Spain has nationalized the failing bank Bankia and it proposed recapitalizing it with Spanish government debt:

Spain is considering directly injecting its own government debt into BFA-Bankia to help fund the stricken lender’s €19bn nationalisation, in an attempt to sidestep borrowing money directly from the bond markets.

The plan, viewed as highly unorthodox by analysts, involves Madrid issuing Spanish government guaranteed debt to Bankia in return for equity, with the bank then able to deposit the bonds with European Central Bank as collateral for cash.

On Friday Bankia, Spain’s third-biggest lender by assets, announced that the state would invest €19bn in what will be the country’s largest ever bailout, with the government expected to control about 90 per cent of its shares.

This would have the effect of the ECB purchasing Spanish debt, which the ECB (the German Bundesbank) is opposed to.

It would be a win win for everyone, but since there is no pain for the ordinary Spaniard involved, the European Central Bank has rejected the deal:

A Spanish plan to recapitalise Bankia, the troubled lender, by indirectly tapping the European Central Bank for cash, was bluntly rejected as unacceptable by the ECB, European officials said.

News of the rejection came as Spain faces elevated borrowing costs in the bond markets, tries to persuade investors it can contain problems in a banking sector weighed down by €180bn of bad property loans and, on Tuesday, saw its central bank governor stand down early.

Madrid had floated the unorthodox idea over the weekend of recapitalising Bankia by injecting €19bn of sovereign bonds into its parent company, which could then be swapped for cash at the ECB’s three-month refinancing window, avoiding the need to raise the money on bond markets.

The ECB told Madrid that a proper capital injection was needed for Bankia and its plans were in danger of breaching an EU ban on “monetary financing,” or central bank funding of governments, according to two European officials.

At this point, the best action for the Spanish government is to allow the bank to default on its bonds (not its deposits), where I am certain that German bank exposure is high.

The Spanish should not make the same mistake as the Irish.  Do not make the bondholders whole.

If you do, you are simply taxing your citizens to fund foreign investors bets.

There is no obligation, either legally or morally, to do so.

H/t Eschaton