Spain Back in Cross Hairs

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The brief afterglow from Greece's vote Sunday to try to remain in the euro was quickly extinguished by a cascade of bad news out of Spain that again rattled faith in the currency bloc's ability to support its most troubled members.

Fresh data from Spain's central bank showed the country's lenders were sitting on the highest level of bad loans in 18 years and that their deposits continued to leak away. The gloomy figures—and worries that consultants scouring the creaky banking system will find yet more problems—helped drive Spanish bond yields deep into territory that is widely viewed as unsustainable.

The yield on the Spanish 10-year bond was at 7.18% late Monday in London, an unwelcome euro-era record for the zone's fourth-largest economy. The worrying signal demonstrates how Spain's troubles continue despite what plays out in Greece or elsewhere in the bloc.

The Spanish stock market fell 3%, and Italian stocks slid 2.8%. Italian bonds weakened somewhat, and other global markets largely shrugged off the Athens results. Asian equities rose, but in the U.S. the Dow Jones Industrial Average slipped 0.2%.

"Spain is the bigger uncertainty and until there is greater clarity around Spanish bank recapitalizations and sovereign funding costs, risk in financial markets will remain elevated," said Jeffrey Rosenberg, chief investment strategist for fixed income at asset manager BlackRock Inc. in New York.

Greeks voted Sunday for pro-Europe parties who will try to continue the troubled country's bailout program, relaxing fears of a popular uprising that could have threatened Greece's place in the euro zone. Many analysts had feared that a vote for antibailout forces in Greece could cause sudden deposit or capital flights there that would quickly spill over to Spain.

The streets were calm in Athens Monday as political leaders met to wrangle over the terms of a coalition government. That effort appeared on track, and even as Germany stressed it would not abide any delay in Greece fulfilling its budget-cut targets, the Athens stock exchange ended the day up 3.6% and the country's thinly traded, highly volatile bonds were stronger.

But Greece's results did little to help Spain's troubles. "The picture doesn't change that much for Spain," said Juan Pablo Lopez, an analyst with Espírito Santo Investment Bank in Madrid.

The country appears to be in a vicious cycle in which the deteriorating economy weighs on the banks, whose declining fortunes weigh on the government, which moves to slash spending, hurting the economy.

Spain's chief problems are its banks and its bonds. Last week, the country was thrown a lifeline of as much as €100 billion ($124.5 billion) from other euro-zone countries to rescue the banks from a morass of bad real-estate loans that is worsening amid the diving economy. There hasn't been any conclusion on how much bailout money is needed or whether the latest pledge will be enough.

That has helped crush investors' appetite for Spanish government bonds. The country's financial plan calls for it to sell more than €30 billion of long-term debt this year.

This week, the Spanish government is expected to receive the results of a "stress test" on its banking system, done by consultants Oliver Wyman and Roland Berger Strategy Consultants. Preliminary news reports, which rattled investors Monday morning, said that the total needed funds recommended by the outside consultants could be higher than the €100 billion bailout figure.

Spain hired the external consultants in May, amid a surprise announcement that one of Spain's biggest banks needed €19 billion in funds. The government could disclose some aspects of the report as early as Tuesday, according to people familiar with the matter. Both firms declined to comment on the contents of the report.

There also was speculation among analysts that banks could be required to increase loan-loss provisions against their massive portfolios of residential mortgage assets that would be on par with what external consultants' required previously for Irish banks, further stirring market worries.

Concerns over the consultants' tally was only one factor affecting Spain's borrowing costs Monday. The Bank of Spain said April bank deposits had fallen by 2.5% from March, and by 5% compared with a year ago. In addition, Spanish banks' percentage of troubled loans, which has been steadily climbing since the start of the crisis, jumped to 8.72% in April, from 8.37% in March, the highest in 18 years.

With its own bond yields soaring, Spain appeared to be fast running out of options.

On Monday, it again made a bid for relief that has fallen on deaf ears: Asking the European Central Bank to step in and help.

"The ECB should respond with strength and credibility to the market pressures that still try to undermine the common euro project," Spain's budget minister, Cristobal Montoro, said Monday in parliament. "Doubts persist over the present and future of the euro and over the Spanish economy."

In recent weeks, Spanish officials have repeatedly called for ECB action to help calm the region's debt crisis, which has been interpreted as a demand that the ECB revive a dormant bond-buying program designed to help lower bond yields.

Still, in Mexico, Spanish Finance Minister Luis de Guindos said, "We're convinced that, with the reforms we've carried out and the ones we'll carry out, and the move toward financial union in Europe, the market situation will correct itself."

For now, the bond yields are dangerously high. The two-year bond was at 5.46% Monday, up from 5.10% Friday. Jumps in the nearer-to-mature bonds suggest investors believe a crisis is becoming imminent.

The country said it would auction short-term Treasury bills Tuesday and two-, three- and five-year bonds Thursday. It will aim to raise just €2 billion in the bond sale. That auction will be another test of investor demand for Spanish debt. If Spain can't sell enough bonds to finance its deficit and repay maturing debt, it will have little choice but to accept a giant bailout to keep the government afloat.

In the secondary market, where the debt is bought and sold, one trader said Monday that buying is virtually at a standstill, with even reliable domestic Spanish buyers pulling back.

A full bailout of Spain may not be realistic given the European authorities' current set of resources, say many investors and economists. There are broad calls for European leaders to craft far bolder approaches quickly—before Spain falls into the abyss.

"Someone suggested locking European leaders in a room," said Nick Firoozye, head of European rates strategy at Nomura in London. "This market pressure is a way to do that."