Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Sunday, 10 June 2012

Spanish Bailout: No Rejoicing

Investors were provided the usual large helping of Eurofudge to drink along with Kool-EuroAid this weekend. Eurozone leaders promised a bailout of great size with no one to know where the funds would come from. Ostensibly there are so many sources of funds that the actual source of funds is immaterial. Before swallowing this Eurofudge and washing it down with Kool-EuroAid, one must see how it all stacks up.

First glass of Kool-EuroAid: No added conditionality is German surrender and sets precedent for covert unconditional bailout of everyone
Reality: The Germans have not caved in; they are sticking to the plan.

The big deal that Mr Rajoy is making about no additional conditionality for the €100bn is slightly disingenuous. In the 21 July 2011 meeting (which, if one remembers correctly, had “solved” the crisis) EFSF was given the mandate to lend for bank recapitalisations. And aid for the banking system was considered to be different from general macro-economic aid programme. According to the EFSF “The request for and control of this instrument [bank recapitalisations] needs to be ‘lighter’ than in the case of a regular macro-economic adjustment programme in order to increase the speed of funding as well as to reflect the sectorial nature of the loan.

Therefore even though the details have not been divulged, it is likely that EFSF gets tapped.

Second glass of Kool-EuroAid: Quick bailout agreement is positive for Spanish assets
Reality: The prospect for Spanish assets hasn’t improved; in fact sovereign debt is riskier

If the EFSF funds the €100bn then according to the conditionality attached to bank recapitalisations, shareholders have to bear the first brunt. EFSF guidelines state “The following pecking-order in the financing of the recapitalisation should be respected. First, before considering a public intervention, the primacy of private sector contributions should be reasserted. Recapitalisation of a financial institution should be first and foremost financed by its shareholders, as the owners and those ultimately responsible for past business decisions.” Buying Spanish bank stock last week isn’t looking so hot now is it?

ESM funding the total or a part of €100bn requires ratification of the fiscal compact by Spain. This will doom Spain into an austerity-led deflationary depression much like Greece. Another reason why conditionality was not imposed; no further conditionality is required. The prospect of deflationary collapse means that Spanish assets are in no way cheap.

Sovereign debt has also become riskier. ESM’s status as a senior creditor subordinates existing debtholders. In addition, ESM can call for the private sector to share the burden before aid disbursal (aka PSI).

Moreover, €100bn is approximately 10% of Spanish GDP. The debt-government revenue ratio[1] will be next only to Italy and Portugal in the Eurozone. And this is excluding its off-balance sheet obligations (such as guarantees to EFSF). The rapid rise in indebtedness is on the lines of what was seen in Ireland as it decided on a policy to save the banks and crucify its citizens.

Third, a helping of Euro-fudge: €100bn is more than IMF estimated and well within Eurozone’s means
Reality: IMF always underestimates the quantum of rescue required and this bailout further depletes “firewall” funds

Spain contributes 12.75% of EFSF and 11.904% of ESM. If it is no longer able to fund itself in the market to rescue its banks, it is for all intent and purposes unable to contribute to either bailout fund. This is similar to Ireland, Greece and Portugal not contributing to EFSF. Based on this, the recalculated capacities are:
  • Spain’s EFSF contribution = €92.544bn (out of €726bn)
    • €192bn committed for Portugal, Ireland, Greece.
    • If Spain is taken out total drops to €633.456bn.
    • This implies €383.9bn of actual total lending capacity.
    • Therefore, remaining lending capacity drops to €191.8bn.
    • If one makes the heroic assumption that, if called upon, Spain can pay its commitments to the EFSF, the reduction in remaining capacity is smaller. It reduces to €216.38bn.
    • If Spain obtains funds from EFSF then remaining EFSF capacity is €91.8bn (€116.38bn if one is optimistic)
  • Spain’s ESM contribution is 11.904% of capital
    • If Spain cannot contribute to capital then ESM firepower of €500bn reduces to €440.48bn.
    • Since total EFSF and ESM lending capacity was capped at €500bn once ESM comes into being, Spain’s exclusion reduces the total lending capacity to €440.48bn unless other European partners are feeling rich, generous and full of solidarity.
Given IMF and EU’s optimism about funds required as demonstrated throughout this crisis (and IMF's optimism in other crises), €100bn is likely to be only bailout part uno. Moreover, the depleted firewall cannot protect Rome from the barbarians.

Fourth, final helping of Euro-fudge: “Victory” for Spain and demonstration of will to resolve crisis
Reality: Nothing concrete has been agreed as usual

The agreement for bailout has been made in principle and nothing more. The Eurogroup statement makes it quite clear: “The Eurogroup has been informed that the Spanish authorities will present a formal request shortly and is willing to respond favourably to such a request.” The final terms are yet to be determined and may differ from what Mr. Rajoy wants people to believe. Given the rapidity at which the crisis is spreading, the final package and the terms are anyone’s guess.

Meanwhile Moody’s has already warned: “We would also consider an increased reliance on indirect support, such as external lending targeted at banks in order to relieve a distressed sovereign of the burden of support for its banking system, to be strongly indicative of increasing financial strain. Depending on the extent of intervention and the degree of financial strain it was intended to alleviate, we might consider such action to be tantamount to direct dependence on external support, also warranting downward rating action.” Moody’s is the only rating agency keeping Spain above the higher ECB haircut threshold of BBB+. A downgrade would lead to increased haircuts demanded by ECB on Spanish debt increasing the burden of those LTRO carry trades.

Even if the terms are finalised and funds disbursed quickly, it will only have reduced the near-term probability of default. As pointed out above, the bailout has increased loss given default for existing sovereign bondholders and may even have increased longer-term probability of default. As a result any bond/CDS/Euro rally should be faded.

[1] This is more relevant than debt-GDP (see what I wrote earlier)

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