The Spanish death spiral has begun

By Edward Harrison On Jun 14, 2012

The situation in Spain has turned decidedly worse today. After yesterday’s 3-notch downgrade by Moody’s, yields on Spanish 10-year bonds are now hovering just around 7%. Credit default swaps for Spanish debt are now trading at 605 bps with a 40% chance of default over the next five years. These are the market indications that the Spanish bank bailout package is not credible. And for good reason; as details of the discussions surrounding Spain come to light, it is now clear how harsh the terms of the bailout could be.

Here is what I am hearing:

Penalty rates. There are scenarios being considered under which Spain would pay 8.5% for the bailout funds instead of the 3% being bandied about now. I assume this rate is a penalty rate associated with the Spanish drawing from the temporary EFSF bailout facility instead of the ESM facility where the bonds would be senior to existing sovereign debt. Also, Eurostat, the European statistics agency, said Wednesday that it hadn’t decided how much the Spanish sovereign’s debt would rise because it depended on how the loan for the bank bailout would be calculated. If the interest rate on that bailout is too low, the money would be considered a gift rather than a loan and would count against the deficit.
Troika occupation. Contrary to claims by the Spanish government that the "line of credit" Spain is receiving is a "victory", in fact the Germans and Brussels are demanding oversight for the 100 billion euros and how it is distributed. Moreover, the Finns have said they want collateral for the money they loan.
Bank liquidation. According to a spokesman for Competition Commissioner Joaquin Almunia, the EU is saying it prefers to liquidate banks when it’s cheaper for the taxpayer. So, rather than just bailing out these bankrupt financial institutions, the EU may force Spain to sell off their assets in a controlled liquidation. It is not clear what would happen to bondholders in such a scenario. I assume they would be paid only based on the value of the assets liquidated. The Spanish government has accused Almunia of disloyalty and have asked for his resignation.

What is clear from the market action on Spanish debt is that markets believe the Spanish sovereign is on the hook for a lot of bank sector losses and are concerned about Spanish sovereign solvency as a result. With yields now at 7%, it is very possible that Spain could be forced into a sovereign bailout of some sort, though I am not sure where these funds would come from. Seven percent is the rate at which the death spiral began for other bailed out nations and I expect the same here as well unless the ECB intervenes.

The chart from Reuters’ Scott Barber makes this clear.

Spain’s bankrupt financial institutions being forced into liquidation with bondholders taking haircuts makes sense. However, forcing the Spanish sovereign to take those losses via a loan at 8.5% does not make sense. This policy can certainly lead to fire sales, bank runs and more debt deflation in Spain.

The euro zone is an absolute mess. Every day gets worse. Whereas I used to be hopeful that Europe would pull through I am no longer. I have thrown in the towel on Europe. I now expect a disorderly breakup and depression as a base case in Europe. Recent policy responses show that Europe doesn’t get it. We should prepare for much worse to come.