Market Overview

The Pain in Spain and the Private Sector Subordination Continues in the Latest Sovereign Bailout


As the European Debt Crisis has now taken down its fourth nation, now batting .800 or four out of five, let us discuss the bailout that may not be as stellar as originally thought. As I wrote on Friday, a European TARP could not work, and so the question became of what shape would the Spanish bank bailout take? Well, now we know that it is no different than the deals that Greece, Ireland, and Portugal all got. Yes, it does not have the harsh budgetary restraints that the prior three got, but remember that Spain has been cutting largely the same amounts as Portugal et al, and so there really is no more room to "austeritize."

Unintended Consequences: that is what Ben Bernanke called the inflationary effects of quantitative easing and it is the fear of all policy-makers around the world. The fear with the Spanish bank bailout is that there will be unintended consequences, and I can already present a few. First of all, the bailout is a loan to the Spanish government that bears interest and thus adds to Spanish debt. Spanish debt-to-GDP is set to jump about 9.1% to 77% of GDP of admitted sovereign debt. Remember, this excludes all of the other liabilities that Spain has.

Another unintended consequence (or intentional potentially) is the subordination of private sector creditors. We have seen this all along in the bailouts, the Troika getting preferential treatment to all private sector creditors. The European Commission just released a statement saying that the EU Commission will have preferential treatment to all creditors except the IMF. This follows the Greek restructuring where the Troika (IMF, ECB, and European Council) were all preferred to other creditors. Lastly, watch the market reaction on Italy and how investors feel about the safety of the nation's balance sheet. The fact is that this is a scary outcome.

With Spanish bond yields soaring 20 basis points, this is exactly the sort of unintended consequence that traders should be scared of. The market is telling you that the continued subordination of private investors to the Troika means that they will be less willing to buy sovereign debt. This will continue to send yields higher, making borrowing more difficult, and only making the Spanish sovereign crisis worse.

Spain, welcome to the party. If you thought that 25% unemployment was bad, just wait until you realize how harsh the bailout conditions of your banks will be. Also remember that this is not a done deal. Spain has only formally applied for an EFSF recapitalization plan, but it has not been approved. First, the European Commission, ECB, EBA, etc. need to verify that Spain fits the criteria for a pure recapitalization loan (distress starting in the financial sector and a strict adherence to budget poilicies). Second, if approved, the amount of capital needs to be approved and an appropriate interest rate decided.

There are also questions over the size of the recapitalization. Estimates for a necessary capital buffer for Spanish banks are as high as 150 billion euros, so the reported 100 billion figure may not be enough. Further, JP Morgan estimates that, when said and done, the total bailout of Spain will amount to a whopping 350 billion euro, which will include public sector support a la Greece, Ireland, and Portugal. All in all, this is just step one in a long process. Every time we get some announcement it takes so long to roll out the plan that by the time it does happen it is obsolete, and this should be no different.


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