Stocks in Europe are enjoying a reprieve from the gloom of May in large part due to a successful bond auction in Spain. This is probably the first time I have ever mentioned a Spanish bond auction as news in my 20 years of writing investment advisories,  but there has been a lot of fear that when the government came to market with a $4.3 billion debt sale the market would give it the one-fingered salute. Instead, the maximum amount set was sold at reasonable prices to parties looking for some good yield at a price that apparently compensated for the risk involved.

Some more good news came when the Bank of Spain said it would publish the results of stress tests it has performed on its lenders. An European Central Bank exec said the same would be done for other major banks on the Continent, which was great to hear. You may recall that the announcement of stress tests was a major contributing factor to the turnaround of the bear market in the United States in spring of 2010.

Now since we are in sort of a flamenco mood, I thought you would want to hear some more positive thoughts on Spain. This one comes from analysts at Stratfor, which is an unlikely source since it is usually so cynical in its brilliance.

The reason we care: Rumors erupted Wednesday that Madrid is negotiating a credit line of up to 250 billion euros ($335 billion) with the International Monetary Fund and the European Union to stave off debt default. Spanish newspaper El Pais reported Tuesday that many Spanish banks have been unable to borrow from other European banks and so have been forced to go hat-in-hand to the keeper of the euro, the European Central Bank.

Analysts at Stratfor agree that there are reasons to be concerned, but insist that Spain is a different animal from Greece. Here’s their view, with the minuses first — and then the pluses.

Minus – Real estate. Spanish banks are directly linked to the construction and real estate sector, which collapsed when the Spanish housing bubble popped. These sectors have outstanding debt equal to 45% of the country’s GDP (imagine if the U.S. subprime crisis had been worth more than $6 trillion rather than “merely” a few hundred billion or so). Add a global recession and a 20% unemployment rate and you can see why people are worried about these banks’ mortgage exposure.

Minus – Problematic Architecture: Local savings institutions own more than half of all Spanish mortgages. These “cajas” are semi-public institutions with a mandate to reinvest half of their annual profits in local social projects. Political elites use these funds to return favors, making this system great for public officials but bad for creating stable banks. Reform of the system is unlikely as it would deprive local officials of a valuable bonus for their public service.

All things considered, then, it is not surprising that Spanish banks are being denied interbank loans by many of their European peers and thus must hit up the ECB instead. But here’s why Spain is no Greece.

Plus – Cajas are tiny. A closer examination of Spanish banks suggests more stability than bears suspect. The cajas are a small part of the banking system. Even if half of all their outstanding loans went bad, it would only account for around 100 billion euros ($135 billion), which is around 10% of Spain’s GDP. With Spain’s public debt only at 52 % of GDP at the end of 2009 — compared to more than 120 percent GDP for Greece — Madrid would have considerable room to maneuver.

Plus –Big banks are OK. Spain’s two largest banks, BBVA (BBVA) and Santander (SAN), comprise 60% of the country’s banking sector and are insulated from the housing crisis. They are still highly profitable and well diversified, with a large portion of loans in Latin American and the United States. Even if every caja failed, BBVA and Santander would be able to pick up loans for pennies on the dollar and become even stronger. In contrast, Greece’s banks are not only in trouble for domestic reasons, but they also face painful exposure to the popped-bubble economies of Central Europe. Athens also suffers under a state debt load that almost makes Japan look fiscally responsible.

Fast action. Unlike Greece, which only started cutting its budget after months of temper tantrums, Spain has been pro-active about slashing public payroll and spending. It is too early to declare success, but the difference in mood and action between Madrid and Athens is palpable. The announcement that stress tests would be made public is an example of this.

I asked credit analyst Satyajit Das for his view on this approach, and here’s what he said via email from Sydney, Australia today: “This is pretty accurate. I think there are deep seated problems but the Spanish economy is more substantial than Greece so it has  greater chance of pulling through. Two things to watch for: 1) Do the government and the unions (which are very powerful) have the will to bring the public finances under control? And (2) does a liquidity crisis for the banks and the government overwhelm the ability of the ECB and EU to give them the time to make the required adjustment? Also Stratfor believe the risk of a military coup in Greece is high. It’s worth remembering that Spanish democracy is not long standing and a reversion to dictatorship is not impossible.”

Final thought: Despite some improvements here and there, a pall of anxiety hangs over European capital markets. They are far from out of the woods. Fundamentals can be meaningless if the market loses confidence in the government or its banking sector, in which case prophecies about poor asset quality and further write-downs can become self-fulfilling. I continue to be very skeptical of Europe overall and Spain in particular, and would at minimum avoid the region and look to re-short via the ProShares Short EAFE (EFZ) or UltraShort Europe(EPV) when appropriate.

Euro Investments – The Pain in Spain

For more color on Spain, let’s turn now to Larry Jeddeloh, chief investment officer at TIS Group in Minneapolis. He travels a large part of the year to visit clients and kick tires on investments around the world, and then tells customers what he’s seen in a series of lively notes. Here are three comments from his latest journey in Switzerland and Spain.  (The underlining is mine, to call your attention to the highlights.)

• ”The search for tax revenue by U.S. authorities is reaching new dimensions.  I was told there was a recent conference in Switzerland offered by tax advisors who specialize in U.S. tax law in which new or perhaps improved tax rules that are being applied were explained.  Among the highlights was the story of a Belgian who lived in Switzerland who died while holding U.S. stocks.  Incredibly, the American government is applying the U.S. inheritance tax to anyone holding U.S. stocks when they die and they are searching for the holders through custodian banks.  They tried to tax a Belgian, living in Switzerland, holding a U.S. stock.

• ”Can you imagine the effect this will have on foreigners holding US securities?  Just at the time America should be attracting capital inflows, they appear to be placing an impediment in front of foreigners to buy some classes of dollar assets.  I was told several Swiss banks are selling their US stocks as a result of this rule and will not buy them again until the rule changes”
• ”Most advisors I spoke seem relatively calm about equities.  The view across Europe on Greece is that Athens will have to default on their debt via a restructuring.  I did not run into one person who thinks Greece will pay off their debt.  The best thing Greece can do is after the French/Germans get Greek bonds which they own off their balance sheets and into the ECB or wherever else the catcher’s mitt is, that Greece leaves the Euro system and then devalues their new currency.  That may become one of the great trades of all time, shorting currencies of counties as they leave the Euro system, because that is how the economies in those countries can survive.”
• ”Last week I flew into the southern Spanish town of Malaga, about 90 miles north of Gibraltar.  I then drove south to Sotogrande, a sort of Spanish Beverly Hills, beautifully sited along the Mediterranean Sea just 12 miles from the Rock of Gibraltar.  The skies were clear and so from the Sotogrande port, I could see the Rock of Gibraltar and North Africa across the Straits of Gibraltar.  As amazing as those sights were, it was the unsold real estate which got my attention.  Over the course of that drive of about 75 miles, it seemed like every hilltop had a condo/townhouse project perched above the sea and they looked empty.”

• “I have never seen so many empty properties in my life, stretched across miles of gorgeous landscape .  In talking to local real estate agents, it seemed pretty clear, buyers could just about name their price.  A developer told me that the banks who used to lend 80% of the value of a project, could no longer lend against the land and only borrow 50% of the value of the buildings after 50% of the project is completed and sold by the developer. Doesn’t sound like a prescription for growth does it?  What it does sound like is a bunch of Spanish banks with a pile of bad loans on their books.”

The upshot from TIS Group is to be skeptical of the iShares Spain ETF (EWP) and hopeful for the iShares Switzerland  ETF (EWL), which you can try as a pair trade in their exchange-traded funds.

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