Yesterday’s sharp dip in US 10-year note, particularly in the early trading, signaled inflow of cash into the US debt space on the news, deemed initially positive, that Spain got a “line of credit” to recapitalize the banks but interpreted as negative in the bond world where the pesky issue of subordination (see video below) may have spooked debt holders to dump Spanish debt (and Italian) and park cash in US.
For bond folks, at issue is the source of the “line of credit” because, fear is, they may come from the European Stability Mechanism (ESM) where point 13 of this Treaty stipulates the packing order that creditors must take (emphasis added):
Like the IMF, the ESM will provide stability support to an ESM Member when its regular access to market financing is impaired or is at risk of being impaired. Reflecting this, Heads of State or Government have stated that the ESM loans will enjoy preferred creditor status in a similar fashion to those of the IMF, while accepting preferred creditor status of the IMF over the ESM. This status will be effective as of the date of entry into force of this Treaty. In the event of ESM financial assistance in the form of ESM loans following a European financial assistance programme existing at the time of the signature of this Treaty, the ESM will enjoy the same seniority as all other loans and obligations of the beneficiary ESM Member, with the exception of the IMF loans.
Now, there are all sorts of legal wrangling about this including claims like:
- If part of the cash comes from EFSF then ESM subordination superiority goes null
- ESM Treaty comes in effect in July based on states signing it which is legally different then ratifying it
- The most reassuring: public statements by EU officials that bond people should not fear!
Besides noting that another EU country is soon to go by way of Greece, Lee Buchheit, the lawyer that renegotiated Greek debt and many others, also notes in his paper, from experience of course, that no country “would lightly consider a change of local law as an easy method of dealing with a sovereign debt crisis”. Buchheit also warns why:
- “If done once, future investors will fear that it could be done again.”
- “A dramatic change in local law by one country might allow a worm of doubt to slip into the heads of capital market investors in other similarly-situated countries, driving up borrowing costs around the board.”
- Fear that the law will “unleash the forces of contagion and instability upon other countries”
Taking these legal points all together, selling Spanish and Italian bonds ASAP may be prudent if one expects the subordination issue to begin dominating the Spanish bailout debate, and by implication, the Italian one.
Fitch is already warning that policymakers are losing their grip and, of course, one sees a bailout paradox emerging out of this – a policy intended to do good contaminates the sovereign debt and spiral the financial situation out of the reach of containment of policy makers thus reinforcing the cliché that the path to hell is indeed paved with good intentions.
At any rate, another, more macro issue, is percolating about the funding source itself.
If EFSF + ESM = €700bn, and Spain used up €100bn while Spanish total funding needs are €370bn through 2014, the bailout source is left with €700bn – €100bn – €370bn = €230bn.
With Italy needing €620bn in funding then the source is short by €230bn – €620bn = – €390bn.
With the Spanish “luck” of a first draw, no wonder eyes are on Italy now and its yields are rising.
For US equities, rough ride ahead…