Tough Save
Spain's Martinez catches the ball during a training session at Gniewino

Mariano Rajoy faces a Hobson's Choice of bad options as the Spanish Prime Minister attempts to prevent his county's banking sector from careening into total collapse, providing perhaps the sternest test yet of the European Union's financial resolve.

Reuters has reported extensively today that Spain will surprise no one with a formal request to the EU this weekend for a bank rescue package that could be anywhere between €50bn and €150bn.

Few outside of Spain have accepted the government's pledge to solve the banking crisis "in house" but fewer still are able to agree on what Spain needs to do in order to shore-up its banks with enough capital to protect against mounting real estate losses while still leaving enough breathing room for it to fund its expanding budget deficit and those of its semi-autonomous regions.

Encapsulating the problem is easy, prescribing a cure a bit less so.

Spain seems now forced to choose between stigma and subordination: suffering the humiliation of financial rescue - and the conditions it will demand - or alienating bond holders who will likely find their debt pushed further down the repayment queue.

The latter might seem like the more desirable option - after all, we've been conditioned to think bankers and lenders are cloven-hooved devils - but it's fraught with risk.

But let's walk through the former first.

If Spain chooses to accept EU funds, it will most likely arrange a massive low-interest loan because the European Stability Mechanism, the Euro area's permanent bailout fund, has no legal capacity to directly recapitalize banks.

Of course, this is largely impossible at the moment, given that the ESM's existence (as opposed to the temporary European Financial Stability Fund) has yet to be agreed by its contributing members (including Germany).

But assuming that is will, we can estimate Spain's capital needs of somewhere in the region of €100bn and comfortably within the range of the ESM's €500bn lending capacity.

That could, under some scenarios, prop up Spain's banks for a two to three year period and allow the government to focus on austerity measures and growth delivery.

However, conditions tied to that loan will very likely include limits on government expenditures and demands for large-scale structural reforms of its banks.

Slowing economy

Collectively, both will very likely limit credit growth, slow the public sector's contribution to GDP and thus amplify the pressures on not only the existing €145bn of non-performing loans (8.3 percent of total portfolios, according to Bank of Spain) but also accelerate the deterioration of loans that are currently clinging on for dear life.

Improvement is unlikely: the economy is mired in recession, capital is fleeing, unemployment is officially pegged at 25 percent and consumer sentiment is bleak.

Spain could choose to wait for the results of the audit it announced three weeks ago, but preliminary figures won't be in until at least 21 June and a more detailed analysis isn't available until the end of July.

Go it alone?

In the meantime, there's the small matter of the 17 June election which could, plausibly, set the stage for a Greek exit from the single currency and ignite the kind of market turmoil that could take Spain's borrowing costs well over the 7 percent precipice that has trigged bailouts for Greece and Portugal.

In effect, it seems Spain's borrowing costs are going to rise regardless of its choice: and ESM loan will subordinate existing holders and waiting to "go it alone" is far too risky given the peripheral risks.

The "go-it-alone" option, as well, is largely predicated on Spain's ability to stuff it banks with government bonds that can be "flipped" to the ECB in exchange for liquidity.

Of course, the value of those bonds is under threat now that Fitch has followed Standard & Poor's and downgraded the debt to cusp of junk status (both ratings are now in the triple B range).

The ECB, at present, takes the highest of three ratings when accepting government bonds as collateral. If Moody's Investors Service cuts its current A3 rating into the triple-B rank, Spanish government bonds will be subject to a 5 percent "haircut" in value when used as borrowing collateral. Once the cut comes (and it does seem a matter of "when", not "if") Spain's cash-strapped banks will need to meet margin calls that could trigger even more discussion as to their solvency.

And we start the whole conversation over again.

What began as a potential banking crisis has quickly evolved into a real one, as evidenced by the tripling of the required cash to steady Bankia's teetering balance sheet in just a few short weeks.

What seems increasingly clear is that both of Spain's options now seem very unlikely to prevent what's sure to be the next phase in the drama: an EU/IMF bailout which could reach as much as €400bn.

It's going to be long, hot summer.