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Spain's Economy Minister Luis De Guindos, listens to Spain's Prime Minister Mariano Rajoy's speech during a control session at the Spanish Parliament, in Madrid, Wednesday, July 11, 2012.

Andres Kudacki/AP

Spain's Economy Minister Luis de Guindos recently said bank preference shares should never have been sold to mainstream retail investors. It's easy to see why. Euro zone lenders may be about to force Spain to follow Ireland and impose losses on junior creditors of bailed-out banks, many of whom are retail clients. This would be deeply unpopular and carry risks. But it is the right way to reduce the cost of Spain's mega bank bailout.

The Irish experience was not pleasant for subordinated debtholders. The government had a powerful stick in the form of new laws that allowed it to change the terms of their securities. Investors recovered on average around 20 per cent of face value.

Brussels has decided that Spain's bank bailout should be accompanied with similar legislation and force junior creditor losses "to the full extent possible" – although it's not clear what that means. BBVA and Santander aside, Spanish banks have €47-billion ($58.7-billion) in subordinated debt, according to Barclays' estimates. Recently bailed-out BFA-Bankia has an estimated €12-billion in subordinated debt, including preference shares.

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The threat of new legislation might itself encourage voluntary haircuts via debt exchanges. Under the current rules, lenders needing state support would have to buy investors out for no more than a 10 per cent premium to the market price. Given that even the most beaten-up of these bonds currently trade at discounts of 70 per cent of par, creditors probably face more modest losses than in Ireland.

Spain needs to tread carefully. The preference shareholders of Spain's four nationalized banks are also their best clients. In Bankia's case, they lost a packet in its initial public offering, too. Clients complain they thought they were investing in a quasi-deposit. Upsetting them may trigger deposit flight and compensation claims. Spain is also being asked to pass tighter regulation in this area.

But Madrid can't afford to be too gentle on these creditors, whether institutional or retail. The euro zone won't cover capital shortfalls if related debt exchanges are botched. And it could have been tougher. So far there's no suggestion of forcing losses on senior creditors.

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