Monday, June 11, 2012

The Myth of Spanish Fly?

Tiziana Barghini of Reuters reports, Spain bank deal may not work, bolder reforms needed:

Europe's plan to lend money to Spain to heal some of its banks may not work because the government and the country's lenders will in effect be propping each other up, Nobel Prize-winning economist Joseph Stiglitz said.

"The system ... is the Spanish government bails out Spanish banks, and Spanish banks bail out the Spanish government," Stiglitz said in an interview.

The plan to lend Spain up to 100 billion euros ($125 billion), agreed on Saturday by euro zone finance ministers, was bigger than most estimates of the needs of Spanish banks that have been hit by the bursting of a real estate bubble, recession and mass unemployment.

If requested in full by Madrid, the bailout would add another 10 percent to Spain's debt-to-gross domestic product ratio, which was already expected to hit nearly 80 percent at the end of 2012, up from 68.5 at the end of 2011. That could make it harder and more expensive for the government to sell bonds to international investors.

With Spanish banks, including the Bank of Spain, the main buyers of new Spanish debt in 2011 - according to a report by the Spanish central bank - the risk is that the government may have to ask for help from the same institutions that it is now planning to help.

"It's voodoo economics," Stiglitz said in an interview on Friday, before the weekend deal to help Spain and its banks was sealed. "It is not going to work and it's not working."

Instead, Europe should speed up discussion of a common banking system, he said. "There is no way in which when an economy goes into a downturn it will be able to sustain policies that will restore growth without a form of European system."

Stiglitz, a former economic advisor to U.S. President Bill Clinton, is a long-standing critic of austerity packages. He also wrote book attacking the International Monetary Fund for policies it has imposed on developing countries as a precondition for emergency loans.

What the European Union has done so far has been minimal and wrong in its policy direction because austerity measures to restore risk have the effect of reducing growth and increasing debt, he said.

"Having firewalls when you're pouring kerosene on the fire is not going to work. You have to actually face the underlying problem, and that is, you're going to have to promote growth," Stiglitz said.

Instead, sweeping reforms to make Europe more of a fiscal union are needed to solve the debt crisis, reinforce the single currency and ultimately help Germany which, as the richest country in the union, will have to bear the highest cost of guaranteeing any commonly issued debt and providing more resources to boost public spending.

"Germany keeps saying that the strengthening is fiscal discipline, but that is a totally wrong diagnosis," Stiglitz said.

Germany is expected to propose at the end of June a road map toward a European fiscal union, but Berlin favors joint euro bonds, backed by all the area's governments, only as a medium-term goal, once other countries have fixed their high debts and budget deficits through austerity measures so they are not reliant on Berlin's deep pockets.

"Eurobonds is just one institutional arrangement that could work, there are others: a common treasury," said Stiglitz adding that ultimately "there has to be a way of raising revenue across Europe, to support the weaker countries in case of an economic downturn."

While the economies of Spain, Greece, Italy and Portugal are contracting, Germany grew 0.5 percent in the first quarter. The divide in the euro area in many cases reflects austerity programs to tackle debt and deficit problems.

Critics have said the focus on cutting costs is aggravating Europe's crisis and jeopardizing the future of the single currency. Greek elections next week could bring to power parties opposed to the tough conditions attached to the country's EU and IMF-led rescue plan and raise the possibility of Greece leaving the euro zone.

"Germany is going to have to face the question, do they want to pay the price that would follow from the dissolution of the euro, or do they want to pay the price of keeping the euro alive?" Stiglitz said. "I think the price they will pay if the euro falls apart will be greater than the price they will pay for preserving the euro. I hope they will come to realize that, but they may not."

Stiglitz's latest book, "The Price of Inequality: How Today's Divided Society Endangers Our Future," is scheduled to be published on Monday. It challenges the idea that inequality is an unavoidable evil needed to sustain economic expansion.

"We could have more growth and less inequality," Stiglitz said, "so we could do better in both dimensions simultaneously."

Joe Stiglitz is a giant in the field of economics. He understands the shortsightedness of these bank bailouts and along with other reputable economists, like Paul Krugman, has been warning global policymakers to reverse austerity programs and focus on growth.

While markets might welcome the news of a Spanish bank bailout, it will be a temporary reprieve. As I commented last week, the end of Germany's illusions is near. Ms. Merkel and Mr. Schaeuble are only fooling themselves if they think these temporary measures will halt the crisis. Germany will not escape unscathed; the longer they put off meaningful structural reforms, the worse it will get.

As far as the actual agreement on bailing out Spanish banks, Reuter's blogger, Felix Salmon, asked an excellent question: Why didn’t Europe bail out Spain’s banks directly?:

So really there are two bailouts here. The Spanish government is getting debt finance from Europe, and the Spanish banks are getting equity finance from the Spanish government. Because the money is ultimately going to the banks, the Europeans and the Spaniards have an excuse for not imposing tough austerity conditions on Spain. And that’s good: Spain has never been fiscally profligate in the way that Greece was, and there’s no reason why it would ever benefit from some kind of Germanic nanny double-checking and second-guessing every check it writes.

On the other hand, all the money for bailing out Spain’s banks is immediately going to become Spanish sovereign debt. And that’s not good, for anyone worried about the Spanish fiscal situation. What’s more, it’s unclear how much of the money is going to come from the ESM rather than the EFSF. That might seem like a niggardly distinction, but it’s an important one: the ESM has preferred-creditor status, which means that it’s senior to anybody buying Spanish sovereign bonds. And as a result, at the margin, the more ESM debt that Spain has, the higher the spread on Spanish government bonds, since every euro of ESM debt effectively subordinates every euro owed by the Spanish government to bondholders.

The way to avoid all this would have been for Europe to recapitalize the Spanish banks directly, rather than doing so by lending money to Frob. The IMF couldn’t participate in such a plan, since it can only lend to governments, not to banks — but the IMF isn’t participating in this plan, either. And by taking equity in the Spanish banks, Europe would actually have a chance of turning a substantial profit on the whole operation, instead of just lending money to Spain at concessionary rates. As it is, if the equity that Spain takes in the Spanish banks ends up rising in value, all that rise in value will accrue to the government of Spain, rather than to the Europeans who provided the money.

But clearly Europe hasn’t yet reached the point at which it’s willing to directly help out the financial sectors of member countries, no matter how necessary or potentially profitable that might be. Taking equity stakes in Spanish banks — or any other private-sector institution, for that matter — is clearly something which Europe wants to leave to individual countries, and I can understand that, at least in theory. In practice, however, I suspect that Spain and the markets would have been much happier if the flow of money had been direct, rather than being intermediated by the Spanish government.

Andreas Koutras echoed similar concerns in his excellent analysis, The Spanish Position:

Over the weekend, the ECOFIN/EUROGROUP decided to throw around 100billion of good money after bad. The 100billion is the initial maximum amount that has been allocated. It would be given to FROB, the Spanish bank restructuring vehicle. We do not know as yet the conditionality or the terms imposed by Europe.

One can assume that there would be some conditions albeit not as stringent as one might think. This is not a state bailout like in Greece and Ireland but a bank handout. The Spanish government did not want to be completely humiliated and asked for bank money. But do not forget, this is how the crisis in Ireland started. First, Mr Trichet of the ECB pushed the Irish government to guarantee the insolvent banks and then the whole country was pushed into Troika hands.

The 100billion also signals the demise of the EFSF. Taking Spain out of the pool would reduce the available cash for further bailouts to a trickle. The rest can cover possibly only Cyprus. So long EFSF. EFSF’s replacement the ESM is not yet activated or ratified.

I say initial 100billion because the new Spanish Dynasty serial has more episodes to come. The “Spanish recap estimates” remind me a bit of the “Greek statistics”. Every revision pushes the amount up. Now the IMF is estimating around 40billion and many market analysts put this number to 100, hence the ECOFIN number.

The question is why if it is only 40billion as estimated by the Spanish government and the IMF the Kingdom did not raise this cash on its own. After all it is not a huge amount of money. It is only 4% of the GDP and FROB could have issued the bonds under their guarantee and give them to Spanish banks which in turn would hand them over to the 3Y LTRO. Apparently, the ECB objected to this solution. Of course it is also a question of cost. The EFSF money is cheaper than the current funding rates of the Kingdom.

Are the 100billion going to be enough? Let me drop some numbers from the end of 2010 report of “Associacion Hipotecaria Espanola”. Remember the Spanish GDP is roughly 1050billion.

  • Total outstanding non-financial lending of 1652billion.
  • Total residential and commercial real estate lending 1,100Billion. Out of this 673billion are residential lending and 427billion are Commercial Real estate, construction and development.
  • Lending for pure construction totals of 112billion
The current numbers of outstanding debt are probably somewhat better but the Spanish economy is not powering ahead either. So, the 40billion looks like an underestimate. The 100billion plus some more from the next few years looks more realistic. Unless of course the Spanish economy turns really belly up in which case a lot more would be needed.

So welcome to the second official subordination of Spanish debt. The first one is already under way as the ECB considers the SMP holdings as a sacred monetary policy cow. Presumably the 100billion would be added to the Spanish taxpayer’s bill and would push the government debt even higher. The next episodes may involve some kind of PSI restructuring. An overview of the process can be found in PSI lessons to Investors. Whether it is going to be a “maturity extension”, a haircut, or bond swap, Greece has proved that the tool is there and ready to be used. It is called Article 9 of EU 593/2008 (more later).

FROB (Fondo de Reestructuración Ordenada Bancaria)

The Spanish restructuring vehicle FROB has capital of 15billion and guarantees of 47billion by the Kingdom of Spain. FROB issues debt under the unconditional guarantee of the Kingdom. So far 43 savings banks out of 45 have taken part in the FROB exercise and only 4 have been found non-viable. Most of others were merged. Three banks needed capital injection of 4.7billion. In all cases FROB issued common shares, with a time horizon of 3years.

Will the new recap be with common or preferential shares as before? Will there be any closures or mergers? Restructuring the Caixas may be a good warm up game but the big banks is like playing in a Champions League. Europe has done this exercise before in Ireland. And it was a shameful exercise. Holders of senior bank debt were saved and taxpayers and pensioners left to foot the bill. If they do the same in Spain as they did in Ireland then Europe risks arming a much bigger bomb than they diffuse. Apart from the moral hazard that it creates and perpetuates, Europe would be alienating the people of a much bigger and more economically significant country.

The situation is not at all similar to that of Greece. In Greece, banks were the victims of lending money to the government as any loyal local lender does or is expected to do. Their main cause of failure was not bad loans (they have them but not the main cause). In Spain as in Ireland and Portugal local lenders engaged in bad loan practices.

The bubble in the real estate/construction sector was obvious for everyone to see. On average, in a developed economy, construction accounts for around 4% of the GDP. In Spain and Ireland it was close to 12%. Policy makers were either incompetent or willing collaborators in this bubble. The Irish developer-politician-banker links are well documented for example.

In Greece if you are holding senior bank debt you are safer than holding a Government promise to repay you. This is because the ECB refuses to let any bank go bust while EUROGROUP is happy to let a country go bankrupt. Would this be repeated in Spain? I do not know but my guess is that, better to place bets with the central bank than with any European politician.

Recent historical lessons from Greece

Last week a rare event happened. Despite hints that Greece may blow up Europe, the World and the Universe it was Spain that captured the destructive imagination of the markets and policy makers. Is Spain experiencing a Greek May 2010 event and if yes what could be the differences and similarities on the way ahead?

If you remember in May 2010 Greece activated the newly formed bailout mechanism. At the time, as it is the case now with Spain, Europe’s politicians were deluding themselves that an injection of new good money after bad would do the trick. The ECB insisted that banks should be saved at all costs and that no failure is allowed (see Ireland). But let’s take a step and look at the path to oblivion.

Downgrading a European Country

Once upon a time all Eurozone members were also members of the investment grade club, whether they deserved it or not. The ECB had a rule that said as long as a government bond was rated at BBB+ and above it was accepted as collateral for Eurosystem transactions. i.e. Repo funding. The rule still stands but with exceptions. If a country like Greece goes below the threshold, then the rule is amended to accept that country’s collateral. What kind of a rule is a rule that when broken, it is not enforced but amended? Only the ECB can answer this.

The issue however, is not so much the ECB but market practice. Most funds, whether pension funds or other bond and investment funds have internal rules that are much harder to break than those of the ECB. Here is the problem. The great majority of institutional bond buyers are only allowed to buy and hold investment grade bonds.

When the credit rating of a country approaches the edge of the investment grade, most investment managers would start selling. Having to go to your investment committee and ask for an exception is politically (internal) much harsher than monetizing a small loss.

Path to oblivion

So, there is a clear dichotomy in the bond market. If the market for investment grade securities is 5trillion (say) the junk market is a small fraction of it. This is especially so in European Government Bonds (EGB).

Thus there are a huge amount of sellers and only a handful of natural buyers. When there are more sellers than buyers, common wisdom tells us that prices fall.
  1. So the first step is to get rid of the bond that breaches or is on a path to breach your internal investment rules (near junk rating or BBB).
  2. As there are more sellers than natural buyers in the junk rating section prices fall. Politicians who do not have a clue about how the markets work or want to have a cheap shot at it claim that the “bad” speculators and derivatives are driving the country down. There are calls for CDS to be outlawed and for short selling to be banned.
  3. Quantitative boffins calculate the probability of default based on the price action and publish their finding in major newswires.
  4. The new probabilities scare investors who do not understand how erroneous and misleading these calculations are and sell even more (For those interested click Greek Default Probabilities)
  5. Rating agencies need to respond. Otherwise they would be accused of being behind the curve. They respond to this by downgrading even more the country in question after making the same probabilistic calculation as in step 4.
  6. Now go back to step 1.
Of course, in between these steps we have the reaction of the ECB and the financial institutions of the country in peril. Here are the steps:
  1. ECB announces that no matter how low the rating is as long as it has not defaulted it would continue to accept the bonds as collateral.
  2. Concurrently either the ECB or the banks of that country or both engage in supporting the market by buying up everything that is dumped by non-local investors.
  3. All this buying is reducing the available liquidity of the bonds in question in the real market. The ECB does not re-hypothecate the bonds and this means that the free stock is reduced. The country’s banks can now only repo and fund these bonds with the ECB reducing the availability of collateral even further. As the rating of the banks falls it becomes increasingly difficult to offer these bonds for repo with Euroclear.
  4. The end result is that liquidity is reduced, bid-offer spreads widen as market makers lose access to bonds, and prices fall further.
  5. In other words the action of the ECB is like the kiss of death for liquidity. But this is not the whole story. Now we have “official” holders of debt (ECB, bilateral loans) that totally refuse to be restructured. In other words they create a new species of investor. The preferential investor. Some claim that this a blatant disregard of market practice and the law. Notice the irrationality? It is not the bond or the loan that has preference over other bonds (like Senior and Subordinated). We are now taking into account the reasons an investor bought the bonds for. It’s like this. You buy tickets for a concert and the concert is cancelled. All tickets are the same and Pari Passu. However, the organisers decide to reimburse only a specific class of ticketholders (say corporate ticket buyers) by giving them new tickets for another concert.
Never Forget Article 9 of EU 593/2008. Enter PSI.

So you end up with a great majority of the bonds owned either by the official sector or by the local banks. Here is where the fun starts. Politicians who up to now refused default and restructuring are beginning to see the merits of forcefully reducing the debt load. Here is how it can happen:
1. All of a sudden the government realises that the great majority of government debt is under local law and guess what. They are the law! They can change it with a simple parliamentary act.
2. Most of the debt is now owned by local banks who would be bribed to take part in the restructuring since recapitalisation is promised.
3. Next they need a good marketing strategy to make it look as if they are doing it for the benefit of the people.
4. As many of the bonds are owned by friends and family (Official sector and local banks) they devise a strategy to compensate them for their losses. The official sector would be immunised and all the debt would be passed from tradable bonds to loans to the EFSF/ESM.
5. Next come Article 9 of EU 593/2008. This allows any European country to suspend contractual law and change the terms of a contract (Bond, Loan etc) unilaterally claiming the public interest (and Mandatory provisions). For those who still don’t get it, a European sovereign has the right to change a bond’s terms (if it is under local law) and the rest of Europe or investors can do very little about it. This is how the Greek PSI was done and this is most probably how the next restructuring is going to be done. BTW, do not blame the Greeks for this. It was not their idea.
Moral of the story. Buy international English law periphery bonds if you must. Otherwise invest in EGB at your peril. Owning senior debt in a European BCCI (Bank of Crooks and Criminals) is probably safer than owing a politically volatile government debt.

Conclusion

The first 100billion to save Spanish banks is a repeat of the Greek game of buying some time before a more concrete and possibly harsher solution is concocted by politicians. Ultimately, though we should not have illusions. A restructuring of Spanish bank and/ Spanish government debt would happen. It just takes time to prepare for it.

In urban myth, Spanish fly is known as an aphrodisiac, an elixir made from the extract of the beetle Lytta vesicatoria. Don't get too excited about it, however, as the wild claims associated with this magic potion are all groundless and even dangerous.

I suspect the same thing will happen with the latest Spanish bank bailout. Once reality sets in, markets will lose their hard-on, and we're back to square one, meaning Germany will have to step up to the plate and introduce meaningful fiscal reforms either by backing a common eurobond market or, as Stiglitz suggests, by backing a common European treasury.

The focus will now shift to Greece where Mr. Tsipras and the Syriza party are spreading their own set of myths, claiming Greece can have its cake and eat it too. Below, former Greek Prime Minister George Papandreou talks to Bloomberg on the European debt crisis, warning if Spain falls, Europe falls. Also, watch a couple of funny Greek political ads. You don't need to speak Greek to understand that while the ads are humorous, there is a serious message to those thinking of voting Syriza.



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