Why the Spanish Memorandum of Understanding is a disaster for Spain and Europe

We now know that Spain has received a standard bailout package like Greece, Portugal and Ireland before it despite attempts by the Spanish government to dress this bailout up as something different. Below is a quick analysis of just what Spain and the Troika have signed up to.

Just to review the rhetoric on the deal first, let’s remember what led to the deal and how this deal was advertised over the past two weeks. I have bolded the key parts:

• Reuters – 7 Jun: Fitch slashes Spain rating by three notches to "BBB": "Spain’s credit rating was slashed by three notches on Thursday by Fitch, which signaled it could make further cuts as the cost of restructuring the country’s troubled banking system spiraled and Greece’s crisis deepened."
• Bloomberg – 9 Jun: Spain Asks for $125 Billion Bank Bailout as Crisis Worsens: "Just seven months after winning a landslide victory, Prime Minister Mariano Rajoy was forced to abandon his bid to recapitalize Spanish banks without recourse to external help as a deepening recession forced lenders to recognize spiraling losses… De Guindos said the terms of the rescue loan are “very favorable” compared with market rates and the funds will be channeled through Spain’s FROB bank rescue fund, whose liabilities count as public debt. The maximum amount of the loans is equivalent to about 10 percent of gross domestic product and interest paid on the loans will affect the deficit, which is the euro-area’s third-largest."
• Reuters – 11 Jun: Skeptical Spaniards pour scorn on Rajoy over rescue: "Confused and anxious Spaniards heaped scorn on Prime Minister Mariano Rajoy on Sunday for portraying a 100 billion euro European rescue of the country’s zombie lenders as a triumph, expressing skepticism about whether the plan will work."
• ABC – 12 Jun: Merkel afirma que la ayuda a España tendrá una «condicionalidad» diferente a la de Grecia o Portugal: Angela Merkel confirmed that "of course there will be conditions" on the Spanish bailout deal but that the conditions would be different than for the earlier rescues associated with sovereign countries. The inference at the time was that Spain would escape harsh austerity measures as a pre-condition of the deal but that the programme would still be administered and supervised by the Troika.
• Telegraph – 18 Jun: Spain pleads for ECB rescue as bond markets slam shut: "Yields on 10-year Spanish bonds surged to a record high of almost 7.3pc as investors ignored the victory of pro-bailout parties in Greece’s elections. The closely-watched two-year yield rocketed by 65 basis points in a matter of hours, signalling a near-total collapse of confidence in Spain’s €100bn (£80.3bn) rescue from the EU last week to shore up its banking system. Cristobal Montoro, the economy minister, warned that Spain is now in a "critical" condition and pleaded with the European Central Bank to act with "full force" to defeat markets hostile to the euro project."
• WSJ – 22 Jun: Spanish Aid Plan Is Flawed, Says IMF: "The IMF, which is a contributor to the European rescue programs and is providing technical assistance for the Spanish bank support, on Thursday came out sharply against the euro zone’s insistence that any aid be channeled through the government. The euro zone needs to quickly set up a mechanism that allows it to directly recapitalize weak banks, "in order to break the negative feedback loop that we have between banks and sovereigns," IMF Managing Director Christine Lagarde said after a meeting with the bloc’s finance ministers in Luxembourg.
• Guardian – 29 Jun: Spain lifeline after EU allows direct access to eurozone bailout funds: "The European Council president, Herman Van Rompuy, called it a "breakthrough that banks can be recapitalised directly". In addition, the leaders agreed that EU countries that were following budget rules could apply for bailouts that would not come with the stringent conditions that have accompanied previous EU bailouts – a recognition, said the Italian premier, Mario Monti, who pushed for the deal, of the work such countries were already doing in reforming their budgets."
• Telegraph – 29 Jun: Germany caves in over bond buying, bank aid after Italy and Spain threaten to block ‘everything’: "Under the deal, Spanish banks will be recapitalised directly by allowing a €100 billion EU bailout to transferred off Spain’s balance sheet after the European Central Bank takes over as the single currency’s banking supervisor at the end of the year. The decision, taken by a meeting of eurozone leaders in the early hours of Friday morning, will be based on a move to put the ECB at the centre of a “effective single supervisory mechanism” for banks after an EU summit in December. “We affirm that it is imperative to break the vicious circle between banks and sovereigns,” said a summit statement."
• Guardian – 10 Jul: Spain must produce two-year reform blueprint to get eurozone money: "The Spanish government has until the end of the month to produce a persuasive two-year blueprint of structural reforms in order to qualify for a €100bn (£79bn) eurozone rescue of its distressed banking sector. A draft memorandum of understanding between Madrid and the eurozone authorities, to be finalised on 20 July and obtained by the Guardian, stipulates that the centre-right government of Mariano Rajoy has to come up with more spending cuts, tax reforms and implementation of labour market changes for the bailout to go ahead."

My analysis of the events says that:

1. Spain was forced into a bailout because it was clear that the Spanish government was going to have to bail out several large Spanish institutions and the market for Spanish bonds doubted the Spanish government’s ability to do so.
2. Originally the bailout carried less conditionality but did not break the sovereign-bank tie.
3. After the market rejected this deal by forcing Spanish yields higher, a new deal was struck at the euro summit by which Europe claimed "We affirm that it is imperative to break the vicious circle between banks and sovereigns". No mention was made of conditionality.
4. Now, the Troika has backtracked on this deal and not only is there huge conditionality in the Memorandum of Understanding but Spain is also still on the hook for the bailouts.

Nothing has been accomplished. The Spanish bailout is a failure.

When you look at the terms of the Spanish Memo of Understanding (pdf), it contains a lot of problems for Spain and the credibility of the Spanish government, specifically the following:

• Yielding to Troika oversight: For the duration of the EFSF financial assistance, the Spanish authorities will take all the necessary measures to ensure a successful implementation of the programme. They also commit to consult ex-ante with the European Commission, and the European Central Bank (ECB) on the adoption of financial-sector policies that are not included in this MoU but that could have a material impact on the achievement of programme objectives – the technical advice of the International Monetary Fund (IMF) will also be solicited.
• Committing sovereign to bank liabilities like Ireland: Segregation of impaired assets: Asset Management Company 21. Problematic assets of aided banks should be quickly removed from the banks’ balance sheets. This applies, in particular, for loans related to Real Estate Development (RED) and foreclosed assets. In principle, it will also apply to other assets if and when there are signs of strong deterioration in their quality. The principle underpinning the separation of impaired assets is that they will be transferred to an external AMC.
• Allowing fiscal conditionality for funds: VI. Public finances, macroeconomic imbalances and financial sector reform29. There is a close relationship between macroeconomic imbalances, public finances and financial sector soundness. Hence, progress made with respect to the implementation of the commitments under the Excessive Deficit Procedure, and with regard to structural reforms, with a view to correcting any macroeconomic imbalances as identified within the framework of the European semester, will be regularly and closely monitored in parallel with the formal review process as envisioned in this MoU. 30. According to the revised EDP recommendation, Spain is committed to correct the present excessive deficit situation by 2014.  In particular, Spain should ensure the attainment of intermediate headline deficit targets of [x]% of GDP for 2012, [x]% of GDP for 2013 and [x]% of GDP for 2014. Spanish authorities should present by end-July a multiannual budgetary plan for 2013-14, which fully specifies the structural measures that are necessary to achieve the correction of the excessive deficit. Provisions of the Budgetary Stability Law regarding transparency and control of budget execution should be fully implemented.
• Equity and subordinated debtholder losses: 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 MoU is a clear victory for Angela Merkel and a humiliating defeat for the Spanish government. Not only has Spain agreed to Troika oversight but it must also agree to "consult ex-ante with the European Commission, and the European Central Bank (ECB) on the adoption of financial-sector policies". That’s a full-on occupation. They have committed to larding the sovereign balance sheet via the FROB with dud Spanish bank assets with zero recourse to a EU-level entity. Rajoy has also accede to the standard European bailout package austerity conditionality, making claims that the deal terms were favourable ridiculous. And finally, Spain must deal with the contentious issue of forcing preferred equity and subordinated debtholders, many of whom were depositors tricked into these financial instruments to avoid the low savings rates of financial repression, to get wiped out before any aid money comes their way. This is a disaster for Rajoy.

The Spanish bank bailout deal is also a disaster for Europe as well. Clearly, Spain is on the road to debt deflation. Losses at banks will crystallise quickly as the economy crashes, making the likelihood of losses at the banks even greater. At some point soon, markets will see this and Spain will not be able to fund itself. At that point, the options have narrowed considerably and Europe will be forced to monetise or let Spain default.

It is going to get a lot worse from here on.