The Spanish Bailout, the Eurocrisis & the myth of Seniority

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Note: This Note has appeared on Business Insider & has been picked up by Reuters. There is a raging debate over who should lend money to Spain, the European Stability Mechanism (ESM) or the European Financial Stability Fund (EFSF). At the heart of the matter is clause 13 in the preamble of the treaty setting up the ESM “the ESM loans will enjoy preferred creditor status in similar fashion to those of the IMF, while accepting preferred creditor status of the IMF over the ESM.”

A number of commentators and market actors say that this seniority is one of the main reasons why markets have reacted negatively to the announcement of a nearly Euro 100bn loan package for Spanish banks. They say that seniority means that once the ESM comes in, it reduces the effective claims of the private bondholders in the event of a restructuring. Hence they would prefer the EFSF, which does not have the seniority claim, to do the lending instead.

They also use the example of Greece, where public lenders did not take outright haircuts which fell only on private sector bondholders. They also refer to the fact the European Central Bank (ECB) did not tender the Greek bonds it had purchased in the secondary market for restructuring.

Below, we expose the flaws in this thinking and suggest that while seniority may be important as a concept, the importance being attributed to it at the present stage misses the point altogether.

First, the bilateral loans given by other member states to Greece did not specify seniority in their clauses. Nor is there anything in the ECB’s statues or any of its statements that led investors to believe that its claims would be treated differently to those of private bondholders. And yet, when push came to shove and Greek debt was restructured, both of these sets of claims were treated as senior. Hence, it is impossible to know in advance, particularly if public opinion strongly favours public loan seniority over private bondholders, that the EFSF would not be treated as senior in the event of a restructuring.

Second, Greece was a special case. As we had written at the time, the likelihood that Greece needed a debt restructuring was 100% both before and after the first bailout package, so deep were its problems. The public sector intervention in the form of the first bailout merely delayed the outcome and it’s far from clear whether the total losses inflicted on the private sector would have been lower under a scenario where no bailout money would have been available and Greece would needed to have gone in for a deep restructuring immediately after the scale of its problems first became known. So it’s very hard to say whether de-facto seniority left Greek private investors in a worse shape that they would have been in a complete absence of public support.

Third, the relevant question is not whether pari-passu public bailouts for a country are better for private bondholders than interventions with embedded seniority, of course they are. In fact, for private bondholders the best option would be if the public sector provided bailouts to countries in trouble under subordinated terms, but that is simply not politically feasible; neither internationally nor in Europe.

The real question is what is a better situation for private bondholders; that a troubled economy gets no assistance or that it gets assistance from the IMF or the ESM or another public entity but with an embedded seniority of claims? The historical evidence on this is clear. In a majority of IMF bailouts over the past several decades, private bondholders and creditors ended up being better off than they would have been if the country had not received a bailout at all.

This is logical if you consider crises of the kind where a country is facing temporary problems that can be tackled. The most obvious example of these is liquidity shortages where, for whatever reason, a country loses access to financing at reasonable costs. If external help were not provided, the existing private creditors would need to be bailed-in immediately. Spain, which has seen its borrowing costs rise steadily to near-unsustainable levels, would need to go for this option if help in the form of cheaper funds from the European public sector was not available.

In most such liquidity crises, external public help, whether with seniority or not, improves the eventual returns for private bondholders. To the extent that liquidity support helps reduce the likelihood of debt restructuring and the losses in the form of liquidation penalties associated with it, such support should be welcomed by private creditors, whether senior or not. The problem in the case of Greece was that such support could not really change the inevitable outcome because Greece faced a fundamental solvency problem, not a temporary liquidity shortage. Spain is clearly different and faces what looks more like a liquidity crisis for now.

It is, of course, very hard to tell the difference between insolvency or mere illiquidity ex-ante, but what is very clear is that illiquidity unless mitigated, can lead to insolvency. Provision of liquidity alone may not be enough to prevent insolvency if the economic environment is very bad.

Fourth, public bailouts with embedded seniority for countries facing insolvency may still be better than no bailouts from the perspective of private bondholders. This is because insolvency is not a certain outcome and is very sensitive to borrowing costs and assumptions about long term growth. If a public intervention at a concessional rate of finance helps bring the borrowing costs down, it reduces the likelihood of insolvency. Similarly, if public funds can be used to make positive Net Present Value investments, this also reduces the likelihood of insolvency and eventual restructuring. In both cases, private bondholders will be better off.

Imagine a country has an NPV of expected future primary surpluses equal to x euros, which defines its sustainable debt carrying capacity and that its debt stock is y euros; we don’t need to say whether x is bigger than y or not. Now on a date say the 1st of Jan 2013, it gets a public bailout equal to z euros. Its debt repayment capacity is x+z euros as it now has the equivalent of z euros in a bank and its total debt is now y+z euros. If y>x then y+z>x+z and nothing changes. Assume x = 0.8 y, then bondholders would face a 20% haircut, whether before or immediately after the public injection of z euros.

Now imagine that the z euros bailout is at a concessional rate of interest. Then it will improve the sustainability of debt, all else remaining the same and increase the potential pay out to private bondholders. Equivalently, if the country invests the z euros it obtains in NPV positive projects, the sustainability of its debt improves, making the outcomes for private bondholders more positive.

The only circumstances under which a public bailout will make private investors worse off is if the public bailout money is ‘wasted’ or spent on items that are NPV negative.

There is one exception to this rule, which is when the conditionality accompanying a public bailout is so flawed that it makes the recipient country adopt policies that actually hurt growth prospects and reduce its debt carrying capacity thus increasing the likelihood of insolvency and the size of private sector losses. This is a big and legitimate fear given the current excessive focus on austerity in the Eurozone and may play some part in the panic around Spain and in what happened in Greece.

Fifth, even under a scenario where a public intervention leaves the eventual haircuts that private bondholders may face unchanged, by delaying the date of such a restructuring, public credit with embedded seniority may help the private bondholders make preparations for the eventual day of reckoning; by increasing their capital buffers, for example. This did happen in the case of the Greek restructuring wherein bondholders had more time to ‘prepare’ for the eventual event.

Sixth, the reason that Spanish spreads have spiked in the aftermath of the announcement of the bailout package has little to do with seniority. I can wager that it will matter little what the source of funds is. The problem is with the prevailing environment in the Eurozone, with the way the bailout is structured and with the conditionality that may be applied. Let me explain.

  • The problems with the Spanish banks existed before the bailout was announced but the magnitude was unclear and there was no consensus on how serious the problem was. The sudden announcement of the 100 billion euro bailout gave everyone a benchmark to focus on, which highlighted the seriousness of the problem and naturally eroded confidence in Spain contributing to rising spreads.​
  • The second factor was the announcement that the bailout would be channelled through the Spanish sovereign, something we at Re-Define have long opposed since it intensifies the sovereign-bank dance of death that is currently the biggest threat to the Eurozone.  Already, the Spanish state is far too exposed to its fragile banks through previous equity injections and the much larger direct and indirect funding guarantees provided. This would mean that the state would be making yet another risky Euro 60bn – Euro 100bn investment. In the terminology used earlier in this note, this has the hallmark of a NPV negative investment.​
  • The third factor here is that the conditionality, whether implicit or explicit, that is likely to accompany this bailout will be bad for growth and looks bad for the sustainability of Spanish debt and asset prices from where we stand now; another logical reason for the negative market reaction.​
  • Last but not the least, the uncertainty overhang given the Eurocrisis is so large that this bailout makes little difference to the outcome as much bigger, mostly political, factors are at play. Again, in terms used earlier in this piece, given the large uncertainty overhang, this bailout is not able to demonstrably reduce the eventual likelihood that Spanish debt may need to be restructured.

If the EU wants to rescue Spain, the trick is not to remove seniority from the ESM but 1) to remove all uncertainties around the future of the Eurozone 2) make conditionality more growth friendly 3) channel the bailout directly to needy banks without going through the sovereign.

Any further discussion of seniority, particularly in the case of Spain, misses the point.

Sony Kapoor

Managing Director