The Implications of Spain's Deal

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Investors ought not let the recovery in the global capital markets, that has been seen in response to the broad brush strokes of an aid package for Madrid, obscure the fact that the underlying quagmire just got deeper.  The favorable market response is largely technical in nature and related to extreme positioning and the out-sized moves in May.  

The weekend produced not so much a Spain request for aid as the EU offering Spain up to 100 bln euro to support its banks.  Rajoy appears to have won most of his demands.  The IMF is not included.  It cannot provide assistance for a strictly bank recap program, so it may have been an easy concession to make. This is especially true because Rajoy also refused to consider additional conditions in the form of additional deficit or debt targets.
 

Moreover, there has been not further encroachment on Spain's sovereignty.  In effect, Spain is getting financial support, not a bailout in the sense that Greece, Ireland and Portugal got sufficient funds so that they would not have to go back into the market for a couple of years.  Spain still needs to raise about 47.5 bln euro this year, with a concentration of maturities in early in Q4.  The regions also have to refinance almost 16 bln euros in H2.  

With loss of investor confidence in Spain palpable, and this ahead of the Greek elections, which are seen as a wild card--a known unknown--European officials had to act.  The Rajoy government seemed paralyzed.  First it was in utter denial.  As recently as two week ago, Rajoy was claiming the banks did not need more government funds.  Then it went flailing about, seeking the ECB to come to its rescue or joint bonds.  

Officials filled that vacuum, but they may have panicked. The implications are far reaching and will take some time to fully take in and appreciate.

The IMF's 77-page report that claimed Spain's banks were suffering a crisis that was "unprecedented in modern history".  And yet its estimate of the amount of funds Spain needed was not commensurate with the assessment.  It said Spanish banks would need at least 37 bln euros to withstand a sharper economic contraction.   

The 100 bln figure was pulled from the air to impress investors, though it does match the high end estimate that Fitch gave when it slashed Spain's rating three notches last week.  The independent auditors' report is expected within two weeks.  

The Bank of Spain has called 180 bln euros of the 300 bln euros of real estate related loans "troubled". This does not include any of the 655 bln euro mortgages portfolio of Spanish banks.  Less than 3% are considered non-performing and are being carried at full value even though house prices have fallen by more than a quarter since the 2007 peak and one in four Spanish workers are unemployed.  

There is considerable headline risk stemming from Moody's.  Moody rates Spain's creditworthiness at A3. This is out of step with the other main rating agencies.  S&P puts Spain at BBB+ and Fitch has it at BBB, after last week's downgrade.  Pundits can bemoan that rating agencies are slow to respond, but to claim that they are irrelevant misses the boat.  

When determining the size of discount to apply to different collateral, the ECB takes the highest of the three ratings.  If Moody's does cut Spain's rating as it has suggested it may, Spanish bonds fall into a new collateral bucket and an additional 5% discount will be applied across the yield curve.  

In principle the ECB could change the rules, but that seems unlikely at this juncture.   The larger discount then would require those using Spanish bonds as collateral (see Spanish banks)  to pony up cash or repay the loans to the ECB. 

Another dimension that might not have been thoroughly thought out is what happens now to Spain's contribution to the ESM and the rest of it share of guarantees in the remaining commitment to the EFSF.  Spain's share is about 12%.  That is 60 bln euros of the ESM that cannot be count any more.   If the EFSF has 220 bln uncommitted guarantees, Spain's 24 bln share might not be there either.  

Either the remaining countries not receiving aid have to increase their commitments or the firewall is marginally smaller.  And what about Cyprus?  Because the EU offered Spain funds, prior to the latter's request, does that mean that Cyprus will have to share the cost of Spain's aid before seeking its own ?  

Giving Spain an essentially unconditional loan weakens Europe's negotiating hand.  Surely this feeds into Syrzia's claim that Europe will compromise.  Ireland too should feel emboldened. 

There is another rub: Seniority.  The EFSF does not have senior status.  The ESM does.  The ESM does not exist now.  Judging from official comments, they prefer that Spain's assistance comes from the ESM.  Private sector investors are at a greater disadvantage.   After the experience in Greece, investors will prefer bonds on international (UK) law to domestic law bonds. 

Even if the doubts raised here are accurate, Spain has been given time.  The loser here is Italy.  The smaller dominoes have fallen--Greece, Ireland and Portugal.  Spain is twice as big as the three of them put together and Italy is bigger still.   Monti's reform agenda is stalling, unemployment at 10.2% is the highest in a decade and consumer confidence is the lowest in fifteen years.  Italy is positioned to be the next lightening rod in the euro area.   

As goes Italy, so goes France.  Hollande's honeymoon may last through the final round of the parliament elections on June 17, but then things will become more difficult as the new budget, expected early July, must include spending cuts as well as tax increases.