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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European Banking Monitor: Spanish Bank Bailout Expectations Prompted Across-The-Board Tightening

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

Key Takeaways:


*  Spanish bank bailout expectations prompted across-the-board tightening for EU peripheral countries, EU banks and US global and credit-sensitive banks.


* On the other side of the trade, Germany's swaps widened (the only country in the EU to show this) as did swaps of US insurers, as expectations for low rates persisting longer than previously expected rose.


* Spanish bank bailout euphoria also rippled across junk bonds, leveraged loans and munis, with both indices showing improvement week-over-week.


 If you’d like to discuss recent developments in Europe, from the political to financial to social, please let me know and we can set up a call.


Matthew Hedrick

Senior Analyst





European Financials CDS Monitor – French banks, still the canary in the coal mine, showed the biggest WoW improvement in swaps. Across Europe last week, 37 of the 39 reference entities we track showed spreads tighten. The median tightening was 4.7% (16 bps).  


European Banking Monitor: Spanish Bank Bailout Expectations Prompted Across-The-Board Tightening - 11. banks


Euribor-OIS spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread held flat at 40 bps.


European Banking Monitor: Spanish Bank Bailout Expectations Prompted Across-The-Board Tightening - 11. euribor


ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  The latest overnight reading is €788.22B.


European Banking Monitor: Spanish Bank Bailout Expectations Prompted Across-The-Board Tightening - 11. ECB liq


Security Market Program – For the thirteenth straight week the ECB's secondary sovereign bond purchasing program, the Securities Market Program (SMP), purchased no sovereign paper for the latest week ended 6/8, to take the total program to €212 Billion.


European Banking Monitor: Spanish Bank Bailout Expectations Prompted Across-The-Board Tightening - 11. SPM

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What’s in a bailout? Who cares – it doesn’t even matter anymore. Central planning has become the de facto catalyst in the markets. Everyone is hoping and praying for Bernanke to reload his clip and destroy the dollar despite being out of bullets, according to Hedgeye CEO Keith McCullough. No wonder Hank Paulson is busy puking in garbage cans; this bailout business is enough to make anyone sick to his stomach.




Hedgeye Financials Sector Head Josh Steiner noted an interesting point earlier today, which is that the IMF has $750 billion in “commitments.” What’s in a commitment? $100 billion from the U.S., $100 billion from Japan and $178 billion from the EU, to be exact. When the collateral call comes (and it will), will these countries actually be able to step up to the plate? Time will tell.


Growth IS slowing. China at least will admit to that. July 17th’s GDP report will be yet another data point that’s hard to swallow. But for now, all eyes are on Europe and it’s something not to be taken lightly.

The Domino Effect of Spanish Housing

This note was originally published April 12, 2012 at 12:34 in Macro

Conclusion: Another leg down in Spanish home prices seems likely and this could potentially be the event that leads to an acceleration of stress in Spanish sovereign yields.

The focus of the sovereign debt crisis in Europe has been, rightfully so, on Greece and the potential derivative effects of a Greek default.  This despite the fact that Greece’s economy, based on the CIA’s 2011 Fact Book estimates, is only $312 billion, or less than 2% of the European Union in aggregate.  With an estimated 2011 GDP of $1.5 billion, Spain has the 12th largest economy in the world and an economy that is almost 5x the size of Greece’s GDP.


As the chart below of debt-as-percentage-of-GDP shows, Spain, so far, has been able to manage its balance sheet somewhat better than many of its neighbors with a debt-to-GDP of roughly 68.5% as of the end of 2011. (Incidentally, many believe that when incorporating regional debts, Spain is closer to 90%, currently.) Based on Spanish government estimates, this ratio will jump to 79.8% at the end of 2012.  While still below the Eurozone average of 90.4%, this is the highest acceleration in the Eurozone.  This last fact is at least partially reflected in the credit default swap market with Spain’s 5-year CDS accelerating in price in the year-to-date.


The Domino Effect of Spanish Housing - Sp.debt


Spain’s most significant headwind going forward is, simply put, growth.  Over the last two fiscal years of 2010 and 2011 combined, the lowest average growth rates in the European Union were the following countries in order:

  • Greece at an average annual growth rate of -5.2%;
  • Iceland at an average annual growth rate of -0.45%;
  • Portugal at an average annual growth rate of -0.1%;
  • Ireland at an average annual growth rate of +0.08%; and
  • Spain at an average annual growth rate of +0.15%.

Clearly, this is not an enviable group of countries and Spain is the only one amongst them that hasn’t had a complete sovereign debt meltdown.


As any sovereign credit analyst will tell you, the easiest way to resolve a sovereign debt issue is to grow out of it.  Spain’s economic growth outlook is constrained by two separate, though related, factors: employment and housing.  


In the chart below, we’ve highlighted Spanish unemployment going back to 2000.  The unemployment rate of Spain hit 23.6% in February for the 8th consecutive monthly increase, which is both the highest rate since 2000, but also literally the highest unemployment rate since World War II.  As if that weren’t enough, the government expects the unemployment rate, already the highest in the industrialized world, to increase to north of 24% this year.  The current number of unemployed in Spain is equivalent to 4.75 million, which is the highest number since the Spaniards began keeping the data in 1996.


The Domino Effect of Spanish Housing - SP.unempl


The counter view to this abnormally high unemployment rate in Spain is that there is a large and thriving underground economy, which means that government reported employment figures are understated.  Certainly, there is likely credence to this, but, even so, most estimates suggest accounting for the underground employment would only reduce the overall unemployment rate by 400 basis points.  In the shorter term, there is also the employment head wind of a recently implemented labor reform law in February that will make it easier for employers to unilaterally lay employees off and cut salaries.  Eventually, though, this is expected to make the Spanish employment market more fluid as it will likely make employers more willing to take on the risk of hiring.


The chart below highlights the structural employment issue in Spain versus the remainder of the Eurozone.  Specifically, it emphasizes the year-over-year change in unemployment by country.  In 2011, Greece was the only nation that saw unemployment increase at a quicker pace than Spain.


The Domino Effect of Spanish Housing - CH


A key reason that Spanish unemployment rates have ballooned versus the rest of the Eurozone is because Spain had a vastly more inflated housing and construction sector during the boom years.  In fact, according to Eurostat, Spain employed 2.9 million people in construction industries at, or near, the peak in 2007.  In total, this was about 1/5th of all construction workers in the EU-27 despite the fact that Spain has less than 10% of the total population.  Clearly, an improvement in Spanish employment will be predicated on a recovery in the construction sector.


Unfortunately, a recovery in Spanish housing and construction markets appears to be a long way in the coming.   Unlike most industrial nations that experienced extended housing price inflation in the late 1990s and mid-2000s, Spain actually had two bubble periods with the first beginning in 1985.  As the chart below highlights, from 1985 – 1991 home prices basically tripled, from 1992 – 1996 they basically remained flat, and from 1996 – 2008 prices more than doubled.   So far, from the peak, Spanish home prices are in aggregate only off about 20%.


There are two potential proxies for how much further home prices in Spain may have to fall.  The first is wage growth, which has historically tracked housing prices.  Intuitively, this makes sense.  The more consumers have in their pockets generally, the more they have to spend on housing (all else being equal).  As the chart below shows, wages and home prices tracked each other steadily until 2000, at which point home prices began to accelerate beyond wage growth.  Currently, home prices would need to decline just over 30% to revert back to wage growth. 


The Domino Effect of Spanish Housing - SP.housing.wage


The second proxy for further correction in Spanish home prices is the path of U.S. home prices.  Based on the Case-Shiller 20-city seasonally adjusted series, U.S. home prices have already corrected 34% peak-to-trough.  Comparing Spain to the U.S. is not quite apples-to-apples as home prices were driven much higher due to ownership rates that eclipsed 80% at the peak in Spain.  So, depending on the data set we use, from the start of the second leg of the Spanish home price bubble in 2000 compared to the U.S., Spanish home prices have a potential downside of more than 35% from current levels.


The Domino Effect of Spanish Housing -


The risk to the downside in Spanish home prices is being clearly reflected in real estate transactions in Spain.  The chart below highlights year-over-year real estate transactions by month.  In the most recent month of February 2012, transactions were down more than -30% from the prior year.  Without a sustainable pick up in the real estate market, it will be impossible for employment to improve meaningfully.  


The Domino Effect of Spanish Housing - Sp.transactions


The second derivatives of continued decline in real estate prices in Spain are both economic growth and the health of the banking system.  On the first point, the Bank of Spain estimates that a decline in home prices of one dollar will decrease consumption by $0.03.  Thus, a 15% decline in housing should reduce GDP by almost 2% over the next two years. (Hat tip to Carmel Asset Management for highlighting this analysis in the WSJ.)  This would obviously have a direct impact on Spanish banks.


Currently, the Spanish banking system is estimated to have a 1.8 trillion euro loan book.  It is estimated that roughly 20% of that is in real estate assets, of which almost half are considered troubled.  Obviously both declining real estate prices and slowing economic growth generally put increased pressure on the portion of the loan book which is currently not troubled, and equates to almost 150% of Spanish GDP.


Certainly Greece has been the rightful focus of the sovereign debt issues in Europe, but the likelihood of another serious leg down in Spanish home price could put Spain front and center in 2012.




Daryl G. Jones


Director of Research








MORGAN STANLEY: The next Lehman?

Morgan Stanley can not catch a break, especially from Hedgeye Financials Sector Head Josh Steiner. Triple trouble for Morgan Stanley CEO James Gorman and Co. this week as whispers indicate that Moody’s will pull the trigger on its wave of bank downgrades. Combine that with the CDS problems that are reminiscent of Lehman Brothers, the problems with the European Union and the $9 billion+ collateral call courtesy of Moody’s and things are not looking good. 


We have three key takeaways on what’s really going on inside MS:

• It is the most exposed US bank to EU contagion. Greece’s election represents a potential catalyst for things to go from bad to worse.


• It is incredibly vulnerable to counterparty confidence flight. Default swaps are already reflecting great uncertainty about MS’ future. Coming downgrades must be watched closely for any impact on business flows. Counterparty concern can go from gradual to sudden virtually overnight.


• Even though the company’s liquidity and capital are much improved vs. 2008, the market is trading it as though there is no implicit US backstop. A further slowdown in the economy or in its core business could raise concerns about a downgrade to junk status, which would throw their institutional business into chaos.


Once again, when the time is right, we will short MS and will enjoy doing so.



MORGAN STANLEY:  The next Lehman? - chart ms june11


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