June 6, 2012

How the Property Bubble Crushed Spain

By Anthony Harrington via QFinance

Spain is following Ireland in giving a graphic demonstration of just how difficult it is to recover from the bursting of a major property bubble. As Greece edges ever closer to a messy exit from the eurozone, the attention of the markets is moving ever more to the Spanish government's frantic efforts to shore up its tottering banks.

In an excellent recent briefing paper on Spain's debt position, Raoul Ruparel, Head of Economic Research at Open Europe, the European think tank body, argues that it is now doubtful that the Spanish economy can survive without external help.

"One in five loans to the real estate and construction sectors held by Spanish banks is now potentially toxic, a situation which could explode if house prices continue to drop," Ruparel says.

He gives the Spanish government plenty of credit for the structural reforms it has managed to put in place so far, but argues that Spain's labour market in particular, needs to be fundamentally reformed before Spain can be confident of having a future inside the eurozone.

The key facts that emerge from Ruparel's paper, entitled "Not so bullish now? The short term prospects for Spain inside the euro" (published April 2012) is that some 80 billion euros worth of loans by Spanish banks to the country's completely broken construction and real estate sectors are now considered near worthless, being at serious risk of default. The banks only hold some 50 billion euros in reserves which could be set against those losses. Moreover rapidly falling house prices which experts think could still fall another 35%, will further erode bank revenues and push up bad debt provisioning as more and more households default on their bank based mortgages. House prices in Spain fell by 11.2% through 2011 and Ruparel argues that as with Ireland, there could be another 35% drop in property values to come . Since the €80 billion in doubtful loans originates with a 20% fall in real estate prices a 35% fall is likely to be catastrophic for Spanish banks.

He cites the Spanish Ministry for Housing as saying that there were approximately a million unsold houses in Spain in 2009 and as credit dries up, so the number of people able to afford homes shrinks. Mark-to-market values are also plummeting across the Eurozone and they will further shrink the value of the property portfolios being held by Spanish banks, particularly by the Casas, or smaller regional banks.

Since most of the Spanish government's debt raising at present comes directly from Spanish banks buying Spanish government bonds, a bankrupt banking sector would mean that there would be virtually no takers for Spanish Government debt, except at absolutely penal interest rates. Yet the onus would be on the Spanish government to bail out its banking sector. If this sounds worryingly like the last act of a Ponzi scheme, it's probably because it is. Ruparel argues that any failure of the Spanish banks would create a highly damaging environment for Spanish debt, leading to a bond run on Spanish debt, which in turn would push the whole country into a full bailout. There is no way The Spanish Government could fund this, so Spain would have to turn to the EU's bailout mechanism, the ESM.

ECB President Mario Draghi staved off the day of reckoning for Spanish banks through the ECB's Long term refinancing operation (LTRO), which gave Europe's banks cheap long term funding. The first LTRO operation began in late 2011 and put some US$500 billion worth of euros into European bank coffers, at a rate of just 1%, year on year, for three years. At the end of February 2012, the ECB went in for a second round of LTRO, with some 800 European banks tapping the ECB for a total of 530 billion euros, putting the total LTRO programme slightly north of $1 trillion. Draghi wants banks to use LTRO funds to improve their lending to households and businesses, which, the ECB hopes, will stimulate growth in the region.

In his latest "Economic Musings" blog, David Schawel, an ex investment banker, makes the excellent point that although Spain's citizens are deleveraging and saving, their savings are, by and large, not staying put as deposits in Spanish banks. Instead, Spanish capital is fleeing to Germany. This is pushing up Spanish yields and is pushing down German bond prices. At the same time, if Greece exits the euro and returns to the Drachma anyone with euros in a Greek bank will have them exchanged for Drachma and will lose possibly some 70% of their value overnight. Faced with this, if the Greek population gets any advance warning (more than they are already getting with the writing being on the wall, as it were), they will shift their euros north on the spot.

So one can expect a Greek default to happen suddenly, and to be kept as secret as possible by the Greek authorities until the moment it happens. Schawel points out that Argentina makes an interesting parallel case. When Argentina threw out the dollar peg it did so overnight and most people did not get the chance to ship their pesos out the country. However, Schawel argues that with all the advance warning that citizens in the European peripheral states have had, any state defaulting now will have to have troops on the border between the country concerned and the rest of Europe to stop cash travelling out the country in car boots and suitcases - "Otherwise you are going to lose half the value (of your deposits) the day that the rest of the PIGS do a 'Greece'."

Will Spain eventually be forced to go down that road? According to Ruparel, there are still steps the Spanish government could take to stop its slide into default. It should begin by doubling provisions against doubtful loans to 100 billion euros, and use stress tests to improve market confidence in the robustness of Spanish banks. And it should accept that it might need to go to the ESM for help in bailing out its banks in order to avoid the need for a full (and largely unfundable) bailout for Spain itself.

Courtesy Anthony Harrington via QFINANCE (EconMatters author archive here)


The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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