Spain’s Cracked Credibility and Europe’s Bailout Messaging

Positions in Europe: Short Spain (EWP); Short EUR/USD (FXE); Long German Bunds (BUNL)

 

“We’re building it up, to break it back down.”

-Linkin Park, “Break it Down”

 

TRADING VIEW: Spain’s €100B “credit line” to recapitalize its banks may bid the broader equity market higher over the short run; however, we see significant headwinds for Spanish growth ahead, including another 30% leg down for housing and property values, further credit ratings downgrades on the sovereign and banks, and the inability of PM Rajoy to reduce the country’s 8.9% deficit (as % of GDP) as the country’s debt expands alongside this newest loan.  

 

It’s worth pointing out the market’s message from today’s results: The IBEX35 gave back all of its morning pop, and closed down -0.52%; the EUR/USD has traded flat to down intraday at $1.2492, the S&P500 is down slightly, and 5YR CDS for Spain and Italy have risen considerably since this morning: Spain gained 16bps to 595bps, just short of an all-time high of 604bps recorded on 6/5!  And Italy rose from 533bps to 554bps intraday.  How about that for some confidence in Spain!

 

 

On Spain’s Cracked Credibility:

 

While the headline number may prevent a full-on Spanish crash, we think there are numerous headwinds ahead for Spain, the sovereign, and its banks. The major one stems from a lack of credibility that PM Rajoy can follow through on his fiscal consolidation targets, in particular to materially budge the public deficit off 8.9% of GDP.

 

We see numerous risks to growth, with signals including:

  • Bombed out PMI Services and Manufacturing numbers (both around 42 = major contraction).
  • Housing and Property values that have another 30% to fall.
  • Further credit ratings downgrades on the sovereign and banks.
  • Rising debt levels (68% of GDP in 2011) as the future credit line, funneled through the FROB, adds to the debt.

 

On the banking side our Financials sector head Josh Steiner points out:

  • To put things in perspective, a €100bn bailout to Spain’s banking system is the per capita equivalent of providing $875bn to the US banking system, which is roughly 25% larger than TARP.
  • Expectations are that the infusion will rank senior to existing creditors, which means there will ultimately be a PSI-style loss taken by existing creditors.
  • This may calm systemic fears around counterparty risk and breakup of the Euro in the short-term, but individual holders of Italian, French and even German bank debt should find this far from comforting, as unfavorable resolution protocols are being established.
  • This may ultimately put more pressure on the banking system, not less, as banks find fewer willing non-governmental sources of funding.

 

Shape of the Loans?

  • The bailout plan is short on details, a draft really. It’s not clear if funds will come from the EFSF, ESM, or both. Remember, the ESM has yet to come online, expected for July, and in its current state does not have the directive to fund bank recapitalization/bailouts.
  • The proposed loan is expected to carry an interest rate of 3%.

 

Eurocrat Messaging:

 

---We were frankly surprised by the timing of Saturday’s announcement that the EMU is prepared to lend up to €100 Billion to recapitalize trouble Spanish banks.  Why?

  • We expected a bailout to be named after the IMF’s review of the recapitalization needs (expected today) and the results of two independent audits from Wyman and Berger (expected by June 21).
  • We expected Eurocrats (led by Chancellor Merkel) to wait on a decision before the results of the Greek election to send a signal to the Greeks that a certain level of austerity is required to remain in the Eurozone and that Brussels will not simply write blank checks.
  • Risk signals have not elevated to extreme levels over recent days: Week-on-week (as of Friday) Spanish bank CDS actually came in and the 10YR Spanish bond has held relatively stable in a range of 6-6.30%.

 

So why did the loan hit Saturday?

  • We think Europeans were greatly pressured by Geithner and more largely the Obama administration to inflect the bearish headlines to help Obama’s reelection chances. This position was likely made clear during the finance chiefs G7 conference call on Spain last week.  We also view the IMF’s Lagarde positioning for direct IMF loans to Eurozone countries, a position that goes against the original charter. No other facts point to why a loan had to be presented over the weekend.

 

What are the implications for the Greek election on 17. June?

  • We’re assigning an equal probability that sentiment from this bank bailout adds positive support (messaging) for the pro-austerity New Democracy and the anti-austerity Syriza.
    •  New Democracy may position that Greece cannot “survive” without the help from Troika, and therefore must do everything to remain in the Eurozone.
    • Syriza may position the bailout demonstrates that the Greeks have called the Eurocrats’ bluff, namely that austerity is conditional to stay in the Union.
  • By law we will see no election opinion polls heading into Sunday’s vote. We still expect a victory by a coalition of New Democracy, however Saturday’s bailout news simply puts one more hitch in this highly uncertain and close election. 

 

“We’re building it up, to break it back down”

 

This weekend’s actions prove yet again how committed Eurocrats are to keeping the Eurozone project alive, without having a credible roadmap to do so. In short, we expect more “bailout band-aids” ahead as politicians refuse to let sovereigns or their banks fail. We expect risk, as we’ve seen over the last two years, to ping-pong around Europe. Is Italy next?

 

We’re highly aware that we cannot get in front of Eurocrat actions –witness this weekend – its critical to signal just how strong the resolve of Eurocrats is to keep their jobs. We’ll continue to monitor for any signs of a third LTRO, the re-engagement of the Securities Market Program, or any other non-standard measures that could have significant implication for markets.

 

However, our fear is that the backbone of the Eurozone is so compromised that despite all that is being built up to support these countries, the Union is doomed to fail. Here we’ll caveat the statement by saying that a fiscal Union alongside the existing monetary Union is a necessary must, however such a transition will be trying given the cultural resolve not to give up fiscal sovereignty to Brussels.

 

If market expectations continue to be set for a solution yesterday, we expect much disappointment ahead, and a very long road if Europe can shore up the imbalances across its weaker members to find a productive path forward. 

 

 

Matthew Hedrick

Senior Analyst


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