Saturday, June 16, 2012

Spain's Problems Were Made by the ECB in Greece

Spain's banking bailout last week has been less then successful, but the blame has not managed to get to the responsible party.  There is little question that Spain's problems stem from the property bust, and resulting banking crisis.  Spain has not helped it's cause by acting as if the banking problem could be solved without state support.  However, considering that the problem is a banking crisis, and the 100 Billion Euro bailout should be sufficient to recapitalize the banks, it is curious that the bond market's judgement of Spain is so harsh.  The 10 year government bond for Spain crossed 7% on Thursday.  If Spain is forced to pay that rate for long, then a full bailout will be required.  So why does the Spanish banking bailout appear to be such a failure?  The answer lies with the ECB, and the way they handled the Greek debt restructuring.

Europe's handling of Greece has been a comedy of errors, but possibly the biggest error or all was the ECB's idiotic insistence that they be spared the effects of the debt restructuring.  When Greece restructured their private bonds on April 25th the ECB had held approximately 50 Billion of the bonds which they had bought in the open market in an earlier effort to support bond prices.  The bonds that the ECB owned were the same bonds that were being restructured, and the long standing legal principle of Pari Passu states that ALL bondholders (including the ECB) must be treated equally.  The ECB didn't like this idea, and pulled an audacious, illegal kludge to insure that their bonds would be treated differently.  The did this by exchanging their bonds for new ones, but since this treatment was not offered or granted to any other bondholders, it was an absolute travesty.  The outrage was muted because the other bondholders (mostly European banks) are so beholden to the ECB that they did not want to bite the hand that props them up.  However, just because no one complains does not make it right.

Additionally, just because they thought they got away with it in Greece does not mean that they actually did.  Today, we see the fallout of the ECB's behavior in Spain.  The banking bailout should have been enough to calm the market, but it only made things worse.  Bondholders of Spanish debt understand that they are implicitly subordinated whenever official support is provided.  The subordination can be legal (in the case of the ESM) but the real concern is the illegal kind.  The precedent has been set, and it states that  in a pinch the ECB will change the rules in their favor at the last minute.  How the rules get changed is unknown, all that can be certain is that it will be to the detriment of anyone holding Spanish debt.

The ECB is getting their comeuppance, and it's poetic justice in a way, only it's a shame that Spain and the Euro will suffer for the ECB's poor judgement.

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