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Pressure on Spain eases, but bailout still likely

(MoneyWatch) Spain's successful bond auction this week may well have forced it into reported talks with the EU about the terms of a bailout. Why? Because the major buyers of that government debt were bankrupt Spanish banks.

Demand was so strong at Thursday's auction of 10-year Spanish bonds that the country's borrowing costs fell to 5.6 percent, their lowest level since January. Typically, such a decrease in borrowing costs would ease the pressure on a nation to seek a financial rescue. But the Financial Times reported that, even following the auction, EU officials were in talks with Spanish officials about a bailout, citing "senior EU officials" in noting that the rescue is expected to be unveiled next week.

Spain's financial institutions have been heavy buyers of Spanish bonds over the last couple of years. According to a report in the El Economista newspaper, the amount of government debt held by Spain's banks has doubled in just the last seven months.

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These banks almost certainly hold more debt than the value of their assets because of the ongoing collapse of Spain's real estate bubble. But they have been able to continue loading up on sovereign debt because of two decisions by the European Central Bank.

Nine months ago, the ECB said it would provide more than $1.2 trillion in three-year loans to banks in the eurozone. This move, designed to spur lending and spark economic growth in the currency union, helped avert a short-term credit crunch by reducing banks' reliance on markets for funding. The largest users of this program have been banks in Spain and Italy.

In early September, the ECB also moved to allow banks to use assets that were decreasing in value, such as mortgages, as collateral for more loans. Financial institutions then used some of this money to buy Spanish bonds, effectively lending money to the government that it could use to bail out these banks.

In the "whack-a-mole" nature that has characterized many of the supposed remedies to the European financial crisis, this in turn adds to Spain's debt. That increases how much the government may need to borrow to fund the bank bailout.

The ECB money also diminishes the incentive for banks to scrub their balance sheets of toxic assets, notably soured real estate loans. "Some banks, especially in Spain and Italy, are just taking in the money that they can get from the ECB, which should be a short-term measure in order to enable them to manage while they implement structural reforms," Simon Maughan of Olivetree Securities told Bloomberg. "It successfully staved off a funding crisis, but its real aim of facilitating restructuring hasn't even started."

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