On May 5, Greeks raged and global markets convulsed. Feral specu­lators trained bloodshot eyes on Spain as one of the next wounded euro-zone members ready for the kill.

In Spain itself that day, the country's prime minister and the leader of the political opposition conducted a rare face-to-face meeting. They didn't fashion emergency spending cuts to counter negative impressions of bloated budget dyspepsia or make an impassioned plea for European monetary security. Instead, they pushed for quick mergers of Spain's troubled savings and loans so these banks, known as cajas de ahorros, can better handle bad real estate loans that threaten to bury them.

Provincial fiddling while the center burned? Not at all. Bank exposure to a spectacularly overbuilt and now decimated property market is not just a huge concern to Spain; it's the key to its economic woes. The panicked focus on Spain's budget deficit as an outgrowth of Greece's anguish is in many ways a distraction.

"We're very, very far away from the Greek situation," says Antonio Fernández Rodríguez, a Madrid-based partner at law firm Garrigues.

Spain's afflictions aren't new. The real estate bubble burst in late April 2007, and two of the country's biggest property developers went bust a year later. The market, however, hasn't improved since. The banks that financed them are in increasing danger. If anything, Europe's latest bout of economic uncertainty serves to underscore just how much Spain needs to repair its property mess.

"The domestic [real estate] market is so paralyzed," says Orson Alcocer, a partner at DLA Piper Spain SL, speaking from Madrid. "The sovereign debt crisis only brings more problems."

To understand Spain's real estate problems, it's helpful to examine its insolvency regime, its effectiveness and how it is likely to be used in the months ahead. Following reform legislation in 2003, Spain's insolvency regulations changed in 2004, with a few amendments enacted in 2009. They're more practical than before but continue to pose obstacles to effective restructuring.

"No specific measures have yet been developed which truly work when it comes to restructuring companies under distress, before they file for bankruptcy protection," write Angel Martin, head of restructuring at KPMG Europe LLP in Spain, and Mikel Ortega, KPMG Spain's senior manager of restructuring, in a joint e-mail. "Once these proceedings begin, the company's image deteriorates, key management leaves, no refinancing is available, and a high percentage of cases are eventually wound up."

Among other limitations, there are no provisions for prepackaged bankruptcy, debtor-in-possession financing or superpriority new money. Even if there is no fraudulent intent, anything done by the debtor up to two years before filing that somehow jeopardized asset structures can be unwound. Tough employment retention provisions supersede insolvency laws. It's a time-consuming, cumbersome process. The default response is to avoid insolvency at all costs, or at least until finances have deteriorated so badly that there's no other choice.

That helps to explain why perhaps 95% of all insolvencies end in liquidation. Only the largest companies stand a chance of reorganization, but those are the ones creditors are least likely to pressure into insolvency. "With large clients, creditors are not inclined to foreclose; rather, they prefer to keep these clients alive," says Alfonso López-Ibor, a name partner and insolvency specialist at Madrid-based Ventura Garcés y López-Ibor Abogados SLP. "On respirators," he adds.

After the European Union wrapped up its €1 trillion ($1.27 trillion) rescue package in the early hours of May 10, world markets collectively exhaled. Had Europe lost control of the Greek crisis and panic washed through the Continent, all bets would have been off. Even now, some financial critics believe the agreement is far from a permanent fix.

"A country like Spain is helped in the short run," says Jonathan Tepper, who heads the independent economic research firm Variant Perception, based in London and Charlotte, N.C. "They still have to get their fiscal house in order."

Prime Minister José Luis Rodríguez Zapatero announced May 12 that his government would cut civil service pay, public-sector investment and foreign aid to pare the budget gap. The economy during the first quarter of this year increased 0.1%, reversing six straight quarters of negative performance.

That bit of good news is easily lost in other indicators. The country's unemployment rate topped a staggering 20%. That's the worst showing in the EU, although the figure could be somewhat deceiving, since Spain's tough labor laws tend to favor informal, or gray market, jobs.

The euro crisis certainly hasn't helped. Borrowing costs in Spain spiked. Bond spreads widened. "We've moved into a world of uncertainties," says Alcocer, who is quick to add: "This is important. The sky isn't falling. There is no panic."

Spain's economy resembled some mammoth real estate junkie. According to a recent study by two researchers from the London School of Economics, Spain accounted for two-thirds of all housing units built in Europe between 1999 and 2007. By 2007, loans to construction companies and property developers totaled half the country's gross domestic product, say researchers Vicente Cuñat and Luis Garicano.

When Spain's real estate market crashed, it took the economy down with it. That began three years ago. There are still no signs of a clearing out. Property developers, construction companies and construction supplies manufacturers are all either dead or crippled. A few obtained court bankruptcy protection. Many simply closed down and liquidated. In the first quarter of this year, one-third of the 1,373 companies declared bankrupt were related to construction and property development, according to Spain's Instituto Nacional de Estadística, the national statistics institute.

Far more restructured out of court but will face their day of reckoning in the months ahead as reworked loans come due and chances of further restructuring narrow.

According to the Bank of Spain, Spanish banks had lent a total of about €445 billion to the residential property development and construction sector as of the end of last year. Officially, a little less than 10% of underlying assets are labeled doubtful. The Bank of Spain lists 14% of construction and property development-related loans as substandard.

Those ratios, however, far underestimate the actual extent of the trouble. Cuñat and Garicano cite estimates that 50% of the loans made to developers "will be irrecoverable."

Already, Spanish banks have written down tens of billions of euros worth of loans in return for real estate that is worth only a fraction of its original value.

Spain's previous lack of reform urgency in part can be found in the nature of its banking system. Its two biggest national banks, Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, or BBVA, are insulated against domestic real estate concerns by both bank ownership outside Spain and lending abroad. They've done well through the financial crisis. The Bank of Spain earned kudos for an anti-cyclical approach that required commercial banks to beef up balance sheets during boom times. Only one bank, Caja de Ahorros Castilla La Mancha, failed during the crisis, with receivers appointed by the Bank of Spain.

The focus now is on the country's remaining 45 cajas, many of which are barely hanging on. By charter, they're family-owned, unlisted and can't raise capital on the public market. They lent wildly into the property market, now own a huge cache of real estate and owe tens of billions of euros to offshore lenders in Germany and Sweden.

In January, the EU blessed a banking rescue package, enacted in June 2009, that in English translates as the Fund for Orderly Bank Restructuring. Known under its Spanish acronym Frob, the fund authorizes up to €99 billion to support financial institutions, help pay for job losses and assume toxic assets. To gain access to funding, however, savings banks must increase capitalization through consolidation. Stronger cajas are expected to absorb weaker ones and reduce the total number by as much as half.

The first merger was announced May 11, when Unicaja and Caja Provincial de Ahorros de Jaén said they would combine forces.

Most cajas have ties through boards of directors to regional politicians, who show no willingness to step aside. Negotiations on a proposed merger between Unicaja and CajaSur, for example, have dragged on for well over a year. "Cajas are a big, big mess," says the Madrid-based partner for a multinational law firm, who asked not to be identified.

Political patronage holds sway on cajas boards and the government refused to pressure them too much. Only after Zapatero met with opposition leader Mariano Rajoy on May 5 did the two forcefully call for quick mergers, making a point to cut off political horse-trading.

Under Frob, the Bank of Spain has the authority to sack directors and force restructuring. It has so far refrained from such drastic action, although central bank officials have expressed growing frustration at the lack of progress.

The EU demanded that the rescue mechanism expire June 30. But everyone expects the government to extend the program until the end of the year. "The process of consolidation will happen," says López-Ibor. "I don't think it will be finished by June 30, but by the end of this year, the beginning of next year, it will happen. There's now a consensus."

While López-Ibor and others are hopeful that a political united front can break the resistance, some skepticism remains. "We actually have to see it happen," says Tepper. "The government dithered for a long, long time. They have zero credibility."

Even if the consolidation efforts succeed, however, they won't solve the real estate debacle. "All real estate is distressed in Spain," says Alcocer, who specializes in property law.

Some trace the real estate mess directly to the single currency. After Spain became one of the 12 original euro-zone members and the peseta disappeared in 2002, interest rates plummeted from 15% to 3%. Spaniards and expatriates alike jumped on the low-interest-rate regime to score property. A frenzy ensued. Spain's savings banks didn't have nearly enough capital themselves and borrowed elsewhere in Europe, notably from Germany and Scandinavia, to fund the mortgages.

Housing prices skyrocketed. Construction went into hyperdrive from the villas overlooking Costa del Sol to housing projects dotting suburban Madrid. The country became spectacularly overbuilt. In 2006, at the height of the market, Spain constructed more residences than France, Italy and Germany combined. That year, almost half of all EU housing starts took place in Spain, a country whose 64 million inhabitants compose only about 9% of the EU's population.

By mid-2007 the landscape changed radically. Media reports began to describe newly built "ghost town" apartment complexes with no buyers and beach towns with an epidemic of "se vende" signs. According to one estimate at the end of last year, Spain had 1.7 million vacant homes and apartments, with a further 300,000 under construction.

Two of the country's largest developers went bust. In July 2008, Martinsa-Fadesa SA filed for court-supervised administration with €5.2 billion in liabilities. It was Spain's largest-ever bankruptcy. Four months later, smaller rival Habitat filed for administration as well, with debts of €2.3 billion.

Many others avoided administration and restructured out of court. Garrigues' Fernández Rodríguez says his firm advised on €40 billion worth of out-of-court refinancings. Competitors, he believes, were equally busy.

"Some projects that should have been dead have been kept alive," says Javier Torre de Silva, a Madrid-based partner at CMS Albiñana & Suárez de Lezo SLP.

One of the most high-profile restructurings took place in December 2008, when property developer Metrovacesa SA swapped a 55% equity stake with six bank creditors for a €2.1 billion debt write-down. Inmobiliaria Colonial SA was saved from bankruptcy only by a €7 billion debt-for-equity restructuring by a consortium of banks earlier last year.

Beginning in mid-2008, banks regularly reworked property development loans and extended them for two to three years. They also undertook debt-asset swaps, gaining a toxic "combination of nonperforming loans and nonperforming assets," says Antonio Ramirez, Spanish bank analyst at London-based Keefe, Bruyette & Woods Ltd.

Banks, which set up property affiliates to sell their holdings, are now the biggest property peddlers in Spain. In April 2009, domestic banks held €20 billion in real estate assets. That figure mushroomed to €59.7 billion a year later.

The original rationale made some sense: After one or two years, the market would recover, prices would stabilize, and lenders could unload stock, while property developers would begin to move inventory as well.

Unfortunately, none of that happened. "It will take several years before [lenders] can have an exit," says Torre de Silva,

According to official statistics, housing prices have dropped only about 15% off their 2007 peak. In reality, real estate has fallen far more. If forced to sell now, bank-held real estate would fetch anywhere from 20% to 50% below book value, a Bank of Spain official acknowledged in a speech in March.

Banks simply refuse to significantly discount their inventory. They would rather hold these assets at near book value rather than take a hit on their balance sheets. Spain's central bank demands that banks reserve only 10% of a property loan that it has taken over. A further 10% is set aside if the property isn't sold within a year, although Bank of Spain Gov. Miguel Fernández Ordóñez in a February speech suggested he might push to raise that provision to 20%.

Neither are Spanish banks in a rush to lend money to potential homebuyers, who in any event know better than to buy real estate at still-inflated prices.

The result: a moribund real estate market with so few transactions that it's pretty much impossible to establish a realistic pricing mechanism. "We are in the middle of a swamp," says Alcocer.

Many of the development loans that were restructured after the bubble burst come due from now until the end of 2011. Restructuring them again will be almost impossible unless there's a dramatic, sooner-than-expected property rebound.

As Fernández Rodríguez explains, banks originally lent to property companies anywhere from 60% to 80% loan-to-value ratio. After restructuring, that ratio dropped to 25% to 35%. If anything, it's deteriorated since. "There's no more room to refinance," he says.

A spate of insolvencies is expected to follow. Fernández Rodríguez and others believe banks will attempt to work with their largest clients while allowing smaller companies to fold. "Smaller companies simply are dead," says the multinational lawyer.

How effective rehabilitation will be is a matter of debate. "Finding bad companies in Spain is pretty easy, but finding companies to turn around and which can mitigate the downturn is pretty tough," says Jérémie Le Febvre, a former lawyer and head of new business at Paris-based placement agent Triago.

No one has great faith in the country's insolvency regime to handle any onslaught. In addition to serious structural barriers within insolvency, there are judicial limitations that imperil any reorganization efforts. For one, commercial courts handle administrations, and they're already jammed with other cases. "The machinery is overloaded," says López-Ibor.

Then there are cultural barriers. "The stigma here for those in insolvency is incredible," says the multinational lawyer, who specializes in restructuring. He and others describe suppliers cutting off trade and customers going elsewhere when companies file.

Insolvency practitioners point to a few successes. The court has tentatively approved the reorganization of part of Martinsa-Fadesa, which will get six years to repay creditors. Habitat also should reorganize, say lawyers.

But these are exceptions. While there's talk of further modification of insolvency laws, this appears to be on the margins, and no one is suggesting a complete Chapter 11-style reform.

Meanwhile, cajas face their own day of reckoning. According to one estimate, from now until the end of 2012, cajas must repay a total of about €140 billion worth of bonds syndicated outside Spain.

It appears that most everyone is counting on some kind of property market rebirth to eventually lift Spain. When that will happen is another matter. "For the past two years, there's been almost no new investment in new houses," says López-Ibor. "By 2012, demand will probably be higher than supply."

Others think that timetable might be overly optimistic. "Nothing good is going to happen in the next four years," says Torre de Silva. That would mean more trouble.