Friday, November 18, 2011

High bond rates and the Spanish economy

Although I’ve seen a lot of press worrying about the ability of the Spanish/Italian governments to fund themselves at the current rates, what I haven’t seen much has been the knock-on effect this has had on other lenders.

This happened to me yesterday, when La Caixa phoned me flogging a CaixaBank junior 5-year bond at 7.5%. Holy Crap! 7.5%! I thought… what a great deal! Then I thought about it some more… hell, I could by a Spanish Government bond that would yield 6+%. Why would I want to make a much more risky loan for only 1% more? (It would also be interesting to see how much this junior bond trades for on the secondary markets…)

The bottom line is that if the Spanish government has to pay 6+%, anyone else in Spain is going to have to pay significantly more to make it worthwhile for any lender. How many businesses are able to get a real 6% return on money, especially with inflation this low?

The other thing you got to wonder about is how a bank can make money lending at 2% and borrowing at 7.5%… let’s see how that would work:

La Caixa borrows €1000 at 7.5% per year. They then lend it to a bunch of homeowners and create a €1000 “covered bond”, which they can fob off to the ECB for (let’s say 10%) haircut and get back €900 from the ECB. They then lend out the €900 to another bunch of homeowners, etc. If they keep doing this, eventually they’ve lent €10,000 euros to the homeowners and are collecting €200 euros a year of interest, paying you €75 euros and paying the ECB €125 in interest, for a profit of €0.

Now, suppose instead that La Caixa buys some 1 year Spanish government bonds with the money instead:

Instead of a 10% haircut, they can now get a 0.5% haircut, and get paid 6% instead of 2%. Holy wheelbarrows of money batman! They could leverage this almost 200X and buy €200,000 worth of government bonds paying 6% per year interest. Now they would get €12,000 in interest from the Spanish government, pay the ECB €2500 and pay you €75, for a profit of €9,425.

So yeah, businesses and consumers can just piss off if they want to borrow money because the banks are busy lending free ECB money to the government.

So really, the situation is identical to the ECB just buying the government bonds directly, except that in theory the bank that fobbed off the bond is responsible for any losses. BUT the bank itself would go under if the government were to default, so the guarantee from the bank is worth zero, but the bank is effectively being given a huge subsidy for providing this worthless guarantee.

1 comment:

Tita said...

Thanks for the detailed comparison. I had to reread it a few times, but now I finally understand how this type of leveraging works.

And I can't think of a polite way of expressing what I think of it...