Sunday, 10 June 2012
Over the past 24 hours, Zero Hedge covered the various key provisions, and open questions, of the Spanish bank bailout. There is, however, much more when one digs into the details. Below, courtesy of Deutsche Bank's Gilles Moec is a far more nuanced analysis of what just happened, as well as a model looking at the future of the pro forma Spanish debt load with the now-priming ESM debt, which may very well hit 100% quite soon as we predicted earlier. Furthermore, since the following comprehensive walk-thru appeared in the DB literature on Friday, before the formal announcement, it is quite clear that none other than Deutsche Bank, whose "walk-thru" has been adhered to by the Spanish government and Europe to the dot, was instrumental in defining a "rescue" of Spain's banks, which had it contaged, would have impacted the biggest banking edifice in Europe by orders of magnitude: Deutsche Bank itself.
From DB: *Spain: the mechanics of “recap only” loans*
The guidelines for an EFSF bank recap are quite precise. There will be no conditionality on fiscal policy or structural reforms. The loan will also sit on Spain's balance sheet, meaning the volume of recapitalisation – to be established after a new, independent stress test – will be crucial: it needs to be big enough to convince the market that Spain's banking issue, which has been festering for three years, is addressed in a credible manner, while not being so large as to jeopardize Spain's public debt sustainability. We model possible trajectories for Spanish public debt for various recapitalisation volumes. In an intermediate recap scenario of EUR80bn, Spain could realistically, in our view, keep public debt below 95% of GDP at peak and bring it back below 90% by 2020.
*What would Spain need to do to access the "recap only" EU loan?*
The "recapitalisation tool" created in July 2011 is normally open to countries "when the origin of the financial distress is strongly anchored in the financial sector and not directly fiscal or structural". In addition, "a beneficiary country will have to demonstrate that it has a sound policy record, such as the respect of its SGP commitments". The first condition would normally be met by Spain: while in-built issues, such as poor fiscal coordination between the regions and the central government, or the extreme rigidities of the labour market, have been revealed and magnified by the current crisis, the point of origin of Spain's difficulties clearly stem from the need to absorb the property boom of the early 2000s and the subsequent need to de-leverage. The second condition may seem more difficult to meet, but the EFSF guidelines make it plain that "countries under excessive deficit procedure would still be eligible (...) provided they fully abide by the various Council decisions and recommendations", which is still the case for Spain after the Council agreed to relax the fiscal targets for 2012. EC Commissioner Olli Rehn's mention of the possibility to give Spain an extra year to reduce its deficit to 3.0% of GDP is another sign that, at least at this stage, there is no open conflict between Madrid and its European peers on fiscal policy.
*As a first step, a country triggering a "recap only" loan will submit to the EU a list of "institutions in distress". *In principle, the only eligible institutions should be "systematically relevant or posing a threat to financial stability". This may be a problem since Spain would probably include in such a list a number of smaller Cajas. However, a movement of concentration has already started last year and the government can argue that "interconnectedness", one of the criteria for the assessment of the "systemic dimension" mentioned by the guidelines, could justify a sweeping recapitalisation.
Once the request has been formally made, Spain would lose control over much of the process.
First, a joint assessment of the country's eligibility will be conducted by the European Commission, in liaison with the ECB and where appropriate with the relevant banking supervisory bodies such as the EBA. They will in particular decide whether or not the "recapitalisation pecking order" has been respected. Indeed, the guidelines specify that the private sector should be first to bear the costs of a recapitalisation, followed by the national government and only in last resort the EFSF/ESM. As far as private sector participation is concerned, only "shareholders", and not bondholders, are mentioned. The text refers to "special crisis management and resolution intervention powers for national supervisors which could expand the possibilities for the private contributions via mechanisms such as bailing-in bondholders IN THE FUTURE". As it stands today, the "recap-only" loan does not trigger bailing in. Note that under the EC's proposal on crisis prevention, management and resolution, released on 6 June, unsecured debt would not be bailed in as part of
the "default" bank restructuring before 2018.
The Europeans would probably consider that Bankia's flotation last summer, which did not raise enough capital to deal with the company's shortfall, allows Spain to tick the first box. For the second box, they will have to consider that the current market conditions would make it impossible for the Spanish sovereign to issue enough debt to recapitalise banks in a credible manner.
*Second, the amount of capital needed would be determined by a stress-testing exercise, which will be conducted by the national supervisor (i.e. the Bank of Spain), but also involving the EBA and "national experts from supervisory authorities from other member states".* This means that once the process is underway Spain will lose control over the final loan amount. Note however that the guidelines offer the possibility of a twostep procedure, with a first estimate being confirmed by a more comprehensive analysis "at a later stage". The assessments provided by Oliver Wyman and Roland Berger, which are more a valuation exercise than a proper “stress test”, and more particularly by the IMF, could provide a first basis. The IMF's FSAP (Financial Sector Assessment Program) is due for publication on 11 June.
*The conditionality attached to the loan would be limited to the recapitalised institutions themselves and financial system reforms in the beneficiary country*. No conditionality on fiscal policy or structural reforms pertaining to non-financial system issues is needed - apart from continued compliance with the European Council's recommendations already enforced under the Excessive Debt Procedure framework. The "institutionspecific" conditionality will pertain to EU's state-aid rule, as well as the obligation for every recapitalised bank to be restructured. So-called "horizontal" conditionality pertains to financial supervision, corporate governance and domestic laws on crisis prevention, management and resolution.
The final decision will be made by the Eurogroup under the EFSF, or by the ESM board if, by the time the full procedure is completed, the change-over has taken place. The IMF’s involvement in the process – always a touchy political issue – would be minimal. The guidelines only point to an “additional assessment of the quality of national supervisory practices by the IMF”, which needs to be “actively sought” by the beneficiary member state while the package is being implemented. The Fund is not supposed to be involved in the approval of the package itself, even if the FSAP will probably be an important input in the EU’s assessment of the recapitalisation need.
*The monitoring of Spain's compliance with the conditionality to such a package would be the responsibility of the European Commission, the ECB and the EBA*. The guidelines specify that "these institutions must be granted the right to conduct on-site inspections in any beneficiary financial institutions". They will have the possibility to involve other relevant experts, "such as external auditors or monitoring trustees". Note however that, in practice, the recapitalization funds are provided upfront. Therefore the effectiveness of the monitoring may be somewhat diminished.
*What would be the consequences for Spain?*
*The current rules are unambiguous: “The beneficiary member state will remain the ultimate liable counterparty”. In our opinion, ideally such a provision should be changed, to help stopping the “sovereign/banks loop”. *Still, the probability to change the ESM terms in order to allow direct recapitalisation, i.e. without raising the receiving country’s public debt, is low for now in our view. Note that a “federalization” of bank recapitalisation would always come with tricky moral hazard issues. At the very least, the receiving country would have had to offer a “first-loss guarantee” to the EFSF/ESM to protect the European peers from the financial consequence of failing recapitalisation/restructuring. *This means that in any case the receiving country would still have to stomach an increase in its contingent liabilities.*
Political opposition in some core countries, lack of time and daunting legal complexities are the main reasons why Spain will probably have to trigger the system as it is today. Indeed, to allow direct recapitalisation, awkward questions on the relationship between bailed-out banks and the ESM would need to be sorted out very quickly. The current guidelines state that the “capital injected… is expected to be of the highest possible quality”. Under Basel III, common equity will be the highest form of capital. Hybrid debt would not qualify. The choice for the ESM would be difficult: either inject common equity and get involved in the banks’ governance – which would entail very rapidly the creation of a federal agency with the relevant staff and expertise – or take shares stripped of their voting power, but then the ESM could neither control the banks’ management nor hold a claim on the assets. This would put the European rescue mechanism in a fragile position In any case, the possibility to change the ESM’s rules of engagement without renegotiating the entire ESM treaty – with the subsequent parliamentary ratification process in all member states – is not clearly established.
True, Article 19 of the treaty allows the ESM board to “review the list of financial instruments provided for (...) and make changes to it”. On the face of it, another instrument, specifically allowing for a “recapitalisation only loan” which would bypass the sovereigns could be added. However, this could be seen as too blatant a contradiction with the initial spirit of the treaty as well as to letter of its article 3, which describes the ESM’s purpose as “mobilise funding and provide stability support to the benefit of ESM members”.
The ESM members are the contracting parties, i.e. the governments. It is a very gray area, but that a full revision of the treaty would be needed seems to the position of the German government, as well as the ECB’s interpretation, as stated by Mario Draghi this week “the ESM forbids direct recapitalisation”.
Spain therefore has, in our view, a high probability of triggering a “recap only” loan under the current system. Discussions reported in the Sueddeutsche Zeitung and the Financial Times about the possibility to channel the funding via the FROB, Spain’s recapitalisation vehicle, would not change the fact that *the loan would appear on the government’s balance sheet*. It would simply help the Spanish government to “sell” the deal to its public opinion, by highlighting the fact that the EU loan would be strictly earmarked to recapitalise banks, contrasting with the “full program” approach, covering the government’s “ordinary” funding needs in Greece, Ireland and Portugal.
The size of the “recapitalisation loan” is going to be crucial to Spain. It has to be large enough to convince the markets that it will address the country’s banking issue in a credible manner, while not being large enough as to jeopardize debt sustainability.
Some estimates are already available. Fitch for instance considers in a base case that a recapitalisation effort of EUR50bn would be needed, EUR 100bn in an adverse scenario. Since the announcement that Bankia alone – c.13% of all real-estate related assets - needed an additional EUR 19bn, out of which EUR 15bn for credit impairment, the market is probably expecting large numbers, even if it would be wrong to extrapolate from Bankia, which tends to concentrate the worst risks.
According to El Pais on Thursday, quoting “parliamentary sources”, the Bank of Spain considers that two other nationalised banks, CatalunyaCaixa and Novagalicia need additional capital to the tune of EUR 9bn. The Spanish press on Thursday (El Pais, ABC) was mentioning a range of EUR40-80bn for the IMF’s assessment, to be published on Monday.
We calculate here different trajectories for Spanish public debt for three different recapitalisation scenarios: EUR 50bn, EUR 80bn and EUR 120bn. See box next page for the details of the calculations.
Under the EUR 120bn scenario (see Figure 1 in the last page of this article), Spanish public debt would remain at peak marginally below 100% of GDP (97.2% in 2014 and 2015). That would still be significantly below Italy, but Spain would be unable, in our model, to bring back by 2020 its debt below the 90% of GDP threshold which Rogoff suggests is associated with adverse macroeconomic consequences.
*A figure above EUR 120bn for the recapitalisation need could become an issue for the “recap only” approach, since the guidelines make it clear that the size of the loan should remain consistent with a “sound fiscal position” for **the receiving country. *The risk then is that the country would be pushed in a “full program”. Another risk would also be to see Spain pushed below investment grade status by rating agencies. Fitch’s “top range” for the state-funded recapitalisation stands at EUR 100bn as they downgraded on 7 June the sovereign by 3 notches to BBB with “negative outlook”.
In the other two scenarios, however, Spain would be in the same “club” as France.
Naturally, this type of models does not take into account the risk of “market over-reaction”, where interest rates climb further so that the sustainability conditions can no longer be met. We note incidentally that it may make sense for Spain to trigger the support under the EFSF scheme, before the ESM takes over in July. Indeed, EFSF loans are pari passu, *while ESM loans – except for the countries currently under program – are senior.*
*Since ordinary investors could be spooked by the “subordination risk” post-ESM funded recap, it would make sense for Madrid to hurry. *Also it would be reasonable to expect the ECB to be more aggressive in its support of Spanish banks and sovereign following a recapitalization effort that it has consistently called for.
Still, as we stated in Focus Europe last week, we think that resorting to the euro rescue mechanism is the only option for Spain to ultimately regain credibility in the market, by giving the banks the financial strength which will allow them to precipitate the fire sales (accompanied by a further significant fall in prices) which will start clearing the housing overhang. In the meantime, Spain will have to convince on its capacity to reduce its deficit. The latest data – completely ignored by the market in the midst of the “recap drama” – are somewhat encouraging. Correcting for the acceleration in transfers to the regions to help them cope with their refinancing issues (0.7% of GDP) as well as the anticipation in the VAT paybacks (0.1%) of GDP, among others, the central government deficit for the first four months of 2012 stood at 1.4% of GDP against 1.5% in the same period of 2011. This makes the official target of 3.5% for the whole year not out of reach. The regions, also correcting for the acceleration in transfers from the central government, have reduced their deficit to 0.45% of GDP in Q1 2012 from 0.75% in Q1 2011, before some of the most important measures (50% increase in university tuition fees, cuts in healthcare) actually kicked in.
Another crucial issue, in terms of market perceptions of the fiscal adjustment’s feasibility, will be the growth outlook. The effort is obviously daunting, but we think that our assumptions there are reasonable. The impact on GDP growth of the fiscal retrenchment would peak at 1.8 pp in 2012, using the Bank of Spain’s multiplier, which takes into account the lagged impact over three years of the fiscal stance. Our headline GDP growth forecast for this year is - 1.5%. In other words, our assumption for “underlying growth”, i.e. the pace of activity, stands at +0.3%, which in our view reflects the very negative impact of construction. However, after 3 years the impact of the fiscal retrenchment would fade significantly. The scenario we describe here does not sentence Spain to “eternal austerity”. The effort would be concentrated on three years. We note as well that the unlocking of arrears accumulated by the regions worth 3.1% of GDP this year, under a syndicated loan with the main Spanish banks, should have a mitigating impact on the recession.
*However, credibility has been dented in Spain. *We therefore think it is going to take time for the non-residents to flock back to the sovereign bond market. Regional finances, for instance, looked fine according to the figures published in the first three quarters of 2011 before revealing a massive slippage when the annual data came up. In the meantime, local banks will need to take the slack.
Reassurance on the capital position could encourage them to support the sovereign market further, but as we suggested several times in Focus Europe these last few weeks, another round of long term liquidity by the ECB would be welcome. A credible recapitalisation of Spanish banks was probably one of the conditions for the central bank to contemplate further quantitative action, but Draghi’s press conference this week suggested that a third LTRO was not yet a possibility. *It may take a few more months of sluggish credit origination to prompt the central bank into more action.*