Spain … Of bonds, banks and bailouts

June 21, 2012

It’s well and truly a Spain day.
Its 10-year yields may have ducked back below the 7 percent pain threshold but Madrid’s auction of two-, three- and five-year bonds could still be tricky. It is only aiming to sell up to 2 billion euros and should manage to thanks largely to weak Spanish banks buying them up but the five-year bond is likely to command yields last seen in 1996.

After that, an independent audit of Spain’s stricken banking sector is due to be published which will give a guide as to how much of the 100 billion euros offered by the euro zone the banks need to take to be recapitalized. Madrid may then make a formal request for aid at a meeting of euro zone finance ministers later in the day. We’ve had from sources that the audit will say up to 70 billion euros is needed but Spain would be well advised to take more to try and convince markets that it has all bases covered.

The audit is expected to divide the banks into three groups: the weakest regional savings banks heavily exposed to bad property debts, a group of mid-sized banks which face temporary liquidity problems and two ‘good’ banks – BBVA and Santander – that won’t need any help.

The announcement of the bank bailout two weeks ago did nothing to alleviate the pressure on Spanish borrowing costs. One reason was that if the money came from the euro zone’s new ESM rescue fund, it would be a preferred creditor over private investors who could then lose out in the event of a default. With the ESM only up and running at some point in July, one solution could be to start the bailout via the existing EFSF then switch it to the ESM, thereby operating under the former fund’s rules which say nothing about subordination. The Eurogroup could shed some light here too.

It has much else to discuss besides. No decision will be taken on whether to relax Greece’s bailout terms until the EU/IMF/ECB troika has returned to Athens to see how far off track Greece is but it seems a done deal that Spain will be given an extra year to meet its 3 percent of GDP budget deficit goal. That could come up.  Cyprus is to decide by the end of the month whether it too needs a bailout to recapitalize its banks which have been damaged by the Greek crisis. That could well be discussed in Luxembourg too.

The idea floated by Italy’s Mario Monti at the G20 summit, for the euro zone rescue funds to buy Italian and Spanish bonds direct, has failed to gather momentum. Nonetheless, it was that that has taken the edge of Spanish and Italian bond yields. Denials from Brussels and Berlin have been fairly emphatic – Germany’s Angela Merkel, back from the G20, described it as a “purely theoretical” question which was not being discussed.

Finnish PM Katainen, who also rejected the idea, put his finger on it, saying the funds were not big enough to turn the secondary bond market around. That’s almost certainly true given the ECB had to spend up to 14 billion euros a week in Italy’s defence last year. Anything like that – and the effects were pretty short-lived anyway – and the 500 billion euro ESM would soon look utterly incapable of handling a sovereign Spanish bailout so the much-vaunted firewall would have been trampled underfoot. Then there is the seniority problem highlighted by the reaction to the Spanish bailout offer. With the ESM having preferred creditor status, if it piled in, private investors might head for the exit.

The ECB remains very reluctant to fill the gap, so it was no surprise to see board member Coure in the FT last night saying he was mystified as to why the EFSF hadn’t bought bonds in the secondary market already. By the way, the preferred creditor conundrum applies to ECB purchases too after it was spared any writedown in the second Greek bailout while private creditors took a massive hit.
So what is to be done?

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