The plight of Spain is well known among market participants by now. While LTRO temporarily brought government yields (seemingly) under control, here we are four months later with 10yr Spanish yields pushing 6%. The concerns, among others, entail:
- Spanish unemployment recently surpassed 23% and is even higher among the younger generation. Some say that underground markets skew these figures to the upside, but unemployment is elevated nonetheless.
- Can Spain stick to their well advertised deficit target of 5.3%? It appears as if they cannot hit the target and Prime Minister Mariano Rajoy recently said they will not abandon this target. How they meet this target is puzzling. Clearly austerity measures could send Spain spiraling even deeper into recession. As JP Morgan recently said, “The Government has restated its objective of reducing the 8.5% of GDP deficit for 2011 to 5.3% of GDP in 2012. It is seeking to reduce the deficit by 3.2% of GDP this year in an environment when cyclical forces will be acting to push the deficit wider by around 1.5% of GDP. (We derive that 1.5% impact assuming an 0.4 elasticity of the fiscal position with respect to growth, that real growth of 2% is neutral for the budget, and that GDP will contract by 1.7% this year as forecast by the government). That suggests a total fiscal effort of near 4.7% (almost €50bn) of GDP is needed.”
- The Spanish banks are no doubt still knee deep in dealing with delinquent real estate loans left from the ongoing fallout of the housing market. I’ve heard anecdotes from distressed credit investors that these banks are giving 2nd loans to delinquent borrowers to stay current on their first loans so they don’t have to report the loan as delinquent. Tell me how this ends well?
- Spanish banks took the bait of LTRO and used the cheap three year funding to buy government bonds. It’s attractive in theory at least. Borrow 3-year money at 50bps and invest in government bonds yielding hundreds of bps higher. As stated above, yields are now higher than pre-LTRO, thus ALL banks who purchased bonds with LTRO money are underwater and thus are taking MTM hits. I’ve seen estimates that Spanish banks purchased in excess of 50bil euros of Spanish government debt. Even this amount of purchases failed to keep a lid on yields.
Possible Solution 1: SMP Program
Could the ECB just continue to expand their balance sheet by buying up sovereign bonds on the open market? The short answer is maybe. The longer answer is that it is uncertain whether this is feasible for a variety of reasons. First being that the past effectiveness of SMP is debatable. Next, it is likely that in order to make a large enough impact in suppressing yields, the program’s size would need to be dramatically increased. Would such a concept, largely viewed as monetizing debt, have enough support politically? Even if the ECB went down this path, the maximum upside would be to keep yields under control – it would have no impact on the greater problem which is the solvency of the banks.
Possible Solution 2: Additional LTRO
I hear numerous people bringing this up as a panacea for the EZ problems. Listen: LTRO is just cheap funding. 3 year money at 50bps to be precise. Even if a banks entire amount of liabilities were funded through LTRO, it doesn’t change the asset quality. The cost and length of your funding (LTRO) doesn’t matter if the banks’ loan book & holdings of sovereign debt threaten their capital position. Again, liquidity is NOT capital. Furthermore, banks have had an unlimited ability to draw down on LTRO (provided they have enough quality collateral). What would additional LTRO rounds really do?
Possible Solution 3: Debt for Equity Swaps
As Solomon said in Ecclesiastes, “What has been will be again, what has been done will be done again; there is nothing new under the sun.” While I can’t say that debt for equity swaps date back to the days of Solomon, I can say that they were around and used extensively during the South Sea Bubble in the 1600’s. This obviously isn’t a new concept.
It is estimated that there is ~800billion euros of government debt in Spain. Of that, banks own roughly 300 billion. Assuming that eventually sovereign debt holders will not be made whole, it is clear that banks (domestic & foreign) will pay a large price. A debt for equity swap could be used in this situation. Bank creditors could be turned into equity, simultaneously relieving the banks of debt service while plugging capital holes that could be used for write downs of real-estate assets or the potential losses of the sovereign bonds. Capital needs to be raised and the possibility that this burden is placed on the banks’ debt holders is well within reason.
Hard to know exactly how this plays out but a few things are clear: 1. the banks are heavily exposed between deteriorating real-estate assets & sovereign bonds. 2. Equity is bound to be diluted. It’s difficult to come up a situation in which equity holders don’t get smashed.
Possible Solution 3b: Debt for Equity Swaps on Bad Loans
I’ve just recently heard about the idea in which I’m going to propose, and it might be quite unrealistic. Apparently in Ireland, plans are being discussed that would see a SPV take equity stakes in return for a reduction in borrower payments.
Citing in its proposal the example of an individual struggling to meet a €1,190 monthly repayment on a €220,000 mortgage, IFG says that a debt-for-equity swap — in which 35 per cent of the home is given over to a trust — would see the mortgage drop to €145,000. Repayments on this reduced principal would fall by €405 a month to a more manageable €785…..Asked where the proposed trusts or SPVs (special purpose vehicles) buying up the equity in borrowers’ homes would source their funding… “The banks will use their provisions to fund the SPV, and the SPV will act independently of the banks.
This may be completely far-fetched to be implemented within other European countries, but you can begin to see the types of ideas that are floating around in attempts to stem banks from taking massive capital losses. Problems are far reaching between legacy loans as well as the newer concerns of sovereign debt holdings. Debt for equity swaps of some sort seem to be likely at some point.
By DavidSchawel of Economic Musings
