Europe's Latest Bank Deal is Still a Flop

Psst, Angela. What if we just say the crisis is over? Will that work?

(Reuters)

Is this time different. Maybe? Please?

Probably not.

If you're wondering what this funny feeling is, don't worry. This is what good news out of Europe feels like. It won't last. The big overnight development was that Germany seemed to reverse itself on the terms of the botched Spanish bank bailout. For the first time, it looks like Europe's leaders at least know what they have to do to save the common currency. And, as you'll recall, knowing is half the battle.

Unfortunately, winning half the battle isn't enough.

A quick recap. The Spanish bank rescue was more of a failout than a bailout for three big reasons. First, the bailout loans added to Spain's public debt. Second, those loans were senior to other debt. And third, the loans came with major strings attached -- the so-called Troika of the European Commission, ECB, and IMF would "oversee" them. In other words, even more austere austerity. So, the deal added to Spain's debt, made that debt riskier for private investors, and made it harder for Spain to pay back its debt. It was a disaster of the utter variety.

No wonder Spanish borrowing costs spiked after this "bailout". Even worse, Italy's borrowing costs started creeping up again thanks to contagion. It was enough to prompt even a mild-mannered technocrat like Italian prime minister Mario Monti -- who is facing increasing anti-euro political pressure domestically -- to resort to apocalyptic rhetoric. Monti proclaimed that the common currency had a week to save itself. It was something big or bust at the latest euro summit.

They got something big. Or rather, something that sounded big-ish. But it's looking smaller with each passing minute. Insofar as they got anything of any size, give Monti credit. The summit appeared destined to be just another confab where Europe's leaders would agree to agree to things they'd already agreed to that wouldn't solve anything. Then Monti threatened to blow up the proceedings unless they did something to help Italy and Spain. It looked like they did for a few hours. Now, not so much.

THE GOOD, THE BAD, AND THE EURO

Let's start with the good news. First, they announced that the ESM -- Europe's yet-to-ratified bailout fund -- will be able to directly recapitalize banks once they set up a single euro zone banking regulator. Second, they declared that ESM loans would not be senior to other debt -- but only in Spain. And third, they said that countries could borrow from the EFSF -- Europe's current bailout fund -- without setting off Troika monitoring. (More on that in a bit). In plain English, this plan would 1) bail out banks without adding to government debt, 2) not make government debt any riskier for private lenders, and 3) not make it harder for governments to pay back their debts by forcing austerity on them.

But remember, this is Europe. There's no so such thing as "good news". Here's the not-so-good news. First, it's not clear that the ESM will actually recapitalize banks. It will take unanimous approval -- something Finland isn't likely to give -- for the ESM to start investing in banks. But even if they do get approval, Europe won't have a single bank regulator until January 1, 2013 at the earliest -- meaning that the ESM (if it, you know, actually exists) won't be able to start this new plan until then. Second, it's not clear at all that the ESM still won't be senior to other debt. The EFSF isn't supposed to be senior, but it was when Greece restructured its debt. In other words, the ESM might not be explicitly senior anymore, but it will still be implicitly senior. Third, it's looking like EFSF and ESM loans actually will come with Troika strings still attached. Merkel has already walked back any suggestion otherwise. Oops. And fourth, the ESM isn't even up and running yet! This is a lot of talk about something that is just a hypothetical, and might need a legal makeover.

I haven't even gotten to the biggest problem. The biggest problem is that the ECB isn't involved. The bailout funds aren't big enough to push down Spanish or Italian borrowing costs for long. You need infinite euros to do that. Only the ECB can create infinite euros. Why do you need infinite euros? Suppose the EFSF buys Spanish bonds. Yields will come down a bit. But what happens when the EFSF start to run out of money? Yields will go back up. You need an unlimited pile of cash to end the panic. The EFSF and ESM are just band-aids.

The immediate market reaction was decidedly positive, then decidedly not so positive. The chart below from Bloomberg shows the yield on 10-year Spanish bonds since the wee hours of the morning.

We'll see if this lasts through noon. If past bailouts are any guide, the answer is no.

But even if the rally fizzles out, there is a glimmer of long-term good news here. Spain and Italy have leverage over Germany. That's something Greece, Ireland and Portugal couldn't say. That leverage means that Spain and Italy should be able to drag concessions out of Germany step by tiny step. They only got cosmetic changes this time, but they're on the right track. And Monti and Rajoy know that know.

Salvation, doom, and everything in between. Or, as they call it in Europe, Friday.