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Originally published Monday, June 25, 2012 at 6:01 AM

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Spain pays sharply higher rates in debt auction

Spain's borrowing costs doubled and even tripled in an auction of 3- and 6-month bills on Tuesday as investors worried that the country would not be able to manage an expensive rescue of its ailing banking sector.

Associated Press

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MADRID —

Spain's borrowing costs doubled and even tripled in an auction of 3- and 6-month bills on Tuesday as investors worried that the country would not be able to manage an expensive rescue of its ailing banking sector.

The Treasury auctioned (EURO)3.1 billion ($3.9 billion) in the two maturities, just above its target range, and demand was strong. But the cost was very high.

The interest rate on 3-month bills was 2.36 percent, compared with 0.85 percent in the last such auction on May 22. The rate on the 6-month bills was 3.24 percent, from 1.7 percent in May.

The auction came a day after Spain formally requested financial aid for its banks from its partners in the eurozone. The move was a formality - it had expressed its intent a week early - and it did not specify how much it would use of the (EURO)100 billion lifeline.

But while the bailout will help the banks, the government is ultimately responsible for repaying the money. That has raised fears that it will be stuck with huge expenses. Investors worried that Spain may have trouble handling its debt have been demanding sharply higher interest rates to lend the country money in bond auctions.

A key problem for Spain is that its banks hold massive amounts of its government bonds. So as those bonds lose value, the banks take losses, fueling a vicious cycle of uncertainty over the banks' and the government's finances.

Moody's rating agency late Monday made a sweeping downgrade of 28 Spanish banks, including international heavyweights Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA. The agency cited the banks' exposure to the government's bonds and said they are vulnerable to further losses from Spain's real-estate bust.

"The problem facing Spanish banks, which is again being reflected in rising Spanish bond yields, is that no-one is clear on how much bailout money Spanish banks will end up needing," said Michael Hewson of CMC Markets wrote in a note to clients before Tuesday's debt auction.

Hewson noted that it also remains unclear what conditions will come attached to the aid for Spain's banks. If, in the event one of the rescued banks fails, the eurozone bailout fund gets the right to be repaid before other creditors, that will scare investors away from the banks.

The Moody's downgrade had been widely expected and stock markets were mostly steady on Tuesday.

But tensions remained high in bond markets. In the secondary bond market, where auctioned debt is traded freely, the yield on Spanish 10-year bonds edged up 0.07 percentage points to 6.65 percent, a painfully expensive rate. The yield last week punched through the 7 percent level, a level seen as unsustainable over the long term.

Moody's long-term rating on Banco Santander, the eurozone's largest bank by market capitalization, remains in investment grade despite a two-notch downgrade. The rating agency cited Santander's diversified holdings that reduce its exposure to the government's finances. Banco Bilbao Vizcaya Argentaria SA's new long-term rating is one notch below Santander's and just one notch above non-investment, or "junk" status.

The debt of several others, however, is now considered junk. Those include Banco Popular Espanol, Bankinter SA and Bankia.

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