Now let’s look at the internal workings of the bailout. Spain is going to receive 125b and they will use it to recapitalize their banks. The Spanish government will then take an equity stake in these banks, like what US did with TARP. They will likely receive preferred shares and receive a dividend payment. Spain will pay 3% on the loan to the EFSF or ESM. The mechanism being used is still undetermined at this time. Depending on the entity being used, it will raise a few issues. If EFSF is used, then Finland will demand collateral. Finland is demanding collateral because there is no subordination clause with the EFSF. Meaning if Spain truly defaulted, the EFSF will not be paid back first. This is rather pointless because the contagion risk caused by Spain’s default would mean Finland is screwed anyway. If the ESM is used, then two issues arise. First, German parliament has not ratified the ESM and there are already rumblings that the German parliament does not want to pass the ESM for a bank bailout purpose without a financial transaction tax. Merkel is opposed to the tax. Second, subordination of debt by the ESM and ECB will prevent private investors from buying more Spanish debt in fear of the larger write down. Also, in the ESM treaty there is a collective action clause like the one used in Greece to force the bondholders into the “voluntary” write-down. The 125b loan will be placed onto the balance sheet of Spain. This is what Spain’s balance sheet looks like:
Spain’s GDP $1.295 trillion
SPAIN’S NATIONAL DEBT
Admitted Sovereign Debt $732 billion
Admitted Regional Debt $183 billion
Admitted Bank Guaranteed Debt $103 billion
Admitted Other Sovereign Gtd. Debt $ 72 billion
Total National Debt $1.090 trillion
SPAIN’S EUROPEAN DEBT
Spain’s Liabilities at the ECB $332 billion
Spain’s Cost for the EU budget $ 20 billion
Spain’s Liabilities for the Stabilization Funds $125 billion
Spain’s Liabilities for the Macro Fin. Ass. Fund $ 99 billion
Spain’s Guarantee of the EIB debt $ 67 billion
Spain’s Total European Debt $643 billion
Spain’s National and European Debt $1.733 trillion
Spain’s OFFICAL debt to GDP Ratio 68.5%
Spain’s ACTUAL Debt to GDP Ratio 133.8%
* * *
Now we have another €100 billion or so in admitted sovereign debt to add to the top of the list. In other words, total Spanish admitted debt will likely increase by up to 17% from $732 billion to $857.
If you are a private investor, why would you buy bonds that will likely have to be written down at some point? Also, the bonds will be forced to have a higher write down because your debt is subordinated. The 125B plus whatever the ECB bought through the SMP will subordinate all debt. This is likely not the one and only bailout. Foreign holding of Spanish debt has already dropped from 50% to 37%. So, who will buy their debt from now on after what happened to the holders of Greek debt with their “voluntary” participation in the PSI? The domestic Spanish bank might, but they are just piling on more toxic assets at this point.
On why this is the most asinine QE attempt in history. Banks bought Spanish government bonds and now the Spanish government is taking an equity stake in the banks that bought their bonds. The Spanish government will pay the EFSF or ESM 3% for the 125b loan. This loan increases their debt burden by another 10% of GDP. The yield payment from the sovereign to the banks is probably in the range of 5-7%. The rate depends on the maturity of debt held by the banks. The banks being bailed out will pay back to the sovereign a high preferred dividend for this bailout. The banks will pay 1% to the ECB for their loan and a dividend likely higher than the yield on the sovereign debt. That is one massive cluster fuck. Compare this scenario to the US QE and TARP. Most banks have paid back TARP to the Treasury. The FED is paying .25% with IOER for the banks. The US banks excess reserves are held at the FED and getting interest on it. They are getting interest payments on the treasuries as well. US banks are receiving interest payments and Spanish banks are paying interest. It simply does not make sense and assumes no further contraction in Spain’s economy.
If there is further deterioration in property loans and an increase further in yield on the sovereign bonds, where will the banks find money to pay the dividend and the ECB’s 1%? Also, what happens if there really is a margin call by the ECB? Simple answer is they are screwed. The banks of Spain took on more leverage by buying the Spanish bond and they could be taking on a negative yield for all their trouble. If you are an investor that is interested in financials, why would you touch anything Spain related or even European related at this point? Not all the terms are laid out for the banks on this bailout as of yet. Will there be bail-in conditions attached to this bailout? Will the equity holders get wiped out and will the bond holders suffer losses as well? This bailout will do just enough as long as nothing else goes wrong and their economy does not deteriorate any further. After 2 years of this European crisis, nothing has gone according to plan. A further bailout at a later time is likely. At this point, the bulls can rejoice in their triumph over the bears in the near term. The bears will have their day and then get slaughtered again. This cycle will repeat for probably a few more weeks, if not months. The only thing that will break the market out of its sideways action is if the FED initiates QE 3 or the mythical Eurobonds are issued. Rumors of Eurobonds have occurred the past 2 weekends. Last weekend the rumor came out of the Australian and now the rumor is coming out of Der Spiegel. Neither scenario is likely in the near term. Europe will continue their piecemeal approach towards fixing their problems and the market will likely continue its range-bound motion for a little while longer.
An outright Eurobond is very unlikely; however, a twist on Eurobonds is gaining momentum. It is called the Eurobond Redemption plan. The specifics of the plan will be discussed at a later point.