Bloomberg News

Germany Pressed to Scrap Senior Status on Spain Rescue Loans

June 26, 2012

EU Leaders Ease Debt-Crisis Rules for Spain as Merkel Retreats

Visitors view the city skyline from the roof of the Circulo de Bellas Artes in Madrid. Photographer: Angel Navarrete/Bloomberg

Germany faces pressure to surrender preferred status on rescue loans to Spain’s banks in a standoff that echoes Chancellor Angela Merkel’s rejection of debt sharing to fight Europe’s deepening financial crisis.

Along with Finland and the Netherlands, Germany wants official loans of as much as 100 billion euros ($125 billion) to Spain to be repaid first in the event of a default, putting bondholders at a disadvantage, said two European officials.

Finance ministers from the three AAA rated countries stood their ground last week, said the officials who asked not to be named because the talks were private. The decision next goes to Merkel and fellow government leaders who have been forced to renounce previous attempts to put taxpayers ahead of investors in structuring bailouts.

“This is one of the focal points for market anxiety about the Spanish bailout,” said Nicholas Spiro, head of Spiro Sovereign Strategy in London. The move to assert seniority “undermines the credibility of the bailout. This is partly what is fueling ‘bailout creep’ in Spain -- the fact that the price Spain is paying for this new bailout, due to its flawed structure at present, is a price that is too high.”

The threat of a subordinated status was one reason why Spanish bonds tumbled after the bailout offer was made on June 9. Ten-year Spanish yields have risen 49 basis points to 6.71 percent since then. They rose as high as 7.29 percent last week.

Spanish Bid

Spain made a formal bid for the aid yesterday, ushering in talks over details -- the size, potential breakup of individual banks, and the remaking of Spain’s supervisory system -- that will culminate when finance ministers next meet on July 9.

One issue has gone above the ministers pay’ grade: the question of which creditors are first in line in the event of a default. It is on the agenda for the June 28-29 European Union summit, which will also try to lay out the building blocks of a post-crisis economy.

“All eyes will be on Germany,” Merkel said in Berlin yesterday.

European proposals today to reshape the crisis-struck euro area ran into immediate criticism from Germany for putting too much emphasis on debt sharing and too little on controlling national budgets.

Seniority Reversals

In their on-the-job training in crisis management, European leaders have had to twice reverse investor-unfriendly moves, conceding they were self-inflicting mistakes that roiled markets. The first was the Merkel-led push starting in October 2010 to make bond writedowns part of the toolkit of the permanent bailout fund.

That drive pushed up Ireland’s borrowing costs, forcing it to fall back on official credits a month later. It culminated with a second Greek aid package that foresaw bondholder losses of 50 percent, and a political declaration that the treatment of Greece was a one-off.

The second flip-flop involved lending by the permanent fund, the European Stability Mechanism, originally intended to enjoy seniority over other creditors. Finance ministers last year ditched that status on any loans to Greece, Ireland and Portugal, the three countries then drawing on official aid.

“Very good news,” said Irish Finance Minister Michael Noonan at the time. By ceding the first claim on getting repaid, creditor governments made it easier eventually to lure private investors to buy Irish bonds, the reasoning went.

Fund Flexibility

Euro leaders went on to rewrite the statutes of the permanent fund, in an effort to make future bailouts more appealing to investors. New language recalled that European leaders had voiced a preference for senior status on loans to debtor governments, while giving them room to wriggle out of it.

The handling of Spain -- the euro area’s fourth-largest economy, bigger than Greece, Ireland and Portugal combined -- will test that flexibility. Finance chiefs last week eyed the permanent fund as the main vehicle for Spanish aid, agreeing to start with the temporary fund only if the ESM isn’t ready.

Official creditors could defuse the issue by granting loans over longer maturities than Spanish bonds, Spanish Deputy Economy Minister Fernando Jimenez Latorre said.

“The longer the maturity and the grace period, and the lower the interest rate, the lower the risk of it being considered senior,” Jimenez Latorre said in Santander, Spain, yesterday. The issue will be resolved “satisfactorily,” he said.

Temporary Fund

From the bondholders’ perspective, the 440 billion-euro temporary fund known as the European Financial Stability Facility is a better deal. Its lending doesn’t outrank private investors on the scale of creditors.

For governments, the EFSF is unwieldy. It operates on a system of guarantees that add to each country’s debt. The permanent 500 billion-euro ESM, due to be declared operational on July 9, is structured more as an investment fund, with capital contributions not counting toward the national debt.

Since Spain still has to conduct a “bottom-up” test of its banks and give them time to seek financing from the market, the first disbursement of aid probably won’t be needed until the end of the year, an official involved in the talks said.

By then, the ESM will be up and running, making the senior status an option. Dropping it would produce complications with Finland, which in the absence of the priority repayment guarantee would want Spain to offer collateral instead, an official said. Finland also extracted collateral as part of the second Greek bailout.

To contact the reporter on this story: James G. Neuger in Brussels at jneuger@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net


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