Why The Market Will Not Be Safe Until Spain Throws Out The Bailout And Institutes A Bail-In

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Includes: EWP, FEZ, FXE, SPY
by: Colin Lokey

It appears Spain may have but one option left for rescuing its struggling banking sector, a Citigroup-esque 'bail-in.' The independent audit of the country's banking sector released Thursday shows the country's banks needing 62 billion euros under the 'adverse' scenario. The rationale behind that figure is that 260 billion euros in expected losses will be absorbed in a variety of ways, one of which involves the use of 35 billion in 'excess capital buffers' and another of which channels around 60 billion in expected 'new operating profits' to the cause. As I noted in a previous article however, the 'excess capital buffer' is really not 'excess' at all. It is derived by chopping the banks' Tier 1 capital ratio down to 6% from the European Banking Authority recommended 9% and calling the leftover 3% 'excess'. In other words, it's only excess if you believe a 6% Tier 1 capital ratio is sufficient which almost no one does. As to the 60 billion in expected new operating profits, this assumes projections about the banks' ability to earn in the most difficult environment imaginable prove to be accurate (Spain's banks are expected to earn around 25 billion euros in operating profit in 2012).

Given that these assumptions are far from sound, one is led to believe that Spain's banks will need more like 150 billion euros at minimum. In short, the bailout just isn't enough. From the Economist:

A year ago, a proper clean-up of Spain's banks with this kind of outside support might have been enough. Not now. The country's property and bank bust has been compounded by a massive loss of investor confidence (see article). Capital has drained from Spain at an accelerating pace in recent months, for two reasons. First, investors are worried by the vicious spiral of a weakening economy, tottering banks and worsening government finances. Second, they are losing confidence in the single currency and Spain's place within it. This bank rescue does too little to assuage the first worry, and nothing to deal with the second. That is why it won't work.

Not only will it not work, we now know--thanks to the subordination fear sell-off in Spanish bonds on June 12 and the Moody's downgrade of Spain on June 13--that it is poisoning the system while it is not working.

The truly detrimental part of the Spanish bank bailout is the fact that, under article 15 of the ESM, the bank recapitalization funds must be channeled through Spain (the funds cannot be directly injected into the banks). As such, the 100 billion euros goes on Spain's balance sheet and boosts the country's debt-to-GDP ratio. This in turn caused Spain's sovereign debt ratings to be cut, which necessitated haircuts on the Spanish government bonds held by the ECB as collateral against LTRO loans made to Spain's banks, triggering margin calls for those institutions. In this way, the bailout is poisonous to both Spain and to Spanish banks.

Additionally, the ESM (unlike the EFSF) does not allow member countries to 'step-out' of their obligation to contribute to the fund even if they are themselves drawing from it (article 8(4)). Spain then, who will pay its first installment to the fund in July totaling 3 billion euros, is essentially bailing itself out.

There are all sorts of intricacies like the ones mentioned above that lead to circular funding between banks, their sovereigns, and the central bank. This ridiculous situation will only get worse should the ECB go through with its plan to begin relying on its own ratings for sovereign debt instead of using those issued by ratings agencies. This is a house of cards and the bailouts are contributing to it. If Europe continues to go down this route, the situation will become more and more of a systemic risk.

The loop must be broken and a good way to start would be to require a swap of subordinated and senior unsecured debt for equity in Spain's banks, regardless of the dilution it would occasion for shareholders. According to the Wall Street Journal,

"converting into equity 100% of the €88 billion of subordinated liabilities, and 40% of the €160 billion of senior unsecured debt, would generate more than €150 billion of loss-absorbing equity for the Spanish banking system. Together with the estimated €25 billion in expected operating profits for 2012, before loss provisions, that would yield about €175 billion in new bank equity, without increasing the debt burden of the Spanish taxpayer or requiring a loan from Brussels."

This sounds infinitely better than reducing the Tier 1 capital ratio of the whole sector by a third (in the adverse scenario) and requiring the sovereign to take on 100 billion euros in debt. Without such a move, the Spanish banking bailout will not only encourage the use of similar rescues in the future, but when implemented will make the toxic link between European sovereigns, banks, and the ECB more inextricable, an eventuality which will continue to weaken investor confidence and continue to undermine the U.S. economic recovery. Short S&P 500 (NYSEARCA:SPY), European stocks (NYSEARCA:FEZ), long volatility, until a satisfactory remedy to the Spanish banking sector crisis is devised.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.