Small Investors Thrown to the Wolves?
We previously opined that it would be very difficult to impose losses on subordinate bank creditors in Spain, because many of the holders of subordinated securities in the capital structure of Spanish banks are their own retail customers. The problem as we see it is that the banks reportedly routinely sold such subordinate instruments under false pretenses – promising depositors high yields coupled with the 'safety of deposits'- a quasi capital guarantee.
Admittedly we know very little about Spain's legal system, but let us think the scenario through: a bank approaches its depositors with an enticing proposition. It tells them, 'instead of leaving your money in a savings account or current account where you currently earn a central bank imposed nada in interest, we propose to sell you a bank-issued security (preferred share, subordinated bond) yielding 7% (or whatever), and we guarantee that your capital will be just as safe as it now is in the form of deposit money'. Half a year later the bank 'restructures' – mainly because it has been insolvent all along and now is finally forced to admit it – and holders of these subordinated securities are wiped out.
However, if the securities were sold to retail clients under false pretenses as described above, then what stops those clients from suing the bank? If courts agree with the plaintiffs that they were intentionally defrauded and sold securities under false pretenses, the concerned bank's liabilities should not only not decline, but actually rise, as punitive damages would likely be added to the judgments as well. In this scenario, the formerly subordinated securities will become senior claims on a par with those of senior bondholders.
It is of course quite likely that the fine print stated that these securities weren't what the banks told their clients they were. So the question is how the courts will interpret the evidence: should retail clients have read the fine print rather than listening to the bank-appointed get-rich-quick advisor, or does the sale of the securities actually constitute an act of fraud?
The reason why we are wondering about all this is that the memorandum of understanding (MoU, pdf, 20 pages) between the EU and Spain declares that holders of subordinated bonds and 'hybrid securities' are required to take losses in the course of the bank bailout scheme before any EU aid is dispensed. It appears however that senior bondholders will once again be spared (otherwise it wouldn't be a bailout…).
European authorities are pressing Spain to inflict billions of euros of losses on small investorsby wiping out certain types of bank debt before its financial institutions are recapitalised using eurozone rescue funds.
The bailout conditions for Spain’s banks would force any lender taking aid fully to write off their preferred shares and subordinated bonds, according to a draft memorandum of understanding seen by the Financial Times.
“Banks and their shareholders will take losses before state aid measures are granted and ensure loss absorption of equity and hybrid capital instruments to the full extent possible,” the document says.
Spanish banks have €67bn of subordinated and hybrid debt outstanding, according to Bank of Spain, much of which was sold to retail investors as savings products.
“The difference between Spain and other European countries is that these instruments are held mainly by retail investors,” said Daragh Quinn, a banking analyst at Nomura. “People who bought them might not have known exactly what they were investing in”.
Luis de Guindos, Spain’s finance minister, has admitted that investors should not have been sold the savings products and he had sought to minimise their potential losses under a eurozone rescue. “It was an error to sell the preference shares, and we will have to look for solutions,” he said in May.
Under the agreement, Spain will have to extend consumer protection rules and restrict the sale of such financial instruments to retail clients. [too late, ed.]
(emphasis added)
The gentleman from Nomura probably was a diplomat in his former life. People “might not have known exactly what they were investing in” ? We believe it's a near certainty that they didn't know – this has the status of an open secret by now. In other words, everyone knows it.
Don't get us wrong, we're all for writing off unsound credit. By their very nature 'bailouts' are usually not about writing off unsound credit, but about shifting losses from their rightful owners to someone else. However, as the MoU states, 'non-viable' banks are supposed to be wound up. So the exercise is not about rescuing every old bank, but only those deemed 'viable, but in need of aid'. What exactly differentiates the two types is no quite clear, since a bank in need of aid seems non-viable by definition. But let's not nit-pick.
The problem is mainly a legal and in further consequence, a political one. The question is whether the holders of said hybrid securities/preferred shares have a good case that they were defrauded. Note in this context that an inquiry into the sale of common shares by Bankia to retail clients about half a year before the bank went belly-up and applied for a bailout is now underway. It seems in hindsight that the prospectus accompanying the share sale was a big bag of lies.
Lastly, should the holders of subordinated securities be unable to get the courts to side with them, the government is still going to have to confront a large group of extremely disgruntled people.
Ceding Control
Another interesting aspect of the MoU is the degree to which Spain will have to cede control over its banking system to EU-level and IMF bureaucrats. So here we can see another aspect of the 'conditionality' that comes with the bailout agreement. It is not merely a transfer of funds coupled with hoping for the best, but the very capable people who have proved their mettle in various bureaucracies in Brussels will take the helm. Of course the day-to-day running of and implementation of the bailout will still be left to Spain's existing bank resolution/bailout bureaucracy, the FROB, with the Bank of Spain in a supervisory role. The outside help will only swoop in from time to time to keep an eye on what is actually happening with the aim of stopping any hanky-panky that might occur. It sounds a bit like the countless 'Troika' visits to Greece that have worked so magnificently, but let's not be too harsh – Spain is probably a bit more reliable than Greece.
A neat graphic has been included in the MoU, showing the time line of the planned restructuring: How to fix Spain's banking system in no time at all, according to the European commission - click graphic for better resolution.
The biggest problem with such plans – as good as they may look on paper – is that the situation is not static, but very much dynamic. A 'stress test' that takes several months to conclude, will create a snapshot at a specific moment in time for every bank concerned. As Ludwig von Mises has pointed out, the balance sheets of corporations are to a certain degree of speculative character and only provide us with the above mentioned snapshot. The speculative character of such assessments is probably more pronounced in the case of banks that are mired in a historic credit and asset bust than it would otherwise be. In short, the 'moving target' problem is very difficult to account for. Much will depend on the future course the economy takes and the additional losses that may be incurred as a result. Let us also not forget that Spain's banks have proved extremely skillful at 'papering over' the situation thus far. It won't be easy for an outside examiner to judge if every loan declared to be current really is being serviced or is only a Potemkin asset.
The MoU requires Spain's banks to attain a minimum tier one capital ratio of 9% by the end of 2014 at the latest. This is a laudable goal, but how is it going to be achieved in practice? If the authorities are serious about this point, it will likely involve a healthy shrinking of balance sheets. This would be a sound development from a long term standpoint, but the economic pressures it may create in the short term could once again prove difficult to weather politically.
The WSJ writes:
“Spain will be forced to give up most of the control over its banks to European institutions—and will be required to impose losses on local investors—in return for a bailout of as much as €100 billion (3 billion), according to the draft agreement accompanying the rescue.
The requirements, some of which could prove to be explosive politically, suggest that holders of junior bonds and preferred shares issued by bailed-out banks will incur losses.
Analysts said a significant proportion of such investors in Spain are small depositors who bought the securities through the banks' branches.
The conditions are a first glimpse into what could be the new framework for euro-zone banks once a new, powerful supervisor has been established—as leaders of the 17 euro countries agreed at a summit in June.
The leaders said at the summit that a stricter euro-zone oversight system for lenders would be a precondition for allowing their bailout fund to directly inject money into struggling banks, rather than funneling the money through the government—a move that could eventually help Spain avoid an even-larger rescue.
In the short run, however, the bailout agreement, a copy of which was seen by The Wall Street Journal and on which finance ministers are expected to sign off by on July 20, gives a taste of the level of control that governments will have to give up in return for euro-zone assistance.
Policy makers say they hope stringent stress tests and tighter oversight from the European Commission, the EU's executive, and the European Central Bank will force banks to finally get to the bottom of a brutal meltdown of real-estate prices in Spain and recognize the losses from bad loans they made. After the stress tests, which should be done by early autumn, banks that have capital shortfalls will either have to raise that money on the market or request help from the government, which by then will have access to the bailout money.
But crucially, the banks won't get taxpayer funds until they have come up with a burden-sharing arrangement with investors. According to the draft document, those investors include not only equity holders, but also owners of hybrid capital and subordinated debt. The idea behind this exercise, for which Spain still has to create a legal basis, is to limit the amount of taxpayer-funded bailout money that has to be pumped into the banks.
But in the case of Spain, such arrangements may still hit ordinary citizens directly, as hundreds of thousands of them bought preferred shares in local banks. Holders of senior debt aren't mentioned in the document, implying that they may escape losses for now—as they have in other large bank rescues in Europe in recent years.
"Senior bondholders within and outside of Spain may be protected whereas pensioners and the little guy who were sold these securities may have to bear a larger share of the burden," said Sony Kapoor, managing director of economic think tank Re-define.
Spanish Finance Minister Luis de Guindos on Monday declined to confirm that retail investors who own preferred shares will be hit by losses, but also didn't rule it out.”
(emphasis added)
This 'burden sharing' program whereby the little guys will take losses while the big guys (some of which are situated outside of Spain) avoid sharing their fate is indeed 'politically explosive'. We are left wondering how Spain's government plans to deal with this particular problem. Will it be possible to simply pin the blame on the EU (or Germany's chancellor Angela Merkel, the world's favorite whipping post)? Or will there be some 'creative solution' that involves a wider socialization of the losses by spreading them among all tax payers, to the immediate detriment of Spain's public debt levels?
We will have to wait and see, but this promises to be interesting. In the meantime, we would however expect the markets to judge this plan to be better than nothing. One should probably steer well clear of Spanish bank stocks though, as massive shareholder dilution will be unavoidable for the eventual survivors under any imaginable scenario.
More Austerity Measures Announced
In the meantime, Spain's government has also announced a raft of new austerity measures designed to help meet the country its new – and considerably relaxed – deficit targets. It was a quite bombastic announcement actually.
“Spanish Prime Minister Mariano Rajoy on Wednesday announced €65 billion ( billion) of new austerity measures in an effort to meet new budget-deficit targets agreed with euro-zone partners.”
[…]
The additional austerity includes an increase in the standard rate of value-added tax to 21% from 18%, and the lower rate to 10% from 8%.
And the measures include a cut in jobless benefits for new claimants, a salary cut of around 7% for state employees, and billions of euros in savings from local government reforms.
"We are trying to stick to a path that is not easy, short or comfortable, but we cannot avoid it — it's the only one that leads to recovery," Rajoy told lawmakers in parliament. Euro-zone finance ministers agreed Monday to relax Spain's budget-deficit targets to 6.3% of gross domestic product this year from 5.3%, down from a deficit of 8.9% last year. The target will be 4.5% in 2013 and 2.8% in 2014.”
(emphasis added)
The increase in VAT is likely to weigh on the economy, but the other reforms all involve spending cuts and are therefore likely to have beneficial long term effects. They are also likely to invoke spirited resistance.
What is impressive is the sheer size of this new package – this makes us a bit suspicious about whether it can actually be realized (what exactly does 'local government reform' consist of?). In combination with the bank restructuring plan it may however give the markets a reason to temporarily calm down and stop the wave of selling in Spain's government bonds for now. This is actually what the chart of Spain's 10 year government bond yield also seems to suggest (see below), although the issue is not yet cut-and-dried.
