Here’s a somewhat scary view on Spain that came this week from alternative economic research house Variant Perception.
The top line: that Spain is now the hole in Europe’s balance sheet, and that misunderstanding the severity of the crisis will prove costly to investors as it could have profound implications for the European banking system. As it explains:
Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the US, even though the US is about six times bigger. Spain is roughly 10% of the EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU. Most of the new homes were financed with capital from abroad, so Spain’s housing crisis is closely tied in with a financing crisis.
The impact on the banking sector will be severe. Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That’s almost 50% of Spanish GDP. Most of these loans will go bad.
Spanish banks, in our view, are now facing a very bleak outlook. Spain’s unemployment rate reached over 17%; there are now four million unemployed Spaniards and over one million families with not a single person employed in the family.
We argue and will document anecdotally in this report that:
• The real estate crash in Spain is worse than is widely believed, much as the subprime problem was much worse than people believed
• Spanish banks are hiding their losses and rolling over debt to zombie companies, much as Japan did in the last decade
• Investors are deluding themselves if they believe that Spanish banks are among the strongest in the world. (This is a new theme. See Forbes’s latest “Spanish Banks In Top Form” for an example of the new fawning articles on Spanish banks.)
If we are right, Spain will soon have zombie banks like Japan and it will face a prolonged period of deflation. However, Spain will be much worse.
According to Variant, Spain’s situation is now pretty reminiscent of the early days of subprime when all the banking results still looked good, until suddenly they didn’t.
But before you can understand the weakness in the system, you have to understand the counter argument — ie, the idea that Spanish banks are among the strongest in Europe. This is based on the idea of “dynamic provisioning” according to Variant, legislation that forced banks to build up reserves against future losses, and prudent lending practice by the large private Spanish banks but which left lending to developers and buyers of second homes to the smaller regional Cajas banks.
The problem, though, is one of magnitude, which is bound to overwhelm even the benefits of dynamic provisioning in the end. As Variant notes:
Spain’s building stocks bubble looks very much like the US bubble and other classic bubbles. It went up 10x and then went down 90%. The math is very simple.
Yet the picture above is not echoed by Spanish house prices, which are down little more than 10 per cent from their peaks:
So how can you explain the mismatch? Well, according to Variant, a lot of it comes down to plain old smoke-and-mirrors. As it says:
We believe that Spanish banks are hiding their problems. We explore how they are doing this through:
1) Getting a boost from accounting changes
2) Not marking loans to market
3) Continued lending to zombie companies
4) Making 40 year and 100% loan-to-value loans
All these are good points.
On the first issue, it is absolutely true that the Bank of Spain has now moved to relax its provisioning rules. So whereas previously banks made provision for the full value of loans above 80 per cent LTVs after two years of payment arrears, they now only need to reserve for the difference between the value of the loan and 70 per cent of the property’s market value. Variant says that for many Spanish banks, this has allowed them not to lose money this year.
In April, meanwhile, Spain’s Expansion reported that Spanish banks control 25 per cent of appraisals directly and another 25 per cent indirectly through their shareholdings. Which means they are mostly in charge of valuing the assets themselves. As Expansion reported:
This situation has placed the focus once again on the links between banks and the real estate appraisers that goes beyond in many cases a mere commercial relationship.
Which means official housing statistics are not often corroborated by anecdotal evidence, which suggest prices have already dropped between 30-50 per cent in some coastal regions.
And even if the Spanish banks came into the crisis with prudent practices, these, notes Variant, may now be changing quickly:
Spanish banks are now the largest real estate holders in Spain. They have come to own properties through many different avenues. In order to hide from the effects of the real estate crash, Spanish banks have been buying properties before the loans on them go bad and trying to dispose of them through their own real estate companies. They have also come to own dozens of thousands of homes through debt for equity swaps. Estimates put the value of property repossessed or swapped for debt by Spanish banks at about €16 billion. Consider the following: Spanish banks are now running their own real estate companies and have websites set up to move their stock. Among selling points are: pricing discounts of 25-50%, financial terms of Euribor plus 0% over 40 years, and guarantees to re-purchase the property in the future.
You can view Variant Perception’s rather impressive evidence for the above as well as the full report here.