As Thursday draws near and the world frets over what form the ECB's bond buying plan will take, it is worth reminding investors that Mariano Rajoy, in all his wisdom, is adamant about "seeing the details" of the ECB's bond buying plan before making a decision on whether Spain will make a formal request for aid. Specifically, Rajoy said the following:
"If I believe it is good for Europe as a whole, for the euro, and for Spain, I will do it, and if not, not."
Rajoy says this as though the interests of all these parties are somehow one and the same. Clearly the prospect of the ECB buying billions of euros worth of Spanish bonds in the secondary market is not unequivocally good for Europe as a whole.
No matter your views on the issue one thing is certain: the cost of purchasing Spanish debt and the risk inherent in carrying that debt on the balance sheet is ultimately borne by eurozone taxpayers and make no mistake, there are risks involved. As Societe Generale notes,
"...the thorniest question out there [is]: How will the ECB address seniority?"
Recall that the ECB did not write down its holdings of Greek debt during the PSI, adding insult to injury for private creditors who took a 75% haircut as part of the bond swap. Making matters worse, a few hedge fund holdouts who dared challenge the troika and Greece on the issue were rewarded handsomely for their obstinance. Consider the following quote which appeared in a Financial Times article from a hedge fund manager who held out for full payment during the Greek PSI:
"Effectively, we are now senior to the officials sector. They have boxed themselves in."
This rather unpleasant experience is still fresh in the minds of all the private creditors who did not hold out and as such,
"...if the ECB is senior...then investors will discount higher loss given default for new programme countries."
This will have an adverse effect on the bid for Spanish debt going forward and will serve as an impediment to the very thing the ECB is trying to accomplish: lowering Spain's borrowing costs. As an aside, it should be noted that holdouts in the Greek PSI in many cases held non local law Greek bonds whose terms were more difficult to circumvent. Nonetheless, this isn't much consolation to the creditors who lost 75% of their investment.
Of course if the ECB is not senior, it exposes eurozone taxpayers to the risks inherent in a Spanish restructuring. This is a point usually glossed over by those who say the ECB will never have to write down its bond holdings: in the event of a Spanish debt restructuring, unless the ECB can once again put the entire burden on the private sector (a decidedly unlikely outcome given these creditors' experience in the Greek swap), the official sector will be forced to participate in order to provide an appropriate level of relief to Spain. The more bonds they hold, the more their participation will cost them. When that debt is written down, the ECB's balance sheet will take a massive hit which could force it to ask eurosystem governments for recapitalization funds which will come, in the final analysis, out of taxpayers' pockets.
Going back now to Rajoy's comment about who benefits from the bond purchases, while it isn't at all clear that the eurozone as a whole benefits, it is equally unclear how Rajoy could spin the programme so that it isn't beneficial to Spain. That is, no matter how harsh the conditions attached to the bond purchases, Spain needs help. Rajoy's contention that the real problem is the difference between the financing costs paid by core countries and those paid by periphery countries is an absurd attempt to divert attention from the fact that there are very real reasons why the market charges the periphery a premium to borrow. One may be able to argue that the premium is excessive, but if he were being honest, Rajoy would just come out and say "The problem is that we are broke."
There are those who point to Spain's relatively low debt-to-GDP ratio as evidence of its (again, relatively) better situation. But being a little better off in one area does not make up for the fact that it struggles mightily in others. Spain's autonomous regions are rapidly requesting bailouts from the country's hopelessly underfunded regional bailout fund (10 billion euros out of 18 billion available is already committed and that's just for three out of a possible 17 regions) and the country's banking sector is a black hole especially considering that thanks to twelve years of using 'dynamic loss provisioning', the sector was grossly unprepared to absorb losses on bad real estate loans.
There are no good options for Spain. In my view, a restructuring is all but inevitable. After playing for an initial relief rally in Spanish bonds in the weeks surrounding the ECB meeting, investors should seriously consider positioning for a Greek-style end to the Spanish drama. This means betting against Spanish equities (EWP), the euro (FXE) and Spanish debt.