Spain: The hole in Europe’s balance sheet
- Is Spain = Japan 2.0? Reasons:
- The bursting of the property bubble in Spain is worse than most people realise.
- Spanish banks are covering up their losses.
- Investors must be out of their minds if they think Spanish banks are among the strongest in Europe (see ‘Spanish Banks In Top Form’ at Forbes). If all of the above is true, Spain will soon have ‘zombie banks’ like Japan.
- Banks are covering up their losses: We believe that Spanish banks are not valuing their mortgage loans at market prices, and are renewing loans to ‘zombie’ construction firms and property developers. And they are doing this by exploiting accounting changes, failing to value assets at market prices, renewing loans to ‘zombie’ companies, extending mortgages granted at 100% of the unrealistic value assessed at the height of the bubble for up to 40 years, and engaging in other practices typical of the bubble era.
- Spain is experiencing deflation: In a deflationary environment, servicing debt is even harder, as even with zero interest rates, the real value of the debt increases. That is why deflation is such a terrible thing. Eastern Europe, Spain and Ireland are only just entering their deflationary phases. We believe we will see much more deflation, which will have far-reaching repercussions for the European banking sector.
- Who puts up with all this? The peripheral countries are net debtors, whilst the rest of Europe is a net creditor. When a debtor is unable to pay, the creditor suffers. Germany, France and others will have to cover the shortfall by recapitalising the peripheral countries and Spain.
Strategies:
We recommend going short on, or reducing holdings of, Spanish government bonds in favour of German ones, as well as taking a bearish stance on Spanish equities – particularly banks, construction companies and similar sectors – and any consumer-related sectors.
Is Spain = Japan 2.0?
We have absolutely no wish to be overly critical of Spain, but we believe it is on the brink of disaster. If the severity of the crisis is ignored – given its far-reaching implications for the European banking system – the cost to investors could be high.
Spain is doomed to a long and painful period of deflation, which will manifest itself in extremely high unemployment for an industrialised economy, the collapse of the property sector and widespread bank failures.
Spain experienced the mother of all property bubbles. To put this into perspective, there are currently as many houses for sale in Spain as there are in the US – a country six times its size. And yet its GDP is barely 10%, whilst it accounts for 30% of all the houses built in the EU since 2000. Most of these properties were financed with foreign capital, and therefore the Spanish property crisis is closely linked to the financial crisis.
The impact on the banking sector will be severe. Let us bear in mind that the value of mortgage loans granted has risen from just €33.5 billion in 2000 to €318 billion in 2008. That is an 850% increase over 8 years. If we add the total value of all loans granted to property developers and construction companies, the figure rises to €470,000 million. This is almost half of Spain’s GDP. And the majority of those mortgages will default.
In our view, the Spanish banking sector faces a very challenging outlook. Unemployment in Spain stands at over 17% (twice the EU average); there are more than 4 million unemployed people and over a million households in which none of the members are in work.
Facts:
- The property crash in Spain is worse than most people realise, just as the subprime crisis was also far worse than people thought.
- The Spanish banking sector is concealing its losses and rolling over the debt of ‘zombie’ companies, just as Japan did in the last decade.
- Investors are deluding themselves if they think that Spanish banks are among the most sound in the world, despite articles such as the aforementioned Forbes piece that uncritically praise their strength.
If we are right, Spain will soon have ‘zombie banks’ like Japan and face a long period of deflation, but in its case it will be much worse.
As Edward Hugh, the most prescient guru amongst Spain’s analysts, puts it: «Japan was able to boost savings and achieved a current account surplus of 3% of GDP. Spain has a massive external debt (in 2007, the current account deficit stood at 10% of GDP) and most of its export industries are in a precarious state.».
Let’s lay everything out on the table
We try not to go on too long in our articles. If something cannot be explained with a few charts, it is better not to explain it at all. In the case of the Spanish banking sector, the subterfuges and cover-ups surrounding non-performing loans have forced us to piece together many parts of the puzzle: Interviews with bankers insiders and other sources of information have been needed to find out what’s going on with the puzzle. That reminded us very much of the early days of the subprime mortgages, when all the published banking results looked good – until they no longer did. We believe the same will happen with the Spanish property sector.
The situation in the Spanish property market is far worse than people realise.
The courses of action most widely accepted by analysts regarding the Spanish banking sector are as follows:
- Dynamic Provisioning: In 2000, the Bank of Spain introduced the dynamic provisioning system, which required banks to set aside reserves against future losses. Spanish banks set aside provisions three or four times more than most of their competitors. In fact, the Bank of Spain was creating countercyclical ‘airbags’ to prepare for a potential credit crisis.
- Prudence when borrowing: The major Spanish banks, with their exemplary risk management, were able to concentrate the bulk of the mortgages granted on primary residences, in major cities and with reasonable loan-to-value ratios, thereby leaving developers and buyers of second homes (and speculators) largely in the hands of the savings banks.
However, despite dynamic provisioning, during the recent rally, Spanish banks have been taking measures left, right and centre to shore up their capital. For the most part, they have done so by foisting preference shares on their retail customers retail the most uninformed. It’s a good start, but we don’t think it’s enough. They need much more.
The scale of the problem in Spain is staggering, and it is rapidly eating into the dynamic supply of properties. Even by conservative estimates, Spain has over 1,000,000 unsold homes. Unfortunately, many of them are on the coast, and without the return of a new flood of tourists with deep pockets (GBP/€), many of them are doomed to remain on the market indefinitely. Spanish homes are all in the wrong place.
The construction share bubble bears a striking resemblance to the US bubble and other classic bubbles. They shoot up tenfold and then plummet by 90%. The maths never fails.
Given this deplorable state of affairs, we might conclude that property prices in Spain have fallen to a similar extent as those in the US. But that’s not the case.
As the following chart shows, statistics indicate that property prices in Spain have fallen by just 10 or 15% from their peak.
Why haven’t Spanish banks suffered the same fate as their American, Irish or British counterparts? We have always wondered why the property bubble and the collapse of Spanish industry have not claimed more victims.
We believe that the Spanish banking sector is concealing its problems. Let’s see how it is doing so:
- Taking full advantage of accounting flexibility
- Not valuing the collateral at market value
- Debt roll-over for zombie companies
- Renegotiating 40-year mortgages at 100% of the initial value
Let’s look at them in detail:
1) Exploiting accounting loopholes
The Bank of Spain is known for being a prudent and conservative institution. And that is true, but things are now changing. It should be deeply concerned and keeping a close eye on the dire situation facing some Spanish banks, and some analysts believe it is helping them to avoid reporting losses this year.
In July, the Bank of Spain changed the rules on provisioning for non-performing loans. Previously, banks had to set aside provisions for the full value of mortgages where the loan-to-value ratio exceeded 80% and where payments had been in arrears for more than two years. Under the Bank of Spain’s new guidelines, banks are now only required to set aside provisions for the difference between the value of the mortgage and 70% of the property’s market value (as stated in this article in the Financial Times and in this one from Economist.com). This has meant that most Spanish banks have not had to report losses this year.
2) Not valuing the collateral at market value
We also believe that Spanish banks are not valuing their balance sheets at market prices. According to an article published on 19 April in *Expansión*, Spain’s equivalent of the *Financial Times* (sic), entitled «Banks and building societies carry out one in every two property valuations», banks and building societies control 25% directly and a further 25% indirectly through their shareholdings.
In the words of Expansion:
The valuation of collateral in the mortgage portfolios of savings banks and banks, and of their property assets, is becoming increasingly important. In 2007, the thirteen companies linked to financial institutions accounted for 47% of the property valuations carried out.
The valuation of property assets has, if anything, taken on new importance for the banking sector in the current context of economic recession. The valuation of collateral in banks’ mortgage portfolios and of properties they are acquiring through judicial foreclosures and debt-for-asset swaps is key to gauging the solvency of the financial system. This situation has once again brought into focus the links between banks and valuation firms, which in many cases go beyond a mere commercial relationship.
Official statistics are not based on anecdotal evidence, internet searches or actual property sales carried out by the banks themselves. According to a El Mundo study, property prices in many coastal areas have already fallen by 30–50%.
Spain is also grappling with the problems faced by banks that record non-performing assets on their balance sheets at the value of the outstanding debts (payment in kind). However, when a property development ends up in the bank’s hands, the bank has, in effect, purchased those properties for the value of the debt. They have turned a non-performing loan into an asset they own. And despite being the owner, the bank is unable to sell the property and will, in all likelihood, continue to carry that debt for the «price paid» on its own balance sheet for many years to come. Banks have no experience as property developers or builders, and are creating problems for themselves which they are forced to mitigate by pushing accounting practices to the limit. As an alternative, they are bundling these properties at a discount and selling them to associates and holding companies, which they finance indefinitely (roll over) through virtual mortgages until the latter manage to sell them, as we can read in Surveyspain.com.
3) Debt roll-over for zombie companies
In recent weeks, we have seen many estate agents and property developers announce that they have refinanced their debts, which allows them to stave off bankruptcy for a while. Realia announced this recently, and Aisa, Afirma, Royal Urbis and Renta Corporación did so earlier. Following the collapse of Colonial and Martinsa Fadesa in 2008, bank share prices plummeted, and very few bank executives are willing to see that happen again.
These loans to ‘zombie’ property developers merely postpone the moment of reckoning.
The Spanish banking sector has realised that pushing property developers or construction firms – which are unable to renegotiate their debts or sell their properties – into insolvency is not in the interests of either those companies or the banks themselves. They are now trying to give these companies as much breathing space as possible so that they do not have to report losses that are excessively threatening to their survival. In the words of one banker himself insider on Cotizalia:
When a small business owner defaults on their payments – even if they have been a good customer for many years – it’s like a «every man for himself» situation, with everyone shunning them as if they had the plague. But in the case of large property developers or builders, as the bank has had enough of taking on assets, it grants them lines of credit so that they can at least continue to pay the interest on their huge debts, thereby giving them a reprieve for a couple of years whilst they wait for the miracle that will enable them to repay their mortgages.
The banks« willingness to give developers free rein is nothing new. As they say in the banking sector: »If you owe me a million, you’ve got a problem. But if you owe me a billion, I’ve got the problem.’
4) Renegotiating 40-year mortgages at 100% of the initial value and other practices typical of a property bubble.
Spanish banks are the largest holders of property in Spain. They have acquired properties in various ways. To avoid the effects of the property crash, Spanish banks have been buying properties before the mortgages went into default, and are trying to offload them through their own property companies. They have also acquired tens of thousands of homes through debt-for-asset swaps. Estimates suggest that the value of properties repossessed by Spanish banks through foreclosure or payment in kind exceeds €16,000 million.
The Spanish banking sector has created websites to clear their stock. The favourable terms include: price discounts of 25–50%, interest rates at Euribor +0%, repayment terms of up to 40 years and guarantees of future repurchase.
Loans to Spanish property developers have been formalised through agreements between the banks and the Spanish Association of Property Developers and Builders (APCE). Banks will provide 100% mortgages over 40 years for all properties on which the developer offers a 20% discount. The buyer will not be required to pay any deposit. Santander and La Caixa signed that agreement with the PACE in a desperate attempt to reduce its stock. And that is another indirect way of providing credit to zombie developers.