Portugal’s bailout is pretty much priced-in, right?
Well — it might be time to consider an intriguing, and plausible, game-changer.
According to Marco Valli, chief eurozone economist at Unicredit, and colleague Tullia Bucco (emphasis ours):
… the handling of previous rescue packages indicates that reactive rather than proactive action by policymakers may not suffice to re-establish investors’ confidence, and we now see increased urgency for policymakers to try to get ahead of the curve. Accordingly, it would be desirable that the announcement of any rescue package for Portugal comes along with, or is followed shortly after by, a strong European commitment to tackle Spain’s most problematic issue, the banking sector.
The move would be a game-changer not just in its timing, but in terms of how much a Spanish bailout will end up costing the eurozone’s core sovereigns.
Here’s a self-explanatory chart from RBS (click to enlarge):
Hence official discussions reported by the WSJ — although first aired in the FT weeks ago – about up-sizing the EFSF, or forcing it to purchase sovereign debt directly.
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Portugal’s bailout numbers…
With that background in mind, it’s almost… easy to work out what kind of bailout funding Portugal would need.
Assuming that Portugal is best off with some sort of bailout (you could argue that coming off the market for years and then eventually refinancing the bailout loans will do more harm than good), we like the look of these numbers from Valli and Bucco.
Writing ahead of a critical pair of auctions of Portuguese debt on Wednesday, they note this:
Regardless of the auctions’ outcome, we see little scope for Portuguese spreads to narrow substantially from the current levels (which we deem as unsustainable), making it more likely than not that Portugal will eventually be forced to seek external assistance. In this case, we estimate that the total size of the rescue package could be around EUR 60bn (with the usual 1/3 split between EFSM, EFSF, IMF), sufficient to cover bond redemptions and the expected budget deficit for the next three years, as well as providing EUR 10bn for the stabilization of the banking sector – which however is not in a critical situation.
Numbers which make sense if you assume Portugal will issue around €20bn of government bonds per year in 2012 and 2013, as in 2011. Of course, a lot depends on what deficit target Portugal is given. An actual surplus of one or two per cent of GDP may be Portugal’s only realistic baseline for debt sustainability (2010′s deficit target, which was met, amounted to a deficit of 7.3 per cent.)
At any rate, €10bn for Portuguese banks roughly corresponds to their refinancing needs in 2011 but you may see some debate over whether this should be equity for recapitalisation or just the limit on a funding guarantee. Basically, is it solvency or liquidity that the Portuguese banks have a problem with?
Those are the Portuguese numbers, and they’re pretty cut-and-dried compared to the absolute abyss of potential losses Irish banks had left for Ireland’s bailout in November 2010.
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…and Spanish banks’
Which is the perfect segue to working out bailout numbers for Spain, because here — as we’ve explained before — it’s all about those bank losses.
So why not focus your bailout on the banks and leave Spain’s sovereign debt to the private market. This is exactly what Unicredit propose and it’s very interesting:
We think that this commitment should come in the form of a EUR 100bn recapitalization of the FROB – Fondo de Reestructuración Ordenada Bancaria – with EFSM/EFSF/IMF money (current EFSF rules state that any lending must have IMF involvement). The FROB is the fund set up by the Spanish government and the Bank of Spain to facilitate the restructuring of the domestic banking sector, particularly the troubled savings banks (cajas), and is currently almost empty. According to our bank analysts, EUR 100bn would provide a sufficient buffer assuming a particularly punishing scenario for write-downs on developer loans (roughly speaking, a 40% write-down on developer and real estate exposure coupled with recapitalisation to 10% core Tier 1 ratios).
We’re assuming this is a straight-up application of a simple formula that’s been missing throughout the financial crisis: writedown, recapitalise, rebuild.
The thing is, Europe’s bank bailouts have all been at the national level (Ireland’s deposit guarantee, which caught European officials off-guard, is a kind of original sin here).
The FROB currently ‘enjoys’ the full faith and credit of the Kingdom of Spain, which is a dubious pleasure at the moment. It issues debt in markets on a sub-sovereign basis in order to fund caja capitalisations. Clearly it would have to stop this programme for the above plan to work, if we’re reading the proposal right. This may require changing Spanish law. We’re not sure.
There’s another technicality centered on the EFSF and the EFSM. The EFSF’s Articles of Incorporation state in no uncertain terms that it can only lend to member states, so officially Spain and only Spain would be getting the funding.
One other big technicality to bear in mind — the European Commission must approve any provision of state aid to banks, even if the state aid would just be shovelled in through the back door.
We want to underline those technicalities, because they show that this might be a proposal whose underlying principle could be easily adapted to something much bigger: a pan-EU bank recapitalisation fund.
Some have been calling for just such a fund for a while. In theory you’d just ditch the member-state technicality and possibly solve a few other banking exposure problems that lie beyond Spain and Portugal as well. Moreover, recapitalised banking systems could deal much better with restructuring of peripheral sovereign debt in the future.
In theory.
Because, in practice, any concept of government capital injections has to come to terms with the movement to burden-sharing and bail-ins for subordinated, and perhaps even senior, bank debt. You’ve seen what’s just happened to senior spreads on news that Europe might consider bail-in regime there, for instance. Less than pretty, and a huge problem for funding markets.
Anyway, there are lots of complications to Unicredit’s idea, but it’s well worth pondering. So we’ll close with its take on the mechanics of rerouting the Spanish bailout right around the sovereign and straight to the banks:
The fact that this intervention would address the heart of Spain’s problems, while not affecting directly the sovereign, implies that the Spanish Treasury would need to continue to issue bonds, and therefore the package per se wouldn’t shield the country from a further potential rise in yields. However, by reducing the uncertainty on the recapitalization of the banking sector and lowering chances of a negative feedback loop between banks and the sovereign, the move should have a positive impact on government bond yields. Moreover, with the sovereign not benefiting directly from the aid, there would be a relatively small stigma for the government, although under usual IMF practice this would not be enough for Spain to escape loan conditionality implying a quick and effective consolidation of the banking sector – with a new round of stress tests playing an important role – and further deficit-cutting measures (which are both politically and economically costly). A possible way to face strict conditionality only on the banking sector consists in having the IMF disbursement coming in the form of a Precautionary Credit Line, less stringent than a stand-by agreement (as in the case of Greece) but not as condition-free as a Flexible Credit Line. The PCL was announced as a new facility by the IMF last year but has yet to be drawn off by any country…
We’re getting new Europe-wide bank stress tests in February already.
And as for the PCL — there’s a primer tiempo for everything.
Related links:
Buiter’s €2,000bn solution for the eurozone - FT Alphaville
The Spanish (asset) Elimination – FT Alphaville
How to save the eurozone, by JPMorgan – FT Alphaville