In a revelation that should shock absolutely no one, Reuters reported today that Spain has in fact admitted it may need a troika-backed bailout. Although Spain has publicly denied the report, a eurozone official claims that the country's finance minister Luis de Guindos suggested to his German counterpart Wolfgang Schaeuble that Spain may need as much as 300 billion euros on top of the 100 billion euros it is set to receive for its struggling banking sector. According to Reuters:
Schaeuble told de Guindos he was unwilling to consider a rescue before the currency bloc's ESM bailout fund comes on line later this year.
It is unclear exactly who should be more embarrassed here, Spain or Schaeuble, for they have both said repeatedly that Spain would not need to be bailed out under any foreseeable circumstances. In fact, just nine days ago, Schaeuble said the following about the prospects for a bailout of Spain:
''There is absolutely no reason to speculate, beyond this bank aid application, about a comprehensive aid program for Spain,'' German Finance Minister Wolfgang Schaeuble was quoted as telling the daily Rheinische Post."
Perhaps the inverting of the Spanish 5yr/10yr curve earlier in the week did indeed provide a "reason to speculate." Whatever the case, it appears that there will be no aid for Spain until the ESM comes online. It now appears fairly obvious that yesterday's attempt by Mario Draghi to talk the crisis down was the direct result of Germany's explicit refusal to back a bailout of Spain in the near-term.
Draghi's comments Thursday were indeed enough to bolster confidence in Spanish debt for the time being as yields have fallen precipitously across the maturities over the past 48 hours. This is particularly surprising, and betrays either a lack of sophistication or a simple denial of reality among private creditors. There is certainly a compelling argument to be made that the ECB purchases of Spanish debt would only serve to exacerbate the problem as the purchases would fuel subordination fears among existing bond holders. These fears should be even more pronounced now that it appears Spain has indeed discussed the possibility of a bailout. In the event of a PSI, existing local-law bondholders will invariably be forced to accept a painful haircut while the ECB (barring a restructuring of their Greek debt between now and then) has shown no sign it will do the same. Therefore, the minute the ECB starts buying, private creditors start selling.
Another issue is that the ECB's rate cuts are no longer having their desired effect in the periphery. In fact, research by Goldman Sachs shows that the sign of the coefficients on ECB rates is now negative for loans made by Spanish and Italian banks. This means that the EMU is now completely broken:
Retail rates in Spain and Italy are not responding to ECB rate cuts. Worse, they are experiencing 'transmission reversal', meaning retail rates are actually moving in the opposite direction of the official rate.
Perhaps even worse are the alternatives to bond buying and rate cuts. From Goldman:
The ECB may ... look to support private-sector financing more directly, by further easing of collateral eligibility ... and outright purchases of private-sector assets originating in both the bank and corporate sector
In other words: the ECB may further poison its balance sheet. There is no good answer to this problem. Fortunately for investors, Mario Draghi's comments boosted markets yesterday providing a nice exit point and making put options particularly cheap. The best course of action: exit long positions and buy (cheaper) puts on the S&P 500 (SPY), European equities (FEZ).