Subordination in Spain causes very little pain

By Felix Salmon
June 25, 2012
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.

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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.


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If my fellow commenters are on their games today, FS – this is going to be a rout.

Posted by MrRFox | Report as abusive

Interesting calculations. I don’t disagree that the added austerity measures may be a greater influence on credit spreads but I’m not convinced subordination can be written off so easily.

As Sony notes “The only circumstances under which a public bailout will make private investors worse off is if the public bailout money is ‘wasted’ or spent on items that are NPV negative.”

I don’t think we can write off the possibility that many Spanish banks currently have a negative NPV (due to severely overvalued home loans). In that case, bailouts may very well hurt private and public investors.

Posted by Woj | Report as abusive

Doesn’t that assume the z-euro bailout is put to efficient use? If it’s burned in the public square (or the functional equivalent, loaned to insolvent-before and still-insolvent-after banks to help out their bondholders), then how has the country’s ability to produce anything of value been enhanced?

Posted by PR1 | Report as abusive

Sony Kapoor’s post is horrible.

It resembles another attempt from the financial industry (drug dealers) to sell more drug (debt) to the victims (the public). A pathetic attempt to convince the victims to stop quitting drug (commit to austerity).

The victim is a serious drug addict and for political reason cannot be restrained (ie by military dictator government), yet the victim is surrounded by very fragile pottery (social order). If the drug is taken off right away, serious withdrawal symptoms will appear. The victim goes crazy. There will be a lot of broken pottery (social chaos).

The solution from Germany is the smartest way. Cutting down on drug. The bail out is meant only to smooth out the craziness of the victim when the drug is taken away. Hopefully less pottery is broken (less chaos on the street).

The yield goes up for several reasons mostly speculative.

Posted by trevorh | Report as abusive

Felix – I don’t think Kapoor’s deals very much with seniority. If x = 0.8y, a bailout never makes sense (it only makes sense if x > y, but for maturity or currency mismatches cannot be fulfilled in every period; x < y means the country is fundamentally insolvent). Without a (senior) bailout, creditors in this example receive 0.8y.

But in case of a bailout with senior status to the amount of z and x = 0.8y, creditors receive only 0.8(y-z) since z is repaid in full. For every z > 0, 0.8(y-z) < 0.8y. So if there is any doubt about the fundamental solvency of a country, a senior bailout clearly lowers the expected repayment in case of default…

Posted by jusha | Report as abusive

Great post…

Posted by Temizlik | Report as abusive