Spain's Next Downgrade, Already In Motion, Could Trigger Bank Run

Moody's Investor Service's downgrade of Spain's sovereign debt sent the nation's borrowing costs sky high on Thursday. But as costly as this latest downgrade is, the next one could be even more devastating.

And downgrade No. 4 is looming. Canadian ratings agency DBRS Inc. is reviewing Spain's debt woes. If it follows Moody's, S&P and Fitch Ratings, it would trigger margin calls on hundreds of billions of borrowed euros, forcing the very Spanish banks that just this week required a €100 billion ($125 billion) bailout to wire billions to the European Central Bank (ECB).

In addition, private holders of debt might decide they don't want more Spanish debt, something that would further raise the country's borrowing costs.

Not that the Moody's downgrade has not already made things very expensive for Spain and its banks. On Thursday the yield on 10-year sovereign obligaciones shot up to 7.017 percent at one point, a record high. No country has ever financed its long-run debt with 10-year bond rates above 7 percent, so that mark is psychologically devastating to the markets. And that benchmark rate is jumping from levels of about 4.7 percent in early February.

Prospects for a fourth downgrade could not come at a worse time. Spain has some €81 billion in sovereign debt due this year that it must refinance plus a budget shortfall of about €62 billion. Each percentage point added to the country's borrowing costs makes the price of financing those cash holes go up by more than €1.4 billion in yearly payments.

If DBRS chooses to downgrade Spain below its current A rating, it would trigger collateral rules at the ECB that require any loans backed by sovereign bonds that suddenly become substantially riskier to be backed by more cash. Specifically, a move south of that A rating, would prompt a 5 percent margin call on all loans taken by Spanish banks and collateralized with nationally issued debt. Since Spanish banks have used the obligaciones to back the vast majority of the €287.3 billion they have borrowed from the ECB, as of May, the additional cash collateral posted would need to be around €14 billion ($18 billion).

No one in Spain has that kind of money.

Worryingly, the wheels leading to that next downgrade have been set in motion. On May 22, DBRS said it was reviewing the Spanish sovereign rating in anticipation of a cut.

Back then, DBRS said it would look at the risks stemming from Greece and to what extent uncertainty over the future of Greece, combined with concerns over sovereign debt sustainability and financial sector fragility in the euro area, may adversely affect Spain's efforts to stabilise its public debt. And that was before the bank bailout was in anyone's radar.

Of course, the ECB could always pre-empt the situation by announcing it is suspending its collateral threshold requirements as they apply to loans backed by Spanish bonds. The bank did precisely that for loans backed by Portuguese and Irish bonds in 2011. But in those cases the ECB was cancelling the impending margin calls as a way to recognize the countries had accepted severe programs of economic and financial adjustment. It is not clear the euro zone's central bank would reward Spain in a similar manner unless the country agrees to further austerity measures as part of a national bailout.

But even with an assist from the ECB, a downgrade would place Spanish bonds at the very edge of investment-grade sovereigns, prompting many funds to sell off. As the Wall Street Journal notes, key bond indexes might drop the country's debt, something that, for example, sent benchmark yields for Portugal to more than 15 percent when a similar situation played out in late January.

Catastrophic would not even begin to describe the fallout if that happened to Spain.