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Spain bank rescue underscores financial dilemma

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CIARAN GILES | May 10, 2012 04:03 PM EST | AP

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MADRID — The Spanish government's decision to take control of the country's fourth-largest bank highlights the problem gripping the nation's financial system. Banks are taking huge losses on real estate loans that have soured, but the deeper the government gets involved in providing aid, the greater the risk it will need an international bailout.

Financial stocks in Madrid soared Thursday, a day after the government said it would take a 45 percent controlling stake in Bankia SA, which has the highest exposure to bad property loans of all Spanish banks following a crash in the construction sector that started in 2008.

But because the government – already strapped for cash – will finance the takeover, investors continued to worry that the country might eventually need rescue aid itself. Spain's sovereign borrowing rates remained uncomfortably high on Thursday, suggesting traders are wary of its financial future.

Because the fates of Spain's banking sector and its government are so closely linked, analysts say a new approach – possibly with financial aid from abroad – may be needed.

"Once again the government has reacted late and badly," said Javier Flores, an analyst in Spain with Asinver investment group.

"There is something that everyone knows, it's talked about privately but no one wants to admit to in public," said Flores. "Spain's banking sector is sitting on a huge toxic asset problem that is not worth what it says on the banks' accounts."

Spanish financial stocks have been battered in recent months on growing worries that their bad real estate investments will hurt their earnings for a long time or even cause some of the weaker lenders – such as the regional cajas – to collapse.

The Bank of Spain estimates that banks are sitting on some (EURO)180 billion ($233 billion) in assets that could cause them losses.

In the short-run, the government's nationalization of Bankia eliminates the risk it could collapse, possibly causing a series of bank failures as it defaults on money it owes to other Spanish banks. That would create a credit crunch similar to the one that paralyzed global markets in 2008.

Analysts warn Bankia's rescue cannot be enough, that the wider sector needs more help, though the government has little financial firepower left to do so.

Concern that the Spanish government's finances may be overwhelmed by the cost of rescuing banks has pushed investors to ask for high interest rates to lend to the country. Those worries persisted on Thursday, with the benchmark 10-year bond yield at the perilously high level of near 6 percent. Bond yields indicate the rate the government borrows at when it taps financial markets. Rates of above 7 percent are seen as unsustainable in the long-run.

Healing the banking sector is crucial to clear the air and set the stage for a recovery in the economy, which is in its second recession in three years, with a 24.4 percent unemployment rate, the highest in the Eurozone.

But uncertainty over Spain's government finances is likely to continue as long as it is unclear how it will finance a big rescue of the banking sector.

To help Bankia, Spain will convert (EURO)4.5 billion ($5.9 billion) it had given it in 2010 and 2011 into shares. That means that instead of getting that money back to help reduce public debt, for example, it will take control of a loss-making bank.

On top of that, the government on Friday is expected to announce an injection of up to (EURO)10 billion to help keep Bankia afloat. It is unclear where the government will find that money, but such a move is likely to stir popular anger against the government, which has been making painful austerity cuts in key areas such as education and health.

On Friday, the government is also expected to present a broad plan to help the banking system. But whatever the reforms, the bottom line is that many of these banks need new money, analysts say.

The government has already asked banks to set aside (EURO)50 billion in rainy-day funds to protect them against losses in the property market and elsewhere. That could be raised to (EURO)80 billion in the government's announcement on Friday, analysts say.

"The key issue will be if banks can't afford to put aside a greater level of provisions," said Mark Miller, a European economist in London for Capital Economics.

The Spanish government can't inject much money in the banks without raising real concerns about its own finances. Its bond yields suggest investors consider it the next most likely country in the 17-nation Eurozone to take an international bailout.

If the banks don't have the money to set aside as capital buffers, they would have to try to raise it from private investors, who would ask for big discounts to put money in an ailing lender.

Ultimately, the best solution may be a partial bailout for Spain – but not for the government, just the banking sector.

"The bigger picture clearly is of concern and the chances of a bailout for the banking sector in Spain are high and rising," said Miller.

Spain could take loans from the European bailout funds to inject directly into the banks. That would reassure investors about the banks' ability to survive their losses on sour real estate assets and increase confidence that the government will not in the future be overwhelmed by the costs of rescuing failing banks.

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Alan Clendenning contributed to this report.