Conference Call

There Is No Vaccine for the Spanish Flu

Meeting date: June 11th, 2012
Start time: 11:00 AM EDT
Duration: 1 Hour
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The RGE Macro Strategy Team apply our views on the eurozone crisis to each of the asset classes, provide updates to our model portfolio and review our active tactical trade ideas. The discussion covers:

  • Macroeconomic Themes 
  • Global Equity and the RGE Cross Asset Model Portfolio
  • Commodities
  • Government Bonds/Rates and Credit
  • Currencies
  • Emerging Markets

Below are responses to client questions by RGE economists and strategists:

Don't you think that the 100 billion loan to Spain has only been agreed upon in the context of a banking union, and how would your views on the Spain bailout and euro crisis change if the banking union were a reality?

It seems that the €100 billion credit line was agreed upon (in principle) with a view to calming markets ahead of the Greek elections and perhaps buying time, rather than making a concrete step toward a banking union. After all, this loan would be channeled through the "sovereign" via the FROB, hence the "contract," i.e., liability, exists between the sovereign and the creditor (core taxpayers?). In a banking union, the implicit "contract" of fund transfer should be between the recipient banks and the core taxpayers. So a direct recapitalization bypassing the sovereign would be a more concrete step toward a banking union. 

A banking union would ameliorate the crisis in that it could slow and possibly reverse capital flight from the eurozone (EZ), as the signaling effect—i.e., a step toward debt mutualization—could be quite positive. If this is implemented with bank restructurings and recapitalizations, then it would free up the credit capacity of banks. However, it would not address structural growth issues or credit demand. Additionally, Germany will only agree to a banking union in tandem with a fiscal union. If steps taken toward debt mutualization are significant, that could catapult us into the EZ endgame upside scenario ("muddle through B"), to which we currently attribute a 10% probability. But this involves a lot of "ifs."

RGE has for some time been publishing a year-end target on the S&P 500 of 1,300. Today we are around 1,325. Has RGE’s target changed, and if so, what is it now? Also, what does RGE see as the high and low “risk window” to its target. Stated another way, based upon its current research, what does RGE see as a downside possibility and what does it see as an upside possibility?

We still hold our year-end target of 1,300 with risks now significantly tilted to the downside. We see a downside of 1,150 and an upside of just 1,350. On a 12-18-month horizon, our target moves down to 1,200. Our target takes QE3 into account but sees it as a wash as we expect the policy easing in Q3 with a potential rally no greater than 7-8% (from a 1,200-1,250 level) and lasting just a couple of months. Thus before year-end the markets will shift again back to fundamentals, and they are weak! 

Which EZ rescue vehicle will be used to recapitalize the Spanish banking sector?

The announcement on EZ leaders providing Spain with €100 billion to recapitalize its banking sector does not state specifically which rescue vehicle will be used. Up until now, financial support for EZ countries has been provided by the temporary EZ rescue fund, the European Financial Stability Facility (EFSF), which will be replaced as the primary lending vehicle as of July 1, when the European Stability Mechanism (ESM) is scheduled to be activated. (The first Greek bailout came before the EFSF’s creation, and Ireland also got bilateral aid from the UK.) The key difference between the two funds is that in contrast to the EFSF, which is equal in rank (“pari passu”) to bondholders, the ESM enjoys preferred creditor status. It is possible that the first tranche of the program will come from the EFSF—which is also allowed to issue bonds in the name of the ESM for a transition period until July 2013—with the remaining tranches to be paid out by the ESM. However, assuming that banking sector support does not have to be imminent, it is likely that the first tranche will only be paid out in several weeks once the ESM is up and running.

What are the consequences of subordination?

If the rescue funds are provided by the ESM, then official creditors will enjoy preferred creditor status, junior only to the International Monetary Fund. In the case of a restructuring or a default, this means that bondholders will be even farther down in the capital structure, which will lower their recovery value. As the amount drawn from the ESM increases and the probability of default rises, this has a larger and larger impact on bond prices, which will eventually shut Spain out of bond markets, as happened with the first three sovereign “bailout victims.” However, Spain has a government bond market of over €500 billion, so the subordination issue only becomes more meaningful with a larger, full-fledged sovereign stabilization program. RGE doesn’t expect this before early 2013, but it could come earlier should a (second) Greek default or EMU exit become disorderly.

Will the subordination trigger CDS?

Some news organizations, and market participants, have been fueling worries that the forthcoming Spanish bailout would trigger credit default swaps (CDS) by subordinating bondholders. While it is true that the ESM will be a preferred creditor, RGE is quite certain that a loan program would not trigger CDS; IFR concurs [hat tip, Elisa Parisi-Capone]. The loan is going to be funding for the FROB, not the Spanish government, but even if the money were going directly to the Tesoro, we already had what was essentially this same question go to the ISDA Determinations Committee in the case of the Ireland loans, and it was rejected. The ISDA ruled that IMF seniority is not a "subordination" that triggers CDS. See here and here. They would rule the same way on loans from the EFSF/ESM, even if loans were de jure senior to bondholders (however, pledging collateral, as Finland has demanded, should loans come from the EFSF might run into negative pledge issues on Spanish international law bonds; if those were subsequently accelerated after a bondholder meeting and vote, CDS would be triggered by a formal event of default).

That's the risk you take as an unsecured senior bondholder: You're at the top of the bond food chain, but loans and securitization can leave you high and dry. You can’t have your cake (bailout) and eat it too (stay senior to everyone). When Spain finally gets a full support package with conditionality and the works, not a mere credit line with no new commitments, it will probably be several hundred billion euros, and ESM seniority will indeed reduce recovery value should default occur. This “bailout” may then lead to a rise in longer-term yields, making bond issuance impossible and eventually leading to a bail-in, i.e., default or restructuring. So subordination is a serious issue, but will not directly lead to a CDS credit event. 

However, it is important to keep in mind that even though subordination does not trigger a CDS event, it may eventually have negative rating implications, which will continue to push yields out and further pressure bank liquidity portfolios; we have mentioned before that negative ratings drift could be the trigger that drives Spain into the arms of a full-fledged bailout.

I would like to know more details about the impact that the banking bailout will have on the fiscal side of the Spanish economy. Also, does the RGE macroeconomic team consider there still to be a possibility for Spain to receive a "full bailout"? In terms of the credit line for 100 billion enough?

RGE’s base case expects Spain to have to ultimately request a full bailout. See the Spain scenarios piece. Also, regarding the comment on whether €100 billion suffices, see this short forum post written in reaction:

Because the €100 billion is being lent to the FROB (a government agency), the cost of the banking bailout will be foisted directly onto the sovereign's balance sheet. Public debt will consequently rise; official estimates are now above 90% of GDP by the end of this year. A bailout for the banks only deals with one piece of the puzzle in Spain. In the absence of economic growth, it is our base-case scenario that the Spanish sovereign will need a bailout as well.

Some more of our thinking on the Spanish banking sector recap: Will this remove concerns about the Spanish banking sector and stave off a full troika package and a sovereign debt default? The announcement to recapitalize the Spanish banking sector is a positive development, after years of denial and fruitless hopes of recovery. However, appropriate measures to stabilize it should have been taken months if not years ago. Further, concerns remain regarding the final amount that Spain will request in the end and whether it will suffice to restore confidence in the sector, as well as the sovereign. If the amount is perceived as too small, banking-sector worries will persist, while a very large package could fuel an increase in concerns about the sovereign’s capacity to service its rising debt burden (although a 3% interest rate on the €100 billion would add just 0.3% of GDP to Spain’s annual debt service, the equity stakes taken may eventually become worthless). A better assessment as to the success of the banking-sector recapitalization plan to restore confidence and hence remove the risk of a full troika bailout will be possible in late June, when details on the total amount requested will be released. Worryingly, the plan for the credit line does not address the issue of potential capital flight from southern European banks, driven by concerns of redenomination and restricted access to funds. Yet, even if the headline figure seems sufficient in the short term, normal lending is unlikely to resume, especially if troubled assets remain on the balance sheet and losses are recognized only gradually.

Further, balance-of-payments and competitiveness issues remain unaddressed and no appropriate measures to restore growth have been taken so far. As the Spanish economic recession deepens, not only will the country’s public debt dynamics continue to deteriorate, but pressure on banks’ balance sheets will also re-escalate. Market uncertainty remains high and is bound to intensify further, particularly with a Greek EZ exit (which we expect to take place in Q1 2013), and our baseline scenario continues to envision the Spanish sovereign losing market access in 2013 and requesting financing from the EU-IMF firewall. Although that will help Spain delay a debt restructuring, it will probably not succeed in avoiding one eventually. We recently advised using the rally of the past few weeks to short/underweight Spanish bonds, having taken profits on such positions earlier. With Spanish 10y yields at 6.3%, we would continue to sell on incomplete reforms and bailouts that may cause temporary strength, but will end in a bondholder bail-in, which is not priced into the current yield curve with sufficient likelihood.