Spain: Nothing and Everything. Details Examined.

Change of Attitude or One More Last Minute Plea Bargain?

On a standalone basis, the deal announced yesterday does relatively little for Europe. It once again looks like a last ditch attempt to cobble together something to appease the markets. It relies on ESM which hasn’t yet been set up. It lends to the FROB rather than to Spain or capitalizing banks directly, creating some potential confusion. The plan, under the most positive interpretations, is reasonably meaningful to Spain, and under the worst execution, may do virtually nothing even in Spain.

The key is whether there has been a shift in attitude in Europe. Is this different than prior plans and is this only the first of many steps? The ECB was extremely dovish in words if not action last week. This plan does seem to bend over backwards to fit within the existing treaties and yet offer the most flexibility possible. If this is all we get, the rally, if there is one, will be short lived. If this is just the beginning of a series of actions such as

• Renegotiating Greek Austerity Package
• Working with Ireland, Portugal, and Greece to restructure existing programs
• Project and/or Redemption Bonds
• New LTRO, Renewed SMP, or Rate Cuts
• Global Policy Intervention with the PBOC and Fed leading the way

then we may yet be at the early stages of a liquidity and money printing and “growth” rally. It too will likely fail, but that will take time.

The temptation to fade this Spain deal is high (and higher after Rajoy claimed victory and jetted off to the football match). It really is so tempting to sell the news, but there is enough evidence of a change in attitude, that I think there will be more rumors of new policies, and after this weekend, the market will respond strongly to those.

ESM vs EFSF?

The “plan” as always is vague. It talks about the EFSF and ESM being possible lenders. Since the ESM is not yet up and running and is unlikely to be until at least July, any early “drawdowns” will have to come from the EFSF.

One issue facing the EFSF is that it hasn’t been able to leverage it’s guarantees. Depending on what I see, the EFSF has about €450 billion of usable guarantees (usable means they come from a country with a high enough credit rating, the market will lend money against that guarantee). Of that about €250 billion have already been used or pledged. There may be some double counting in what has been used or pledged, especially if some programs are renegotiated, but the EFSF is quickly running out of capacity.

Europe would like to be able to use the ESM. It is much more realistic to expect the ECB to find a way to leverage the ESM than the EFSF. With some “paid in” capital, the ESM could use that as initial margin for repo agreements to leverage up their holdings. Even better, from a simplicity standpoint, would be to get ESM a banking license so that the ESM could access programs like LTRO.

So the ESM would be better because there are more ways to prevent a 1 for 1 drain on commitments. The ESM also envisages having participation from all members. This gives the politicians that warm and fuzzy feeling of “burden sharing” even though there is no possibility that the weak countries would ever meet their full quota if called upon. Remember, for all the talk of “paid in” capital, the amount of money actually paid in is small relative to the amount that could theoretically be called upon.

Finally, by treaty, the ESM loans should be senior to other loans. How that will be done is beyond me. It may be a key consideration in the desire to use ESM. If Europe is changing its tune, maybe that seniority is less important. It is also highly unclear what being a senior lender to FROB would mean.

Direct vs Indirect and Spain vs FROB?

There has been a lot of chatter about “direct” vs “indirect” bailouts of the Spanish banks. Somehow the media and many pundits have glommed onto the idea that one is massively better than the other. I think there is a difference, but it isn’t that material. If the EFSF and ESM could inject equity stakes directly, that is better for Spain because they don’t have to take the risk of those investments turning out to be worthless. Direct investment would mean that ultimately Germany and France are on the hook for performance of Spanish banks. On one hand, having less risk, the Spanish sovereign debt would be less affected. On the other hand, pitching direct bank investments to the people of Germany and France is a much harder sell and would have required new treaties – the last thing this already convoluted process needed.

The use of the FROB (“Fondo de Reestructuration Ordenada Bancaria”) is potentially interesting. The details of how this is planned aren’t out, but it may be a sign that Europe is attempting to play very nice rather than hardball.

Looking at FROB documentation from April 2012, it is guaranteed by the Kingdom of Spain (the government). According to the document that guarantee was for €27 billion, but could be increased to €90 billion with the approval of the ministry of the economy. I am sure it would be increased to meet the size of any loan from the EFSF or ESM.

By lending to the FROB, whether via the EFSF or ESM, the EU has justified not demanding new programs to be implemented by Spain. The EU went out of its way to provide money to Spain to recapitalize the banks without demanding new commitments from Spain. If this is a one off deal with Spain, it doesn’t mean that much. But is it one off, or is this a clear sign that Europe is changing and is shifting to an even more liberal policy of throwing money at the problem and hoping it goes away? That distinction will determine how strong any rally is.

Any ESM lending to FROB opens up the question of “seniority”. As mentioned earlier, EFSF is designed to be pari passu with other lenders, but the ESM is meant to be senior. If the ESM lends to FROB, what is their seniority in relation to other Kingdom of Spain debt?

It is easy to make ESM the “senior” lender to FROB. The ESM could be given first lien interest in all of the assets of FROB (or they could just go with the typical vague language that somehow they are senior). That is easy and largely trivial for Spain since FROB only has €14 billion of debt outstanding, and the EFSF and ESM will be primary lenders. That would certainly qualify as making ESM “senior” without greatly impacting the Spanish government.

If the FROB cannot pay back the EFSF, ESM, or other creditors, what happens then? Then these creditors would rely on the Kingdom of Spain guarantee. The Spanish government would have to make them whole on any losses. Simply put, if the FROB invests in banks who don’t repay the FROB, so they can’t repay their lenders, the lenders would go to the Spanish Government for the difference.

Would these claims against the guarantee be senior or pari passu with other claims against Spain? I have no clue whether the ESM would lend to FROB rather than Spain is a subtle way of getting around subordinating other Spanish debt holders, whether it is pure oversight, or whether they will demand that claims under the guarantee are also senior. This is unclear, but if the actual intention is to lend to FROB so that other lenders to the Kingdom of Spain aren’t subordinated, then it is a big deal. I suspect this was just an oversight and unfortunately not enough details will come out in a timely manner, that by then other policies will have been implemented or we will be back in full crisis mode.

IMF Involvement is Good

IMF oversight is good. I haven’t agreed with a lot of what they have done, but they seem to be the one part of the TROIKA willing to run numbers and stick with the numbers and not get overly wed to a position or a philosophical view. I think their involvement in overseeing the disbursement lends credibility. Seriously, would you trust the Spanish government to provide funds to the banks on anything other than a crony capitalism basis? The more the IMF is in control, the more the outside world will view the process as reasonable.

Bringing the IMF in without demanding IMF money is also good. To the extent the IMF really has this firewall, it is good that they weren’t asked to use it. They can pitch to their members that they are involved, that they are forcing countries and banks to do the right thing, and keep their firewall money in reserve. That is definitely a bit of a Pollyannaish view, but since this whole situation is as much about politics and perception, this move does create a decent perception that Europe is helping themselves (their own recycled money) but accepting outside guidance.

One and Done, or First Step in a Long Journey?

I think markets will react positively overnight and Monday, but think the real performance will hinge on whether the market decides this is really just another one-off deal, or this represents a step in a bigger plan to change how Europe and the world is changing.

After this weekend, the markets will respond strongly to any rumor. For all the rumors that were out there, this “deal” is about as good as most suggested. Not a horrible lot of disappointment. The direct vs indirect crowd can complain, but honestly, that difference was overhyped. The pan-european bank guarantee crowd can complain, but that isn’t off the table. Nothing seems to have been taken off the table, and any rumor floated has a much higher probability of being believed, and heck, might even be true.

Depressingly, Rajoy’s trip to watch football might be the most costly “road trip” ever. It really does send a bad message. You would think €100 billion trumps arrogance, but I don’t see how this can make anyone happy as Spaniards are already annoyed with him, and the countries providing the money can’t be happy to see this attitude.

So, while the temptation to fade remains strong, I think it is time to control it and see if more policy actions are coming. There is little to stop Ben from launching another QE (even if the last ones sunk) and the PBOC has the most flexibility of all.