As discussed here in April (see this post), Spain's banking system needs Ireland-style bank recapitalization. And that's precisely what Spain's banks are going to get. The "bad bank" entity, unceremoniously named the Asset Management Company (AMC), will become the proud owner of bad property loans. This is the equivalent of the Irish Bank Resolution Corp.
EFSF bonds will be used instead of cash for recapitalization (discussed here back in June). The banks as well as AMC will be able to use the EFSF bonds as collateral at the ECB.
|Source: Barclays Capital|
The theory that somehow EFSF financing will not force haircuts on debt holders is nonsense. Haircuts are coming and they will be particularly painful for subordinated debt holders. The subordinated component of these banks' capital structures is quite large.
Barclays Capital: - ... the Spanish authorities will amend existing legislation by the end of August to ensure full participation in the liability management exercises. We expect the new legislation to give the Spanish authorities the power to alter the terms of existing subordinated debt in a way that is detrimental to bondholders...What makes this process especially difficult is that many of the sub debt holders are retail customers of these banks.
Spanish banks have large subordinated capital structures. There is €64bn of subordinated debt outstanding at Spanish banks, of which €38bn is tier 2 and €26bn is tier 1. We estimate that €15bn of capital could be raised through a combination of voluntary and mandatory subordinated liability exchanges.
We expect these transactions to include a coercive element. For example, early stage transactions could be voluntary, but could contain a collective action clause (CAC). If activated, which usually occurs when voluntary participation in the transaction is above a certain threshold, the CAC would reduce the claims of the holdouts by modifying the terms of the instruments. If this fails, Spanish authorities would be able to invoke the powers granted to them under the new legislation to effectively reduce the bond principal through statutory means.
WSJ: - According to the draft, Spain will have to introduce a new law by the end of the summer that would allow losses to be forced on subordinated debt holders and hybrid capital holders. Many subordinated debt holders are ordinary depositors.And the losses at Spanish banks continue to pile up. Unwilling to write off or mark down bad debt quickly, Spain's banking system is taking in losses in a painful liner fashion (see chart below - those who have seen a number of economic charts over the years will recognize that this linear pace of write-downs looks artificial). The latest release from the Bank of Spain (see this post from Kostas Kalevras) once again shows an increase in "Doubtful debtors" balance.
|Doubtful debtors (€bn)|
The subordinated debt CDS for Spanish banks is widening as loss expectations increase. Given the anticipation of significant haircuts on the subordinated debt, the sub to senior CDS spread ratio, particularly for the weaker banks has risen in the past week.
|Source: Barclays Capital|
Expect a number of these sub CDS to trigger as the recap process goes into full gear and true losses are recognized.