Why Spain's Bank Bailout Failed: It's Called 'Subordination'

Since Saturday's EU bailout, which is actually a loan to Spain's government, the yield on the government's 10-year bonds has soared. At one point Tuesday, the yield reached 6.83 percent, the highest since the euro was introduced in 1999, according to Bloomberg News.

The reason that the bond market has been punishing Spain for the bailout has to do with the two-fold way sovereign bond investors calculate how much interest they should charge a government. On the one hand, investors must gauge the probability that the government will default; on the other hand, they must calculate how much money they can realistically expect if the government does default.

Thus, if their expectations for default goes up or their view of how much they could recover after a default goes down, they will demand a higher premium, driving up the interest rate, or yield, that the borrower must pay. 

The €100 billion bailout succeeding in assuring bond investors that Spain was less likely to default, simply because the government now has a huge amount of cash with which to prop up its ailing banks. 

But the bailout also resulted in existing Spanish bond holders -- currently holding $1.09 trillion in Spanish obligaciones -- being subject to subordination of their claims. That is, because Spain is now on the hook to the EU for a  €100 billion loan, the amount that existing bond holders stand to recover if Madrid defaults is diminished by €100 billion.

When investors realized that they had been subordinated, they sold off Spanish bonds, launching their yields to record heights.

The Spanish bailout was viewed as taking money from one pocket and putting it in the other, said Tim Quinlan, an economist for San Franciso-based Wells Fargo Securities

Markets suddenly threw their hands up because you're trying to solve a problem of debt by adding more debt. At some point, the market says 'No más'.

Indeed, the fact the market was not falling for the European money-moving shell game seemed to be the most cited reason by bank analysts explaining why the bailout hadn't worked.

At Japanese financial services firm Nomura, London-based rates strategist Guy Mandi mentioned the circular nature of the sovereign/bank linkage as making solutions to the current crisis susceptible to failure.

Nobel Prize-winning economist Joseph Stiglitz put it more succintly, explaining the system in an interview with CNBC: The Spanish government bails out Spanish banks, and Spanish banks bail out the Spanish government.

Not that there aren't other reasons the Spanish bailout is also being rejected by the markets.

At global Swiss investment bank UBS, George Bory, a Connecticut-based credit strategist, wrote a note Tuesday that explained the amount of the rescue, while large, might not be enough, and would create a situation where banks would find it difficult to fund themselves in the future.

Also, the nature of the loan (no economic austerity measures imposed on Spain in return) makes it more likely for Spain to get downgraded further if its fiscal situation does not improve rapidly, Bory wrote. And that would immediately cause the chances of  a write-off on Spanish debt to increase, going back to the default probability the bailout was meant to address.

So far, the political forces behind the banking bailout have dismissed those concerns, with the ECB staying firm on its 13-week-old policy of not intervening in the credit markets to help lower borrowing costs for specific countries. But that position, like the bailout, might be destined for failure

The ECB is talking tough and acting as though they're willing to take the heat, Quinlan, the Wells Fargo economist, noted But if they get up to 8 percent, it's going to be very hard for that country. If they get up to 9 percent, they're not going to be able to make payroll, to pay their government workers.