Update: Draghi Says ESM Will Not Be Functional Until 2013

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At a speech in front of the European Parliament in Brussels, European Central Bank (ECB) President Mario Draghi stated that the European Stability Mechanism (ESM), the permanent bailout tasked with recapitalizing Spain's embattled banking sector, will not be able to pay out any bailout funds by the end of the year. The delay in the bailout payments is further pain for Spain, as Spanish bond yield have been rising on fears of the bailout not coming into effect fast enough.

The further delay in the bailout payment means that Spanish banks will continue to be exposed to European debt markets, as Spanish banks owned about 30 percent of Spanish bonds at the end of May. As yields rise, prices fall, and banks will be forced to write down any losses sustained through these holdings. The interconnectedness of Spanish sovereign and bank finances will continue until the banks can receive ESM bailout funds.

Spanish banks and the government have seen their financial positions continually converge and become more mutually dependent recently. The LTRO's, the cheap liquidity operations of the ECB which eased credit conditions globally in the first quarter, saw banks deposit cheap capital into sovereign bonds to earn the carried interest. However, now that banks are more exposed to sovereign finances via these debt markets, strains at the macro level hurt the banks, forcing the government to bail them out. A bailout from the Spanish government, not the ESM, would be added debt on the balance sheet of the Spanish government, which could hurt bond prices, send yields higher, and cause the banks to take more losses. This cycle is what leaders were trying to break by having the bailout go directly from the ESM to the banks.

Surprisingly, the EUR/USD has not moved on the news, however it is already near two-year lows at 1.2287.

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Posted In: NewsBondsForexGlobalEcon #sEconomicsHotIntraday UpdateMarkets
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