(This title is attributable to Miguel de Cervantes Saavedra – “Don Quixote”)
Recovery Partners was interviewed last Friday and again this past Monday regarding developments in the European debt crisis. Unfortunately these interviews only allow a little time to get some sound bites in and not a whole lot of time for reasoned analysis. ThereforeÂ this blog is aimed at adding some needed color and insight to the SUN TV and BNN interviews that underline the seriousness of the situation.
The simple reality is that not much has been done to solve any of Europe’s financial problems since they started over three years ago and, as a consequence, the available runway that European policymakers have left with which to craft workable solutions to the debt mess is getting very short. What is extremely concerning therefore, is that the latest events indicate that the Euro-strategy of incrementalism and trying to stretch out the process before hard decisions have to be made is being pursued by the Eurocrats and politicians there with even more vigor now.
After dithering for years about the rot in the Spanish banking sector and botching the recapitalization of several failed banks a few short weeks ago, the political authorities there finally and reluctantly agreed to accepting aid from the Eurozone this past weekend. In flippant style, Spanish Prime Minister Rajoy triumphantly declared that he had arranged a â€œhandy credit lineâ€ and that the crisis was â€œnow overâ€ before jetting off to Poland to see the Spanish footballers tie the Azzurri 1-1 in Gdansk.
When have we heard this type of denial before?
There is in fact much to worry about in the wake of the news regarding the Spanish bank bailout not in the least because there are more questions than answers coming out of this series of announcements
As we mentioned Â in the TV interviews, these issues include:
- The fact that the EUR 100 MM amount mentioned, while much larger than the authorities may have admitted they were short in the past, is still likely far below the amounts that are really required. Certain estimates place the size of the hole at around EUR 400 Billion.
- The housing and real estate markets have been artificially propped up in Spain for years. Not only does this mean that it is now almost impossible to understand values without significant due diligence, this strongly suggests that there may be another downleg to the real estate bust there that would see even those lofty bailout requirements climb.
- This â€œcredit lineâ€ as Rajoy so euphemistically termed the panic decision involving EUR 100 Billion (or more) piles more debt onto the very large debt load that Spain already has. Spanish central government funding requirements approach EUR 220 Billion for 2012 and almost EUR 170 Billion for 2013. Unfortunately, Spain is all but foreclosed from the traditional bond markets. Where will that funding and the not insubstantial funding for local governments not included in those requirements come from?
- But even before we consider the source of general Government funding requirements it is not even clear where this bank bailout money is going to come from or the specific terms of the deal. This table, drawn from a speech we recently delivered at an RBC Dexia client seminar, shows that for all intents and purposes that the EFSF mechanism is already tapped out. After accounting for dud guarantees and monies already earmarked, there is almost nothing left over. Note that the “Bank Recap” line in the table refers to the EUR 110 Billion that was only a few short months ago estimated by the ECB and IMF that the entire European Banking system needed. Now we find that Spain itself has gobbled up EUR 100 Billion. Also please note that the EFSF/ESM mechanism has been unable to fund itself and has been dowdgraded.
- What will the Greeks, Portuguese and Irish now think about the deals that they agreed to and will they now demand a â€œlook-backâ€ adjustment to the terms of those deals? Almost equally as important: What will now happen to the Italians who have mountains of debt to refinance and a government that, as admitted by Prime Minister Monti last week, is in its death throes and will likely have to call a snap election before its term expires next Spring? Italy is next in line to be punished by the markets and everyone knows it, yet there is no lifeline in place and moreover, none of the myriad zombie problems festering away elsewhere in Europe have been durably fixed.
- Similar to the Greek re-boot, this transaction calls into question the seniority of existing Spanish government debt obligations, potentially subordinating those to the creditor group that will make the â€œhandy credit lineâ€ (ie BAILOUT) money available. This action has increased the risk of these obligations and has thus cast significant doubt over the ability of the Spaniards to raise any money at all from domestic and international bond markets.
Boiling all of this down, we come to the conclusion that we are seeing a tragedy play out in Spain that is very similar to the one still underway in Greece: The central Government has been foreclosed from raising money in the open market; there is an accelerating bank run in progress; to cope, Â a hastily conceived bailout patch is applied by the ECB, IMF and EU which results in the very significant probability that Spain will continue to be unable to meet its financing requirements in the normal course. This Financial Frankenstein thus threatens to run smack into the refinancing obligations that loom just ahead.
Given the magnitude of Spain’s funding requirements and the cross border exposures it has to the rest of Europe, this policy is thus far from being a â€œhandy credit lineâ€ as described by Prime Minister Rajoy. It rather more completely resembles a financial time bomb with the detonator already having been set in motion.
Nothing in this is therefore any cause for renewed confidence.
We reiterate the point that we have been making for several years now: Nothing has been solved by the various policy patches that have been applied by the Fed and other Central Banks together with the politicians in Europe and North America. Since the onset of the Global Financial Crisis all that has been achieved are temporary delays and the imposition of growing and severe constraints on future policy flexibility, while at the same time the risk of unanticipated open-ended outcomes, second order effects and other nasty surprises (Black Swans) has been vastly increased because of the approach followed. There is now a non-trivial risk that this Black Swan phenomenon could overwhelm the ability of existing institutions to successfully and properly cope with the various problems unless decisive action â€“ loss recognition, write-down and remediation â€“ is taken soon.
The experience so far easily proves that anything short of swallowing that bitter pill simply wonâ€™t work.