Spain bond pain?
We first had a hint that bondholders of Spanish bank debt may suffer losses. This is a significant change of position for the ECB. Draghi’s predecessor Mr Trichet vehemently opposed banks inflicting losses on the holders of their bonds (See Ireland). Now, it does not seem to be such a bad idea. Forcing senior bond holders to accept losses would ease some of the money needs of the Spanish banks. It would also be according to the principle of private sector burden sharing that Germany insisted for Greece too.
Of course there is also the issue of the Tier1 equity instruments. There are about 67billion Euro worth of subordinated or hybrid capital bonds issued by Spanish banks. You know the ones. The Tier 1 perpetual with a step up call in. Those that were sold by investment banks back in the boom years as the best investment since Dutch tulips. Many are also structured with 10Y minus 2Y constant maturity swaps (10Y-2Y CMS).
Who owns these beauties? Well many have been sold to retail investors or private banking clients as they had huge profit margins. So, taking a haircut on these might not hurt European banks much.
Is this a precondition for recapitalizing the Spanish banks? We do not know. We can only suspect that this is one of the ideas. In an indirect way this is already happening. The buy-back of these bonds by the issuing banks at knock down prices has identical effect on the balance sheet of these banks. Greek banks did the same by buying back some of their hybrids.
The market rejoiced at the recent comment by Draghi regarding action that needs to be taken. Let me repeat his words “These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty - they come into our mandate. They come within our remit”. By “convertibility”, Draghi means, you guess it, exiting the Euro and reintroducing national currency. I guess the word “exit” is prohibited from the ECB vocabulary so an acceptable alternative had to be used to confuse us. So, if a country defaults, or wishes to exit the Euro, it becomes a monetary policy issue and thus ECB can act under its remit. In the same way they baptised the Greek SMP holdings a monetary policy instrument. We now have the basis of the excuse of introducing a massive buying program.