Monday, June 11, 2012

Unending Subordination of Private Creditors Continues

Surprising virtually nobody, Spain officially requested a bailout this past weekend. Unlike the bailouts of Greece and Portugal, but similar to that of Ireland, these funds will be directly used to bailout Spanish banks. Although the final sum will only be determined after independent reviews of Spanish banks have been completed, the initial sum being reported is a maximum of 100 billion euros. While equity markets continue to rejoice at the sign of any and all bailouts, credit markets are finally waking up to the reality of the situation and sovereign yields are already higher throughout most of Europe.

I continue to be (foolishly?) surprised by the mainstream media optimism, touting each successive bailout as bringing an end to the crisis or one step closer to a full fiscal union. The simple fact that, after three years, Europe is now finalizing details of the sixth bailout should be a clear sign that previous optimism has been badly misplaced.

Looking beyond the initial optimism, there remain numerous aspects of the newest bailout that are troublesome for the sustainability of the EMU. For beginners, Spain is apparently going to receive funding for its banks without having to make any further fiscal commitments. On a positive note, the peripheral countries are finally recognizing the strength of their position and will not be speeding up attempts to reduce deficits. On the other hand, Ireland has already asked to renegotiate the terms of its previous bailout and the trend of weaker conditions to receive funds continues.

Apart from the fundamental currency issue at the heart of the crisis, at this point Europe is also suffering from too much aggregate debt (compared to incomes). Unlike the last Greek deal, this bailout will not reduce the amount of outstanding debt. Instead, the debt of Spanish banks will effectively be shifted to the public sector via loans from the EFSF/ESM. These new loans will become senior claims, once again subordinating the outstanding debt currently held by private creditors. Private creditors are slowly coming around to the fact that a possible endgame in Europe leads to the complete subordination and eventual writedown of privately held debt. While the structure of Spain’s bailout may encourage private creditors to lend to banks, it will likely further discourage creditors from owning sovereign debt.

By accepting funds from the EFSF/ESM, Spain also removes itself from the group of countries contributing funds to back loans from those entities. Although this slightly improves the position of Spanish public debt (outweighed by the new bailout sums), the liabilities of all other countries will increase. This is especially troubling for Italy, which is already paying interest rates on its sovereign debt that are unsustainable. The combination of increasing debt and discouraged private creditors may drive yields on Italian debt higher at increasing pace.

Lastly, the supposedly maximum amount of this bailout (100 billion euros), while three times larger than recent estimates, still almost certainly undershoots the necessary amount by a wide margin (maybe 200 billion?). By only providing half-measures, Europe continues to shoot itself in the foot. The preliminary bailout of Spanish banks buys Europe a bit more time, which I fully expect to be used in an unproductive manner. Since the fundamental problems remain unaddressed, after this moment of optimism subsides, Europe’s problems will once again resurface with a vengeance.

Update - Clarifying a couple errors from above: If funds for Spain's banks come from the EFSF, the new loans would not explicitly be senior to other private claims but Spain would no longer be able to guarantee the previous loans to Greece, Ireland and Portugal. If the funds come from the ESM (which has yet to be ratified by Germany), the new loans would explicitly be senior to other private claims, however Spain could continue to guarantee loans from the EFSF and ESM. It appears the details of Spain's bailout are much murkier than initially reported...

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