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

Tuesday, 10 July 2012

Spain's Memorandum of Misunderstanding

The memorandum of (mis)understanding on the Spanish bank bailout has been released. Thankfully Rajoy won an unconditional bailout with his hostage taking tactics. Because if this is unconditional then Schauble only knows how painful a conditional package would have been.

The gist is as follows:
  1. Spain has lost sovereignty over its financial sector
  2. Banks will be forced to take losses under pain of death
  3. The gullible retail guy is going to take a bath on his subordinated debt holdings (just as he was coming to terms with his Bankia equity loss)
  4. Spanish regulatory regime has been deemed unsatisfactory
Apart from shocking the perennial optimists, this has the potential to worsen the situation in Spain through negative wealth effect. It also has the potential to spread contagion to subordinated bank debt of other countries deemed to be at risk. A short-lived victory for Rajoy and Monti indeed. 
More detail is below. All emphasis in quotes is mine.

Loss of sovereignty

Loss of sovereignty is made clear in the second paragraph itself. The EC and ECB are now the overlords.
For the duration of the EFSF financial assistance, the Spanish authorities will take all the necessary measures to ensure a successful implementation of the programme. They also commit to consult ex-ante with the European Commission, and the European Central Bank (ECB) on the adoption of financial-sector policies that are not included in this MoU but that could have a material impact on the achievement of programme objectives – the technical advice of the International Monetary Fund (IMF) will also be solicited. They will also provide the European Commission, the ECB and the IMF with all information required to monitor progress in programme implementation and to track the financial situation.

The other conditions are fairly standard for an EU/IMF package but notable due to the big fuss made by Rajoy about unconditional aid and the market’s euphoria. The relevant paragraphs are given below.
The European Commission, in liaison with the ECB and EBA, will verify at regular intervals that the policy conditions attached to the financial assistance are fulfilled, through missions and regular reporting by the Spanish authorities, on a quarterly basis. Monitoring of the FROB activities in the context of the programme will take place regularly.
State-aided banks and the Spanish authorities will report to the European
Commission on the implementation of their restructuring plan via the appointed monitoring trustee.”
“The European Commission in liaison with the ECB and EBA will be granted the right to conduct on-site inspections in any beneficiary financial institutions in order to monitor compliance with the conditions

Banks forced to take losses. No free money

The €30bn EFSF first tranche is not available for use. It is dry powder to be used only in case of emergency. Meanwhile banks have been told to line up for a balance sheet strip search (aka asset quality review and stress test) after which they will be told to join one of four groups given in the table below. Overlord approval is necessary before any funds are disbursed.
For banks in Groups 1 and 2, no aid will be provided until a final restructuring or resolution plan has been approved by the European Commission, unless use has to be made of the funds of the first tranche.

0 (Strong as bull)
No capital shortfall identified; no further action required. (Likely to be Santander, BBVA)
Make shareholders happy and management rich.*
1 (De-facto public sector)
Banks already owned by FROB (BFA/Bankia, Catalunya, NCG Banco, Banco de Valencia)
Restructuring/resolution plans approved by EC by November ’12.
Impaired assets moved to AMC by year end.
2 (Soon to be public sector)
Banks with capital shortfalls which are likely to require state aid
Restructuring/resolution plans presented to EC by October ’12. Approval end-December
3 (Hopium set)
Banks with capital shortfalls which will get private recapitalisation funds
For capital raise of more than 2% of RWA, COCOs to be sold to FROB by end-December ’12. These can be redeemed if private funding is arranged by 30-Jun-13. Lack of such funding results in COCOs being converted to ordinary shares.

For capital raise of less than 2% of RWA, private funding needs to be arranged by 30-Jun-12.
*Not stated in the official documentation

There is also a zero tolerance policy for zombies:
The Spanish authorities and the European Commission will assess the viability of the banks on the basis of the results of the Stress Test and the restructuring plans. Banks that are deemed to be non-viable will be resolved in an orderly manner.

Innocents get slaughtered. Again

The Greek myth of uniqueness has been shattered as the dreaded ‘B’ word appears.
Recapitalisations will only take place after the adoption of a restructuring decision by the European Commission, requiring burden sharing and restructuring, unless funds of the first tranche are deployed.”  

Unsurprisingly the household sector has been handed the bill as Northern European creditors seek to protect their aid.

After allocating losses to equity holders, the Spanish authorities will require burden sharing measures from hybrid capital holders and subordinated debt holders in banks receiving public capital, including by implementing both voluntary and, where necessary, mandatory Subordinated Liability Exercises (SLEs).

Bank debt holders are going to take a bath as legislation forces losses onto them. Is SLE pronounced 'silly' and can anyone smell contagion in the air?
Legislation will be introduced by end-August 2012 to ensure the effectiveness of the SLEs. The Spanish authorities will adopt the necessary legislative amendments, to allow for mandatory SLEs if the required burden sharing is not achieved on a voluntary basis…The Banco de EspaƱa will immediately discourage any bank which may need to resort to State aid from conducting SLEs at a premium of more than 10% of par above market prices until December 2012.

And to add insult to injury, the MoU recommends that the stable door be closed after the horse has bolted.
Consumer protectionshould be strengthened, in order to limit the sale by banks of subordinate debt instruments to non-qualified retail clients and to substantially improve the process for the sale of any instruments not covered by the deposit guarantee fund to retail clients. This should include increased transparency on the characteristics of these instruments and the consequent risks in order to guarantee full awareness of the retail clients. The Spanish authorities will propose specific legislation in this respect by end-February 2013.

If as the FT reports, there is €67bn of subordinated and hybrid debt outstanding mostly with retail investors then this is going to negatively impact consumer spending, mortgage and loan servicing. The negative wealth effect may be quite large. Combined with high unemployment (24.6%) and nonsensical austerity, the effect may be catastrophic.

In case the Spanish try to be cute and find loopholes:
Any capital shortfall stemming from issues arising in the implementation of SLEs will not be covered by the EFSF assistance.

Slap on the wrist for the Spanish regulatory regime

The reputation of the much vaunted Spanish counter-cyclical buffer is in shreds. The lack of confidence oozes out.
 “The current framework for loan-loss provisioning will be re-assessed…the Spanish authorities will make proposals to revamp the permanent framework for loan loss provisioning…Furthermore, the authorities will explore the possibility to revise the calibration of dynamic provisions...To this end, the authorities will submit by mid-December 2012, a policy document for consultation to the European Commission, ECB, EBA and IMF on the amendment of the provisioning framework

Furthermore, Europe will have no more of sinecures (in Spain only; other nations are free until they request aid).
The governance structure of former savings banks and of commercial banks controlled by them will be strengthened. The Spanish authorities will prepare by end-November 2012 legislation clarifying the role of savings banks in their capacity as shareholders of credit institutions with a view to eventually reducing their stakes to noncontrolling levels.

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