Moody's Investor Service carried out a sweeping downgrade of 16 Spanish banks on Thursday, including Banco Santander, the euro zone's largest bank, citing a weak economy and the government's reduced ability to support troubled lenders.
All the banks' long-term debt ratings were downgraded by at least one notch, and some suffered three-notch cuts.
Spain's banks, awash in bad loans after a real estate boom went bust, are at the heart of the euro zone debt crisis because markets fear a state bailout would put a severe strain on the country's already stretched public finances.
Spain relapsed into an economic recession in the first quarter and likely faces a prolonged slump as the government tries to shrink its budget deficit by slashing spending.
"Amidst the ongoing euro area debt crisis, the Spanish government's rising budget deficit and the renewed recession, sovereign creditworthiness has declined," the ratings agency said. "This decline is a driver of today's bank rating actions."
Moody's had cut Spain's sovereign rating by two notches to A3 in February, placing it in the middle of its investment grade rating scale. It maintains a negative outlook on the credit.
Thursday's move came after Moody's downgraded 26 Italian banks on Monday and followed a press report about a run at troubled lender Bankia, Spain's fourth largest bank. The Spanish government, which took over Bankia last week, denied the report.
Santander suffered a three-notch cut to its long-term rating to A3 from Aa3.
Moody's also cut BBVA's long-term rating by three notches to A3 from Aa3 and put the credit on a negative outlook. BBVA is Spain's second largest lender.
BAD LOANS, LIMITED ACCESS TO FUNDING
Moody's said on April 13 it would begin issuing conclusions to various reviews for European banks and global financial securities firms, including big U.S. investment banks. This process was to begin in mid-May and conclude by the end of June.
The agency cited restricted bank access to funding and rapid deterioration of asset quality for all the downgrades.
Spain's banks have 307 billion euros ($391.15 billion) of exposure to a property market that crashed in 2007-2008, of which 184 billion euros is considered problematic, according to government estimates.
Four separate government reforms of the financial sector have failed to persuade investors that the banking system is safe, even though banks have set aside enough funds to absorb losses in up to 45 percent of their total exposure, including performing and non-performing loans and real estate holdings.
Caixabank's long-term rating was cut by three notches to A3. Moody's cited the bank's having reported a 32 percent increase in problem loans at the end of 2011.
The ratings agency cut Bankinter's long-term rating by three notches to Baa2, two notches above junk status. It cited the bank's heavy dependence on wholesale funding and restricted access to market funding.
Rival ratings agency Standard & Poor's took negative ratings action on 16 Spanish banks in April, days after it downgraded Spain's sovereign credit rating by two notches to BBB-plus.
Fitch Ratings has Spain's sovereign credit rating at A, about the mid-point of its investment grade scale.
The government's borrowing costs shot higher on Thursday after data confirmed the economy was back in recession.
Prime Minister Mariano Rajoy said Wednesday his government, which is struggling to reduce the budget deficit, could soon have trouble financing itself in the bond market unless the pressure eases.
The government's strained finances are another risk for banks, since many have used cheap loans from the European Central Bank to buy three-year and five-year government bonds.
Through March, Spanish banks held almost 150 billion euros of Spanish government bonds, up from about 76 billion at the end of November.
AFFECT ON U.S. BANKS
U.S. bank stocks are likely to face pressure because of investor concerns about their exposure to Spain, analysts said.
But because the Spanish bank downgrades were expected and because U.S. banks had ample time to reduce or hedge exposure, the financial impact is likely to be limited.
"The downgrades have been pretty well telegraphed but I don't think that means U.S. bank stocks won't sell off," said Keith Davis, an analyst with Farr, Miller & Washington. "There's a knee jerk reaction; when things go wrong people sell first and ask questions later."
(Reporting by Steven C. Johnson; Additional reporting by Luciana Lopez, Daniel Wilchins and Steven C. Johnson in New York and Sonya Dowsett and Fiona Ortiz in Madrid; Editing by Leslie Adler)