Spain and Italy to Get Debt Relief, Direct Bank Recapitalizations

Early Friday, a memorandum released by the Eurogroup at the conclusion of night-long meetings revealed that the European leaders may be one step closer to a grand solution for solving the European debt crisis. European leaders have agreed to give debt relief to Spain and Italy by allowing direct bank recapitalizations through joint bailout programs.

Leaders agreed that "it is imperative to break the vicious circle between banks and sovereigns," which has potentially been a key shortfall in previous crisis relief efforts. For example, as Bloomberg's Tom Keene pointed out Friday morning, Spanish banks have been the only sizable purchasers of Spanish debt. Thus, as the banks weaken due to bad credit conditions, the sovereign is responsible for bailing out the banking sector. This puts pressure on sovereign debt, causing a sell-off in bonds with climbing yields. The banks have to take losses on this and thus need even more bailouts.

To break this cycle, European leaders have agreed to allow the existing European Financial Stability Fund and the future European Stability Mechanism, the joint bailout funds, to directly recapitalize banks. First, a European banking regulator will need to be created. Leaders have agreed to house this regulator within the European Central Bank. On June 15, Benzinga speculated, "The best solution would be to give the ECB [the powers to regulate and backstop banks] until the nations can ratify the plan. If this happens, the ECB would be free to recapitalize the banks, and since it can print money, it would not stretch fiscal finances any further. In this scenario, the ECB would have to step up and verbally declare a back-stop of all euro-denominated deposits. This would limit capital flight, insure deposits, and give the banks the capital they need cheaply."

This speculation has largely come true. However, the recapitalization money is to come from bailout programs instead of the ECB's balance sheet power. Further, the new bailout procedures would exempt the sovereign governments from having to take liability for the bailouts, effectively creating joint liability across the Eurozone. This is a large step in the direction of a full European Union, as joint liabilities are the first step towards a full fiscal union (including Eurobonds).

The Eurogroup memorandum also detailed an agreement that the bailout programs will not be senior to existing bondholders. This agreement may have largely been responsible for overnight gains in peripheral nation's sovereign bonds. During the Greek Private Sector Involvement (PSI), the debt swap, the ECB and other programs that had bought Greek bonds were made senior to other bondholders, getting paid in full while private bondholders got principle reductions. By retracting the seniority of the funds, the bonds of peripheral nations can be bought without scaring private sector bondholders out of the market. The lack of a risk of subordination has thus led to an enormous rally in peripheral bonds, with Spanish 2-year yields rallying over 80 basis points.

Lastly, what has shocked markets is the expediency to which these processes are set to take place. Leaders hope to establish the banking authority within the ECB by the end of the year and look to implement the other proposals by July 9, less than two weeks from the announcement. This is a change for the leaders, who have been reluctant to act with speed in crisis fighting. For instance, the European Stability Mechanism was meant to be the grand solution but has taken over a year to approve and still has yet to be approved by all member nations. Only four of the seventeen nations have ratified the treaty change that accompanies this program. Thus, the newly found expediency is to be applauded.

Friday's news may have removed uncertainty from the market. The risk of an imminent Spanish default or Italian banking crisis has potentially been relieved, at least for the short term. Markets were seen rallying on the news, with U.S. equity futures climbing ahead of the open. S&P futures rose almost 2 percent and NASDAQ futures rose in tandem. Financials, as measured by the Financial Select Sector SPDR ETF XLF, rose more than 2 percent.