Why Spain’s Bailout may NOT Work

Author and derivatives analyst Satyajit Das at the Minyanville.com has an insightful dissection of why Spain’s bailout will not likely succeed (all bold emphasis mine)

1. Spain’s bailout package overlooks the requirements of larger banks

The amount -- 100 billion euros or more depending on the independent assessment of the needs of Spanish banks -- may not be enough. On the surface, the amount appears around three times the 37 billion euros the International Monetary Fund says is needed. The capital requirements of Spanish banks may turn out to much higher -- as much as 200 billion to 300 billion euros.

The IMF assumes only the smaller Spanish savings banks (the Cajas) will need help. In reality, the larger Spanish banks may also require capital.

Spain’s banks have over 300 billion euros in exposure to the real estate sector, mostly through loans to developers. Around 180 billion euros of this exposure is considered “problematic” by Spain’s central bank.

Estimates suggest that there are about 700,000 vacant newly built homes, but including repossessed properties the total could be as high as 1 million or even higher. At current sales levels, it will take many years to clear the backlog, which will be compounded by more properties being completed and coming onto the market. Housing prices have fallen by 15% to 20% but are forecast to fall eventually by as much as 50% to 60%. A severe recession and unemployment of 25% means that losses on Spain’s over 600 billion euros of home mortgages loans are likely to also rise.

2. The bailout excludes sovereign debts

The proposed amount also does not include any provision for write-downs on holding of sovereign debt. Local banks are estimated to hold over 60% of outstanding Spanish government bonds.

3. The conditions of Spain’s bailout may prompt for a domino effect or demand for changes in the conditions or covenants of existing bailouts by other crisis affected EU nations.

The bailout will be provided with no conditions, which creates its own problems. The lack of conditions may lead to Greece, Ireland, and Portugal seeking relaxation of the terms of their assistance packages. The lack of conditions also prevented the IMF from contributing.

4. The bailout lacks the discipline of keeping the house in order, unlike crisis affected Asian economies during the 1997 Asian Crisis.

In an opinion piece in the Financial Times, Jin Liqun, chairman of the supervisory board at the China Investment Corporation, pointedly noted the contrast between the treatment of European and Asian countries.

Viewed from China, the management of the eurozone debt crisis offers a stark contrast to the handling of the 1997-98 east Asian crisis. In that episode, Thailand, South Korea and Indonesia were all forced to implement tough austerity programmes imposed by the International Monetary Fund.... Unlike many of today’s Europeans, the people of east Asia did not have the luxury of large relief funds from outside their countries. The people had to tolerate hardship...In a poignant case, the Korean people contributed gold and household foreign exchanges to the government to help ease fiscal pressure.

Amen to that.

Western politicians think that they can elude the laws of nature. Markets will eventually prevail.

5. The bailout overestimates on the sources for funding.

Future international support, either bilateral or through the IMF, may be difficult.

The funds will come from either the European Financial Stability Fund or the still to be approved European Stability Mechanism. Since 2010, the eurozone has committed 386 billion euros to the bailout packages for Greece, Ireland, and Portugal. In theory, the EFSF and ESM can raise a further 500 billion euros, beyond the commitment to Greece, Ireland, and Portugal, allowing them to contribute the 100 billion euros for the recapitalisation of the Spanish banking system. The EFSF/ESM also assumes that it “can leverage resources." The reality may be different.

For a start, Finland has indicated that it may seek collateral for its commitment, an extension of its position on Greece which the European Union ill-advisedly agreed to.

As Spain could not presumably act as a guarantor of the EFSF once it asks for financing, Germany’s liability will increase further from 29% to 33%. France’s share also increases from 22% to 25%. The liability of Italy, which is in poor shape to assume any additional external financial burden, rises from 19% to 22%.

The EFSF’s AA+ credit rating may now be reduced. Irrespective of the rating, the EFSF and ESM will have to issue debt to finance the bailout. Support for any fund raising by these instrumentalities is uncertain.

Commercial lenders have been reducing European exposure. Emerging market members with investible funds lack enthusiasm for further European involvement. Lou Jiwei, the chairman of China Investment Corporation, the country’s sovereign wealth fund, has ruled out further purchases of European debt: “The risk is too big, and the return too low."

6. Spain’s bailout will worsen Spain’s financial ratios which could likely dissuade participation from the private sector.

The bailout also does not address fundamental issues.

The funds will be lent to the Spanish government, probably its bank recapitalisation agency Fondo de Reestructuracion Ordenada Bancaria (FROB), rather than supplied directly to the banks because of legal constraints. This will add 11% of GDP to Spain’s debt level. The transaction will do nothing to reduce the country’s overall debt level -- over 360% of GDP before this transaction.

Spain’s access to capital markets or its cost of debt is not addressed. The last auction of Spanish government bonds saw yield around 6.50% per annum with the bulk of bonds being purchased by local banks. Spain and its banks also face pressure on their own ratings, which are now perilously close to becoming non-investment grade.

The bailout may actually adversely affect the ability of Spain and its banks to funds. Commercial lenders are now subordinated to official lenders. Based on the precedent of Greece, this increases the risk significantly, discouraging investment.

The European Union has stated that it believes that these measures will help the supply of credit to the real economy and assist a return to growth. This optimism is unlikely to be realised.

Restoring the bank’s solvency will not result in an increase in credit. The capital will allow existing bank debts to be written off. Spanish banks have limited access to funding. They are heavily reliant on the European Central Bank for money, a position which the assistance does not address.

Interventionism begets more interventionism which substantially deepens the distortions of the markets, through more misallocations or malinvestments and which consequently aggravates the problems.

Policymakers do NOT have the KNOWLEDGE and the RESOURCES to deal with the worsening crisis.

The basic 'commonsense' solutions are to keep the proverbial house in order through fiscal discipline “austerity”, allow unsustainable institutions to fail or for the markets to clear and to induce competitiveness by removing structural political and regulatory obstacles (e.g. labor market reforms).

Yet commonsense has been disregarded for wishful thinking.

The current path of policies of sustained bailouts only increases the risk of MORE inflationism which serves as the fundamental reasons to be bullish on gold and commodities.