Tuesday, June 12, 2012

What Is Subordination? Creating A Spanish Bond Run

The sell off in Spanish and Italian government bonds has been relentless throughout the week. 10 year Spanish bonds hit new all time euro era lows today at 6.83% (rising rates means falling prices). Italian 10 year bonds have soared up to 6.3%.

The bailout for Spanish banks announced over the weekend was designed to bring calmness back into the market. It has done the exact opposite. Why?

Something called "subordination."

What subordination means is that the creditors providing the bailout to Spain have asked to be paid out first in the future if Spain were to default.

Imagine you lend your friend Michael, who has run into some tough times financially, $100 per month to help him out temporarily with his bills. Michael decides that he needs even more money and asks the local unemployment office for an additional loan. The unemployment office agrees to provide him a loan under one condition: When he pays his debts back in the future the loan to the unemployment office must be paid in full before any other lenders can collect any money.

Under this scenario you would obviously be pretty upset at your friend for agreeing to such a deal. Michael stops by your house the first of next month to pick up his regular $100 friendship loan. Unfortunately, this time you decide not to come to the door or return his calls.

This is exactly what happened this week when Spain went back to the bond market to ask for more money. The bond market is turning its back on Spain because investors do not want to be left in the wind should Spain default (under a normal scenario all lenders would be treated equally).

Let's say your friend Michael has borrowed $500 from you. He received an additional $500 from the unemployment office. In the future he may have to "default" on his debt and tell you both that he can only pay back $200. You would each collect $100 of Michael's pay out (splitting the $200).

With subordination in place the unemployment office now collects the full $200. They are first in line.

Spain is now following the exact path Greece moved through. Italy, Portugal, and Ireland are not too far behind and could easily jump ahead in the crisis at any moment. Look for these other PIIGS to begin a renegotiation process on their bailouts after watching Spain's recent sweetheart deal. Spain was asked to take no additional pain through austerity, something that was demanded for all the previous bailouts up to this point. Ireland in particular is in almost the same exact situation (a real estate crash has created a banking crisis).

Will the current band aid be enough? Spain's government has admitted another potential 35% downside risk to home prices. Their government debt to GDP, which is officially around 70%, is actually closer to 150% when factoring in regional debt, bank aid, obligations to the EU/ECB, and the most recent bailout. Their banking system, regional debts, and government debts have become one merged mountain of toxic subprime ready for implosion.

Keep your popcorn ready and your computer monitor tracking the 10 year bonds. I'll be with you every step of the way as we move through this massacre.

For more on the bailout details see The Spanish Bank Bailout: A Larger Mountain Of Toxic Debt.


2 comments:

  1. Your analogy is wrong.

    Spain's 'friends' stopped lending it money quite some time ago.

    The only money lent to the country has been from the LTRO programmes which started in December.

    No private institutions have touched Spanish debt since then.

    What is happening though, is anyone who loaned money to Spain before LTRO is cashing out now so that they don't lose it all when Spain defaults.

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  2. You're right. A vast majority of the money being lent to Spain since the LTRO began has come from their own banks, something I have been discussing here since December. The analogy was used to explain how subordination works in easy to understand terms.

    There are still a few buyers beyond just the Spanish banks, although they are the minority, and there are still an enormous amount of Spanish bond holders around the world. A discussion on subordination should be focused on what happens to that ocean of Spanish debt, which will most likely be sold in a Greece like panic.

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