Tuesday, June 12, 2012

Pain in Spain Falls on All but the Megabanks

So, the media is full of stories that the Eurozone is bailing out Spain--but it is not and will not work. My objection is this: in fact, Spain is not being bailed out. The Spanish people are bailing out the Eurozone megabanks by undertaking $125 billion of new indebtedness so that the Spanish banks can continue to pay Eurozone banks interest and principal and Spanish bankers can continue in power.

Let me explain, using the FDIC Resolutions Handbook for failed banks. According to the FDIC resolution manual, when the FDIC takes over a failed bank it only protects the depositors. Senior management gets sacked (p. 85) and unsecured creditors only get "receivership certificates." A receivership certificate "entitles its holder to a portion of the receiver’s collections on the failed institution’s assets." (p. 5). In other words, the unsecured creditors get any positive net worth remaining after resolution--which is usually nothing because healthy banks with positive net worth are generally not placed in receivership. Simply put, neither managers nor unsecured creditors get deposit insurance, backed by the full faith and credit of the United States Government (see official FDIC teller decal, above).

On the other hand, the Eurozone guidelines for EFSF bailouts, like that for Spain, are only available for systemically important financial institutions and do not preclude payments to unsecured creditors. Indeed, the whole point of the Eurozone bailout for systemically important institutions is to assure protection of the financial system--that is payment to other big banks in Europe. (As the EFSF guidelines state: "A candidate for recapitalisation will have to be a distressed financial institution systemically relevant or posing a threat to financial stability."). Thus, while shareholders do appropriately suffer losses under an EFSF bailout--general unsecured creditors do not necessarily face pain of loss, particularly if "contagion" could result. Finally, the Eurozone guidelines allow each nation-state to indulge its financial elites by failing to mandate their dismissal (much less investigation leading to possible indictment or civil liability). Derivatives counter-parties get protection as do megabanks more generally (under the rubric of "contagion").

This is nuts! Sovereign nations now effectively guarantee derivatives contracts involving megabanks. At a cost of hundreds of billions of Euros the Eurozone now stands behind every derivatives contract involving a Eurozone bank. Overstatement?

Well, the depth of the Eurozone commitment to saving the big banks is evident in the pain it tolerates for the people of Spain. Spain has Great Depression levels of unemployment approaching 25%. Over 50% of its youth is unemployed.  The government continues to push extreme austerity on its people with wage freezes and deep cutbacks for public sector employees. Health and education expenditures face high cuts. And, now Spain promises more austerity ahead. Yet, here in Spain, I see no evidence that the banking elites that caused this crisis face any loss of power, prestige, position or money. (Although the Socialist Party is stirring).

None of this makes economic sense. When I worked at the FDIC we worked to maintain rational economic incentives for bankers. Those committing bankicide were served subpoenas and it was my job to make criminal referrals or to sue to recover damages. I recall bankers breaking down in tears under questioning about how their bank had failed. It was on many levels unpleasant work. But rational banking incentives matter. Today, these bailouts send an inescapable message: bankers may speculate all they want because the governments will bankroll their folly to the tune of billions or even trillions. The only way to stop bank failures is to stop guaranteeing bank failures and to make the failure of a bank very painful for senior managers and unsecured creditors like bond holders or derivatives counter-parties. 

So, the Eurozone now provides hundreds of billions to protect the megabanks from their own speculative excess and pain and economic misery for people who foot the bill. It is difficult to imagine a more destructive economic reality or a more morally reprehensible policy. This new policy of giving megabanks an unlimited and first claim on public wealth will doom us all.

As in World War II, perhaps Spain is again a prelude for the challenges coming to the US. 

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