EZ screws Spain’s citizens

A draft Memorandum of understanding for the Spanish bank bailout became available overnight (available below). Much of the document makes sense in terms of assessing, monitoring and implementing corrective action on the banks. Specifically there is mention of using Special Purpose Vehicles to remove non-performing assets from banks balance sheets:

Segregation of impaired assets: Asset Management Company

21. Problematic assets of aided banks should be quickly removed from the banks’ balance sheets. This applies, in particular, for loans related to Real Estate Development (RED) and foreclosed assets. In principle, it will also apply to other assets if and when there are signs of strong deterioration in their quality. The principle underpinning the separation of impaired assets is that they will be transferred to an external AMC. Transfers will take place at the real (long-term) economic value (REV) of the assets. The REV will be established on the basis of a thorough asset quality review process, drawing on the individual valuations used in the Stress Test. The respective losses must be crystallized in the banks at the moment of the separation. The Spanish authorities, in consultation with the European Commission, the ECB and the IMF, will prepare a comprehensive blueprint and legislative framework for the establishment and functioning of this asset separation scheme by end-August 2012. The Spanish authorities will adopt the necessary legislation in the autumn with a view to assuring that the AMC will be fully operational by November 2012.

There are, however, some very important sections of the document which need highlighting.

Back in April I wrote a post in which I mentioned that Spanish banks were getting “creative” in order to maintain their capital ratios against the backdrop of the failing Spanish economy. One things that stuck out was this:

The key in a banking crisis is to keep the confidence of depositors. But while many countries relied on capital injections and government guarantees, Spanish banks have added a unique twist of effectively turning some depositors into equity holders. That puts customers on the front line.

Some banks started by persuading depositors to switch from low, interest-bearing accounts into preference shares, which paid a fixed, higher interest rate. The benefit for the banks was that these securities counted as core capital under banking rules. UBS says Spanish banks issued €32 billion ($42.7 billion) of such instruments from 2007 to 2010.

But as the crisis deepened, these instruments became illiquid, trading at deep discounts. At the same time, they ceased to count as core capital under new rules known as Basel III. So banks have encouraged investors to convert preference shares into either common stock or mandatory convertible notes, which pay a high initial yield before later converting into stock.

And here is what I said about it:
Liability to asset conversion. Very clever, and fair enough unless you are an existing shareholder. I just hope those depositors understand the risks of what they have just done.

As it turns out these depositors had no idea what they were in for. From today’s MoU:

The restructuring plans of viable banks requiring public support will detail the actions to minimise the cost on taxpayers. Banks receiving State aid will contribute to the cost of restructuring as much as possible with their own resources. Actions include the sale of participations and non-core assets, run off of non-core activities, bans on dividend payments, bans on the discretionary remuneration of hybrid capital instruments and bans on non-organic growth. 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.

So it would appear that under the guidelines of the MoU many Spanish citizens are about to take a huge bath. But that may not be the only issue for them. Lower down in the document is this:

VI. Public finances, macroeconomic imbalances and financial sector reform

29. There is a close relationship between macroeconomic imbalances, public finances and financial sector soundness. Hence, progress made with respect to the implementation of the commitments under the Excessive Deficit Procedure, and with regard to structural reforms, with a view to correcting any macroeconomic imbalances as identified within the framework of the European semester, will be regularly and closely monitored in parallel with the formal review process as envisioned in this MoU.

30. According to the revised EDP recommendation, Spain is committed to correct the present excessive deficit situation by 2014. In particular, Spain should ensure the attainment of intermediate headline deficit targets of [x]% of GDP for 2012, [x]% of GDP for 2013 and [x]% of GDP for 2014. Spanish authorities should present by end-July a multi-annual budgetary plan for 2013-14, which fully specifies the structural measures that are necessary to achieve the correction of the excessive deficit. Provisions of the Budgetary Stability Law regarding transparency and control of budget execution should be fully implemented. Spain is also requested to establish an independent fiscal institution to provide analysis, advice and monitor fiscal policy.

31. Regarding structural reforms, the Spanish authorities are committed to implement the country-specific recommendations in the context of the European Semester. These reforms aim at correcting macroeconomic imbalances, as identified in the in-depth review under the Macroeconomic Imbalance Procedure (MIP). In particular, these recommendations invite Spain to:

1) introduce a taxation system consistent with the fiscal consolidation efforts and more supportive to growth,

2) ensure less tax-induced bias towards indebtedness and home- ownership,

3) implement the labour market reforms,

4) take additional measures to increase the effectiveness of active labour market policies,

5) take additional measures to open up professional services, reduce delays in obtaining business licences, and eliminate barriers to doing business,

6) complete the electricity and gas interconnections with neighbouring countries, and address the electricity tariff deficit in a comprehensive way.

VII. Programme Modalities

32. Spain would require an EFSF loan, covering estimated capital requirements with an additional safety margin, estimated as summing up to EUR 100 billion in total. The programme duration is 18 months. FROB, acting as agent of the Spanish government, will channel the funds to the financial institutions concerned. Modalities of the programme will be determined in the FFA. The funds will be disbursed in several tranches ahead of the planned recapitalisation dates, pursuant to the roadmap included in Section IV. These disbursements can be made either in cash or in the form of standard EFSF notes.

VIII. Programme monitoring

33. The European Commission, in liaison with the ECB and EBA, will verify at regular intervals that the policy conditions attached to the financial assistance are fulfilled, through missions and regular reporting by the Spanish authorities, on a quarterly basis. Monitoring of the FROB activities in the context of the programme will take place regularly. The Spanish authorities will request technical assistance from the IMF to support the implementation and monitoring of the financial assistance with regular reporting.

So as far as I can tell this MoU is very much a framework for a standard European bailout package. The funding is through a sovereign entity, the FROB. Also, as the Guardian reports,  the funding is contingent on Spain implementing its existing fiscal obligations under European treaties including additional recommended action. In addition there appears to be a Troika of sorts, including the ECB and the IMF.

The EU summit statement stipulated that it was “imperative to break the vicious circle between banks and sovereigns” but I can see little in this particular document to suggest that this is happening.  As we know there has been a vague promise of transferring liability over to the ESM which would supposedly disconnect the Spanish sovereign from the funding pipeline but this is dependent on an agreement and implementation of an ECB controlled banking supervisor. In fact at this stage it isn’t even certain the ESM will come about because it is yet to be ratified by national governments and the German Constitutional Court is yet to pass judgement.

That being the case, this MoU looks like a terrible outcome for the Spanish public. Not only are many billions of Euros of their assets about to be bailed into banks, but it appears that they will still be holding the can after the fact.

Draft Spain MoU

Twitter: @DE_fromMB. He is a contributing analyst at Macro Investor, Australia’s independent investment newsletter covering trades, stocks, property and yield. Click for a free 21 day trial.

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  1. Great pick-up, DE. Do you have any idea of how much has now been converted into shares (or mandatory convertible notes)? 32B was the potential, but only back in 2010.

    • “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.”

  2. Of course it won’t work. None of it will work.

    Samaras & his coalition are taking a beating already in Greece, for not even putting up the pretence of sticking to pre-election promises of renegotiating the Bailout. The coalition here will fall by end of September.

    Monti stated last night that he won’t renew his term because he cannnot fight the political establishment parties who won’t reform an inch. Cue deepening recession in Italy.

    And Rajoy is breaking every promise he made to the Spanish electorate about standing up to the EU etc and saving Spain. Spain is heading to a depression akin to Greece’s.

    The whole house of cards is resting on the hope that money will be found from somewhere (ANYWHERE!) to fill craters in the insolvent banking system and dying economies. The ESM has callable capital of €700bn from the self-same bankrupt states that need the money (and that MUST be paid immediately once called). It’s a farce. If a semi-retarded investor was presented with the ESM as an investment they’d laugh you out of the room, but Euro-politicians not only see it as sane, but crucial.

    sigh…. The Euro will collapse in 6-9 months…

  3. Iberian-Exile

    Hi from Spain, Kudos on this post.

    Here in the street, the average Spaniard is basically worried about the IVA (VAT) tax and the cut in unemployment dole payments.

    But almost no one understands that they as Spanish citizens will carry this debt burden forward and likely pass it on to the grandchildren.

    This reforms leaves the dysfunctional Spanish decentralized and uncontrolled regional governments in place for now.

    For more on Spain see our blog: http://magicalspain.blogspot.com.es/2012/04/economic-challenges-of-spain.html

    saludos desde Madrid,