The Spanish Transfer

2012 June 10
by SJ Leeds

Quick note – I receive a lot of emails.  I read them all, I really enjoy them and I learn a lot from them.  Unfortunately, there’s virtually no way for me to respond to emails – from a time perspective.  I really do wish that I could respond – but there’s no way to do everything.  (Unlike Congress, I realize that there are constraints that exist.)  I hope this doesn’t discourage you from writing.

 

I’m going to be sending out some more stats later this week, but I decided to share some numbers about Spain – since it’s such a timely issue.  I’ve put all amounts in dollars (rather than euros) — because that makes it easier for most of us.

 

A big loan.  The EU is going to loan (up to) $125 billion to Spain’s Fund for Orderly Bank Restructuring.  It is unclear whether the money will come from the European Financial Stability Fund (which started with ~$550 billion) or the new ($625 billion) European Stability Mechanism.  These new loans will have priority (a superior claim) to existing Spanish bonds.

 

Sizing the loan.  Spain’s GDP is ~$1.35 trillion.  As a result, this loan is almost 10% of GDP.  This would be like the U.S. taking on a $1.5 trillion loan.  (Of course, since we’ve been running 9% deficits, we have been increasing our debt by this amount each year.)

 

Cause of the problem.  The Bank of Spain estimates that Spanish banks may have $225 billion of toxic assets (bad property loans).  There are estimates that the banks could have to write off 60% of these bad loans.  This is how we (approximately) get to the $125 billion number.

 

EU banks are highly levered.  The average EU bank has a debt-to-equity ratio of 22.  In the U.S., this is now 10.4.

 

Different from Greece.  Spain’s problem originated with a housing bubble (not from government overspending).   For many years, EU members were all seen as the same by the credit markets – so Spain could borrow at low rates.  Spaniards used cheap money to buy real estate.  Since 2008, real estate prices have dropped approximately 25% (in Spain).

 

Cost per person.  Spain has a population of 47 million.  Effectively, Spain is borrowing ~$2,600 per person.  (Be careful, an AP story that was widely distributed mistakenly calculated this amount at $26,000 or 21,000 euros.)  The net effect is that all Spaniards will pay for the bad loans that their banks made.

 

Why Spain needed a loan.  Spain’s interest rate on publicly issued ten-year debt is 6.15%.  So, if they borrowed $125 billion, they’d be paying almost $8 billion of interest per year.  These new bailout loans are likely to have much lower rates.  Most importantly, it’s difficult to go out and borrow 10% of GDP!  At the very least, borrowing this money from the public markets could have driven rates much higher and created greater fear.

 

Spain is in recession.  Spain’s economy is in the midst of its second recession in three years.  GDP is expected to shrink 1.7% this year.

 

Spain’s job market is horrible.  Spain’s unemployment rate is near 25%.  This is the highest in the EU.  (If your country has an economic statistic that is worse than Greece, it’s not a good sign.)  Approximately 52% of Spaniards under the age of 25 are unemployed.

 

The debt-to-GDP ratio.  In 2011, Spain’s debt-to-GDP ratio was 68.5%.  This is not particularly high.  But, their fiscal (budget) deficit is approximately 9% of GDP.   With budget deficits, high interest rates and low growth, the debt-to-GDP ratio is going to get much worse in short order.  Then, the problem will be a sovereign debt problem.

 

Total debt-to-GDP.  Spain’s current problem is not the amount of government debt.  The problem is total debt.  This includes government debt, corporate debt and individual debt.  In 2011, McKinsey estimated Spain’s total debt-to-GDP to be 363%.

 

Conclusion.  This is another band-aid that doesn’t solve the fundamental problems of Spain.  Spain’s total debt-to-GDP will not decrease – the debt will simply shift from homeowners who will default to the entire Spanish population (who are responsible for repaying this loan).  Market fear may be alleviated temporarily.  We’ve decreased the likelihood of a disruption that would have been caused by a Spanish banking crisis.  We’ve shifted the burden to the citizens of Spain.

 

While helping to improve stability, we’ve imposed a cost on existing bondholders by effectively subordinating existing debt to this new debt.  Over the long-term, the direction of Spain’s interest rates will be determined by whether the value from this stabilization loan has a greater positive impact than the negative impact resulting from the increased debt and the subordination of the public debt.

 

Have a great week.

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