The weekly is on Spain again. Ever since Willem Buiter mentioned the probability of a Spanish bailout some time in 2012, speculation has been rife about a Spanish bailout. In this column I argue that Spain is still too big to bail and that any bailout for Spain must therefore be of Spanish banks and not the Spanish sovereign.
I am going to make this a quick hit this week. Let me start out by pointing out that I certainly think Spain is a problem. See Spain is in big trouble and There will be more defaults in the eurozone for background. As I have said repeatedly, the problem for Spain is the cajas, the savings banks in Spain. They are undercapitalised and dependent on ECB liquidity for funding. From a sovereign perspective, Spain looks better on debts than France and Germany as well as all of the rest of the periphery. Even with unrecognized debts, Spain’s sovereign has a better debt position than any of the rest of the periphery. So clearly the issues are the deficit and the banks.
The deficits are an outgrowth of the pro-cyclical nature of European economic policy that imposes austerity to meet a deficit target even during a deep downturn. Given the balance sheet recession in Spain, this cannot get better without significant private sector defaults and writedowns of debts at Spanish banks. And that necessarily puts Spanish banks into view.
The Spanish have taken the Japanese approach of merging a troubled institution with a relatively stronger in order to bolster the profile of the combined institution. Merging banks doesn’t help because impaired assets are still impaired and the merger risks bringing down the stronger institution with the smaller, making the problem bigger in the event of a single institution’s failure. To make matters worse, the ECB’s LTRO caused Spanish banks to jump into sovereign bonds with vigour. And now that Spanish yields have shot up the LTRO is actually pushing Spanish banking system closer to collapse. The hole in Spanish bank balance sheets is even greater.
Judging by Ireland, Spanish banks have to take a lot more credit writedowns because we should expect property prices to fall much more. They have not fallen in Spain nearly as much as they have in Ireland and they are still falling in Ireland as well. Spanish banks have 300 billion euros of loans to property developers on their books alone. And the default rate there runs at 20%. Even for private clients, default rates in Spain are at record highs as the depression there sucks money out of the economy via high unemployment.
Without the problems of the Spanish banks, Spain’s sovereign debts are definitely solvable. The cajas simply need to be resolved. The question is how to do that. I would suggest that this will not be solved via private sector capital infusions and so will therefore fall on government as it has done in Ireland. The question then for taxpayers is how this gets solved politically. The best way to nationalise is to liquidate the capital structure in order from equity to junior to senior debt, with the senior probably not being wiped out in order to apportion losses appropriately before you allow nationalisation.
Now, in Sweden, the senior was made whole. While in Ireland, there too you got bank debt guarantees, even junior bank debt guarantees. What you want to see is more what happened in Iceland where the government allows the institutions to fail and does not take on its balance sheet liabilities in full. You can reasonably expect the government to not wipe out senior debt but still wipe out junior debt and equity before taking an equity stake. Here, the state is not becoming the lender of last resort. It is becoming the owner. If it is done correctly, after having resolved these banks, the state can resell to the private sector as was done in Sweden.
I think what everyone – including the ratings agencies – is concerned about is the state taking on bank balance sheets and then being liable for their debt in the way that the US is for Fannie and Freddie. That’s expensive and would end up like Ireland with sovereign bailout and an IMF program or default.
If you recall, the real deficit target for 2012 was a 4.4% deficit but Spain unilaterally increased this to 5.8% and were worked back to 5.3% in negotiation. While there had been talk about sanctions for this move, it is now clear there will be none for Spain. What makes for this treatment because clearly Spain has flouted the rules brazenly and they have effectively been rewarded for doing so (just as the Netherlands has been). To me this speaks to Spain’s status as a too big to fail country. The EU is deathly afraid of either Spain or Italy getting into trouble because the existing bailout facilities simply are too small to deal with an economy of Spain’s size. The EU will do almost anything reasonable these countries ask as a result. Spain had to know this and that’s why they felt comfortable disregarding EU policy entirely.
What I suggest then is that the bailout we see for Spain will be a bank recapitalisation plan. Why? Even the Spanish giants like BBVA and Santander which are said to be the best capitalised and have largely escaped crisis are now feeling the pain. Santander’s profit has collapsed by 24%. So, I am hearing that Brussels is quietly preparing for a bank recapitalisation bailout. The variant being most discussed is making the ESM/EFSF bailout funds directly accessible for Spanish banks. Up to this point only countries could use these facilities. The implication then is that the risk for Spanish banks becomes transferred from the Spanish sovereign to the EU as a whole, making the sovereign’s debt path sustainable. I believe this will happen and I will keep you abreast of the developments. If it does happen, it will have very big implications not just for Spain but for sovereign debt, European equities and the global economy.
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