Monday, June 25, 2012

Subordination in Spain will cause pain

Citing Sony Kapoor's post on the myth of seniority in the Spanish bank bailout, Felix Salmon concludes that
Basically, channelling new money to a liquidity-constrained debtor is always good for existing creditors, even if the new money is senior. That’s obviously the case if the new money prevents insolvency, but it’s also the case if it doesn’t:
Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.
Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.
Reading this section I was struck by the presumption of a positive “NPV of expected future primary surpluses.” What if the NPV is negative (ie. the entity is insolvent)?

Felix continues with the following quote from Kapoor:
There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain.
So the question of current insolvency remains unanswered but Felix points out that the real problem is implied austerity from the bailout, not the seniority of public sector funds.

While I agree with Felix and Sony that austerity (a reduction in deficits) is negative for short-term economic growth and therefore repayment, I still have reservations about how decisively positive public bailouts are being described. After clicking through to Sony’s blog, I found the answer to my question:
The only circumstances under which a public bailout will make private investors worse off is if the public bailout money is ‘wasted’ or spent on items that are NPV negative.
This sentence, which appears in between the sections selected by Felix, was clearly omitted on purpose. Both Sony and Felix appear to be downplaying the possibility that bailout money could be “wasted”, however reality appears to suggest otherwise.

Under the terms of the proposed Spanish bank bailout, the funds will be provided either directly or through a sovereign fund to Spanish banks that are probably (certainly?) insolvent at the moment. It is not a stretch to infer that these banks have been engaging in negative NPV activities, which led to their insolvency. Now the hope is that after receiving bailout funds, these banks will cease those actions and begin making smarter, profitable decisions. But why should we expect the banks to perform any better going forward? Having been bailed out once (and gaining implicit future protection), why not increase the level of risk taking and/or double-down on previous actions?
By bailing out the banks, there is a non-trivial probability that public funds will be “wasted”. In that case, private creditors currently facing potential haircuts will have their holdings subordinated as the assets from which they will be repaid are allowed to dwindle further. Subordination therefore will negatively impact current creditors, along with the technocratic stipulations tied to future bailouts.

Related posts:
Unending Subordination of Private Creditors Continues

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