Spain's surging bad loans are spurring doubt on whether thegovernment can persuade investors that it can clean up thecountry's banks without further damaging public finances.

Non-performing loans as a proportion of total lending jumped to8.16 percent in February, the highest level since 1994, from lessthan 1 percent in 2007, according to Bank of Spain data publishedtoday. The ratio rose from 7.91 percent in January as 3.8 billioneuros of loans soured in February, a 110 percent increase from thesame month a year ago. That takes the total credit in the economythat the regulator lists as “doubtful” to 143.8 billion euros.

Defaults are rising and credit is shrinking at a record pace as24 percent unemployment corrodes the quality of loans built up inthe country's credit boom and saps the appetite of banks to makenew ones. Doubts about the extent of Spain's non-performing loansproblem is hurting bank stocks and driving up the government'sborrowing costs on investor concern that the expense of propping upailing lenders may add to the debt burden.

“One of our concerns in Spain is to what extent contingentliabilities could pass to the central government,” said AndrewBosomworth, Pacific Investment Management Co.'s Munich-based headof portfolio management. Non-performing loans “will have to risewhen you take into account the unemployment rate and what'shappening with the economy,” he said.

Prime Minister Mariano Rajoy is battling to convince investorsSpain's finances are under control after his refusal last month tomeet deficit targets set by the European Commission. By seeking tocut the budget deficit to 3 percent of gross domestic product from8.5 percent over two years, he risks driving bad loans as thedeepest austerity measures in three decades push the economy backinto a recession.

“A lot of our doubts are based on the grounds thatnon-performing loans should increase,” said Tobias Blattner, aneconomist at Daiwa Capital Markets in London, adding that heexpects house prices still may fall by as much as 20 percent. “Thatcould make a further hole in balance sheets of the banks.”

Bank shares extended declines today after the bad-loan figureswere released. Banco Santander SA, Spain's biggest lender, fell asmuch as 3 percent and CaixaBank SA, the fourth largest, dropped asmuch as 3.3 percent.

Bonds Rise

Spanish bonds rose for a second day as the extra yield thatinvestors demand to hold 10-year debt instead of German bundsnarrowed to 404.5 basis points from 413.7 basis pointsyesterday.

Rajoy's government announced plans in February to force banks totake their share of costs of 50 billion euros ($65.6 billion) forbuilding provisions and capital to make them recognize losses onreal estate piled up on their balance sheets during the country'shousing bust.

The Bank of Spain said late yesterday that lenders will take atotal of 53.8 billion euros to meet the new requirements, including29.1 billion euros in provisions and 15.6 billion euros to createcapital buffers. While most companies would be able to comply“without major difficulty,” the central bank would tighten itsvigilance over lenders that may struggle to meet the requirements,it said.

The plan implies a loss ratio for those assets of about 25percent based on the fact that banks have already made provisionsof 50 billion euros against total real estate risk of 340 billioneuros, said Daragh Quinn, an analyst at Nomura International inMadrid.

Depending on how much the economy contracts and asset pricesfall, further provisions of as much as 40 billion euros may beneeded, said Daiwa's Blattner.

“In light of the bleak profitability outlook for the Spanishbanking sector, we are concerned whether banks will be able to putaside the provisions the government has requested,” he said.

So far the government's efforts to bolster confidence in thebanks has focused on making them recognize losses linked mainly toreal estate. Banco Espanol de Credito SA, a Spanish consumer bankcontrolled by Banco Santander SA, said April 12 that first-quarterprofit fell 88 percent as it made provisions to cover about half ofthe 1 billion euros in real estate charges the company must makethis year to comply with the government's order.

Other Loans

Still, Spain's deteriorating economy means other classes ofloans apart from those linked to real estate are also at risk ofgoing sour, Blattner said.

The Bank of Spain, which says banks are burdened with about 176billion euros of “troubled” real estate assets, lists about 21percent of the 298 billion euros of loans linked to propertydevelopers as non-performing. The bad-loans ratio for industryexcluding construction has jumped to 5.4 percent from 1 percent in2007, according to the Bank of Spain.

“The 50 billion euros of extra capital looks like it's in theballpark,” said Bosomworth, referring to the government's cleanupplan. Still, the “balance of risks” suggests more funds may beneeded given what's happening in the economy, he said.

One option open to Spain should it need to recapitalize banksfurther would be to take funds from the European FinancialStability Facility, the euro-area's temporary bailout fund, saidDaiwa's Blattner.

That would come with a “certain stigma attached” because it maysignal the government has lost market access, he said. Spain canweather its troubles without a bailout and widening bond spreadsare a “warning shot” from investors, Norbert Barthle, theparliamentary budget spokesman for German Chancellor AngelaMerkel's Christian Democratic Party, said by telephoneyesterday.

Spain has managed to stop the cleanup of the banking system fromhurting government finances by making the industry absorb the costby contributing more to the deposit guarantee fund. The fund hashelped to finance the state's sale of failed lenders including Cajade Ahorros del Mediterraneo and Unnim by covering future losses forbuyers.

Bankia Concerns

To be sure, investors have better information on the risksfacing Spanish banks as the industry has shrunk and the Bank ofSpain has made them unveil their real estate exposure, saidNomura's Quinn.

Bankia, a grouping of seven former savings banks with about 300billion euros in assets, has become a focus of analyst concernsabout Spain's banking system.

Deutsche Bank AG analyst Carlos Berastain said in an April 11 hewas downgrading Bankia to sell from hold because of its “very low”profitability and the weak solvency position of its parent company.While Spanish banks face their “toughest year to date” in terms ofprofitability, 2012 also may be the “turning point” toward earningsthat are more normal in 2013 on reduced needs to make impairments,Berastain wrote.

“Everyone, even the Eskimos, knows that bad loans in Spain aregoing up,” said Antonio Ramirez, a banking analyst at Keefe,Bruyette & Woods in London. “The sovereign is affected by theview in the markets that the banks are in difficulties and in acircular loop the banks are affected by the market view that thesovereign is weak.”

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