It wasn't supposed to be like this. With Greece heading towards a critical election in just over a week, markets were supposed to be cautiously awaiting a positive outcome. Instead, the euro crisis has focused on another victim – Spain. With Spanish banks suffering damaging losses in the wake of the housing market collapse and 25% unemployment, the holes on their balance sheets have ballooned to the point where the Spanish government is probably unable to recapitalise them on its own.
As a result, Spain has asked for help. But once again politics are muddying the issue. Because the government wants to avoid the humiliation of it needing a bailout, it is calling for the EFSF to bail out Spanish banks directly. The problem is that the EFSF is not allowed to do this – it is only able to lend to governments, which in turn then distribute the money according to pre-agreed plans. So, in order to get European money to recapitalise Spanish banks, the Spanish government needs to accept a bailout: Spain is in a similar situation to the one Ireland found itself in eighteen months or so ago. And with German politicians resisting calls for the EFSF to lend directly to banks, a Spanish bailout could be on the cards soon.
This latest episode is yet another illustration of the fact that German politicians clearly hold the cards in the great euro area poker game. Nothing happens unless Merkel (and the Bundestag) agree to it. But the current market focus on Spanish banks actually offers a chance to influence this balance of power.
When a bank posts losses – and in particular when it writes down the value of its assets – that creates a hole on its balance sheet. By definition balance sheets have to balance, so if a bank's liabilities are unchanged (for instance because they are pre-issued bonds) then the bank needs to find some way to make up the difference. Given the damage to assets, this often takes the form of recapitalisation – shareholders put new equity into the bank to absorb the losses, and so total assets once again equal total liabilities.
This pattern was basically set when Northern Rock went under in 2007. Back then, the UK government guaranteed all Northern Rock deposits – people would get their money back from the Chancellor, if not the bank. And, at the same time, the government also promised to make bondholders whole – they promised that Northern Rock's outstanding debt would be honoured. As such, equity was injected to cope with the losses Northern Rock had suffered (although now it looks like we will get all the cash back).
But there is no reason that it has to happen this way – a balance sheet can be balanced on both sides. Or, in other words, the UK government could have forced Northern Rock bondholders to share the pain.
The Spanish government could do the same thing. Instead of committing, say €20bn of new capital to Bankia to sort out its balance sheet, it could promise €5bn of equity and at the same time impose a 30% haircut on outstanding Bankia debt. That would inject some new capital at the same time as shrinking Bankia's liabilities.
There would be uproar in certain quarters, of course. Bondholders do not like taking haircuts, and technically any unilateral move would be classified as a disorderly default. However, if the haircuts and equity provided enough of a buffer, Bankia's future could be assured. At the end of the day, a bond is an investment in the same way that a share is – there is no fundamental reason why bondholders should be insulated from a bank's difficulties. When other companies go bust, bondholders share the pain. And debt restructurings like the one I suggest for Bankia happen all the time in other industries.
Some of the uproar would result from the ECB, which may well have accepted Bankia debt as collateral. But an arrangement was reached for the recent Greek sovereign haircut. And, ultimately, those institutions that had pledged Bankia debt in return for ECB funds would be responsible for filling the gap, by providing further collateral to the central bank.
The biggest uproar, however, would probably be from Germany. German pension funds and banks have been big investors in Spanish (and other peripheral) debt. Forcing them to share the pain – by imposing haircuts – would bring the crisis closer to Berlin in a very real way. The impact on German growth might be subdued, given that the link between pension funds and consumption can be pretty weak. Few of us are genuinely lifetime income utility maximisers. But the fact that Germans were being forced to share the pain – and to repeat, there is no reason bank bondholders should get special treatment – could spur the German government into a more balanced and palatable accommodation with its Spanish counterpart.
This analysis all hinges on the fact that Germany stands to lose a great deal from Spanish bank failures (or a Greek exit, for that matter). But because those potential losses are hidden from the public right now, German politicians are getting away with quite a lot. If eurogeddon does finally arrive, the German public will soon discover just how interlinked and exposed they are to other countries' difficulties. And they might just wish that their leaders had spent less time resisting efforts to solve the crisis, and more time actually trying to sort things out.