If anyone felt on the fence about the prospect of Spanish bond subordination by priming ESM loans, the following feeble attempt at justification by Goldman's Francesco Garzarelli, better known for shorting bonds into one of the biggest rip your face off rallies in TSY history, should really set their mind at ease. Or not.
Relative to the status quo, a net gain to existing government bondholders: Compared to a starting point where the Spanish government would have ultimately borne the credit risk from banks (via the FROB) without enjoying large access to market borrowing, the official sector loan represents a net gain for holders of Spanish government bonds, unless it changes incentives or leads to subordination. We consider both:
- Incentives: Relative to a situation where government bond funding was available almost entirely from the ECB, under no conditionality other than collateral rules (which have been progressively relaxed), Spain’s EMU peers now have more control over the restructuring process along the guidelines defined in 2011 (available here). In a statement, the Eurogroup indicates that progress on the pace of fiscal and structural reforms will continue to be monitored by the European Commission as for other countries under the excessive deficit procedure. As Andrew Benito argues in a separate note published June 10, Spain’s fiscal challenges remain high, but not insurmountable, in our view. To the extent that the stable funding allays fears of deposit flight, and releases pressures on sovereign funding and hence on the interest bill, the official sector aid should increase the odds of a more orderly Spanish deleveraging.
- Subordination: The issue of subordination of government bonds remains a central one for investors. De iure, EFSF loans are pari passu with existing bonds. Concerns have been expressed as to whether de facto the official sector is now a senior creditor. This is always a possibility (as we have seen with discussions over the credit status of the ECB). However, it is also important to note that the EUR 100bn (which are unlikely, on our estimates, to be fully used) represents 13% of the existing Spanish public debt, about 10% of 2011 GDP.
Oh, it is ONLY 13% of outstanding Spanish debt. That's perfectly ok then. Oh wait, most priming DIPs for bankrupt companies tend to be somewhere in the 10-40% of total pre-petition debt too. Sadly however, the mere assumption that €100 billion in senior debt will be sufficient to plug the hole in Spanish banks, which rose from €40 billion to €100 billion in under one week, is laughable. And of course, every incremental dollar of senior debt means less value to existing subordinate Spanish bonds.
Finally, confirming that one should get the hell out of Dodge, is the fact that Goldman now is telling its clients to, wait for it, buy Spanish bonds.
Short-dated Spanish Government Bonds Offer Value
Whilst no ‘paradigm shift’ for the way the EMU sovereign and banking crisis is being tackled, relative to where things stood last Friday (June 8) the decision by Spain to seek financial assistance is a marginal positive. Conditionality is limited to the banking sector and we think the larger size of the loan should help foster confidence that there will be sufficient resources to recapitalize banks and to face quite adverse scenarios.
The amount seems to reflect the IMF assessment published on June 8 that “it is better to overestimate than underestimate” a backstop for capital shortfalls. The IMF estimates that while the largest banks would be sufficiently recapitalized, several others would need EUR40bn to comply with the Basel III transition schedule (Core Tier 1 capital of 7%) and a larger amount to include restructuring costs and reclassification of loans that will be identified by the independent evaluations. The IMF will host a conference call on Monday to discuss its top-down assessment.
Even though the statistics for public debt will increase by about 10% of GDP, the funding program of the Spanish government will not be affected and the loan will come at much more advantageous terms for the public sector than current market rates. The combination of these two factors should reduce pressure on the Spanish sovereign. All else equal, yields should decline, particularly at the front-end of the curve. On Friday, the 3-year benchmark bonds closed at around 480bp over Germany. We could see a rally towards a 400bp spread during the volatile period while more news on the transaction becomes available. A more sustained compression requires a reduction of systemic fears surrounding the EMU project, in our view. Any indications of long-run solutions coming out of meetings taking place this month could be supportive in this direction as argued by the President of the ECB in his last press conference (See Global Markets Daily, Euro Vision).
Yes, we have seen this one so many, many times before: if Goldman is telling its clients to buy, it means Goldman is....
fill in the blank.