Thursday, August 21, 2014

No, Prime Minister, Spain Is Not Uganda

“Aguanta, somos la cuarta potencia de Europa. España no es Uganda.”
---Text message from Spanish prime minister Mariano Rajoy to his finance minister earlier this year.

I’ve been in the credit analysis business since 1978 and I have seen more than my share of “good” credits turn bad. Among them: Continental Illinois, E.F. Hutton, Drexel Burnham, Latin America, Security Pacific, BofA (the first time), the New York money center banks, the Texas and New England banks, the entire S&L industry, Mutual Benefit Life, BCCI, Mexico (again), Credit Lyonnaise, WestLB, Thailand, Korea, Russia, Lehman Bros. (the first time), Argentina (again), Enron, Arthur Anderson, the entire merchant energy industry, the California utilities, WorldCom, Global Crossing, Bear Stearns, Northern Rock, IKB, Allied Irish, HBOS, Lehman Bros. (the second and final time), Merrill Lynch, BofA (again), Citigroup, Greece, Ireland, Portugal, and now.....Spain.

When credit is all you do, your gut sense should become as educated as your intellect. Good credit people should be able to smell bad credits. When Enron began to unravel in the fall of 2001, I read their 2000 Annual Report. As I read, I got a pit in my stomach, almost a panic reaction. Enron’s glossy and entirely invented report was a blinding array of flashing red lights and warning klaxons. I felt in my stomach the utter bottomlessness of their financial situation. Similarly with Thailand and Korea.

What each of these credits (and many of the other catastrophes listed above) had in common was this: a credit whose trajectory was upward. Bad credits (like Uganda) don’t have credit crises, because they don’t depend on market confidence. It is only the “stars” and the “tigers” and the “most admired” companies and countries like Spain that suffer crises because their psychology and their finances were geared for growth, not for reversal. Bad credits are generally ponzi schemes in the sense that they must continuously borrow more to stay afloat.

Recently I have begun I to feel that same fear with respect to Spain, the fear that, like Enron, it is beyond rescue. Like Enron, Spain’s finances are not structured for a credit crisis, only for ponzi-like growth. A cut-off of credit is fatal. I am worried that rescuing Spain is beyond the capability of the mechanisms established to do so. A rough estimate of the price tag for Spain is EUR one trillion, although it could be higher. That is an astronomical sum.

We are not talking about a $30 billion Enron, or a $100 billion Mexico or a $35 billion Greece. Spain is the largest sovereign credit problem since Germany in 1931 . Spain owes the world about a trillion euro in a currency that she doesn’t print.

Unlike the LDCs, she can’t simply impose a payments moratorium and reschedule her bank loans, because her debts are in bonds and deposits, not loans. It is true that many of her official creditors can roll her debt if they choose, and they will have to. But the bulk of her debt remains in unofficial hands, which will not voluntarily roll it as it matures. Spain needs to borrow money from somebody to repay her debt maturities as they come due. That’s hundreds of billions between now and the end of next year. I also don’t know if the ECB will be able to replace all of her banks’ market liabilities with its various loan programs, no matter how low its collateral standards. That’s another huge challenge.

Draghi recently gave a speech in Berlin in which he tried to put a brave face on the situation. Here is the nugget of his remarks:
“My central message to you today is that, provided that all policy-makers persevere with the necessary reforms, we have a number of reasons to be positive about where the euro area is heading. We are seeing signs of improved sentiment in financial markets and we expect the economy to return to growth next year. At the same time, considerable progress is being made on all fronts to strengthen the foundations of the euro area.”

Does that make you feel even slightly better about Spain? When I read this I got that bad credit feeling again. I got the feeling that the captain of the ship wants us to believe that morale-strengthening exercises will restore market confidence, and the ship will sail on.

I have given up on deciding whether Draghi is smarter than all of us, or is himself delusional. In the end it doesn’t matter. Like King Canute, he cannot stop the tide from rising. There is no relationship between what Draghi is saying and what he would ultimately have to do to rescue Spain. So what if he knows the truth? What difference does that make? How is he going to come up with the money he needs as long as the eurozone's price-stability suicide pact remains in place? He has no path to victory, only more of the same disastrous policies with minor tweaks here and there. He says that the OMT is unlimited, which means in practice one trillion euros: can he do that with his current governing council?

This is where my head is at on Spain, that it is a “caso perdido”. Short-term, it can get rescued and the OMT can help. But the restoration of market confidence and market access seems like a chimera. Spain can’t throw her engines into reverse because there is no such lever on her control panel. She needs a new central bank, quickly.