Opinion

James Saft

Same thing, same results in Spain: James Saft

June 12, 2012

By James Saft

(Reuters) – It is shaping up to be a vintage year for doing the same thing over and over again but expecting different results.

The latest: Europe’s attempt to bail out Spain’s banks but not, somehow, have it count against Spain. This is akin to a dieter eating a cookie and telling himself he’s feeding his arms and legs but not his belly.

And while there are different bells and whistles this time, the thread that connects all of the European crisis resolution efforts is an unwillingness, or inability, to address the issue of who will pay for the destruction of excess debt. All efforts, from the LTRO to the bailouts, successively, of Greece, Ireland and Portugal dissembled on this point.

The LTROs made borrowing money easy but did little to make paying it back any more possible, while the bailouts attempted to buy time by perpetuating the fiction that a debt-laden state can be brought to health by shrinking its economy and lumbering it with even more debt.

As a result, the relief brought on by successive “rescues” has been ever shorter and ever milder. This pattern appears to be reaching something approaching the end of the line: Monday’s rally in Spanish bonds didn’t last the day and, ominously, losses spread to Italian debt.

It is difficult to know where to start with what is wrong with the program, but a good place is the contention that this is a credit line to recapitalize Spanish banks, rather than a bailout of Spain. European policy-makers have become obsessed with the idea that they must break the mutual death-grip between banks and states, falsely reasoning that if only banks can be backstopped, mysteriously, credit will flow to states and make unnecessary further outright rescues by Germany.

There are only two ways to break this link – one is to substitute a new sovereign and the other is to cut the banks loose. You can create all the bad banks you want, but someone has to fund the bad assets.

The assumption of investors is that the new funds, equal to about 10 percent of Spanish GDP, will represent a further liability of the Kingdom, thereby making it a less good credit and even less able to both grow and repay.

UNCERTAINTY AND SUBORDINATION

The Eurogroup indicated that money for the bailout might come either from the EFSF, a temporary rescue fund, or the permanent ESM, slated to become effective next month. In either event, indications were that the loans would be senior to private creditors, and that bank bondholders further down the food chain would likely face losses.

Subordinating Spanish debt holders and forcing bank creditors to share losses is correct, but probably needed to be done on a pan-European basis. As of now both groups have had a lesson they may have learned in Greece reinforced: they are on the firing line.

Little wonder then that yields on 10-year bonds issued by Italy rose above the important 6 percent level. Not only is Italy now lumbered with about 20 percent of the liability for the loan to Spain, it was already very highly indebted at the national level. The read-across for other bank systems is similar. Who wants to fund French banks when the assumed rules of the game are changing?

This is not to say that the rules as they stood before, that Germany backed Europe and Europe backstopped its banks, were reasonable. They were unsustainable and an invitation to borrow and skim. If, however, we are changing those rules we need to anticipate the consequences.

For example, the bailout of Spain’s banks is founded on the idea that it will only be a few banks, probably regional lenders called cajas, which will fail. How do you force the weak banks to come clean about their dodgy collateral without affecting the so-called strong banks? ECB willingness to accept doubtful collateral from Spanish banks has kept them afloat but also prevented Spanish real estate from falling to a sustainable level. As a result Spanish real estate prices have only fallen 10 to 15 percent, despite suffering from over-supply akin to Ireland, Nevada or Florida.

Bank bondholders are working out that they will suffer losses as that bad collateral is recognized.

That’s right and proper, and will accelerate the healing process.

It will also make the 100-billion-euro bailout of the banks insufficient, which in turn will focus more attention on Spain’s weakened condition, probably forcing it to seek more aid as investors, outside of its own banks, desert its debt.

On to Italy, where the crisis has more rivers to cross.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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