3 Reasons Spain's Bailout is a Failure

The whole thing is an exercise in misdirection...

THERE ARE at least three reasons to be suspicious that the weekend's Spanish bank bailout brings closure to Europe's crisis, writes Dan Denning for the Daily Reckoning Australia.

First, everyone else is going to want the same 'no-strings' deal. The Greeks are already asking for one. And don't forget, the new Greek elections are on Sunday. The Spanish deal could influence the outcome.

Second, where is this so-called capital actually going to come from? There are two mechanisms in place to provide bailout funds in Europe. The first is the European Financial Stabilisation Mechanism (EFSM). The EFSM is a €440 billion fund, of which €192 billion in funds have already been committed to Greece, Portugal, and Italy. That leaves over €240 billion for Spain, Italy, and any other rainy day crisis country. The European Stability Mechanism (ESM) is supposed to replace the EFSM, but is not yet fully funded.

In theory, then, the money is there to bail out Spain's banks. But in reality, is the money in the EFSM really capital? Or is it just more money promised by governments that don't have any? True, some of the 'capital' in the EFSM has come from the less-indebted and stronger economies of Northern Europe.

But everyone is pretending that money raised by governments through the debt markets and contributed to the EFSM is capital. It's not free money. It has to come from somewhere. And right now, the whole funding mechanism is looking pretty circular (governments sell bonds to banks in order to raise capital to loan to banks that own bad government bonds).

The biggest issue is that national banking systems in Europe are generally too large to be bailed out by national governments. Take Spain. It can't afford to bail out its banks. The bond market looked at the cost and immediately began raising interest rates on Spanish debts. The weekend solution didn't really decouple the banking sector in Spain from the government balance sheet.

If Europe moves more toward the fiscal union Germany wants, you'll see national banking sectors come under the regulation of a pan-European authority. This won't be popular politically, having banks take their marching orders from Brussels or Berlin. But it is more politically palatable than having national governments submit to minute regulation from Brussels and the IMF (the Greek situation).

Of course the whole thing is an exercise in misdirection. Spain's banks are in trouble because they bought into the Spanish property boom. If the past is prologue, bailouts will pour bad money after worse money without considering the real problem: the assets in the banking system are overvalued because of the credit boom.

In other words, the current bailouts assume no more deterioration in the value of the existing loans on Spanish bank books. But in a credit depression, financial assets tend to fall. That means more money will be needed later to keep capital levels adequate with banking requirements. If asset prices keep falling, more capital will be needed.

At some point, we expect the capital adequacy ratios to be revised to whatever level is necessary for the banks to remain technically solvent. When all else fails, change the rules. For now, another stop-gap way of not recognizing the bad loans has been reached. The more things change, the more they stay the same.

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