Spain's "victory" is in fact a defeat and the worst is yet to come

11th June 2012 by Shaun Richards

The weekend just gone has seen the Kingdom of Spain join the countries in the Euro area which have called for international help to deal with debt problems. As ever the first casualty of such an operation was the truth as we saw the Spanish Prime Minister Mariano Rajoy call it a “victory”. Perhaps he just said the word pyrrhic so silently that the microphones did not pick it up. Of course he also contradicted many of his most recent statements because in claiming that Spain did not need and would not take a bailout he was in his own words denying her a “victory”. Let us remind ourselves of what he said as recently as May 28th.

 There will be no rescue of the Spanish banking sector

What was actually agreed

The Eurogroup agreed in a telephone conference on Saturday afternoon/evening on these main points.

The financial assistance would be provided by the EFSF/ESM for recapitalisation of financial institutions.

The loan amount must cover estimated capital requirements with an additional safety margin, estimated as summing up to EUR 100 billion in total.

the Eurogroup considers that the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector,

So to sum up Spain will receive up to 100 billion Euros from her Euro zone partners to help recapitalise her troubled banking sector. But there are problems with this before it even starts.

The (so-called) rescue vehicles are fatally flawed

You may have already spotted that the Eurogroup was unable to decide whether the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM) would make the loans. This means that markets will eventually get around to focusing on the weaknesses of both! You would also think that if you were going to lend 100 billion Euros to someone you might  have thought it through properly.

For the moment it is only the EFSF that is relevant because the ESM does not actually exist and even the Euro area is unlikely to be silly enough to make loans from a non-existent vehicle.

Isn’t the EFSF your unstable lifeboat Shaun?

Yes it is and a myriad of problems are created by using it. We start with the fact that it has already used some 192 billion Euros of its expected 440 billion Euro capacity for Portugal,Ireland and Greece. If add in the fact that Portugal is likely to need more we see that adding another 100 billion Euros means that we are looking at somewhat over 300 billion Euros now likely to have to be used. It is starting to look rather full!

How can Spain now back it?

Before this weekend Spain was responsible for 12.75% of the backing of the EFSF. At the point of receiving funds from it previous guarantors (Greece,Ireland and Portugal) became what are called “stepped-out” guarantors. This meant for example that Spain’s share rose from 11.87% to 12.75%.

The catch here is that Spain “stepping-out” is a much bigger problem as she is the fourth biggest economy in the Euro zone. And as this is the Euro zone where confusion reigns over most of its activities there is a debate over whether a bank bailout means that it will now step out. Frankly this really sums up the mess as the bailout of Ireland was in effect for her banks and she stepped out.

So either she steps out and the EFSF is weakened. Or she does not and the EFSF goes ahead with guarantees provided by a country that plainly cannot afford to make them. Otherwise Spain would have bailed out her own banks! Put another way Spain has to borrow at 6% for her ten year bonds (even after this morning’s bond market rally) but apparently can still guarantee loans at just over 3% to Greece,Ireland,Portugal and oh yes Spain herself!

There is also the issue of how the EFSF raises its money in so-called “cashless operations” as I discussed on the 29th of March.It is going to need up to an extra 100 billion Euros of them. Rather than go into the detail let me give you one issue/problem. Why is an organisation which is now lending for the long-term and probably the very long-term raising 3 and 6 month funding?

The ESM rides to the rescue?

The ESM does have advantages to the EFSF in that it has some capital and that backers cannot “step-out” (although some backers e.g Italy may not be so sure that this point is an advantage……..). But its lending outright calls for subordination with its bonds being senior. To put it simply everything else including Spanish government bonds takes a step further down the queue.

Why will this be an issue?

Already it is quite plainly that the probability of their being a debt haircut on Spanish banks is fairly high. So in any private sector involvement as it was called much official lending would be excluded from the haircut and so the amount of any haircut would move a notch higher. Indeed in the case of Greece the way that official lending avoided a haircut also meant that the haircut turned out to be virtually pointless.

Has Spain escaped scot-free from any conditions of the loans?

On an initial glance this may look true. But as ever this is far from the full story. Spain is already in the middle of a severe austerity programme. This means that her budget deficit is supposed to reduce from the 8.9% of her Gross Domestic Product last year to 5.3% this and 3% in 2013. So you could easily argue that quite a lot of conditionality is already in place. The Euro zone had in effect if I may use a football metaphor got its retaliation in first.

The Extra Borrowing is a burden for Spain

If we assume that Spain borrows the full 100 billion Euros then this repesents some 9.3% of her GDP in 2011 according to Eurostat. If we add this to Eurostat’s estimate of her national debt of 68.5% at the end of 2011 we get to a relatively low for these times 77.7%. The catch is that this is Spain’s central goverment and if we add in the regional governments and unpaid bills we find ourselves adding an extra 20% or so. Suddenly it is heading for the 100% barrier.

Why are Spanish financial markets rallying?

The knee-jerk response to this is to see this as unadulterated good news for Spain. Firstly her Euro zone colleagues have stepped in to help her. Secondly her banks will receive extra funding. Some will even believe that 100 billion Euros is enough. If we progress down this road we see that Spain will pay just over 3% as an interest-rate on the borrowing as opposed to much higher rates if she had to finance it herself. Indeed her ministers had begun to express doubts if she could raise the necessary funding at any price.

So we can see how bank shares are rallying today with Bankia up 13% as I type this and Santander up 5%. We can see how a wider equity market rally can take place with hopes that the banks might lend again. We can also see how Spain’s ten-year government bond yield has dropped back to 6% as she no longer faces the prospect of having to borrow on the markets to pay for a bank refinancing.

The problem is that we have seen this all before. For example the bailout of Greece led to a two week rally before the consequences of the bailout began to be factored in but successive bailouts have led to shorter and shorter rallies. The half-life of such moves has sometimes shrunk to a day or so.

Problems for Spain going forwards

Her Banking Sector is not fixed

Whilst her banking sector will now receive funds from the EFSF/ESM they are very unlikely to be enough. So as the phrase “up to” makes an entry in my financial lexicon we face a future where is we look at the scale of the collapse in Spain’s property sector that 100 billion Euros will prove insufficient. If we recall that Spanish banks have plenty of loans (mostly property loans) that they have not officially acknowledged as sour we can expect that just like what happened in Ireland the bill will rise and rise. Accordingly “up to” is likely to mean above and quite possibly considerably above.

Spain’s own debt problem is made worse

The extra borrowing will lead to more of a focus on the level of Spanish state borrowing as well as increasing the absolute levels as I have described above. Not only will the total number (including her regional governments and unpaid bills) head towards 100% of her economic output but more focus will go on the regional governments.

I have written quite a few articles now on the obvious contraction that is taking place in spain’s economy and have labelled it a depression. If we add an economy that is shrinking to higher debt levels we see the scale of the problem which Spain now faces.

What about those lending the money?

One of the problems of insurance is the credit rating and credibility of the insurer. Up until the end of 2011 Spain herself had provided just under 9 billion Euros of loans for other Euro area countries. This was money she could not afford. Well if we look ahead to future problems we see that Italy will be guaranteeing “up to” 19.18 billion Euros of lending to Spain’s banks which adds to the 13.2 billion Euros of loans she had given to other Euro nations at the end of 2011 plus of course we will see extra help for Greece and probably Portugal. Can anybody spot a flaw in a country with a high public-sector debt doing that?




14 thoughts on “Spain's "victory" is in fact a defeat and the worst is yet to come”

  1. Anonymous says:

    Shaun another excellent insight. I am now of the opinion that the vast majority of thinking people cannot believe Rajoy or the Eurogroup leaders. What we are hearing are “sound-bites” – an endless barrage of blah, blah which are shallow, not thought-through and do nothing to instil any level of much-needed confidence. Yes you are right – a short-lived rally followed by further downward movements. Another case of applying a band-aid to a patient in need of emergency-room treatment. Many times I have seen quoted in comments here “you cannot get out of debt by borrowing more” yet this obvious truth has been conveniently overlooked by all the “big faces”. I hold out little hope for any medium term improvements in the fortunes of the EZ. Thank you. 

    1. Anonymous says:

      Hi Ray

      Thank you. The half-life of this rally was particularly short continuing the shrinking trend. On Sunday night/evening the US Dow Jones was being called up 200 points at its best whereas it in fact closed down 142 points tonight…

  2. JW says:

    Hi Shaun
    Don’t like just posting a link to another blog , but in this case its the Deutsche Bank description of the mechanics of the ‘spailout’ before the weekend.
    We are just after 1pm CET and already the € gains are almost gone, this one has had a shelf-life of less than a day.  Its not enough, it will scare all private funding from Spain, its totally circular. The only real reason for doing it is Germany and France concern about their own banks if Spain’s went under. And no doubt Obama and Cameron made it very clear about their own banking concerns to Merkel last week.
    The only effect of the ‘real’ economy in Spain is the probably further sharp decline in house values as the banks feel more emboldened to own up to losses and put even more on the market at prices 30% below the existing ones ( 60% plus decline overall?). This will do wonders for general confidence in the economy, not.
    If the Deutsche Bank description is correct , this process has been designed to exclude ‘read across’ to Ireland or Greece, so their hopes of renegotiation are dashed. This is basically Germany and France ‘engineering’ a rescue of their own banking sector through the back door.

    1. Anonymous says:

      Hi JW,

      Looks like the Germans have been mugged again, to help rescue French banks.

      Maybe some day the Germans will revolt and refuse to pay. Black swan event anyone ?

    2. Anonymous says:

      Hi JW

      As i have just replied to Ray the half-life was very short this time with the Dow Jones reversing 340 points from the estimated peaks on Sunday night to Monday nights close. The US$/Euro is at 1.2470 too so also below Fridays levels. You dont get much for 100 billion Euros these days do you?

      As to a rescue of the French/German banking sector it may kick the can forwards a little but it also digs them deeper into the mire…..

  3. Anonymous says:

    Hi Shaun
    If earlier reports were correct that Spanish banks used LTRO funds posting some type of collateral ( loans?) at 1% to gorge themselves on Spanish government bonds yielding 6% plus, then suffer haircuts on further escalating yields, one wonders who is bailing out who here? I noted one of the Spanish ministers praise this as a victory for the Euro – strange he didnt talk of victory for the recommencement of lending to the real economy….

    1. Anonymous says:

      Hi Shire

      Ah the real economy! It feels that it is a sideshow in this game does it not? the evidence so far is that letting zombie banks persist does little or nothing for the real economy and that is one of the reasons why I would reform them.

      You are right to highlight the way that the sovereign bank loop played out in Spain. Banks helped bail out the sovereign by buying its debt now the sovereign has to bail out the banks partly because they are losing money on the government bonds they bought! As Spain weakens the danger is that this situation goes from bad to worse like it did in Greece.

      Now the sovereign is too weak to rescue the banks so a supranational organisation has to step in. Of course we will eventually run out of supranational funds… However the buck always stops with taxpayers somewhere or other.

      As the crisis has developed Business Daily on the BBCs World Service has regularly given slots to Professor Richard Verner who time and time again told listeners that all would be better if the banks bought more sovereign debt. Sadly I doubt anyone will get the opportunity to point out what a calamity would have ensued from this.

  4. Rods says:

    Hi Shaun,

    Another great blog.

    The Spanish equivalent of Sir Humpfrey Appleby has been busy over the last few weeks!

    If Rajoy was describing the Spanish Armada of 1588. It would be like this: “Today I can report a great victory over the English and the stormy weather. Of the 130 ships that sailed to invade England, 50, yes 50, have safely made it back to Spain. Rejoice in this victory over the English and adversity, due to the supreme skill and courage of the Spanish Navy. Casualties have been kept to a minimum with under 22,000 dead, wounded or captured”.

    “The Spanish banks that financed the Armada, have also been positive over the losses being less than expected, and will be easily covered by their capital reserves. Shares are up on the news that dividends should not be affected and their will be record trading floor and bank boss bonuses in 1588. I cannot see any circumstances in which  any bank will require the EFSF lifeboat”!

    If I was a betting man I would be betting that the Spanish banks will need to be bailed out to the tune of €200-400bn in total. As I’m sure there are many more skeletons in the cupboard than will be declared out of fear of the debts being too big for the bank to be saved and with the rapidly deteriorating economic situation creating many more bad loans.

    Spanish household indebtedness is second only to the UK at 125% of GDP with 80% being mortgages. With rising unemployment and falling property prices, plenty of scope here for many more bad debts. 

    How many companies are going to go bust, particularly SMEs, perfectly good profitable businesses in normal times, with many lives ruined and families broken before the Eurozone madness stops. I can remember the ERM and recession in 1991/92 for this reason, my business survived, but many didn’t!

    Sadly, the longer this charade goes on the bigger the hole (and debts) is going to be that we all have to climb out of.

    1. Anonymous says:

      Excellent Rods! Enjoyed the Spanish Armada – I guess Rajoy has “snatched defeat from the jaws of victory”?

    2. Anonymous says:

      Hi Rods

      I am probably not doing the story justice but an apocryphal rowing regatta had the following result.


      It was reported in the Soviet Union’s Pravda as follows.

      In an international rowing regatta yesterday the valiant team from the USSR came third whilst the UK was second from last and the USA was only third from last…

      1. Cookie Monster says:

        Fantastic, spinning at its best on both accounts!

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