Just as the summer finally arrives in Northern Europe, the Eurozone crisis is heating up once again. With an increasingly flat (heading to inversion) yield curve, and spreads at record wides, Spain appears to be in a downward spiral of market turmoil that might require a full-fledged TROIKA bail out. However, as UBS points out, rather than taking the country off the market, the program would have to allow Spain to keep borrowing from private investors. Any bail out of Spain would have to be designed in a way that would also be applicable to Italy. Spain has been the most recent crisis focus, and looks to intensify further with nothing immediately in sight that could reverse the trend. We, like UBS, have argued for some time that a full-fledged TROIKA program will ultimately be unavoidable and the following six reasons briefly explain why anything else is a pipe-dream.
Via UBS FX Strategy:
The Eurogroup last week formally approved a €100bn bank bailout but as our banking colleagues have argued, the programme generates no equity and no funding and is thus unlikely to make any lasting difference either to the limited market access of the banks or to the credit crunch affecting the country. Also, the decision at the June EU summit to take a first step towards a banking union has done very little to ease the pressure. The market initially assumed that the €100bn would be offloaded from the sovereign balance sheet to the ESM by the October or December EU summits once an ‘effective supervisory mechanism’ had been created.
However, subsequently it became clear that:
1) creating European supervision might take substantially longer than just a few months, not to speak of a proper banking union, and
2) a strong argument can and will be made that a banking union can only ever be a forward-looking mechanism, never an instrument to deal with legacy debt. Also note that the impatiently awaited bottom-up bank stress tests will not be available until the second half of September.
The question is what the trigger could be for the Spanish government to request a full-fledged troika programme given the political capital invested in being able to avoid calling in the IMF. Last week’s poor bond auction illustrates the increasing difficulties that Spain is facing at refinancing itself. 10-year yields seem to be climbing steadily towards 8%, which if persisting for a few weeks could force the government to give in. The big challenge will then be how to design a troika programme that avoids Spain losing market access. In fact, officials in Brussels and elsewhere have been agonising over the question for months and there certainly is no easy solution.
The most obvious option would be for the EFSF/ESM to use its powers to intervene on the sovereign bond market, as reinforced by the June summit. The problems of such an approach are well-known:
3) the EFSF would first have to issue debt before having any cash to spend on bond purchases,
4) the ESM while designed to have cash from the start will not actually be established before mid-September at the earliest,
5) even if the EFSF/ESM were able to effectively backstop the Spanish bond market, it would not be a model applicable to Italy, and
6) bonds purchased by the EFSF/ESM would be seen as senior to private sector holdings, given the Greek precedent, hence fueling subordination fears.
A mess indeed - or will Spain (like Greece) be forced to sell assets (Jules-Rimet Trophy? securitize Torres?)...
and as Goldman reminds us:
The-end June European Council has also signalled a preference for sovereigns to help other viable sovereigns on ex-ante conditional terms, but not their banks. This appears to us as a large shift relative to the treatment of bank creditors in Ireland, and more recently in Greece. Quoting again from Mr Draghi’s interview: ‘One important point is the involvement of senior creditors of banks: the ECB believes that such involvement should be possible in the case of the liquidation of a bank. Savers must be protected, but creditors should be part of the solution of the crisis. It is a matter of limiting the involvement of taxpayers. They have already paid a great deal.’ Admittedly, Mr Draghi did not say whether this applies to the current situation, or the future ‘steady state’, but we tend to think the former.