As we are drafting this commentary, we are hearing that the Spanish auction of 10-year notes went well. We choose to differ on the situation in Spain.

Spanish banks have significant problems. Just this past week they borrowed from the European Central Bank (ECB) at record levels. Specifically, they borrowed over $100 billion US dollars. Not even in the days of the Lehman Brothers collapse did they borrow that much! They have been absorbing more than 16% of all ECB loans. This percentage is disproportional to the size of the Spanish banking sector and points to the fact that tremors are coming and that the international capital markets are not lending to Spanish banks. The auction on June 17th was not absorbed by the international markets, but rather by domestic customers.

The tensions in the Spanish banks will keep absorbing ECB’s liquidity from the rescue package (close to $1 trillion) that the EU and the ECB along with their new guardian a.k.a. IMF, put together. The problem is that once they start tapping that fund, they can no longer contribute to the fund (per regulatory framework), which will make the EU problems worse. Short and long-term yields are rising in Spain. As the following graphs show, the short term spreads and cost of borrowing has almost doubled since January.

The potential Spanish banks’ crisis would shake European and global markets. When banks cannot find access to funding, the corporate structure in the country is shaken. That could create waves of business failures, which in turn will raise the already high unemployment rate (the official rate is over 20%), and will reduce spending, making a double dip almost certain. However, the problem would not stop there. The waves and tremors will transfer to other EU countries, and we suspect that the next stop will be Italy, with its already high debt level that is close to 120% of GDP.

Weak banks and weak government finances make a lethal combination. The Spanish and Italian banks have big exposures to the real estate sector. Once the tremors start, the cost of borrowing for the country will increase, the cost of insuring the country’s debt (credit default swap, CDS) will also increase substantially. We agree with the Chairman of the Eurozone Jean-Claude Junker that “Spain is not Greece”. We would only differ and say that Spain’s problems would be much more serious than Greek problems.

According to the latest estimates by RBS officials, the total amount of Spanish liabilities that is held by investors outside the country exceeds $1.8 trillion. Such a huge amount is close to 140% of Spain’s GDP. Reports in the Spanish press on June 16, stated that the IMF, the ECB and the US Treasury are preparing an emergency plan.

What is the next stop for the Euro? Your guess-

Please enjoy the ride!