Even the bears aren't bearish enough on Spain's coming sovereign debt problem

(Fortune) -- We often say that investors can be bullish, bearish, or not enough of either. "Our debt is clean, we will not have to ask for help," said Elena Salgado, Spain's finance minister, on April 30th, appealing to the bulls. That is, if there are any bulls left in sovereign debt.

Currently, there is no shortage of bearish sentiment regarding global sovereign debt issues. In recent weeks, Greece, Portugal, and Spain have all had their credit ratings downgraded, with Greece taking on junk status. Yet despite this flurry of negative news, I would submit that investors are still not bearish enough, particularly on Spain.

Historically, Greece is consistently an early and serial sovereign debt defaulter. As a result, it is difficult to consider Greece anything but a leading indicator for sovereign debt issues. While Iceland, Ireland, and Portugal all matter to a degree and will likely have accelerating debt issues, we view Spain as the key mispriced and misunderstood sovereign debt risk globally.

Why Spain is mispriced, and why it really matters

Spain, especially relative to Greece and Portugal, has a sizable economy. According to the most recent estimates from the World Bank, Spain was the 9th largest economy in the world in 2009 with a GDP of $1.4 trillion. From a pure geography perspective, it is the second largest country by land size, after France, in the European Union. It also has a government budget that is more than four times that of Greece, and a commensurate debt balance.

Warning signs for default risk

There are two ways we look at how likely a country is to default on its debt. First, we consider the ratio of budget deficit-to-GDP. Here, Spain is clearly in trouble. As of the end of 2009, Spain's ratio was 11.2% of GDP, and set to accelerate in 2010. Historically, anything beyond 10% is in the danger zone of potential for sovereign debt downgrades, and will lead to an acceleration of borrowing costs. Based on that metric, Spain will need roughly 150 billion euros in debt to fund its budget this fiscal year.

Our second metric, the ratio of debt-to-GDP, does not look as bad for Spain, with the ratio being a lower than the EU average of 54%. Yet while favorable at first glance, the reality is that this ratio has doubled in the last year. This ratio will continue to grow as the Spain's budget becomes ever more funded by debt.

More importantly, Spaniards have a substantial amount of outstanding debt that has to be rolled over this year. Estimates suggest the figure could be as high as 225 billion euros, of which foreigners hold almost 45%. Considering that the total proposed Greek bailout is 146 billion euros over three years, any potential bailout -- and to be clear, we are not there yet -- would be of an exponentially larger scale than Greece.

The rain in Spain is due to the (subdeveloped) plain

As recently as a few years ago, Spain's leadership in growth and stability were a beacon with the European Union. The reality though, was that Spain's economic growth was predicated on the construction and housing industries. Spain was the poster child for the global housing and real estate boom, bubble, and subsequent bust. In fact, home building and construction spending represented 20% of GDP and 12% of employment at the peak. With an economy that has limited exports, the evaporation of the construction sector as a major engine of growth and employment suggests the Spanish government's estimates of 3% GDP growth in 2011 and beyond are overly optimistic.

Countries with less unemployment than Spain? Most of them.

Not surprisingly, as went the global construction market, so accelerated Spain's unemployment. Currently Spain's unemployment is sitting at just north of 20%. Both the Sudan and the West Bank are currently more employed than Spain. There is good news, though: according to Minister Salgado only 290,000 jobs were destroyed in the first quarter of 2010. Good news, of course, is always relative.

Another debt issue as it relates to Spain's fiscal health is private indebtedness, currently at 178% of GDP, according to the recent S&P report that downgraded Spain's long-term sovereign debt. A substantial portion of this debt relates to mortgages and home financing. While defaults have been increasing -- doubling for the last three years in fact -- we believe they are set to accelerate one again due to unemployment and the timing of benefits.

Generous unemployment benefits could be propping up Spanish banking

Spain has a very generous unemployment system that pays the unemployed 65% of the average national earnings for up to two years for those who have worked for the prior six years. The risk, of course, is that as these benefits begin to run out, the ability of the unemployed to pay their mortgages diminishes substantially, which could lead to broad issues for the Spanish banking system.

As noted in the introductory quote, the Spanish leadership does not believe they have to ask for help. In the short term that may be true. In the longer term, they will have to show that they can help themselves. Spain is not Greece, we agree with that. But if the Spaniards do not change their trajectory, they have the potential to be much more than Greece. And that potential is still not priced into the market for their sovereign debt.

--Daryl G. Jones is Managing Director at Hedgeye Risk Management.