So today was the biggest stock market
rally in months and there were a lot of good reasons for it. Though
the ECB left rates unchanged there was some hinting that in the event
that things got worse that there could be some additional easing at
the next meeting. Since virtually all the data coming out of Europe
is negative this seems like a lock. Then there was speculation that
the Fed itself might ease sparking a big rally in gold but when the
Beige Book came out better than expected this afternoon gold fell off
but the rally kept on. Indeed, the strongest part of the rally was in
the final 15 mintues when the market exploded higher on strong
volume. If you ask me the most powerful thing behind the rally today
was the Reuters story about the EU preparing a package for the
Spanish banks.
Now while there has been a lot of talk
about Greece and the Greek restructuring and the new elections on
June 17th which may result in the election of parties
unfriendly to the austerity regime being elected and taking Greece
out of the Eurozone, ground zero for the Euro-crisis as of now is the
Spanish banking system. First of all, by far the most likely outcome
is that the Greeks elect people who will maintain the agreements that
have kept the country solvent. Even in the event that they don't most
of the private sector creditors of Greece have already taken all the
losses they are going to take in the event of a Greek default/Euro
exit. The only people who will be hit by a default now are the ECB,
the IMF and the EFSF all of which are ultimately backed by the
Eurozone sovereigns or the world at large. As far as Greece goes the
pain is over. The worst thing that would happen is that it would
trigger contagion and maybe force Ireland and Portugal out as well
but this is not too likely and in any case would probably not be
fatal to the Euro project.
The same can not be said of the
collapse of the Spanish banking system. Unlike the Greece and
Portugal, Spain is a major economy in Europe and the Spanish banking
system, at least at the top end, operates in the pan-European market
and has close relationships with the other major banks in the
Eurozone. As far as I am concerned the solvency issues in the Spanish
banking system are by far the most important thing facing the
Eurozone and this is because they are so large that if it becomes
necessary for there to be a capital injection into the Spanish
banking system the Spanish state is simply not large enough to do it.
To give you a sense of what is involved the top two banks in Spain
have balance sheets totally $2.45 trillion. Spanish GDP is $1.4
trillion. That is to say the top five banks in Spain have balance
sheets about five times the size of the entire economy of Spain. It
is estimated that the real estate losses on the balance sheets of the
Spanish banking system amount to something on the order of $300
billion. That is a BIG BIG hole in the balance sheet of the financial
system. Another thing to remember about Spain, and the whole of
Europe for that matter, is that there is no such thing as the FDIC.
If your bank goes under because it got smoked lending money to Brits
to buy vacation homes in Marbella guess what fraction of your
deposits are insured: zero. Yep, if your bank folds you get nothing.
This means that once it dawn on people in Spain that there is this
big hole in the financial system you will have an old school run on
the banking system and someone is going to have to step in there and
sort things out. The trouble is, the Spanish government isn't big
enough to do it.
Now thanks to the magic of leverage and
fractional reserve banking the total amount of equity that would have
to be injected into the banking system to maintain its solvency is
something more along the lines of $40-$80 billion but given that
Spain is already borrowing at 600 basis points over Germany just to
fund its regular deficit I think it is safe to say that there is no
way in hell that it will be able to tap the capital markets for
something that size in the event that they need to do so. Especially
if the triggering event is a Greek or Portugese default which will
cause a general abandonment of Eurozone sovereign paper for a while.
So, like it or not, Spain is going to need outside help and the fact
that some Eurocrats rang up Reuters and told them that they were hard
at work on contingencies seems to have calmed the markets fear that
the worst case scenario is off the table.
That said, personally I think this is
just beginning. Spain has not asked for help, and the EU has made no
official announcement. This is simply and off the record discussion
that the EU is making plans to help Spain in the event that Spain
needs the help. What will now commence is a very intricate dance
whereby Spain will move in the direction of taking the aid. It helps
that the EU seems to not want to make aid to the Spanish banking
system contingent on additional reforms or on a generalize EU banking
union but the Spanish government will still be reluctant to accept
outside assistance if it can possibly avoid doing so. As a result it
will be up to the markets to compel the Spanish to do so and I think
the markets will probably oblige. So while today was a great day, I
think there will be some more excitement to come.
That excitement will start tomorrow
when the Spain tries to borrow $1-$2 billion in a debt auction. This
will be interesting because it's very likely that today's
announcement was driven by the Spanish claim on Tuesday that they
were being shut out of the capital markets. Personally I'm not sure
what will happen tomorrow. If the auction goes terribly will the
markets assume that the Spain is going over a cliff and sell off or
will they think that a rescue is now certain and rally. If the
auction goes well will the markets assume that everything is OK and
rally or will they think that the stage has been set for more
wrangling between Spain and Germany and sell off. I really can't say.
All I can say is that this is neither the beginning of the end nor
the end of the beginning. It's just the beginning.
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