German Chancellor Angela Merkel has worked out a deal with Spain to rescue its banks. Global equity markets and commodities, especially gold and silver, have cheered the news.

However, the bond market has let out a big yawn. The yield on Spanish 10-year treasuries dropped less than 3 basis points to 6.281%, hardly a sustainable rate.

Please consider Germany finalizing face-saving aid deal for Spain

While Berlin remains firm in its rejection of Spain’s calls for Europe’s rescue funds to lend directly to its banks, the officials said that if Madrid put in a formal aid request, funds could flow without it submitting to the kind of strict reform program agreed for Greece, Portugal and Ireland.

Instead, Spain would only have to agree to new conditions tied to the reform of its banking sector. Berlin is also exploring the possibility of funneling aid to Spain’s bank rescue fund FROB to reinforce the message that it is the country’s banks and not its public finances which are at the root of its problems.

Berlin is certainly shifting positions. Last week, it signaled it supported granting Spain an extra year to cut its deficit to the EU’s 3 percent of gross domestic product threshold, having previously held fast to the notion that austerity drives should not be diluted.

Merkel has also sent the message that she is open to Europe-wide supervision of the banking sector, albeit as a “medium-term” goal, one element of a proposed “banking union” to break the vicious circle of interdependence between Europe’s financial institutions and its sovereigns.

But she must tread carefully. Some of her political allies and leading conservative newspapers have come out strongly against other aspects of a banking reform, including the idea of a Europe-wide deposit guarantee scheme.

Multiple sources said the German finance ministry was exploring the possibility of channeling EU aid directly to Spain’s Fund for Orderly Bank Restructuring (FROB), but that this would only work under the ESM, which is due to come into force next month.

Lending to Peter so Peter Can Lend to Paul

Got that? Germany is not willing to lend money directly to Spanish banks, but is willing to lend to the FROB so the FROB can lend to Spanish banks.

Eurointelligence explains EFSF to lend directly to the FROB

This would be a straight-forward loan by the EFSF to the FROB, and this loan would raise the Spanish state’s debt. The only relief would come in the form of lower ESM interest rates as opposed to the market interest rates Spain has to pay right now. We doubt that this scheme will have a sustained effect on Spanish spreads.

Any Effect?

Did this sleight-of-hand, shell-game proposal have any effect? Not to the bond market unless you count the small rally in yields from about 6.66% to 6.28% ahead of the news with almost no follow-through today.

While the equity markets are once again willing to settle for ridiculous fluff and promises, the bond markets and gold are not impressed.

How Big is the Sinkhole?

How much money does the FROB need? Estimates range from 30 to 70 billion more euros on top of 80 billion euros of taxpayer money already  wasted.

I suspect the real answer is at least triple the high-end estimate given massive unrealized real-estate losses and the imploding Spanish economy. Whatever the external audit by the IMF shows, figure it to be a lowball estimate designed to make things look better than they really are.

This ploy may be face-saving for Spain but it will cost German and Spanish taxpayers still more money and it will be face-losing for Merkel. 

Mike “Mish” Shedlock
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