By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Rome is in a bind. Arrears to local companies are choking the economy, but funding them upfront could push up the country’s debt and spook markets. So Italy is using banks to front some of the money in a way that avoids pushing up its debt at least for the time being.

Rome’s unpaid bills by local authorities and other government entities to private suppliers are estimated at about 70 billion euros, or 4 percent of GDP. Euro zone accounting rules allow governments to exclude commercial arrears from their public debt levels until they are paid. But accumulating arrears hurts the economy, and a European directive next year will force governments to recognise unpaid bills. Spain has started to bite the bullet; it recently recognised 35 billion euros of arrears owed by its regions as debt, and is taking out a loan to pay them off.

Italy has just announced a plan to clear up to 30 billion euros of arrears by year end – but in a way that won’t affect its reported debt levels. Some of the arrears will be netted off against unpaid taxes that the suppliers owe. A further 6 billion euros was set aside to clear arrears in last year’s austerity package.

To handle the remaining chunk, Rome has come up with an elaborate piece of financial engineering. Italian banks will lend to suppliers once they have obtained a certification to prove that the payments are legitimate. The loans leave the bank exposed to credit risk. But a separate central government-backed fund will provide banks with guarantees. Those, in turn, will cut the risk weighting on the loans so enabling banks to offer suppliers better terms. As these guarantees are contingent liabilities, they too should stay off the government’s balance sheet unless called on.

This jiggery-pokery is a stop-gap solution. At some point the government will still need to pay the bills. And going through the banks may be less speedy than the government just paying the supplier directly. Still, with debt equivalent to 120 percent of GDP and markets febrile from the Greek crisis, it easy to see why Rome prefers keeping things off-balance sheet.

By Neil Unmack and Fiona Maharg-Bravo

The authors are Reuters Breakingviews columnists. The opinions expressed are their own

If Greece quits the euro, Spain’s banks will be the next weak link in the single currency. Hence, the frantic search for ways to prop them up. One solution, advocated in recent days by France’s president and Ireland’s central bank governor among others, involves the direct injection of capital by a euro zone fund into Spain’s lenders. The appeal is obvious: Spain’s banks would be recapitalised but Madrid’s own debts wouldn’t rise. The country would therefore avoid the fate of Ireland which was dragged down by bailing out its lenders – even though its financial system is proportionately a lot smaller.

But there are complex political and technical hurdles that would have to be jumped before such a solution could work. As a result, direct recapitalisation of Spain’s banks, bypassing the sovereign, doesn’t look like a quick fix.

At the moment, neither the European Financial Stability Facility (EFSF) nor the soon-to-be-created European Stabilisation Mechanism (ESM) are able to recapitalise banks directly. Although the treaty setting up the ESM is moderately flexible, such a move would almost certainly require approval by at least Germany’s parliament. Given that direct recaps would require a potentially vast transfer of risk from peripheral countries to taxpayers in the core, that wouldn’t be easy. If Spain got such a good deal, other countries such as Ireland would want one too.

Before taking on such risks, taxpayers in northern Europe would demand far greater oversight of domestic banks, transferring power away from national regulators. They may also insist on “bailing in” bank bondholders as a way of mitigating their risk. None of this would be trivial for Madrid to concede not least because many bondholders are retail savers. Haircutting them would be politically problematic.

These obstacles may be overcome with time. The European Commission is, for example, already working on a continent-wide scheme for bailing in bondholders if banks get into trouble. But it’s unlikely that everything can be nailed down in time to help Spain manage a Greek exit. The main option would then be for the EFSF to lend money to Spain which, in turn, would recapitalise its banks. If a fix is needed fast, Madrid may just have to put up with a higher debt load.

By Neil Unmack and Fiona Maharg-Bravo

The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The carry trade is alive and well in Spain and Italy. Banks are loading up on sovereign debt, thanks to the wave of liquidity from the European Central Bank’s cheap three-year loans. But local lenders can’t fund Madrid and Rome indefinitely, and with markets still dysfunctional, money could run out sooner than expected.

Spanish and Italian banks borrowed 220 billion and 140 billion euros of new money, respectively, under the ECB’s cheap three-year facilities. So far, they have mainly used the cash to replace privately-held bonds that are falling due, or to buy government debt. Spanish banks have bought 85 billion euros of sovereign paper between December and April, while Italian lenders have propped up the state to the tune of 77 billion euros. That’s allowed the two countries to carry on borrowing when international investors are scarce.

In theory, this could carry on for a while. RBC estimates Spanish banks have 82 billion euros of ECB cash left over – double the 41 billion euros that Madrid still needs to raise this year. As some investors – particularly domestic ones – are likely to swap maturing government bonds for new ones, Spain may only need 20 billion euros of new money. Italian banks, meanwhile, have 53 billion euros of ECB firepower, according to RBC. If domestic investors play ball, the government’s funding gap this year is around 70 billion euros.

Moreover, despite their recent splurge, banks have room to increase their holdings. Sovereign bonds account for just 7 percent of total balance sheet assets in Spain and 7.8 percent in Italy. In 1999, the share in both countries was over 10 percent. In Japan, it’s 23 percent.

However, larger banks like Santander, BBVA and UniCredit are unlikely to increase their sovereign exposure. Smaller banks face less scrutiny from markets, but also have less spare liquidity. Besides, banks have more pressing needs: Spanish lenders must refinance about 65 billion euros of funding this year, and there’s little prospect of them being able to tap wholesale markets.

By Neil Unmack and Jeffrey Goldfarb The authors are Reuters Breakingviews columnists. The opinions expressed are their own. Bill Ackman looks decidedly closer to the holy grail of permanent capital. The founder of activist U.S. hedge fund Pershing Square Capital Management is planning a London-listed vehicle with a market value of at least $4 billion. That would dwarf other public funds, many of which trade at a big discount to net asset value. Ackman’s scale, plus some fee sweeteners, may give him an edge. And his focus on easily priced bets could minimize the NAV problem.

The initial public offering of a new fund, which would invest in Pershing Square’s offshore hedge funds, next year is designed to let Ackman do more of what he does best. The bulk of his 22 percent annualized net return over the last eight years comes from successfully agitating at companies like JCPenney and Fortune Brands. By tapping the market, he wouldn’t need to keep half his assets in cash and other liquid investments, as he does now to accommodate investors who want to exit.

But listed alternative asset funds haven’t always worked out for shareholders. The vogue for them in the pre-crisis boom spawned some disasters. Some now trade at a premium to NAV, for example infrastructure funds and Brevan Howard-managed vehicles. But London-listed hedge funds and funds-of-funds trade at a 7 percent and 15 percent discount on average, respectively. The closest thing to Ackman’s strategy – activist Dan Loeb’s Third Point fund – was trading recently at a 16 percent discount to NAV.

Ackman may have more to offer, though. First, the listed fund’s sheer size should create a more liquid investment than most funds provide. Second, there’s a novel fee structure. To entice existing investors to make the switch, Ackman is slashing his performance fee from 20 percent to 16 percent. Investors in the listed fund also will share 20 percent of Pershing Square’s incentive fees. Finally, Ackman’s investments are unlevered and in public stocks, making them easier to value. That could help narrow the traditional NAV gap.

The history of publicly traded hedge funds isn’t on Ackman’s side, as he tries to persuade investors to buy in. But he also hasn’t ignored the industry’s past, which may help spare the fund from repeating it.

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Portugal can avoid becoming a new Greece. There’s a strong likelihood that Lisbon won’t be able to fund itself on financial markets in the second half 2013 – contrary to the timetable agreed in the country’s May 2011 bailout plan. Yet when it turns to its euro zone partners for help, there’s a chance Portugal won’t have to force losses on its private creditors, like Greece did. Still, no one can rule out a worsening of the economic outlook that would tip it into Greek territory.

Euro zone governments have some reasons to agree to a second bailout without restructuring. So far the Portuguese government is doing a good job. It cut its budget deficit by 3.5 percentage points last year, and the International Monetary Fund reckons its 4 percent target this year is within reach. Other euro zone governments, like Spain, are struggling. A Portuguese debt restructuring would make a Spanish one more likely by stoking contagion fears. Portugal has a lower deficit than Spain, and lower government debt-to-GDP than Italy. Furthermore, Greek-style pain would break the taboo that euro governments and the ECB tried to put in place when they swore that the Greek private sector involvement would remain an exception.

Still, the country’s finances are in a fragile situation. Rising bank losses and contingent liabilities for state-owned companies could push up government debt. Austerity may prove self-defeating in the context of serious private-sector deleveraging – something the IMF worries about. Finally, the Portuguese people may reject seemingly endless austerity, especially if the structural reforms enacted by the government take too long to generate positive economic results.

If the choice is made to restructure the country’s debt in 2013 or afterwards, there will be some logic in doing it quickly. Portugal has about 107 billion euros of debt that could be haircut, equivalent to roughly 63 percent of 2013’s forecast GDP. That comes down to 49 percent if the ECB’s estimated 23 billion euros of Portuguese sovereign bonds are excluded. Another 33 billion euros of bonds come due between 2013 and 2015, reducing the haircuttable debt as time goes by. The longer Portugal waits, the smaller the benefit of a restructuring, or the more brutal it will have to be.

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Rising Spanish yields have thrust Europe back into crisis mode. Policymakers thought the European Central Bank’s three-year loans had bought the euro zone some time, but markets are catching up fast.

The flashpoint is Spain. The country’s apparent inability to control its fiscal deficit – which was 2.5 percentage points higher than its target last year – and its decision to raise this year’s target shortfall to 5.3 percent, from 4.4 percent, has spooked investors. Bond-buying by Spanish banks helped to keep yields in check for a while. But the ECB-funded stimulus is wearing off. Yields on the country’s 10-year bonds are back above 5.8 percent.

The government’s decision to relax fiscal targets has placed it at loggerheads with the European Commission. However, the obsession with austerity may be self-defeating. The government is struggling to rein in spending by the autonomous regions, which were largely responsible for the budget spillover. Meanwhile, markets fret about growth; youth unemployment is shockingly high at over 50 percent, and the banking system is still weighed down by real estate exposures. Banks could face losses of 203 billion euros under a stressed scenario, according to Citigroup.

There are few easy solutions. The ECB could throw more money at banks to help them buy government debt. But Spanish lenders are overloaded with government debt having increased holdings by 52 billion euros in the two months to January, according to Citigroup. A full-scale bailout also looks difficult, as it would exhaust the euro zone’s recently-expanded bailout fund.

One option is a targeted bailout for Spanish banks, perhaps in conjunction with an external audit, as has already happened in Ireland. That would at least ease persistent concerns about property exposures, which in turn might lift some of the pressure on the government finances. In the end, however, Spain will have to fix itself. Investors would probably tolerate a loosening of fiscal targets, provided there was evidence that over-spending regions were under control. Spain also needs to press ahead with reforms to boost growth. That means labour reform, and reducing the burden on employers by lowering social security contributions.

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Greece’s debt restructuring has been a total success – almost. A small number of bondholders have rejected the debt swap. The holdouts could drag Athens through international courts. But paying them off would be difficult too.

Greece has so far forced investors holding 177 billion euros of bonds issued under domestic law into accepting a restructuring, as well as some foreign-law bonds. All in all, it has roped in about 96 percent of the private sector bonds targeted in the swap, enough to secure a second bailout from euro zone partners and the International Monetary Fund.

But some holders of bonds issued under foreign law, and by state-owned enterprises, aren’t playing ball. These bonds have similar collective action clauses (CACs) to the Greek-law bonds that Athens used to force losses on creditors. But because the CACs must be activated for each of the 36 different bonds, it is easier for investors to resist. So far, investors in 11 of the bonds have rejected the restructuring, and votes for another nine have been adjourned. Greece has already said it cannot pay holdouts more than they would get under the swap. If they don’t agree, a default will follow.

The threat to Greece is that bondholders then pursue their claim in the English courts, undermining the country’s revival. Argentina is still locked out of markets despite restructuring its debt years ago. The matter will come to a head in May, when a 450 million euro bond matures. The bonds are currently trading at about 70 percent of par, suggesting investors believe they will get a much better deal than the debt swap, which imposed losses of 75 percent. However, Greece has already crossed the default rubicon by forcing losses on bondholders and triggering credit default swaps linked to its debt. Paying the bonds would anger Greek voters, euro zone governments, and creditors who have already been strong-armed into the swap.

Perversely, the choice becomes tougher as more bondholders fall into line. If it is left with just a very small number of holdouts, it might be easier for Greece to offer a better deal, or even repay bonds at par. But for now, it can play hardball.

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How big should Europe’s firewall be? Some analysts reckon the euro zone needs as much as two trillion euros, enough to bail out Italy, Spain, and some others if need be. By comparison, the size of the planned 500 billion euros of the European Stabilisation Mechanism (ESM), the euro zone’s permanent bailout mechanism, looks paltry. Unless it includes the unused funds of the European Financial Stability Facility (EFSF), the temporary structure put in place in the wake of the Greek fiasco.

The current thinking is to lift the 500 billion euro cap in order to create a firewall big enough to convince the International Monetary Fund to cough up funds too. The most ambitious plan, devised by the European Commission, is to fold the EFSF’s unused guarantees into the ESM, which would boost the total size of the facility to 940 billion euros.

But increasing the firewall too much may not be desirable, or necessary. Once the money is there, there is a danger markets will push governments to use it. Countries with high borrowing costs may also become addicted to cheap bailouts. A fund big enough to bail out Italy and Spain could be created, but such large bailouts would be destabilising; governments in northern Europe will be highly reluctant to sign up, and their own credit would be impaired. Then there’s the risk that after Italy, France might one day follow.

Bailouts are necessary sometimes. Greece needs such deep social reconstruction that it will be on life support for years. Portugal may find itself in the same camp if its efforts to reform don’t pan out, and it may need to tap the bailout fund again. Ireland could need some extra money too. But it doesn’t look like other euro zone countries need the full treatment. Take Italy; last year its bond yields topped seven percent, prompting commentators to argue that a bailout was inevitable. But it wasn’t; a few months of high yields was enough to topple Silvio Berlusconi. Keeping countries exposed to market forces may be a better way of enforcing change than bailing them out.

Leaving markets to act unchecked could be dangerous. The Italian crisis last year was contained because the European Central Bank kept bond markets from spiralling out of control by buying government debt. It then protected Europe’s banks by making long-term funds available. Clearly, that requires the ECB to put member states’ capital at risk, just like the ESM will do. But the ECB route is better: market forces are still brought to bear, the ECB lends against collateral, and buys bonds at a discount, even turning a profit. When the crisis eases, it can quickly withdraw, as was done with Italy. Save for their psychological effect, the bailout funds don’t need to be increased at all.

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It could have been worse: that’s the best thing to be said about the Greek debt swap. The euro zone’s first restructuring will not be chaotic. But it has done away with the pretence that a euro zone sovereign’s signature is golden. And Greece will still struggle with a heavy debt load.

The good news is that enough bondholders agreed to the Greek plan to allow Athens to force losses on the recalcitrant private creditors through collective action clauses. Some owners of securities subjected to non-Greek law are holding out, but the hit rate will be at least 95.7 percent. That should allow the second Greek bailout in 18 months to proceed. The deal will trigger a payout on credit derivatives. A failure to trigger would have compromised the credibility of other sovereign default swaps, which are important hedging tools for banks.

Still, the restructuring has costs. Arguably, it wasn’t fair. Private creditors have been punished for lending recklessly, but public-sector lenders have got off lightly even as this second bailout was the proof that they had bungled the first one. The European Central Bank’s holdings of Greek bonds have been protected; euro zone governments have not haircut their loans, although they did agree to charge lower interest rates. This unequal treatment will weigh on the prices of bonds sold by other weak states. More broadly, the euro zone must now cope with a world where sovereign creditworthiness has been impaired, affecting borrowing costs across the region.

Even for Greece, the restructuring isn’t particularly good news. Despite wiping about 100 billion euros from its debt pile, Greece will still have debt equivalent to 168 percent of GDP next year – which will only come down to 120 percent by 2020, at least if all goes according to plan. That will weigh on Greece’s growth and its population’s appetite for reform.

The new 30-year bonds issued under the restructuring could be expected to trade at about 28 percent of face value, according to Breakingviews calculations, assuming a discount rate of 12 percent. The current price in the unofficial “grey” market is about 20 percent, suggesting markets expect more losses. After the biggest sovereign restructuring in post-war history, Greece is only at the end of Act 1.