Subordination in Spain causes very little pain
Sony Kapoor has a very good post on the Spanish bank bailout today, explaining that when Spanish credit spreads rose in the wake of the bailout, that had nothing to do with the fact that bailout funds were senior to privately-held bonds, and everything to do with enforced austerity.
The clever thing about Kapoor’s post is that he explains this empirically, through simple force of arithmetic. Basically, channelling new money to a liquidity-constrained debtor is always good for existing creditors, even if the new money is senior. That’s obviously the case if the new money prevents insolvency, but it’s also the case if it doesn’t:
Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.
Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.
So why are Spanish bond yields now so much higher than they were before the bank bailout? Isn’t the bailout a good thing? Not necessarily:
There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain.
The logic here is scary, but also entirely coherent: the more bailout funds a country gets, the more it ends up being forced into austerity programs which will ultimately do more harm than good.
On the other hand, there’s hope here, too. If Mediterranean Europe eventually manages to tear Germany away from its unhealthy austerity addiction, then all this extra liquidity in the Eurozone could trigger a significant tightening in sovereign yields. Even if it’s subordinating those bonds at the same time.