With all proposed Spanish bank bailout plans so far either shot down, or found to be inadequate, the question always has boiled down to whether Germany, which as we have noted in the past is the true lender of last resort in Europe, not the ECB, will agree to the trade off of preserving the Eurozone, i.e. temporarily ending the latest Spanish risk flare out, in exchange for the risk of political disgrace domestically, where more and more people are against sweeping European bail outs, due to soaring "contingent liabilities" which increasingly more people on the street are realizing are all too real (see: TARGET2 [10]). On the other hand, a direct bank bailout request for Spain using traditional European channels, which would fund the government, would result in a deterioration in the Spanish sovereign leverage, and make the country even riskier, thereby putting more pressure on the banks, and so in a toxic loop. It now seems that this dilemma may have been resolved, at least on paper. As Reuters reports [11], "A deal is in the works that would allow Spain to recapitalize its stricken banks with aid from its European partners but avoid the embarrassment of having to adopt new economic reforms imposed from the outside, German officials say. While Berlin remains firm in its rejection of Spain's calls for Europe's rescue funds to lend directly to its banks, the officials said that if Madrid put in a formal aid request, funds could flow without it submitting to the kind of strict reform program agreed for Greece, Portugal and Ireland."
Whether this is merely more posturing out of Germany to telegraph it is willing to step in, without actually doing it will likely soon be tested. When that happens, expect a backlash: "Merkel has also sent the message that she is open to Europe-wide supervision of the banking sector, albeit as a "medium-term" goal, one element of a proposed "banking union" to break the vicious circle of interdependence between Europe's financial institutions and its sovereigns. But she must tread carefully. Some of her political allies and leading conservative newspapers have come out strongly against other aspects of a banking reform, including the idea of a Europe-wide deposit guarantee scheme." Yet as we showed yesterday [12], Germany may not have an option: the cost of a Eurozone collapse, at least in the short term, will surely be greater than kicking the can one incremental time. Which is why sovereign spreads in Europe have tightened substantially on this latest news. That, and of course, the latest Hilsenrath rumor that the Fed is about to CTRL-P, has sent risk soaring despite the latest ECB disappointment from this morning.
More from Reuters [11]:
Spain would only have to agree to new conditions tied to the reform of its banking sector. Berlin is also exploring the possibility of funneling aid to Spain's bank rescue fund FROB to reinforce the message that it is the country's banks and not its public finances which are at the root of its problems.
The evolving German stance on aid for Spain is the latest evidence that Chancellor Angela Merkel is adopting a more flexible approach to solving the euro zone's deepening debt crisis.
With an IMF report on Spain's banks looming next week, officials say all the pieces are in place to move within days on an aid deal for Madrid. A package is expected by early next month at the latest, after an external audit of the banking system.
"One could imagine that conditionality would be focused mainly on the banks, because Spain has already tackled the other reforms," a senior German government official said on condition of anonymity because of the sensitivity of the situation.
"These packages are not aimed to punish, just to ensure that the necessary reforms are being implemented."
Spain's Economy Minister Luis de Guindos reiterated on Wednesday that his country had no immediate plans to request a bailout and was awaiting the external audit in late June.
Berlin is certainly shifting positions. Last week, it signaled it supported granting Spain an extra year to cut its deficit to the EU's 3 percent of gross domestic product threshold, having previously held fast to the notion that austerity drives should not be diluted.
In other words, Germany is about to onboard even more contingent liabilities, in the form of directly subsidizing the Spanish bailout fund, in what amounts to the latest stealth bailout of an insolvent banking sector. And at this point why not: the sunk costs are so huge that a EMU collapse would disintegrate Germany - may as well perpetuate the illusion that somehow any of this debt will be paid back.
Multiple sources said the German finance ministry was exploring the possibility of channeling EU aid directly to Spain's Fund for Orderly Bank Restructuring (FROB), but that this would only work under the ESM, which is due to come into force next month.
"Nobody wants the EFSF for Spain. It's too restrictive," a second senior official said, pointing to the added flexibility contained in Article 19 of the bloc's permanent rescue mechanism.
That article states explicitly that the board of governors of the ESM are allowed to make changes to the financial assistance instruments laid out in the facility's statutes.
A senior French official who has been in contact with the Germans said negotiations were heating up and that there was a broad consensus now among member states on using the EFSF or ESM to help Spanish banks.
"The Europeans want to cut the link between the banks and the sovereign. That's what is being discussed. There are plans to do that in the long run (through a banking union) but the idea is also to apply that to Spain," the official said.
So for the time being, this is the latest page in the neverending European script of infinite bailout permutations. We expect some informal refutation, which will make things worse, which will merely press the inevitable bailout outcome even more, until one day there is simply no more German money lying around available to preserve the broken European dream, and the illusion that "Europe is fine."