Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 15 February 2012

Spanish Banking System's True Real Estate Exposure


I was sent an interesting presentation made by the Spanish Ministry of Economy and Competitiveness.

The first thing that caught my eye was their proposed solution for the financial sector. The gist was “Don’t worry, we know the problem and we have the solution.” However rather than feeling reassured and calling my broker to buy Spanish bonds on margin, I sold some more Euros.

The first point itself raises an alarm. It is the definition of the problem facing banks. After a huge house price boom and a half-hearted bust (The Economist’s house price indicator graph is very informative – in Q3 2011, Spanish house prices were still ~140% of Q1 2003 compared to flat in US and 90% in Ireland) the Ministry defines the problem as being only loans to developers. This is disingenuous given that total real estate exposure of the Spanish banking system is roughly €1trn (€383bn to developers and approximately €600bn in residential real estate). 

This blinkered view seems to be the official line. Even Banco De Espana (Spanish Central Bank) dismisses residential real estate lending to households as not posing a problem to banks. The ostensible reasons being a historically low default rate and a low average loan to value of 62%. The former reminds me of the ‘never an annual house price decline’ assumption in US house pricing models. The latter however, is a stronger data point to refute. Let us analyse if it can indeed support the hypothesis that Spanish officials are making.

An eventual house price decline similar to Ireland or US will cause the loan to market value (LTMV) to soar to 100%. Even though Spanish borrowers can’t walk away like negative equity borrowers in the US, inability to pay mortgage installments leads to foreclosures irrespective of the total amount of loan, LTV or LTMV. With unemployment at 22.83%, the stress on borrowers and inability to pay is rising. This is seen in the low (for now) but rising bad loan data. Moreover, an LTMV of 100% means that for every foreclosed home the bank just about recoups its principal if lucky (usually the bank makes a loss given foreclosure costs). Therefore the only way in which residential real estate lending can be ignored is if the Spanish housing market is expected to turn around in the near future due to fresh demand. Unfortunately this is a little too optimistic. On the supply side, the boom has left a glut of properties which would take years to clear. And on the demand side, marginal demand is likely to be low given the high percentage of home ownership in Spain (¬80%). In addition, youth unemployment at ~50% implies that contribution to domestic marginal demand from first-time buyers is probably non existent. Foreign demand might provide some solace but it is unlikely to be significant enough to make a dent in the existing unsold inventory (IMF July 2011 report estimated that it will take four years to clear).

Therefore the Spanish banking sector has to be assessed on the basis of a ~€1trn exposure to real estate not €383bn. Of course, residential real estate loans should outperform loans to developers but it doesn't mean that losses will be contained. It is understandable that Spanish officials try and paint a positive picture to jittery markets but hopefully they don't actually believe what they're spinning.

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