The Spanish Bank Bailout: A Larger Mountain Of Toxic Debt

Over the weekend we have received news that the Spanish government has requested, and received confirmation that they will receive, a $125 billion bailout for their banks (100 billion euros). This amount of money may seem small based on the "trillions" that have been recently handed out by central banks through the printing press, but it is an enormous number based on the size of the Spanish economy. To put it in perspective, an equivalent bailout in relation to the economy size of the United States would be $1.6 trillion. This new Spanish banking bailout puts the 2008 TARP program in the US to shame.

We have discussed numerous times why a bailout of this size would be needed. The Spanish banks took on an enormous mountain of toxic real estate loans that were merged with a mountain of toxic Spanish (and other European) government bonds. As the value of the assets on their balance sheets moved into free fall, their underlying capital base was in the process of a modern day bank run as depositors continued to flee week after week.

The entities used for this bailout will be the ESM and the EFSF bailout funds (remember them?) created during the peak of the stress in the market last fall. The ESM has not been fully approved for use by Germany so a discussion on using that fund is premature at this point. The problem I discussed with the EFSF when it was created is that the bailout money funding the piggy bank (which at the time was created for Greece) would be coming from the countries who would also eventually also need bailouts. Today that day has arrived.

The EFSF has close to 200 billion euros in available capital, but 93 billion of that money is coming from Spain. As the crisis deepens and Italian, Greek, Portuguese, and eventually French banks need a similar bailout; who is going to fund the fund? 

Just as with every bailout for Greece, they are providing additional debt to a Spanish banking system which is already insolvent. This allows them to keep their doors open for a few months longer but makes the losses much greater in the long run.

Imagine there is a guy who lives on your street named Tom. Tom has $200,000 in credit card debt, and he has lost his job. The credit card company, which does not want to take losses on the $200,000 in debt they have already lent Tom, decides to provide him with another $100,000 in capital. Tom will now have $300,000 in total debt, but with the fresh $100,000 in capital he can continue to make the interest payments.

Tom, from the example above, does not care if he declares bankruptcy with $300,000 vs. $200,000. In fact, any rational person knows that if you are about to declare bankruptcy you should borrow as much money as possible for as long as possible. With this $100,000 Tom can go on a two year vacation before starting his life over with his debt cleansed.

The bank understands that the $300,000 will never be paid back, but by lending the additional money and keeping payments current it allows them to mark the total $300,00 as an asset on their balance sheet with full value. This allows both management and corporate employee bonuses to be paid out for two more years while Tom is vacationing. Everyone wins.

The lenders of the recent bailout money to Spain and Greece understand that the money will never be paid back. The walls are closing in quickly around them and they are doing everything possible to push back the day of reckoning just a little bit longer.

Most likely a large portion of this $100 billion given to Spanish banks will be used to purchase Spanish government bonds. Estimates are that the interest rate charged on this most recent bailout will be around 3%. With Spanish government debt at over 6% the banks can purchase the debt and pocket the 3% spread. They understand that the Spanish debt will collapse in price, but they are now working together with the government to create one enormous Too Big Too Fail economy/banking system.

What does this bailout mean for the markets in the short term?

Most likely a massive rally in the euro currency, which had record short positions placed against it heading into the weekend (creating an enormous short squeeze opportunity). The financial stocks and stock markets will most likely love the news and rally. The risk off trade (currently treasury bonds) will sell off.

What does this mean for markets in the long term?

Nothing. Stay the course discussed in detail last weekend in 2012 Second Half Outlook.

For more on what led to this banking bailout see Modern Day Bank Run In Europe.

h/t Zero Hedge