While this morning saw a rumor of junior bank bondholder haircuts (and burden-sharing) rapidly denied by Spain's de Guindos, it appears the country's smarter individuals are realizing that perhaps a 'bail-in' (a la Citigroup in 2009 [8]) is the better way to go than an unending 'bailout' when it comes to the problem banking system. As the WSJ noted last week "consider the grim fact that even €100 billion may not be enough to put Spain's banks back on their feet, as they could easily face losses of perhaps three times that amount" confirmed in yesterday's Oliver Wyman reality check.
The bigger issue is not the insufficiency of the loan but the fact that such a relatively small loan was impossible for the sovereign to raise itself as no private investors believe their solvency - implying Spain has reached its debt saturation point. Neither government nor taxpayers can afford to take on more debt (which is what the bailout is).
The solution, a precedent set by the good ol' USofA with the Citi preferreds [8], is to cram-up bond-holders. A compulsory debt-for-equity swap for the subordinated and senior unsecured liabilities, "whereby investors bear the vast majority of the cost of their own mistakes, without liquidating the banks and without pushing the Spanish economy into bankruptcy" may initially cause some turmoil in the interbank lending markets (which would need to be supported by the ECB in the interim as it is already) may be extremely painful for shareholders (who will see massive dilution) and bondholders (arguably rightfully so) but would offer hope for improving market belief in solvency.
A Senior-Subordinated spread decompression trade in credit would seem to make sense - given the considerable hit taken to the subordinated class (whether it triggered CDS or not) and sets up to be the macro trade for the coming months.
[9]
especially given the following 'math' from the WSJ's story [10]:
Converting into equity 100% of the €88 billion of subordinated liabilities, and 40% of the €160 billion of senior unsecured debt, would generate more than €150 billion of loss-absorbing equity for the Spanish banking system. Together with the estimated €25 billion in expected operating profits for 2012, before loss provisions, that would yield about €175 billion in new bank equity, without increasing the debt burden of the Spanish taxpayer or requiring a loan from Brussels.
As The Economist wrote back in 2010 [11]:
Many investors would no doubt complain about the rough justice of a regulator-imposed reorganisation. To preserve value, officials would have to move very, very quickly, leaving little time to fine-tune various claims or observe normal procedures. The new structure would be based on bankruptcy reorganisation principles, allocating value in accordance with investors’ seniority and ensuring that each class of investors would be better off than in liquidation. The process would not be pretty but overall, investors should be relieved by the result.
Why can’t the bankruptcy code do this today? To an insolvency professional, this restructuring looks somewhat like a “prepackaged” bankruptcy, in which creditors agree to a new, less leveraged capital structure negotiated over a period of months. But a lengthy, voluntary process is impractical in the panic surrounding the failure of a very large, complex financial institution.
As Juan Ramon Rallo notes in the WSJ article last week [10]:
Instead of a bailout, the Spanish state should force a "bail-in," in which much of the banks' debt is converted to equity. This would reduce the banks' leverage and increase the capital available to absorb the coming losses... and after some time, short-term credit would flow again inside a country with much more robust and solvent financial institutions.
Perhaps the 'bail-in' is best summarised by a comment from the WSJ story:
Essentially, this is a proposal for financial restructuring (aka bankruptcy) without bothering to go to the courts. Its cleaner, less disruptive, and less expensive than where we are headed otherwise. The money has already been lost. Someone has to book it.
Seriously, when should investors in the debt of financial entities take a loss if not now? Never?