Spanish bond yields surge

Spain's ten year bond yield hit 7% today. At levels such as these, the other PIGS got support through European bailouts. Nobody can be surprised by the fact that the 100€ bn of extra debt that Spanish taxpayers will have to carry due to the banking rescue has not calmed markets - more European multilateral debt means less debt capacity for everyone else, like the ordinary Joe Bloe's who lost a shirt or two in Greek bonds. The debt dynamics are now getting seriously interesting, in a very Greek kind of way -- at borrowing costs such as these, the primary surplus needs to rise a lot. Taxes have hit the Laffer point, where raising rates won't give you much more yield, and may damage growth so much that revenue actually falls. True, there is a lot of untaxed income, but getting at it takes a long time and plenty of state-building. So spending cuts are logical, but they will also produce a deeper recession. So with a primary surplus too small, it looks as if the debt service is not sustainable; interest rates rise further. In no time, only the European partners will be able to offer funds, and even they may give up given the size of the package necessary. When the Euro dies, remember June 14, 2012, when the first European country that is too big to bail out saw its interest rates rise to unsustainable levels. Of course I hope I am wrong, but it is hard to be optimistic at this stage...

Just hand over the cash

Spain has just announced it will be asking for €100 bn in European aid to recapitalize its banks. This was coming for some time now. The only problem was that the dithering and incompetent Madrid team felt it would hurt national pride too much if, in exchange for aid, there were conditions attached. So now we get aid to Spanish banks, not to Spain. Note that this follows the familiar European pattern of announcing great-sounding initiatives, without much of the nitty-gritty clear at all. Neither the EFSF nor the ESM can actually recapitalize banks at the moment. So instead of clarifying things, this will actually cause more anxiety and uncertainty. Second, the aid will be in the form of loans to Spain, via FROB, the Spanish government's recapitalization vehicle. The success of the Paulson plan (beautifully analysed by Veronesi and Zingales) seems to suggest that one should instead go for direct equity injections, with European shareholders having real oversight.

The Spanish regulators - mainly the Bank of Spain - will remain in charge, and therein lies the problem: The idea that the same clown show that gave us Bankia, Catalunya Caixa and CAM is now receive a cool €100 bn in European money without real oversight is sickening. What's worse is the absence of any discussion WHY these banks should be rescued at all. If Bankia, for example, was wound up, the depositors would still be paid. Would the country suffer? The only reason to do bank rescues is to protect "intermediation capital", a mythical property said to reside in the heads of certain bankers - the ability to say, yes, this is a good borrower and I will lend to him, based on past experience, intimate knowledge of an area, clientele, or industry. The fact that Bankia and CAM are now effectively bankrupt tells you that there was no intermediation capital there in the first place, just a lot of venal rent-seeking. Surely the best thing would be to put the financial institutions that are below a sensible equity threshold into bankruptcy, with depositors paid out and the financial firm shut down. That way, the better banks like BBVA and Santander would pick up the slack, win customers and make money; the incompetent bankers could go and join the long queues of unemployed. Ideally, this should have been done with all the small, bust cajas, instead of merging them into things like Bankia - in the US, small banks fail all the time, and nobody panics.

Ode to the missing envelopes...

If you look at income statistics, things are not so bleak in Spain. Wages are falling only a bit; GDP will contract by, maybe, 2-3% this year. And then you come across statistics like this one (hat tip to marketwatch). Retail sales in Spain are falling at a rate of 10% yoy. What is going on? Partly, precautionary savings. Partly, incomes are falling much faster than measured - in the boom, the black economy grew much more than the official one, and it is all those extra payments (in little envelopes) that companies used to make that are disappearing at a fast rate. In boom times, countries love to add the black economy to their GDP statistics. If we captured how quickly it is shrivelling now, GDP growth in Spain for this year would look a lot bleaker...

a good headline

is like a great paper title... worth its weight in gold. Remember the famous "Ford to City: Drop Dead" one by the Daily News, during the NYC budget crisis in the 1970s? Here is another contender for greatest headline (via downtownjoshbrown)

Maybe Mauricio Drelichman and I should have tried to write a paper called "Meet the Fuggers" (about the German banking family's dealings with Philip II...)

everything you need to know

about Spanish banks, lucidly explained, over at fist full of euros. The conclusions are cheerful:

Naturally the whole BFA/Bankia edifice is the first good example I will point to of the use of chewing gum and chicken wire in Spain, since it is hard to imagine a more complicated way of doing something that is almost guaranteed not to work. Basically BFA, the parent bank, was created as a bad bank, where the toxic property assets (largely land) of the seven participating savings banks were to be warehoused, supported by a mixture of preference shares, subordinated debt and own resources in terms of company shares, equity etc, plus a 4.5 billion euro “hybrid capital” loan from the government restructuring fund (FROB), which was to be paid 8% a year. Naturally the value of the toxic assets was bound to drop as time past, and I suppose the hope must have been to tranfer earnings from new (“better” – not “good”) bank Bankia to both offset losses and service the FROB loan. But things weren’t to work out that way (as could have been anticipated), since Bankia itself was created with its own property exposure (especially in the form of developer loans, many of which were on the point of “souring”) as there simply were not enough resources available to wharehouse everything. And when the new government introduced a law requiring more provisioning, well it was all over, bar the large injection of public money now needed to clean up the mess. Others were given the opportunity to kick the can a little further down the road by entering a merger, and thus offseting the write-downs against capital rather than having to charge them directly to profit and loss. But Bankia was already too big, and too about to fall over, to be able to find a “dancing partner”.

Going back to gum and chicken wire, I remember reading in the report on the Three Mile Island nuclear accident, that in the run-in to the problem maintenance had either been neglected or was completely ad hoc. The archetypal example for this was the discovery that a hole in a cooling pipe had been plugged using a basketball. There you go Mr de Guindos... go find a basketball!

fun paper of the week - snow and liquidity

finally, a fun finance paper with some really cool (!) identifying variation:

Based on a sample of highly leveraged Austrian ski hotels undergoing debt restructurings, we show that reducing a debt overhang leads to a significant improvement in operating performance. Changes in leverage in the debt restructurings are instrumented with Unexpected Snow, which captures the extent to which a ski hotel experienced unusually good or bad snow conditions prior to the debt restructuring. Unexpected Snow provides lending banks with the counterfactual of what would have been the ski hotel's operating performance in the absence of strategic default, allowing them to distinguish between ski hotels that are in distress due to negative demand shocks (“liquidity defaulters”) and those that are in distress due to debt overhang (“strategic defaulters”).

who said

that economists aren't working on real-world problems? Here is the abstract of a paper by Diamond and Rajan (QJE 2011):

Is there any need to clean up a banking system by closing some banks and forcing others to sell assets if the risk of a crisis becomes high? Impaired banks that may be forced to sell illiquid assets in the future have private incentives to hold, rather than sell, those assets. Anticipating a potential fire sale, liquid buyers expect high returns, reducing their incentive to lend. Privately optimal trading decisions therefore lead to a worse fire sale and a larger drop in lending than is necessary. We discuss alternative ways of cleaning up the system and the associated costs and benefits.

While one can't apply it 1:1 to the situation in Spain,  it's definitely food for thought...