EU, Spain and “Voodoo Economics”

 

The Bulls Come Home To Roost

After weeks of denying that there was any problem, Spanish officials came to their senses last week and admitted that the Spanish banking sector – awash in bad debt and mismanagement – would require a bailout.

And the EU, now following a very familiar script, worked furiously to hammer out a bailout deal over the weekend, before international financial markets opened today.

Just rumors of a bailout pumped up the DOW on Friday.  DOW futures, as of this writing, are up 50 points.  In Asia, markets closed higher today, based in part on the news that European leaders would yet again plug a leak in the crumbling EU dam.

But amid all the hype, what exactly is the root cause of celebration here? A more careful look at the facts is clearly in order.

First, the $125 billion Spanish bank bailout is nothing more than a general offer. No one – Spanish or EU – knows exactly how much Spain will need.

Early last week, Spanish officials guessed that the total amount needed to stabilize the banking sector would only be about $50 billion, a figure that private sector experts found woefully unrealistic. The EU announcement went “big” to prevent the kind of incrementalism the dogged the EU in the Greek bailout, and to assure markets and investors that EU had a handle on the crisis. But even $125 billion may not be enough. The final figure will be a product of thorough scrutiny by EU banking officials.

Second, no one knows for sure where the money will come from once the Spanish application is received.

The European Stability Mechanism (ESM) isn’t even a functioning entity yet – it does not come into being until July 1, delaying any immediate aid Spain. Of course, there are funds available in the existing, temporary, European Financial Stability Facility (EFSF) which bailed out Greece, Ireland and Portugal.

But the choice of funding mechanism is no small matter. The ESM funding comes with strings that are critical to investors.

Under the EU treaty that set up the ESM, it was agreed that the ESM would be a preferred creditor in the event of default. So, if you are an investor in say, Spanish bonds, and Spain defaults, the ESM is going to get its money before anyone else sees a dime.  This preferred creditor status is ambiguous with the EFSF bailout facility, which is why you hear the Germans making a loud case that the Spanish bailout should be done by ESM.

Third, the very structure of the proposed bailout creates new dangers.

The bailout funds will be channeled through the Spanish government – the state run FROB bank rescue fund – instead of a direct cash infusion into the banks. That means that cash infusion becomes part of the Spanish national debt. Spain is already carrying a debt of $559 billion.

Simply put, there is no way around the fact that Spain’s’ debt-to-GDP will dramatically increase as a result of the bank rescue. If the full $125 billion is used, debt-to-GDP will increase by a jaw dropping 22%.

This, in turn, calls into question Spain’s longer term economic viability to service its debt, with the toxic consequences of higher, even unaffordable international interest rates required to secure loans for debt service, which would then require a full fledged sovereign bailout by the EU.

Fourth, the bailout does not address, and could even exacerbate the unspoken and highly dependent relationship between the Spanish banking sector and the Spanish government.

Spanish banks are sitting on a mountain of bad debt created primarily by the irrational exuberance of the banking sector in the once booming housing sector that has since collapsed. The banks have sat on that debt, hoping for a real estate recovery that has not occured, leaving the banks dangerously under capitalized.

Alternately, since the beginning of the sovereign debt crisis, the Spanish government, which is in the midst of a painful economic restructuring amid one of the worst recessions on the continent, has had its own problems attracting capital on international markets at acceptable interest rates.

In January, in a move to boost liquidity in European banks, the European Central Bank (ECB) lent out over $1 trillion. But instead of using that capital to clean up their balance sheets and to promote more lending conducive to economic growth, the banks took the almost free money and invested it in high yeielding government debt.

This happened in Spain as well.  The banks made a tidy profit on the spreads between the ECB loans and the sovereign debt, and the infusion of domestic capital to buy sovereign debt kept the interest rates for Spanish sovereign debts at acceptable levels.

Now, however, the party is over.

The tidy profits from the ECB arbitrage on sovereign debt could not make up for the structural deficiencies and bad debt in the Spanish banking sector.  Now, Spain will have to go to international markets without a ready source of domestic capital to temper international rates, compounded by the fact that Spanish soveriegn debt will be 22% larger, putting additional pressure on interest rates required to refinance maturing debt or new debt issuance.

But it gets worse.

The incestuous relationship between banks and government finance has put the EU in a pickle. The initial ECB loans were meant to create bank liquidity and lending.  But it went into sovereign debt.  Now, the EU has to bailout a banking sector, whose portfolio is made up not simply of bad real estate deals, but Spanish sovereign bonds, purchased with ECB money. If the Spanish economic situation becomes untenable, any default will hit the EU twice; once for the original ECB loans and then for the bank bailout.

It is madness.

And while all this is going on, don’t forget that the Greeks vote on Sunday.  They see the harsh terms doled out to them in their talks with the EU, and now see how easy it was for Spain to get a cash infusion. Is it going to make the Greek voter go with the pro-austerity party or double down on far left that promises to abbrogate the austerity agreement on the premise that Germany will not allow a country to exit the euro?

If there is a stock market rally, be very wary.