January 18, 2011
Shaky Foundations: Government and Bank Indebtedness in Spain
Shaky Foundations: Government and Bank Indebtedness in Spain
| Jan 18, 2011
The potential cost of bailing out Spain is one of the main causes of anxiety about the euro's survival. Government debt levels are not terribly high. But there is a substantial contingent liability in the banking sector and the fallout from a collapsing property price and lending bubble has yet to be fully felt.
Spain's government is not as indebted or as profligate as Greece, nor are its banks as troubled as those in Ireland, but uniquely, it shares the problem of each country. Spreads of Spanish government debt have risen inexorably over the last year as investors worry not only about the ability of the Spanish government to reduce its budget deficit and to obtain funding, but also about the cost of further support for the country's savings banks (cajas de ahorro). As has been the case elsewhere, vehement denials of vulnerability only serve to increase investors' anxiety. (Exhibit 1)
The central government's debt burden is low compared to the rest of Europe at around 50% of GDP versus over 70% for Germany and France and more than 100% in Italy. The budget deficit for 2009 was 11% of GDP, but prior to the crisis it had been in surplus for several years. Since much of the revenue in earlier years was thanks to the booming housing and construction industries it is doubtful that tax receipts will be equally strong from now on. The central government is only part of the picture, however. The regions of Spain have a high degree of fiscal autonomy and account for half of public sector spending. Still, the most recent government reports suggest that the regions are on target to reduce their budget deficits in 2010.
The biggest worry is the financial sector and the cost of recapitalization of the banks if real estate and housing loans continue to sour. Spain experienced one of the largest property bubbles in the developed world over the last decade. Low interest rates following the introduction of the euro helped fuel a boom in house prices, which increased 2.8 times from 1999 to 2010. The U.S. increase was just over two times.
It is important to realise that an increase in property values does not by itself signal a bubble. If the broad economy is expanding vigorously, the increase in the price of land and buildings could simply be reflecting this growth in GDP. In Japan from 1955 to 1973, land prices increased by 13 times, but so did GDP so the ratio of the two stayed roughly in line. During the subsequent bubble, though, land prices went up a further 600% whereas GDP expanded by just under 300%, leading to the famous situation where the land under Japan's Imperial Palace was worth more than the entire state of California. Twenty years later, land values are still declining. In Spain's case, property values similarly increased much faster than GDP. As Exhibit 2 illustrates, the ratio of household real estate wealth relative to GDP rose just as far as it did in Japan during its boom, and further even than in the U.S. or Ireland. And whereas levels have already declined markedly in the U.S., there has been little adjustment in Spain.1
How much will you give me…?
Since the peak in Spanish house prices in early 2008, most indices show a fall of around 12%, compared to a 30% drop in the U.S. There are numerous doubts, however, about the accuracy of these figures. Anecdotal evidence from Spanish real estate agents suggests prices are down perhaps as much as 30% to 40%. The explanation for the discrepancy is that the published indices are based on appraised values and not on sales. Since appraisals reflect asking prices and sales are slow, the asking price likely does not reflect a home's true market value. Consequently, it is difficult for investors to estimate the true state of the market and they are therefore reluctant to invest in it.
Unreliable house price indices also call into question the value of mortgage assets on banks' balance sheets and whether reserves and write-offs are sufficient. Profitability for both the banks and cajas de ahorro has remained strong. Though they have declined from the peak of 2007, this year's results are on par with those of 2005. But if bank reserves and write-offs are understated, this apparent robustness is unlikely to last.
Given the economic challenges facing the country, we expect that delinquencies will rise significantly. The Spanish economy is expected to expand by just 0.6% next year versus 2.6% for the U.S. (in 2010 Spanish growth is forecasted to be 0.3% compared to 2.8% for the U.S. according to estimates compiled by Bloomberg); official unemployment is twice that in the U.S., yet delinquencies have trailed those in America (Exhibit 3). One reason for this is that mortgages are unsecured in the U.S. whereas homeowners are personally liable for them in Spain, increasing the incentive for the borrower to continue paying on the mortgage even if they no longer own the property. We nonetheless anticipate that Spanish homeowners will find it increasingly difficult to stay current on their loans. More importantly, property developers are likely to be forced to either default or restructure their loans as they are unable to sell their properties at the prices they had initially hoped for, if at all. Of total real estate lending in Spain, over 40% was for construction and property development.
If delinquencies rise, leading to further losses on property lending, have Spain's banks reserved enough against these anticipated losses? The evidence suggests not. The banks and cajas currently have loan loss reserves for their real estate portfolios of 2.7%, up from a range of 0.3% to 0.9% during the beginning of the decade. While this is a significant increase over historical levels, the main mortgage lenders in the U.S. have reserves over 4%, and they surpass 7% for secondary mortgages that might be comparable in risk to the property developers.
The low level of Spanish bank reserves seems inadequate given the increase in doubtful loans already realized and against the level they are likely to reach as prices fall further and banks are forced to recognize the true value of their portfolios. Over the last two years write-offs have been fairly stable at roughly €8 billion to €12 billion per quarter even while doubtful loans have soared. Following the peak of prices in the U.S., cumulative write offs of just single family residential mortgages totaled $113 billion out of a portfolio that peaked in value at $2.1 trillion, for a loss rate of 5.3%. Spain's experience so far has seen write offs reach €45 billion out of a lending portfolio of €1 trillion for a loss rate of 4.2%. But given that property prices in Spain increased by over 30% more than in the U.S. and have only fallen by 12% so far, and that lending to property developers is less secure than primary mortgage loans, we believe this loss rate will increase and that the cajas in particular have inadequate reserves. In fact, while loan loss reserves at the banks have continued to increase against future losses, the cajas have seen reserves fall by 8% since the end of March; caja reserves are now smaller than those at the banks even though total real estate lending by the cajas is €133 billion greater.
To the rescue
The government's Fund for Orderly Bank Restructuring (FROB) has recourse to up to €90 billion, which is intended to promote consolidation in the sector and to help shore up balance sheets if losses overwhelm the cajas' ability to absorb them. The question is whether or not this fund is large enough. Given that €45 billion has already been written off by both the banks and the cajas, following a negligible fall in prices, it is not difficult to imagine a steeper decline leading to much more substantial losses. The amount that might be needed is difficult to estimate because the cajas are not publically traded and hence there is little information available about individual cajas' finances, though there have been hints that the government may try to increase disclosure. Several investment banks have nonetheless made attempts to estimate potential losses. One bank, UBS, put the amount of capital needed to adequately strengthen capital at €70 billion to €120 billion.
It is this combination of inadequate information and potentially large shortfalls that has made markets so sceptical towards Spain's ability to ride out the crisis. We believe the time has passed where investors are willing to accept on faith the protestations of fiscal probity by governments. We believe only disclosure from the government about the true state of the cajas' financing, and a realistic assessment of property values across the country, are likely to restore confidence in the government's ability to manage the crisis. Assuming, that is, that the new information does not simply confirm the market's worst fears. In the meantime, confidence in the euro is likely to remain shaky while investors await the denouement of the broader crisis: either closer fiscal union or breakup of the eurozone.
¹ Note that it is the change in the ratio of real estate values to GDP that is comparable across the different countries, not the ratio itself, as the numerator is not identical across the countries.
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