Felix Salmon

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.

The FT has the best explanation of the way that Europe has this weekend agreed to bail out Spain’s banks. Impressively, the whole deal was done on Saturday, in good time to let all the Spanish negotiators spend Sunday preparing for and watching Spain’s big opening match against Italy in the European Cup. (Portugal lost today; Greece had a draw on Friday; and Ireland isn’t in the tournament plays Croatia tomorrow. According to the odds, Spain has the highest chance of winning both the PIIGS subset and the tournament as a whole.)

The big question, going into this weekend, was whether Europe would be willing to recapitalize Spain’s banks directly, or whether it would simply help Spain bail out its banks. And the answer seems to be somewhere in the middle. Europe is going to lend money to Frob, which is basically the Spanish Tarp; Frob, in turn, will use that money to recapitalize the banks.

So really there are two bailouts here. The Spanish government is getting debt finance from Europe, and the Spanish banks are getting equity finance from the Spanish government. Because the money is ultimately going to the banks, the Europeans and the Spaniards have an excuse for not imposing tough austerity conditions on Spain. And that’s good: Spain has never been fiscally profligate in the way that Greece was, and there’s no reason why it would ever benefit from some kind of Germanic nanny double-checking and second-guessing every check it writes.

On the other hand, all the money for bailing out Spain’s banks is immediately going to become Spanish sovereign debt. And that’s not good, for anyone worried about the Spanish fiscal situation. What’s more, it’s unclear how much of the money is going to come from the ESM rather than the EFSF. That might seem like a niggardly distinction, but it’s an important one: the ESM has preferred-creditor status, which means that it’s senior to anybody buying Spanish sovereign bonds. And as a result, at the margin, the more ESM debt that Spain has, the higher the spread on Spanish government bonds, since every euro of ESM debt effectively subordinates every euro owed by the Spanish government to bondholders.

The way to avoid all this would have been for Europe to recapitalize the Spanish banks directly, rather than doing so by lending money to Frob. The IMF couldn’t participate in such a plan, since it can only lend to governments, not to banks — but the IMF isn’t participating in this plan, either. And by taking equity in the Spanish banks, Europe would actually have a chance of turning a substantial profit on the whole operation, instead of just lending money to Spain at concessionary rates. As it is, if the equity that Spain takes in the Spanish banks ends up rising in value, all that rise in value will accrue to the government of Spain, rather than to the Europeans who provided the money.

But clearly Europe hasn’t yet reached the point at which it’s willing to directly help out the financial sectors of member countries, no matter how necessary or potentially profitable that might be. Taking equity stakes in Spanish banks — or any other private-sector institution, for that matter — is clearly something which Europe wants to leave to individual countries, and I can understand that, at least in theory. In practice, however, I suspect that Spain and the markets would have been much happier if the flow of money had been direct, rather than being intermediated by the Spanish government.

It almost goes without saying, but you have to read Michael Lewis’s tour de force on Ireland in Vanity Fair. It’s long — over 13,000 words — and it’s beautifully written, giving both a big-picture perspective on the Irish economic boom and bust, and a credible account of the fateful meeting at which the Irish government decided that it should go ahead and guarantee the debts of all Irish banks. That move was the single worst decision among all the policymaker actions over the course of the global financial crisis, and Lewis is right to be astonished at how meekly the Irish population has accepted its devastating consequences.

Ireland was unfortunately yet predictably being run, at the time of the crisis, by the business-friendly Fianna Fáil party, full of lawyers and other pillars of the establishment with a tendency to make decisions on a narrow, legalistic basis. The government paid Merrill Lynch €7 million, at the height of the crisis, for a seven-page report saying that “all of the Irish banks are profitable and well capitalised” and that the government guarantee would therefore cost nothing. The result was an immediate overnight windfall for anybody invested in Irish bank debt:

The bondholders didn’t even expect to be made whole by the Irish government. Not long ago I spoke with a former senior Merrill Lynch bond trader who, on September 29, 2008, owned a pile of bonds in one of the Irish banks. He’d already tried to sell them back to the bank for 50 cents on the dollar—that is, he’d offered to take a huge loss, just to get out of them. On the morning of September 30 he awakened to find his bonds worth 100 cents on the dollar. The Irish government had guaranteed them! He couldn’t believe his luck.

Lewis does a great job of presenting the back-story to the way in which the Irish government chose Merrill to be its CYA mechanism: Merrill was the bank which had recently bowdlerized a prescient report from its own analyst, Philip Ingram, which had cast doubt on the quality of the assets at Irish banks. It was unthinkable that Merrill would be honest with the government, and it wasn’t.

Ireland’s bank-debt guarantee was a bit like AIG’s CDO guarantees, only much, much worse. The CDO guarantees were issued when the CDOs were trading at 100 cents on the dollar, and AIG stopped writing them in 2006. The bank-debt guarantee was issued as markets were plunging, at the end of September 2008, after Lehman Brothers had already gone bust. AIG genuinely believed, when it was writing its guarantees, that there was a negligible chance that any of them would result in payouts. Ireland, by contrast, knew full well that its banks were in trouble — the guarantee was a bit like offering free health insurance to someone who’s just been rushed to the emergency room, on the grounds that a Merrill Lynch report says the patient is in fine fettle.

Lewis makes another important point, too: substantially all those bonds which Ireland guaranteed have now been paid off, in full, at par, using money from the European Central Bank. There is no longer a pool of government-guaranteed bank bonds alongside another pool of government debt; everything is now pure government debt, and as a result Ireland is mired in a fiscal crisis from which there is no way out.

All of which is an important cautionary tale for Spain, which needs to work out what to do with its undercapitalized cajas. A blanket guarantee of caja debt wouldn’t be as disastrous as the Irish guarantee, but it’s still a bad idea. On the other hand, letting them go bust doesn’t seem very attractive either. The ideal solution, as Mohamed El-Erian says today, would be to somehow recapitalize them with private money — but there’s understandably little appetite in the private sector to come up with the tens of billions of euros needed to do that. And forcibly merging the cajas doesn’t help much either: as the cliché has it, you can’t tie two rocks together and hope that they’ll float.

The best-case scenario, for me, would be one in which some or all caja debt was turned into equity. Ireland should mark the end of the era of bank bailouts: given the fiscal straits of the European periphery, it’s time to draw a line in the sand. Ireland has avoided riots and chaos, and its upcoming political transition looks as though it’s going to go smoothly. But that’s no evidence that what it did was in any way a good idea.