The question on my mind today is “When will the Spanish banking system collapse?” Spain’s exposure to Portuguese sovereign debt and unrealized losses on real estate loans are two reasons a collapse in inevitable.

The Spanish banking system passed a so-called “stress test” in 2012, but sovereign government bonds are are not included in the evaluation.

We saw how well that worked with Greece (over and over again), and with Cyprus as well. It was Cypriot exposure to Greek bonds that collapsed the Cypriot banking system.

With that backdrop, please consider Will Portugal Bring Down the Spanish Banking Sector?

At its peak in the second quarter of 2008, France’s exposure to Greece totaled $86 billion. That exposure has since plummeted, partly because French banks took advantage of the ECB’s Securities Market Programme (SMP) during 2010-11 to fob off Greek bonds, effectively forcing a eurozone mutualization of the debt. SMP was terminated in September 2012.

What is much less widely known is that Spanish bank exposure to Portugal today, as shown in our Geo-Graphic, is higher than French bank exposure to Greece in early 2010, despite the fact that the Spanish banking sector is only 40% the size of the French. Spanish bank stress tests in 2012 suggested that the capital hole was more manageable than widely feared, but those tests looked only at the domestic lending books; foreign assets were excluded.

A restructuring of Portuguese sovereign debt similar to the one completed by Greece, which involved haircuts of over 50%, could wreak havoc on Spain’s banking system. Yet delaying restructuring, as Greece is showing, may simply drag down Portugal—whose debt-to-GDP ratio is expected to approach 125% next year—faster and further, worsening creditor losses.

Without an SMP to mutualize Spanish bank exposure to Portugal, the way it mutualized French bank exposure to Greece, delaying a Portuguese restructuring will also do nothing to help Spain weather the shock. The euro area has already lent Spain €41.3 billion to recapitalize its banks, but finding a politically palatable way to convert that debt into mutualized eurozone equity may be a necessary cost of sustaining the European single currency.

Stress-Free Tests

Recall that seven banks that now make up Bankia collapsed over bad real estate loans. Exposure to Greek bonds was not even the issue with Bankia, and the banks allegedly passed stress tests. Bankia needed a bailout, then another. And it is going to need another.

Also recall that Greek bonds suffered thru round after round of haircuts which in turn caused a collapse in the Cypriot banking system. Sometime down the line, the same thing is going to hit Spanish banks.

Mike “Mish” Shedlock