By Marc Chandler

Spain's finance minister Elena Salgado says the downgrade of Portugal Tuesday does not put pressure on Spain.

This is true as far as it goes, but, of course, Spain's problems transcend Portugal.

The ruling Socialists in Spain are seven seats shy of a majority, and the Socialists have had to depend on smaller political parties for key votes. The economic austerity measures passed by a single vote in late May. The Catalan Party (CiU) has warned the Socialists that it will not support the 2011 budget proposals, which will be voted on in September and could threaten the viability of the government.

A greater sense of Spain's political climate may be seen in coming days as a state-of-the nation debate gets underway, with votes likely next week on various proposals.

Our proprietary models suggest that Spain's macroeconomic situation is more consistent with an A rating than its double-A rating from S&P, or its Aaa rating from Moody's. Spain's 10-year yield is 202 basis points higher than Germany's and has widened 24 basis points over the past month.

Earlier Tuesday, Moody's placed Spain's bank rescue fund on watch for a possible downgrade. The fund, known by its Spanish acronym FROB, is currently rated Aaa by Moody's.

By putting it on watch, Moody's is signaling a likely downgrade in the next three months.

Separately, Fitch has indicated that FROB has sufficient funds (a maximum of 99 billion euros), when coupled with existence of loan-loss reserves and other reserves (estimated at 68 billion euros) to achieve a 6% common equity assets ratio for the overall Spanish banking system.

But there is an important reason why Moody's placing of FROB on credit watch is so significant: FROB must raise any funds in excess of 9 billion euros in the capital markets as a subsovereign issuer.

Recall that FROB was initially established to help facilitate consolidation among Spain's cajas. Yet as Fitch notes, the cajas' ownership structure is not very clear. Of the 45 existing cajas, Fitch says 37 are engaged in a dozen different processes, including seven outright mergers and a number of integrating mechanisms (Institutional Protection Scheme or SIP). Recent reforms in Spain ban politicians from owning cajas, and this was seen as an effort to make it easier for the cajas to raise capital, if/when necessary.

It is widely appreciated that Greece and Portugal are small compared with Spain. The 6% appreciation of the euro over the past several weeks has seen the talk of the imminent demise of the European Monetary Union quiet down considerably. With the EFSF mechanism and the stress tests due out in a little more than a week, fund managers are looking at the periphery of Europe to see if there is value.

Given Spain's size, some observers see European officials as having successfully built a firewall around Spain.

That said, investment in Spain has three risks that have been sketched out here: The political situation is fragile; the sovereign rating is vulnerable to another downgrade; and the placing of FROB on credit watch ahead of next week's stress-test results raises questions about Spanish bank support.

The immediate risk is not that Spain will default or restructure. Rather, the risk in the coming period is that bond yields will rise.
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