Following the US bailout model will create losses for Spanish bank preferred and sub debt
In Spain, it is well-known that many of the financial institutions need more capital. However, the question is how much capital. Spain has run dubious quality stress tests that say the banks need less than 40 billion euros. Others believe that the banks will need as much as 250 billion euros (see here). This is an important point because larger losses likely mean that equity at the banks will be wiped out. The Spanish government will then need to decide how the losses will be paid for.
What’s clear now is that countries like Finland will resist any kind of debt mutualisation tooth and nail. According to their finance minister Finland would leave the euro zone rather than pay for others’ debt. This leaves Spain in a predicament. While Spain’s government debt to GDP is still lower than France and about on par with Germany’s, its deficit and the potential for liabilities migrating from regional governments and banks to the sovereign will cause Spain to lose all market access very soon. So the question is how to pay for the coming losses at Spain’s banks.
The right thing to do is to make the bank’s creditors pay for this as I have argued many times in the past for the US, the UK and Ireland. The problem, however, is that many of Spain’s bank creditors are also its depositors.
As a group of German academics wrote recently about European banking union done properly:
creditors must be made liable for risky investments, so that the resolution of troubled financial institutions can be executed without taxpayer money. In order to secure the financial stability of a banking union, a common restructuring fund that can intervene and impose binding conditionality on reorganisation plans is needed. The ESM can play this role. A stronger Europe-wide deposit insurance system can also contribute to the long run stability of the banking system.
Now, when the socialist government in Spain attempted to get the bank debt problem under control, it at first tried to get funds for the banks from the private sector like the US did. Using the US as a model, Spain conducted (fake) stress tests that determined how much of a hole the banks’ balance sheets would have. They then tried to get these banks to raise the capital shortfall through private funds, promising to pay the rest. The Rajoy government inherited this plan and began executing on it.
When the banks tried to get private funding, universally they were unable to get institutional and or foreign investors onboard. Bankia, for example, wrestled with whether to pull its IPO altogether after receiving a tepid response from institutional investors. Instead, Bankia went ahead with the IPO, getting the money from Spain’s retail investor base. Other banks raised money by unethically and potentially illegally pressuring bank depositors into preferred equity and subordinated debt instruments they did not fully understand. Reuters says, for example, that 62% of sub debt holders in Spain are also depositors at the same institutions. These debt instruments were touted to customers as higher-yielding, low risk fixed income replacements for the banks’ own lower-yielding savings accounts. Financial repression always has the effect of pushing people into higher risk investments as they look to get out of the low yields that financial repression induces for low-risk vehicles. Interest on savings accounts was virtually non-existent in Spain’s banks and so customers were eager to boost returns.
Spain’s memorandum of understanding states:
The restructuring plans of viable banks requiring public support will detail the actions to minimise the cost on taxpayers. Banks receiving State aid will contribute to the cost of restructuring as much as possible with their own resources. Actions include the sale of participations and non-core assets, run off of non-core activities, bans on dividend payments, bans on the discretionary remuneration of hybrid capital instruments and bans on non-organic growth. Banks and their shareholders will take losses before State aid measures are granted and ensure loss absorption of equity and hybrid capital instruments to the full extent possible.
The Troika will therefore attempt to get Spanish preferred equity and subordinated debt holders to suffer losses before Spanish taxpayer money is used. Nowhere in the Memorandum of Understanding is it suggested that EU funds will be used unless it passes through as a Spanish sovereign liability.
My conclusion therefore is that Spain will make itself effectively insolvent in signing the Memorandum unless it can crystallise bank losses at the preferred and subordinated debt level. However, sticking the sub debt and preferreds with losses will not only be a public relations disaster for the Rajoy government, it is also likely to trigger lawsuits.
Following the dubious American bailout model was a bad idea from the start. But because the US got away with it, Spain went for it too. The US was early and has been lucky (so far). Spain is neither.
Update: What I would like to see in the case of bank insolvency are specific guidelines on how different creditor classes are affected. A best case scenario would see equity take full writedowns before other classes are touched. Preferreds would then be converted to equity and wiped out, if the losses are substantial enough to do so. Subordinated debt would then have guidelines concerning votes for debt-to-equity swaps versus haircuts. All of this would be established beforehand in law, with guidelines on how much equity conversion can take place in lieu of haircuts. Note that European finance ministers are working to put these rules into place but that the rules won’t be live until 2018 at the earliest and so they will not affect what’s happening during this crisis.
Update 2: Karl Whelan says much the same about bond losses and believes senior debt should also take losses:
In Spain, there are serious issues relating to both subordinated and senior bonds. In relation to subordinated bonds, Spain’s case differs from Ireland because many of these bonds were sold (or perhaps one could say mis-sold) to retail investors. The EU memorandum is making write-downs of these bonds a condition of the program and there is likely to be huge political controversy over the decision to inflict losses on retail investors.
Despite this controversy, the EU are taking the correct approach on the issue of subordinated bonds. Europe’s banking system is simply too large for taxpayers to have to guarantee all bank creditors. Paying out on subordinated debt in insolvent Spanish banks would be a step in the wrong direction and set a bad precedent for bank resolutions processes elsewhere.