Thursday, March 10, 2011

Spain's Sovereign Debt Crisis is Avoidable

Despite the recent history of the Irish debt crisis, the Spanish government is insisting on pursuing the same flawed strategies that resulted in a loss of confidence in the Irish banking system and the solvency of its government.  As predicted previously on this blog, these flawed strategies are producing the same results for Spain.

Spain could avoid a sovereign debt crisis by abandoning these flawed strategies and adopting strategies that are consistent with the FDR Framework.

Specifically, the Spanish government should stop trying to convince the market.

Instead, it should require its financial system to provide current asset-level data to the market.  Market participants will analyze this data to determine who is solvent and who is not solvent.  If a financial institution is not solvent, the market participants will determine how much capital is needed to restore solvency.  The financial institution can either raise this capital from private investors or turn to the Spanish government.  The Spanish government can either inject the funds or resolve the financial institution.

If the total amount of capital needed to restore solvency exceeds what is available from the private markets and the Spanish government, the Spanish government can turn to the European Financial Stability Facility (EFSF) for additional resources.

This strategy is the only way to avoid a sovereign debt crisis as it allows market participants to trust and verify that the issue of bank solvency has been addressed.

Strategies that are based on trying to convince the market are doomed from the start.  At best, the actual performance of the underlying bank assets performs in line with the Spanish government's assumptions.

Much more likely, and this is what happened in Ireland, is that the underlying bank assets perform worse.  Since the government staked its credibility on better performance, the government's credibility collapses as the assets perform worse than it expected.  With the loss of the government's credibility, the sovereign debt crisis becomes unavoidable.

A Bloomberg article on Spain reported how investors are telling the Spanish government to abandon the flawed 'convince the market' strategy and instead adopt the 'provide the current asset-level data' strategy.
The Bank of Spain will tell lenders today how much capital they need to raise to meet new rules as the nation tries to convince investors that the cost of rescuing its banks won’t sink public finances. 
The Bank of Spain will publish each lender’s capital shortfall and the overall amount, which the regulator has already estimated won’t exceed 20 billion euros ($28 billion), or 2 percent of Spanish gross domestic product. The government wants most of that to be raised privately even as central bank Governor Miguel Angel Fernandez Ordonez said Feb. 21 that some lenders will ask the state-rescue fund for help. 
Spain, whose credit rating was cut by Moody’s Investors Service today, is trying to stem contagion as investors increase bets that Portugal will need a bailout and Greece lobbies to renegotiate its rescue deal. 
Prime Minister Jose Luis Rodriguez Zapatero’s government is seeking to show that Spanish lenders can weather a fourth year of economic slump and a jobless rate of 20 percent, as bond yields on peripheral euro-area nations surged this week. 
“It’s like a mini-stress test in the type of data we’ll get and any greater transparency is to be welcomed,” said Claire Kane, an analyst at MF Global in London. “What will be clearer is how they come to the 20 billion-euro estimate and from there we can make our own assumptions.” 
Moody’s cut Spain’s credit rating one notch to Aa2 with a negative outlook today, saying the costs of shoring up the banking system will be greater than the government forecasts. 
The overall amount, including funds that may be raised privately, will be 40 billion euros to 50 billion euros, the company estimates. 
...  Spanish banks, mostly savings institutes called “cajas,” have recognized losses equivalent to 9 percent of GDP since 2008, the Bank of Spain said on Feb. 21. 
Cajas’ exposure to the real-estate and building industry amounts to 217 billion euros. About 100 billion euros of that is already classified as “potentially problematic,” of which 38 percent is covered with provisions, the regulator said.
“At the moment, solutions are being found to many of the problems in the financial system,” said Jose Nieto, chief executive officer of Banca March, a bank controlled by the billionaire March family that closed 2010 with a core capital ratio above 22 percent. “All this is good and if it occurs sooner rather than later, all the better.” 
As part of efforts to rein in its borrowing costs, the government approved the new capital requirements on Feb. 18 and said lenders that fail to meet them risk partial nationalization via the purchase of ordinary shares by the FROB bank-rescue fund. 
That facility, created with 9 billion euros and the capacity to take on as much as 90 billion euros of debt, has already committed about 11 billion euros through the purchase of preferred shares. 
“The issue is, how much are the assets worth?” Javier Diaz-Gimenez, a professor at IESE business school in Madrid, said in a telephone interview. “Do you value them at market value, or purchase value or something in between, which is fair value: and what is fair value?” 
... The new rules, which say an independent expert will value the lenders that the FROB buys into, were approved by decree last month and are due to be ratified by parliament today. 
Listed banks must have core capital of 8 percent, while lenders that aren’t at least 20 percent-owned by private shareholders and depend on wholesale financing are required to reach 10 percent. They have until September to meet the new requirements and can seek an extension until the first quarter of 2012 if they commit to listing shares.

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