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The Subordination in Spain Will Cause Pain

Bruce Krasting's picture





 

As of Sunday morning there are no details on the Spanish bank bailout. The only information released is the amount – Euro 100B. This is a nice round number. 

Last week the IMF suggested that Euro 40B might be the right number. Now we get a deal for 2+Xs that. I think this was orchestrated to leave the markets with the impression that massive firepower has been garnered, and therefore the problem is now contained. Rubbish.

I’ll hazard a guess on how this bailout may be structured:

 

The EFSF will make a loan to the Republic of Spain. The Spanish government will use this money to recapitalize the Spanish banks. The critical question is what form the deal will take. There are only two options:

1) - The Spanish government could acquire new common or preferred shares of the banks that are in trouble.

2) - The banks that need a bailout will issue new debt securities; the Spanish central bank (or Treasury) would buy the debt instruments.

#1 is the only option that should be considered. New cash equity in the ailing banks is the only transaction structure that will result in stabilizing Spain’s banks. I doubt that this will happen. I see the “easiest/convenient” solution as #2; more debt.

A bank capitalization structure typically has these components:

.

Deposits
Senior Secured Debt
Senior Unsecured Debt
Subordinated Debt
Preferred Shares
Common Equity
.

Spanish banks have already hocked any available assets that could be used to “secure” the debt that will be issued in the bailouts. Therefore, the only alternative is for the banks to issue new debt that is unsecured. This is a subtle difference, but an important one. It might end up blowing up the entire European banking sector.

There is a simple fact that must be considered. Any debt that a Spanish bank has outstanding to the Spanish government is Senior to all other classes of debt except depositors. It doesn’t matter what the language says in the creditor agreements. What matters is how the markets will perceive the transaction.

I know how the market will react. If one were a holder of a Senior Debt security of a Spanish bank on Friday, you would end up with a functionally subordinated debenture after the bailout transaction on Monday. Any publicly issued senior debt (including senior secured) of that bank issued after the government bailout debt was created, would be perceived as tainted. It would be unsalable swill. The existing bond debt would sink like a stone.

This discussion is somewhat irrelevant when it comes to Spain’s banking system in June of 2012. The capital structure of many Spanish banks is already toast. So the details of the bailout don’t really matter at this point. In all likelihood the market’s knee jerk reaction will be:

 
“Any bailout is a good bailout”.
 

.But not too long after, the reality will set in. A precedent will have been set on what may/will happen to banks in other European countries. Should the bailout of Spanish banks be accomplished via the issuance of new debt (versus equity), then damn near every bank in the EU will have a run on the debt portion of its capital structure. It will happen first with the Italian banks, from there, it will head to Paris.

Holders of senior bank debt have few options faced with this scenario. They could (1) dump their holdings, or attempt to hedge some of the risk. The only hedges available are (2) CDS, or (3) a short of the common stock. A combination of 1,2&3 would be devastating to the EU banking system.

The IMF published a lengthy report on the topic of Senior bank bonds on April 24  (convenient timing). The bottom line conclusion of the IMF? It recommended a “bail-in”, where the senior bondholders of banks get crushed. I found this startling:

.

.

Bail-in, which is a statutory power of a resolution authority to restructure the liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity.

.

The USA set the precedent on Senior Debt of the TBTFs. The shareholders of the TARP banks took losses, but bondholders got a free walk. In the case of Fannie and Freddie, all of the creditors, including subordinated note holders, got paid off at a premium.

If the Spanish bank bailout deal ends up subordinating existing bondholders, it will create a whole new wrinkle to worry about. Portfolio managers who hold senior bank bonds of other EU banks will crap in their pants.

.

 


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Mon, 06/11/2012 - 07:56 | Link to Comment Cosimo de Medici
Cosimo de Medici's picture

One question.....in a "bail-in" is a new class of equity issued and provided to the debtholders who suffered a forced conversion?  If not, meaning there is only one class of shares, then somebody (pre-existing shareholders) is getting something for nothing.  In fact, the more highly leveraged the bank, the greater the free lunch to pre-existing shareholders if forced conversion of debt occurs.  Thus, there might even be an equity premium to the most leveraged banks, owing to this possibility.  I suspect HFs are going to have some fun with this.

Sun, 06/10/2012 - 19:58 | Link to Comment fleur de lis
fleur de lis's picture

Would somebody please explain to me why these oh-so-very sophisticated Europeans are still using a financial system that they and we and everyone else in the Universe knows to be fraudulent? Can they not find Iceland on a map? Do they not know that Iceland picked off the central banker leeches and ditched them and have been in recovery ever since?  

Is there some reason that the European swanks prefer debt slavery over national prosperity and financial independence?  I don't know why they are complaining when the exit door is staring them in the face.   

Sun, 06/10/2012 - 19:37 | Link to Comment The Alarmist
The Alarmist's picture

The rule of thumb is to multiply the first round estimate by 10x ... that will give you the pre-money requirement for the second round.  Greece has shown us that theset things require at least 4 rounds of financing before the financial wizards who are running the show finally throw in the towel.

€ 40B ... just a milestone along the way to despair.

Sun, 06/10/2012 - 19:33 | Link to Comment crzyhun
crzyhun's picture

H roids all round. Period: More debt to solve a probelm of growth is merely stymeing the possible recovery. Now we have another huge roid in the hole.

 

Sun, 06/10/2012 - 19:24 | Link to Comment Orly
Orly's picture

The USDJPY pair is already closing the weekend gap-up.  Is this indicating that US 10Y Treasuries will soon pay an interest rate below one...maybe lower?  Will your US taxpayer dollars go to support Parisian tourism?  German auto-makers?  Have you had your rice today?

All time lows yet to be seen on the yen crosses?

Are you short GBPJPY yet?

Stay tuned, 4X fans.  This could get real interesting, real quick.

:D

Mon, 06/11/2012 - 20:30 | Link to Comment Orly
Orly's picture

So, Bruce, the 10Y did absolutely nothing today, much to my surprise.  One would have figured that something would have happened but it didn't...

Something tells me there is a Fed-induced pump-n-dump on the horizon short-term.  In fact, there may be a long opportunity in the yen crosses, as long as the yield on the 10Y doesn't drop further.  A long Gartley formation has appeared on the GBPJPY Daily chart that looks very interesting, with an eventual upside target of 127.288.

I sold my shorts and am going to see the rebound come out of Asia tonight, looking to get long here.

:D

Sun, 06/10/2012 - 19:17 | Link to Comment lakecity55
lakecity55's picture

Is this for real?  Bank Holiday in Italy?

My Italian is pretty bad.

http://www.adiconsum.it/Pages/News.aspx?n=1675&AspxAutoDetectCookieS...

 

From what I could translate, it looks like 1 bank or 1 bank in 1 city.

Any takers?

We had a bank closure here on Friday, reported on Saturday at the back of the paper.

Sun, 06/10/2012 - 19:26 | Link to Comment lasvegaspersona
lasvegaspersona's picture

This is also a Drudge headline but google translator isn't working at this time. Could be nothing or the beginning of the end.

It was an Austian bank (Credit Ansaltz ?sp, now part of Unicredit largest in Italy) that started the Great Depression. (h/t Porter Stansberry)

Sun, 06/10/2012 - 18:12 | Link to Comment OpenThePodBayDoorHAL
OpenThePodBayDoorHAL's picture

to paraphrase Mellon, "liquidate bondholders, liquidate stockholders, liquidate management..."

Sun, 06/10/2012 - 16:17 | Link to Comment azzhatter
azzhatter's picture

Thanks Bruce. I have no doubt there isn't a prayer this will work but it buys a few more days/weeks. The clueless asshats in Brussels are down to buying days and weeks now

Sun, 06/10/2012 - 15:28 | Link to Comment Black Forest
Black Forest's picture

Thanks for this assessment.

Sun, 06/10/2012 - 14:39 | Link to Comment Freegolder
Freegolder's picture

So, Bruce, you are arguing that existing bank bondholders get to keep all of their capital?

 

Surely not. Stuff them, they lent to a bank doing crap business, they deserve to lose it.

Could you just confirm which you are: capitalist or communist?

(By the way, i'd just protect the depositors, wipe EVERYONE else out, shareholders, directors and staff included).

Sun, 06/10/2012 - 15:42 | Link to Comment RoadKill
RoadKill's picture

This has nothing to do with what Bruce thinks SHOULD happen.

Their are 3 questions:

What should happen in a fair capitalist society - No bailout is needed.  Just have the banks writedown their most senoir debt to $0, then the next tranche, senior debt takes a haircut sufficient to get equity / assets to 10% AFTER A REALISTIC 50% HAIRCUT IS APPLIED TO PEAK HOUSING PRICES.

What should happen for maximum stabillity - Germany borrows money and GIVES it to Spain, and they GIVE it to their banks, taking unsecured debt and maybe a few warrants (TARP).

What will happen - Germany will LEND money to Spain on a subordinating cramdown basis.  This results in Spain Debt/GDP going up.  Even worse, existing lenders to Spain are subordinanted and loose E100bbn of the best (first) collateral.  This COULD be a default event, but likely won't be ruled one by IDSA/Credit Agencies due to threats of investigations into monopolistic practises, pay or sexual harrassment.  Spain will buy new equity in the banks, resulting in equity holders being wiped out (they already are) but no haircuts to the holders of bank debt.

The big question is that now that Spain has tasted 3% debt, when they go to the market and have to pay 7%, 8%, 10% - will they go full monty and ask ESFS/ESM to fund their deficits.  That turns a one-time seizure of collateral into a never-ending flow.  This causes market rates to spiral up in perpetuity, eventually leading to a PSI.  But the biggest question is how will the bond vigilantes approach Italy now.  Italy could get a reprieve as the vigilantes focus on buying foriegn law bonds and shorting CDS'ing local law bonds in Spain.  But if you want to be 1 step ahead - you should be doing this in Italy.  2 steps ahead os France.  Find me some French foriegn law bonds and some cheap local law CDS and I'll show you how to become filthy rich in <3 years.

" And I'm not talking a $400,000 a year working Wall Street stiff flying first class and being comfortable, I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player, or nothing"

Sun, 06/10/2012 - 17:36 | Link to Comment HoofHearted
HoofHearted's picture

So...some of us don't have the cash just sitting around to buy the CDS for Italy (534 bps) or France (213 bps) on 10 million. Any suggestions on how to synthetically do what you are suggesting, even if we have to pay fees to some ETF or to some hedge fund manager??? Anyone have Kyle Bass's number? I'm sure he is all over this too. And he'll probably take nickels, silver, and gold as payment.

Sun, 06/10/2012 - 17:52 | Link to Comment Freegolder
Freegolder's picture

CDS's may never pay out (counterparty??).

 

Just buy some physical gold, and sit tight with it until after the electronic price crashes, and then the physical is revalued to $60,000+. Buy what you can afford, read Fofoa.

 

It's the only certainty.

Sun, 06/10/2012 - 19:19 | Link to Comment lasvegaspersona
lasvegaspersona's picture

Freegolder

this sounds simple

but it is what I am doing too

Sun, 06/10/2012 - 15:02 | Link to Comment John_Coltrane
John_Coltrane's picture

Unfortunately, you can't protect the depositors either.  Its a fractional reserve system, so you can protect maybe 5-10% of the deposiitors, or 100% of them if you give them about 5-10% of their account.  Malinvestment (overpriced RE) destroys capital and there's no way to get it back.

Ah, the false illusion of security in "deposit" insurance during a bank run!  The reality is a bank holiday (or freezing of accounts) and capital controls.  And we will certainly see those implemented when the panic sets in.

Sun, 06/10/2012 - 15:47 | Link to Comment Errol
Errol's picture

Mr Coltrane, you are right - "deposit insurance" is really just another taxpayer subsidy to bank holding companies.  In a truly capitalist system, depositors would do their due diligence on a bank's lending policies and capital structure before depositing money with them.

Sun, 06/10/2012 - 15:59 | Link to Comment egoist
egoist's picture

That's goddam right! Most people I know have zero interest (so to speak) in the goings on of their bank and its health.

Sun, 06/10/2012 - 21:56 | Link to Comment RockyRacoon
RockyRacoon's picture

Remember in the Olde West movies when the folks would come out of the barber shop and the hardware store to help stop the bank robbers?   Hey, it was THEIR money being stolen.   Nowadays folks would just step aside or hit the dirt when bank robbers exit the bank with all the FDIC guaranteed loot.  My how times have changed.  Accountability is the missing factor in this equation.

Sun, 06/10/2012 - 14:53 | Link to Comment Nadaclue
Nadaclue's picture

I assure you sir, after reading Bruce for several years, he is a Capitalist.

I cannot speak for him, but I think he would agree wholeheartedly with your remedy of letting those who took on the risk, suffer the fate of their stupid decisions.

Regards

NC

Sun, 06/10/2012 - 14:33 | Link to Comment Ned Zeppelin
Ned Zeppelin's picture

Excellent Bruce, as always.

Sun, 06/10/2012 - 14:33 | Link to Comment Satan
Satan's picture

FFS...there are some other words that rhyme with Spain.

This crisis is going to be around for a while. If you must rhyme your headlines get a fucking rhyming dictionary.

Sun, 06/10/2012 - 14:45 | Link to Comment Satan
Satan's picture

Good article though.

Sun, 06/10/2012 - 14:29 | Link to Comment etresoi
etresoi's picture

What a circle jerk !  95billion euros left the banks of Spain last month and now 100billion cames back to save the banks.

Sun, 06/10/2012 - 17:17 | Link to Comment asteroids
asteroids's picture

NOT a circle jerk. The goal is to tranfer private bank debt into public citizen debt. The bankers win! The Spanish government should refuse to do this and let their banks fail and the debt be wiped out. Like Iceland did.

Sun, 06/10/2012 - 14:03 | Link to Comment dizzyfingers
dizzyfingers's picture

Where are the guillotines stored?

Sun, 06/10/2012 - 14:02 | Link to Comment mjk0259
mjk0259's picture

Spanish bank bonds were already headed towards worthlessness pretty quickly. Now nothing will happen at least for a couple years.

 

Real losers are savers in Euro's who are having the value of their currency reduced by printing more to give to banks.

 

Sun, 06/10/2012 - 13:49 | Link to Comment sangell
sangell's picture

The Irish might wonder why they had to pay off bank bond holders at par if  'bail ins' are appropriate elsewhere in the EU.

Sun, 06/10/2012 - 13:44 | Link to Comment egoist
egoist's picture

I can't quite figure out if / how much we (the US) are on the hook?

Non-tax-paying Lagarde said that the IMF stands ready to help; isn't she lovely? My take on Obama's rant yesterday (or day before) was that he was merely greasing the skids for a US bailout of Spain.

Beck, a while back, mentioned an extended (maybe forever) trade of US Ts for EUROs.

The entire thing is funny; we borrow from China to "lend" to Europe.

 

Sun, 06/10/2012 - 15:32 | Link to Comment stocktivity
stocktivity's picture

US contirbutes 17% of the IMF funds...by far the largest of course. American taxpayers will end up paying and eventually losing a large chunk of hard earned cash. Bernanke won't be stopped and Obama has an election to win in 5 months.

Sun, 06/10/2012 - 16:13 | Link to Comment Careless Whisper
Careless Whisper's picture

I think you nailed it. At this point $100 Billion is a rounding error to the cartel Federal Reserve balance sheet. Although 17% may be the official contribution to the IMF who knows what's really going on?

 

Sun, 06/10/2012 - 13:37 | Link to Comment breezer1
breezer1's picture

Should I cancel my upcoming trip to Ireland?

Sun, 06/10/2012 - 15:34 | Link to Comment stocktivity
stocktivity's picture

No...Ireland should be fine. However, you may not want to go to Greece this summer.

Sun, 06/10/2012 - 13:59 | Link to Comment Dick Darlington
Dick Darlington's picture

Think what currency u take with You if You go. ;-)

 

Punts & Clones: Fed up with Euro, Irish town cashes in old currency

http://www.youtube.com/watch?v=On3Asjr-WZc

Sun, 06/10/2012 - 13:57 | Link to Comment Dead Canary
Dead Canary's picture

Are you German?

Sun, 06/10/2012 - 13:35 | Link to Comment jeff montanye
jeff montanye's picture

i agree with the imf staff discussion note above.  

the bondholders of insolvent banks are precisely the ones, with the stockholders and management, to pay the price of such insolvency.  strip off the equity, replace management, haircut bondholders generously (from the taxpayers point of view), fully insure depositors and bring the now solvent and transparent bank public with proceeds repaying the taxpayers for the expenses of the reorganization.  

this is what the nordic countries did in the '90's (and the s and l's in u.s. as well) and it worked.  what europe and the u.s. are doing now is what japan has been trying for 22 years and it has not worked/will not work.

Sun, 06/10/2012 - 14:55 | Link to Comment John_Coltrane
John_Coltrane's picture

This is certainly the process that should occur (bondholder cramdown which even Soros advocated in 2008), but I'm guessing they won't let it happen because the bondholders are other financial institutions like pension funds, insurance companies, and other "strong" banks.  Who else is dumb enough to hold bank debt-only those managing other peoples money right?  So, they fear, probably correctly, a complete breakdown of the world financial system via the great entangled web of modern finance.

Living beyond your means for decades using debt instead of savings will bite you in the ass.  Ass meet teeth.

Sun, 06/10/2012 - 14:22 | Link to Comment Bruce Krasting
Bruce Krasting's picture

Well said. I also agree with the IMF position.

But think of the consequences of this. It changes the risk/reward profile of all bank debt. It will rip up more of the weaker bank's balance sheets.

This may be the correct aproach, but the IMF plan would first bring a very big storm, before there was any calm.

Sun, 06/10/2012 - 21:40 | Link to Comment RockyRacoon
RockyRacoon's picture

You know the pertinent formula:  You can have it cheap, good, fast -- but you only get 2 outta 3.  Somebody smarter than I am will have to come up with the 3 options on this scenario.  I'm sure "painless" will be in anyone's list.

Sun, 06/10/2012 - 13:43 | Link to Comment Cursive
Cursive's picture

@jeff montanye

Accurate, concise and correct.  I wish I could upvote this x1,000,000.

Sun, 06/10/2012 - 13:09 | Link to Comment Cursive
Cursive's picture

Therefore, the only alternative is for the banks to issue new debt that is unsecured. This is a subtle difference, but an important one. It might end up blowing up the entire European banking sector.

What do you mean "might?"

Sun, 06/10/2012 - 13:06 | Link to Comment Dick Darlington
Dick Darlington's picture

Finnish PM Katainen admitted "noone has done the math on Spain". So Bruce, You're absolutely correct once again. This is a classic PANIC reaction from the €-fanatics. They just throw a big round number and hope it will assure everybody. Just like with Greece, Ireland and Portugal. Only things that changes here is that DEBT will grow, bondholders will get subordinated and private capital will run away from Spain with accelerating speed.

Sun, 06/10/2012 - 12:11 | Link to Comment Zombie Investor
Zombie Investor's picture

Will we know on Monday whether they went equity/debt route?

Sun, 06/10/2012 - 12:28 | Link to Comment Bruce Krasting
Bruce Krasting's picture

I doubt it.

Sun, 06/10/2012 - 11:46 | Link to Comment jstalin
jstalin's picture

Spain is a kingdom, not a republic.

Sun, 06/10/2012 - 14:28 | Link to Comment cbaba
cbaba's picture

Yes whose king was in African safari when all these bad things were happening.

Sun, 06/10/2012 - 14:47 | Link to Comment Cast Iron Skillet
Cast Iron Skillet's picture

with his girlfriend while his wife was at home

Sun, 06/10/2012 - 16:47 | Link to Comment Sudden Debt
Sudden Debt's picture

Shooting elephants...

Mon, 06/11/2012 - 08:59 | Link to Comment Fred Hayek
Fred Hayek's picture

In his pajamas.
Though, how they got in his pajamas, he'll never know!

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