High returns keep Spanish banks hooked on sovereign debt
* Listed banks still buying Spanish government debt -sources
* Rescued banks, small lenders stop buying sovereign bonds
* Aid request would loosen ties between state and banks
By Sonya Dowsett and Julien Toyer
MADRID, Sept 19 (Reuters) - Spain's listed banks are continuing to stock up on sovereign debt as they chase high returns while keeping the state afloat, financial sources say - a strategy that could backfire if the country fails to fix its funding problems.
The trend marks a setback for EU policymakers' attempts to cut the negative feedback loop between sovereign and bank sector risks, but it seems likely to pay the lenders handsome rewards if Spain finally seeks external assistance to manage its debt.
Penned at the front line of the euro zone debt crisis, Madrid is under pressure from investors to request financial assistance and trigger a bond-buying programme by the European Central Bank and the region's rescue funds.
The country already sought in June an up-to-100-billion-euro credit line for its weaker banks, crippled by the collapse of a decade-long property boom in 2008.
The likely main recipients of this aid - small savings banks and state-rescued lenders such as Bankia - have stopped buying sovereign paper in recent months and some have cut their holdings, the sources said.
"The intervened banks have not been buying Spanish debt, but the other banks are buying like there is no tomorrow," said one major market maker for Spanish sovereign debt who spoke on condition of anonymity.
A small group comprising Spain's main listed banks and topped by the euro zone's biggest lender, Santander, were buying the debt and helping to keep the state solvent, said a sovereign debt broker who also declined to be named.
The Bank of Spain, wary of any direct recycling of bank bailout funds, said state-controlled banks had stopped buying sovereign debt.
"I want to make it very clear that no bank controlled by the (state-backed bank fund) FROB has been or is buying Spanish debt right now," communications director Victor Marquez said. He declined to comment on other lenders' debt market strategies.
The amount of sovereign debt held by Spanish banks has been rising since the introduction of cheap ECB loans in December.
It hit a euro-era high of 166 billion euros in July from 160 billion euros in June, government data shows - accounting for about a third of all the debt in circulation. Meanwhile, foreign investors cut their holdings to a euro-era low.
Most of Spain's listed banks said their sovereign debt positions held steady from March to June, with BBVA saying it had cut its holdings on the quarter.
Santander said its sovereign debt holdings were 36.5 billion euros at end of June, up from 35 billion euros at end-March.
With Spanish 10-year yields hitting euro-era highs of over 7 percent in July, banks can make a hefty profit while supporting the sovereign by borrowing cash from the ECB at 0.75 percent and then buying Treasury bonds.
Yields have come down since the ECB said it would intervene in debt markets if asked, but still offer a handsome spread.
"If Spain goes south, the banks go south, so they can support the sovereign by buying 2 or 3 billion euros worth of bonds and in the meantime gain 6 percent on holdings," the market maker said.
HEDGE FUNDS COMING BACK
The increasing pile of government paper in banks' portfolios as domestic lenders step in to replace foreign investors is seen as a sign of dysfunction in the market.
"The equity markets don't like banks loading their balance sheets with sovereign debt, and the more risk they accrue the worse the equity is likely to perform," said Pavan Wadhwa, fixed income strategist at J.P. Morgan.
The risk/reward equation is also luring back some international investors, especially hedge funds, which a Spanish Treasury source told Reuters had started to buy Spanish sovereign and corporate debt again after the ECB said it was ready to buy bonds of distressed euro zone countries.
Taking advantage of improved market conditions, Spain easily sold 4.6 billion euros of short-term debt on Tuesday, although investors kept demanding high yields, piling pressure on the government to make an aid request to trigger the ECB plan.
This programme, if implemented for Spain, could finally help break the link between banks and the sovereign as the presence of an unlimited buyer in the market would ease pressure on domestic banks and encourage foreign investors.
Last week, in another show of close-knit ties, Spanish banks said they would contribute the lion's share of a loan to the Treasury to form part of an 18 billion euro rescue fund to help the country's cash-strapped regions. (Editing by Fiona Ortiz, John Stonestreet)