to raise the money in markets.
Spain is a weak link in Europe not only because of its banks, but because of poor economic growth prospects. The economy is mired in its second recession in three years and forecast to shrink 1.7 percent for the year. Nearly one out of every four Spaniards is unemployed, and the rate goes to one out of every two for those under 25.
Amid all this, the government is trying to bring down its debt as proportion of its economy down to strict European standards.
Spain's plan is to fund the Bankia bailout through more debt. But the borrowing costs _ or yields _ are close to hitting 7 percent, a level many analysts believe is too high for a country to raise money on the bond markets in the long term. It is also the threshold at which other debt-stricken eurozone countries such as Greece, Portugal and Ireland _ another country brought low by a property bubble and banking sector bailout _ to ask for help asked for an international assistance.
Indeed, Spain's Economy Minister Luis de Guindos has warned that his country's capacity to pay such a high cost to fund the debt it issues is "not very sustainable over the long term."
Markets across Europe fell heavily Wednesday on worries that Spain's banking problems could soon be repeated across the region and push more banks to call for bailouts of their own.
Ultimately, investors fear that the eurozone's No. 4 economy behind Germany, France and Italy could need a bailout of the entire nation _ one that many believe is too big to handle because its economy is bigger than those of Greece, Ireland and Portugal lumped together.
The FTSE 100 in the U.K. fell 1.7 per cent to 5,297 while in France the CAC 40 lost 2.2 percent to close at 3,015. Meanwhile the yields on so-called safe-haven bets such as 10-year US Treasury bonds fell to near-60 year lows.
"The bigger eurozone picture is starting, I think, in the case of Spain to point to the prospect of an external bailout, i.e. with funds coming from the EU, possibly from the IMF," said Mark Miller, an analyst with Capital Economics in London. "That is where the momentum is building."
Spain was thrown a lifeline Wednesday by the European Union's executive body, the Commission. In its economic report, the Commission called on the 17 countries that use the euro to create a "banking union" with the power and the money to take broken banks off governments' hands _ and override national regulators who may be reluctant to force restructuring of failed financial institutions.
That would protect countries like Spain from having their public finances overwhelmed by the cost of bank rescues, but would still be a form of external bailout that Spain is trying to avoid, since it would come with conditions such as new austerity measures.
The Commission also recommended that Spain should be given an extra year until 2014 to get its budget deficit bank within European targets, but only if it can effectively control excessive spending in its semi-autonomous regions that have overspent wildly.
De Guindos Wednesday defended the government as being transparent on what it plans to do with the banking sector. Banks have been asked to set aside another (EURO)84 billion to cover for their increasing portfolios of toxic assets, two independent audits of banks' loan portfolios are under way to put precise figures on the extent of the banks' problems, and an IMF report will come out in June.
"We will shine the light on what the consequences of the financial crisis have been for the banks," said de Guindos, who was forced to deny reports that the European Central Bank had rejected an unorthodox idea for Spain to bail out Bankia using government bonds which would be used as collateral for cash from the ECB.
Spain's current banking problems have startling similarities with Ireland. Both countries have fueled unprecedented property building and buying sprees enabled by their 1999 entry into the euro. Joining currency forces with more stable economies such as Germany lowered their credit-risk profiles and gave their banks unprecedented access to international loans at rock-bottom rates.
Spanish and Irish construction firms and property speculators snapped up the cash in expectation that their housing booms, source of easy profits for a decade, would go on forever. Both governments did nothing to slow or regulate the manic building and collected a tax bonanza and record budget surpluses.
But the 2008 global financial crisis started to weaken the Irish and Spanish property bubbles. Ireland hit the wall first, with Spain second _ however, it was shielded by the larger size and borrowing power of its economy compared to Ireland, which then was forced to bail out its banks and then seek assistance of its own.
Bankia SA, the result of a merger of Spanish savings banks troubled by toxic property loans, probably could have been saved for less years ago but Spain's previous government did nowhere near enough to shore up Spain's banks, reform labor laws, cut government spending and boost taxes, said Gayle Allard, an economist and labor market specialist at Madrid's IE Business School.
It has fallen to the government of conservative Prime Minister Mariano Rajoy to implement wave after wave of painful austerity measures since January.
Spain also has a credibility problem because of government missteps, with officials until recently denying the need for bank bailouts. De Guindos initially estimated the government would inject (EURO)9 billion into Bankia, but the figure rose to (EURO)19 billion last week.
"I would say some of the comments from government officials over a period of time in some ways have sort of, if you like, signaled denial in terms of the true position of the banking sector," Miller said.
Daniel Woolls, Jorge Sainz in Madrid and Shawn Pogatchnik in Dublin contributed to this story.