Spain Sees Strong Demand at Auction, But Yields Jump

Spain's medium-term borrowing costs soared to euro-era record levels at an auction on Thursday, hours before an independent audit was due to reveal how big a capital hole in Spanish banks needs to be filled by a euro zone bailout.

Euro zone finance ministers were due to discuss later in the day how to channel up to 100 billion euros ($126 billion) in rescue loans to Spanish lenders weighed down by bad loans from a burst property bubble. But many in the markets see the package as a mere prelude to a full bailout of the Spanish state.

Spain's financial weakness is in focus a week before a uropean Union summit discusses plans for closer fiscal and banking union in an effort to strengthen the euro's foundations, after bailouts for Greece, Ireland and Portugal failed to end a 2-1/2 year old sovereign debt crisis.

Madrid sold 2.2 billion euros in medium-term bonds, with demand stronger than at last month's auction, but yields on 5-year paper rose to a 15-year high of 6.07 percent, a level regarded by analysts as unaffordable for any prolonged period.

The runaway Spanish yields contrasted with a French medium-term debt auction in which the yield on 5-year benchmark paper hit an all-time low of 1.43 percent as investors sought the relative safety of a core euro zone country seen as backed by Germany.

"The first worry is can they (Spain) fund from the markets? So they raised 2.2 billion versus a 2 billion target, so they can raise the money," said Achilleas Georgolopoulos, a strategist at Lloyds in London.

"Then the (question is), are the yields threatening for the medium term? And yes, clearly they are much higher than the previous auction, which was widely expected. But still they can continue for a few months to fund at these levels."

Two independent auditors are due to deliver a report to the Spanish government later on Thursday on the recapitalisation needs of the banking sector following last month's sudden nationalisation of Bankia, the fourth biggest lender.

Economy Minister Luis de Guindos will present the findings to euro zone colleagues meeting in Luxembourg from 1600 GMT. Banking sources believe the report will say the lenders need to raise a further 60-70 billion euros.

However, a formal request for European assistance may only come on Friday when Prime Minister Mariano Rajoy meets German Chancellor Angela Merkel, French President Francois Hollande and Italian Prime Minister Mario Monti in Rome to discuss the future of the 17-nation euro zone.

"NO DEBT MUTUALISATION"

The finance ministers will discuss which of the euro zone's rescue funds - the temporary European Financial Stability Fund or the permanent European Stability Mechanism - will lend Spain the money. This matters to investors because ESM loans would be senior to other Spanish borrowing, meaning private bondholders would face first losses in any debt writedown.

In Berlin, Germany's government and opposition parties reached an agreement on a financial transaction tax and measures to boost growth that will enable parliament to ratify a European fiscal discipline treaty on June 29.

But the parliamentary floor leader of Merkel's conservatives appeared to dash French and southern European hopes of nudging Berlin towards common euro area debt issuance, saying there would be no mutualisation of debt in Europe.

The finance ministers are also expected to discuss the next steps with Greece, following the formation of a coalition of mainstream parties committed to the country's 130 billion euro EU/IMF bailout but determined to renegotiate some of the terms.

Euro zone officials have said the timing and balance of measures to reduce the public deficit to the EU limit of 3 percent of gross domestic product can be discussed, but the basic structural reforms and fiscal targets are not negotiable.

RESCUE FUND TO THE RESCUE?

The ministers may also consider a suggestion by Monti, made on the sidelines of this week's G20 summit, to use the euro zone's rescue funds to buy the bonds of Spain and Italy in the secondary market to bring down their borrowing costs.

Merkel said on Wednesday nothing had been decided on this and played down the idea, which investors said was a long way from being implemented and might be counter-productive unless the European Central Bank stepped in decisively in support.

"That proposal reminds me of two Friday-night drunkards leaning against each other," said Burkhard Varnholt, Chief Investment Officer of Swiss wealth manager Bank Sarasin.

Any cash injection would come with strings attached in the form of fiscal and structural commitments, equivalent to the sort of bailout programmes that Italy and Spain are trying to avoid because of the stigma attached.

Given the limited capacity of the temporary EFSF and planned permanent ESM rescue funds, with at most 500 billion euros available, a senior EU source said such intervention would make sense only if the ESM had a banking licence enabling it to borrow from the ECB. Germany has so far opposed that idea.

Asked about the idea, Luxembourg Finance Minister Luc Frieden told Reuters Insider television: "Right now we have no requests to buy via the EFSF/ESM, Spanish or Italian bonds. We will discuss that when this question arises."

But he added: "We have funds available if necessary to help those countries in need. That's a big advantage also to ensure stability. We will do whatever is necessary to make sure that this zone, which is in trouble, will remain in the medium and long term a stable monetary union."

On Friday, finance ministers of the 27-nation EU will take their first stab at starting to forge a banking union, seen as a crucial step to stand behind troubled lenders and the euro.

While EU paymaster Germany supports giving the ECB more power to supervise cross-border banks, it has so far balked at the idea of a joint deposit guarantee to deter bank runs or a resolution fund to deal with failing banks.