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Saturday, February 23, 2008

Spain's Balance of Payments, Bank Funding and Covered Bonds

This post constitutes a first attempt at making an assessment of the extent of the damage which has been sustained by the Spanish economy as a result of the global credit crunch.

The first thing to get clear (and very clear) in our heads at the present moment is that the economic correction which is currently taking place in Spain is very unusual one in terms of what we have become accustomed to in developed economies in modern times, since the transmission mechanism for Spain's problems does not run from a problem arising in the real economy (a correction in house prices for example), nor does it run from an attempt by a central bank to "burst" some sort of perceived asset bubble or other (Trichet and the ECB's tightening of interest rates), but rather the mechanism operates via a direct blow-out in the cylinder head gasket of the global financial system, a blow out which has produced an immediate and direct change in global credit and lending conditions, and in the level of risk appetite which prevails in the securitised morgatges/covered bonds sector of the wholesale money markets, and it is this change which is now making its impact felt on the real economy in Spain, with the actual and present danger that these negative consequences for the real economy may then be fed back into the financial sector, in the process creating some kind of ongoing lose-lose dynamic.

As I say, such a phenomenon is certainly unusual in a modern European context, although some may wish to point to parallels with what happened in Japan in the early 1990s, and the subsequent "lost decade". I wouldn't go so far at this point as to suggest that Spain is facing a lost decade, although the situation is very very serious (as I hope to show in the charts that follow), and at the very least Spain now faces several "lost years" and a massive macroeconomic structural adjustment.

Now a quick browse through the back posts on this blog should give any interested reader a reasonable resume of the current state of Spain's key macro economic indicators, and so I am not going to dwell on this part here. There are approximately 500,000 unsold homes standing on someones books in Spain, and the Spanish banks now attend the weekly liquidity auctions at the ECB to raise some 48 billion euros of funding (a figure which is double the 24 billion euro number they needed before the summer).

However, as Jean Cluade Trichet points out, "there is no question that the Spanish - or any other - banks are being bailed out" at this point. This, like so many of Trichet's statements is entirely true. But it is not the whole truth. That is, there is a bigger picture. And herein lies the problem.

It is, for example, also true that the ECB has not changed its rules to accept mortgage backed securities (like the US Fed had to under pressure last August), but this apparent constancy in rules also stands alongside the fact that a banking system which didn't need much recourse to the facility in question has now doubled its use of it, and in a very short space of time.

It is also true that Spanish banks were not allowed by the Bank of Spain to set up special purpose vehicles to finance their lending, but again, they set up the cedulas hipotecarias to find another way to do something which, at the end of the day, is not that disimmilar. The argument against SIVs is that off balance sheet lending is likely to be more risky, but in a certain sense (and as I try to argue and explain in my post here on the cedulas system) the cajas regionales have played the role of off balance sheet entities for the principal banks, and since we still don't know how far down the value of the entire Spanish mortgage pool is going to fall, we have no way at this point of making a valid assessment of the level of risk that has been actually taken on board.

It is also the case that the level of mortgage defaults in Spain is at this point comparatively small, but then again the whole process is only just starting, so it is far to early to say at this point whether or not cover will prove adequate in the longer term, but then again, the problem for the Spanish banking system may not originate in defaults in the first place, but rather from a perceived rise in their risk level if the value of the entire pool of mortgages on their books declines significantly.

Spain's External Balances

My main point of focus here is going to be on Spain's external imbalances. Essentially Spain has been living on a large external trade deficit in recent years. This deficit has produced a continuing deficit in the current account, and this deficit has effectively been balanced by attracting the funds from outside Spain to finance mortgage lending in the recent Spanish construction boom. It is this nexus of relations that I think it is necessary to have clear, otherwise the greater part of what now happens next will catch you completely unawares.

Now as I keep pointing out, another of the very specific characteristics of the way in which the property boom was financed here was the ability of the Spanish banking system to provide very low interest (variable) rate mortgages. Curiously, many commentators imagined that this (variable) component was the greatest rsik element in Spain. That is, they imagined that it was Spain's mortgage borrowers who were assuming the greatest part of the risk here. They were wrong. The risk at present has almost all been inadvertently assumed by Spain's banking system, and this decidedly odd situation has arisen (I'm sure this was never the intention) due to the recourse of Spain's banks to the widespreased use of securitised (or covered) bonds - the so called cedulas - and the provision of variable mortgages at very narrow margins (lets say around 0.75% or 1% over 1 year euribor). Now the banking system considered they were onto a sound bet here, since they in there turn could borrow (thanks to the investment AAA grade assigned to these bonds, making them virtually equivalent to government paper)at very fourable rates themselves (normally three month euribor), so they thought they were on a very safe bet. Again they were wrong, since it is just this very global repricing of risk appetite I mentioned earlier, and the reassessment of the AAA rating which was assigned to their mortgage bonds which goes with it, which has produced the problem.

Oh, yes, and there's a third little detail which makes all of this just that little bit worse. The different term structures of the lending and the borrowing. Basically the Spanish banks, and especially here the regional cajas who undoubtedly have the lions share of the problem, borrowed short and lent long. The majority of the mortgages issued between 2000 and 2007 were for between 20 and 30 years. Indeed during the last two years of the boom it even became fashionable to offer mortgages over 50 years, so sure did the banks feel of themselves.

But they borrowed short. Not the very short liquidity type borrowing we are increasingly seeing Spanish banks resorting to at the ECBs weekly money auctions, but rather the lions share of the borrowing, which was done using cedulas, and normally over a ten year term. That is to say, that while the vast majority of the mortgages issued will still be outsanding come 2025, almost all of the bonds which go with them will need to be refinanced, between 2012 and 2017. And here is where we hit the snag, since the money markets which the Spanish banks need to do the refinancing are currently closed to them. These money markets can of course be reopened, but at a price (ie the price of a risk premium), and that is really the bigger half of the snag, since the debtors are on "variable" mortgages which are effectively fixed (at 1 year euribor plus something, euribor can of course go up, but it can also go down, as I think we are about to see in the next moves at the ECB), so the borrowers, it turns out, really do have a yardstick that lets them know what they are into. This is not the case with the lenders though, since while we do not know what eventual risk premium will be built in to fund Spanish banks (this in part depends on how far and how fast property prices fall, and how much difficulty they have maintaining their mortgage pools), we do know that the euribor 3 month days are over, and we could even contemplate the possibility that if bad goes to worse, and even worse, and then worse again, then they could be asked to pay even more than they are recieving from their mortgage paying clients!

And the amounts of money are not small. One good recent estimate put the total quantity the banks will need to "roll over" in the space of about 5 years at some 300thousand million euros.

OK. Now lets look at some charts. First off we could take a look at the level of incoming bond purchasing funds into Spain over the last several years (thanks to the monthly balance of payments data made available by the Bank of Spain).

Now as we can see on a rough and ready basis the bonds boom really took off sometime in 2002, and it came to a sharp and rather unfortunate end in the middle of 2007 (I would say on or around the 9 August). In any event the height of the boom was in 2005, 2006 and the first half of 2007. Now before going any further with my line of argument, lets just look at one more piece of rather important evidence, the refi interest rate set by the ECB (and which of course regulated 1 year euribor) and the rate of inflation in Spain.

And as we can see here, the take of date for the bonds boom is hardly coincidental, since it more or less coincides with the arrival over a sustained period of time of negative interest rates in Spain, a fact which to a large extent explains the intensity of the housing boom, since under these conditions borrowing money does not seem especially onerous, and indeed it might even be considered illogical not to do so. Certainly Spain's very low level of personal savings in recent years can only be properly understood in these terms.

Now if we return to the task in hand, lets take a close-up look at the most recent years for those bond inflows.

As we can see, the last few months is not the first time that these flows have "wobbled", but this time the wobble is much more sustained and, since the wholesale money markets are at this point effectively closed to the Spanish banks to raise money in this way, there are good reasons for imagining that this time the change will be a more permanent one.

Now, why, apart from the implications for the banking system, is all this so important for Spain? Well lets now take a look at another chart, the one for the current account deficit. And as we can see, the growing consumer boom associated with the construction one had a long term and pretty disastrous impact on Spain's trade balance (and in particular its energy component, all those extra houses use energy remember). And this deterioration in the external trade position has remained, and arguably even gotten slightly worse, even as the economy has started to slow down.

Now normally this deficit has been offset by the sum total balance of funds coming in as part of the financial account, but as we can see in the chart below this has also dropped off somewhat since August last year.

The consequence of this is that Spain's banks are increasingly having to find the money via the eurosystem to make the books balance, and this is basically the significance of that increase in borrowing that the Spanish banks have had to undertake at the weekly ECB auctions (referred to in this post - also please note that I have changed this post at this point thanks to some clarification from a knowledgeable commenter, see comments). If we look at the chart below, which shows the net asset and liability position of the Spanish banks vis-a-vis the eurosystem, those months when the bars are above the zero line indicate there has been an increase in the amount of money borrowed by the Spanish banks from the eurosystem (presumeably largely or exclusively at the ECB weekly auctions), and this money is essentially needed to settle the monthly deficit in the balance of payments account. As we can see, prior to August 2007 these quantities showed no particular trend, but since August, and for every month for which we have data, the Spanish banks have needed to raise additional money at the ECB. This is really a direct result of the fact that the banks have been unable to sell their cedulas for cash in the global markets. What the Spanish banking system lacks right now is a way to generate cash on a stable basis to meet the needs of the current account deficit.

And cash may well not be that easy to find since, while money may be attracted by offering higher interest rates, it is not clear what the funds would be needed or used for (rolling over existing liabilities should be more or less neautral here) and the rate of increase in bank lending has been slowing steadily all through 2007.

A country with a large and sustained current account deficit - as we can see in the case of the United States - can do one of two things. It can tighten money and credit conditions in order to try and use an indirect method to slow internal demand, or it can allow the value of the currency to slide (as we have seen with the dollar) in an attempt to reduce the deficit. Well Spain has no autoctonous currency to let slide, so the only real alternative is to squeeze internal lending to try and reduce the deficit, and in the meantime lean on the ECB for money. The contraction in lending needed to reduce a deficit of this magnitude might be very large indeed, and the consequences for the real economy would be substantial, so it is to be anticipated that in the short term some other alternatives will be sought. However it is interesting to note that in December 2007 the month on month increase in lending came to almost a dead stop. At this point it is too early to know exactly what significance to attach to this. But clearly the position does need watching carefully.

Basically this kind of sudden stop in lending, coupled with a growing sense of systemic crisis in the banks would be the worst of all worlds. To be monitored.

Monday, February 18, 2008

The Spanish Banks' War Chest

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.

Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.

During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?


Commenter Geert sent me a question which possibly reflects some of the difficulties people may be having with this post.

"I must confess that I don't really fully understand this post."

Since I have tried to answer him at length, I though it might be useful if I reproduced my explanation above the fold.

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think, though, that to get the background here you need to go through the posts on the whole blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

Thursday, February 14, 2008

Spain Preliminary GDP Q4 2007

Well, blow me down! Spanish GDP growth apparently accelerated in the last quarter of last year, with the quarter on quarter rate increasing very slightly from 0.8% in Q3 (over Q2) to 0.9% in Q4 over Q3 according to data released by the Instituto Nacional de Estadistica earlier today. The year on year growth rate was still 3.5%. This means something somewhere is resisting the slowdown. Since most of the indicators have been pointing to red during the quarter, and since we have elections coming in March one good guess is an increase in public spending (and I'm not suggesting there is anything improper in that, since this is how fiscal policy should be used, countercyclically). Another possibility, since Spain runs a systematic trade deficit, is that imports slowed on the back of slowing domestic demand, and in this way the trade deficit reduced somewhat, thus constituting less of a drag on GDP. Also construction is still working reasonably steadily at this point - which is why all those unsold houses are accumulating - since builders are still completing houses which were contracted before the August credit crunch, and it is important to notice that Spain is working to some extent back-to-front with the US promlem, since the difficulties really appeared in the financial sector first, and they are only now spreading to the real economy, starting with construction. But all of this at this stage is simply idle guessing, and we won't really know anything for sure till we get the detailed data from the INE on 20th February.

According to the quarterly GDP advance estimate, during the fourth quarter of 2007, the Gross Domestic Product (GDP) generated by the Spanish economy registered a real growth rate of 3.5%, as compared to the same period of the previous year. In this way, the Spanish economy slowed its rate of progress by three points, as a result of a slow-down in national demand, which was partially compensated by the less negative contribution of the foreign sector. Moreover, the quarter-on-quarter GDP growth rate stood at 0.8%, one tenth more than in the previous quarter. By temporary aggregation of the four quarters, real growth of GDP for the entirç year 2007 was estimated at 3.8%, one tenth less than in 2006.

But as I say, all the dials ARE steadily moving over to red in Spain now, and as if to make the point Eurostat yesterday published the December industrial output figures, which show that there is now a significant and steady slowdown taking place.

And indeed, on a month on month basis we had contraction in industrial output in both November and December. Add to this the fact that retail sales also contracted in both the same months and it isn't hard to see that there isn't a exactly a lot of life in the Spanish economy at this point, despite the apparent "acceleration".

Monday, February 11, 2008

Are Spain's Banks Likely To Be Spared Global Financial Pain?

So are Spains banks likely to escape the pain associated with the global financial turmoil? Well the Financial Times' Gillian Tett obviously thinks they are, and she has been argueing her case in two interesting and valuable pieces in the Financial Times - "Spanish banks spared huge writedowns" (Feb4 2008), and "Why the pain in Spain has mainly been contained" (Feb1 2008). In support of her Tett makes the important and valid point that:

"In the past few years, the Bank of Spain, which acts as financial regulator, has prevented banks from holding any kind of special purpose vehicles off balance sheet."

But could it be that in the Spanish case the financial pain, likely the proverbial rain, falls mainly in the plane? Namely, and as I try to explore in this post, could it be that the large Spanish banks have largely weathered (and may well continue to weather) the storm that is brewing in Spain's troubled domestic mortgage market due to the fact that they stayed to some considerable extent on the sidelines in the massive cedula hipotecaria (covered bond) boom market, leaving most of the risk - and comparatively little of the return - to be shouldered by the smaller players, like the regional cajas.

Certainly I would argue that the little model which I present in the diagram in the above linked post of mine probably has some sort of general validity, and may help us to see how things will pan out here.

The argument Tett advances, which is pretty much common currency here in Spain at the present moment is technically correct:

When the subprime crisis exploded in the US last year, a majority of analysts predicted the contagion would soon spread to Spain. Spain, like the US, had an overheated housing market and banks that had lent freely into the construction boom. Six months on, part of this prediction has played out, in the sense that Iberian banks are suffering from the effects of the liquidity squeeze, like the rest of the global banking system. However, many analysts have been surprised to discover that Spain’s financial groups have had no exposure to the kind of mortgage-linked investment vehicles that have wreaked so much havoc in the US and Europe.

It is technically correct in that while the Spanish banks are - as she admits - experiencing liquidity problems, these problems are not essentially connected to the subprime problem in the US, but they are connected with the ensuing credit crunch which has followed in its wake, as I explain here. Indeed Tett also accepts this:

Spanish lenders are now furtively turning their mortgage loans into privately placed bonds to use these as collateral to get access to liquidity from the European Central Bank. Meanwhile, the cost of buying insurance against default for medium Spanish lenders, via the credit default swap market, has recently soared, amid rumours that hedge funds can smell blood.

So not everything in the garden is completely rosy. The Spanish financial sector is essentially having to swallow its own bonds in order to be able to raise day to day liquidity at the ECB, and there is a huge problem looming after 2010 as the 10 year term cedulas need to be rolled over. The problem has assumed a particularly acute form since noone at this point in time has any real ideal what the pool of properties which back Spanish covered bonds is going to be worth in both the near and the longer term future.

Gillian Tett notes that something is afoot in Spain:

Twice a year I travel down to Spain to visit my relatives - and almost always return feeling worried about financial risk. For nobody can fly over the Spanish coastline these days without noticing that the country has recently been in the grip of a construction boom. And that, unsurprisingly, has led to an explosion in the balance sheets of banks, with a corresponding boom in the Spanish residential mortgage bond securitisation (RMBS) market. It is a fair bet that this credit party will produce plenty of hangovers in the coming years. Indeed, where my relatives live in southern Spain, house prices are already tumbling and flats stand empty (albeit, on a scale that still looks modest compared with the subprime-scarred areas of Los Angeles, say.)

Well, Gillian, I don't know what you consider modest, but according to Leslie Crawford writing in the FT last week the IPE business school are suggesting that by March there may be 500,000 unsold homes in Spain - more or less one year's residential construction output at the old pace. And that was the old pace. If we assume that one of the impacts of the current correction may well be a slimming down of Spain's construction industry, then this may turn out to mean that we already have an inventory which is nearer to two years supply, and growing.

From here on in financial market calculations may well take the back seat while the real economy takes over. Most calculations of what we can expect going forward depend on what is going to happen to Spain's economy as a result of this correction, since that will be the factor which ultimately determines where Spanish housing prices finally settle, and since the correction has hardly begun let alone ended most calculations on this front should be treated with a very strong measure of caution.

One problem though is puzzling me, Spain's external deficit. Basically Spain runs a very large balance of trade deficit, and one of the principal factors sheilding Spain from difficulties on this front has been the steady inflow of funds associated with foreign investors purchasing the cedulas. These flows have now virtually stopped so the deficit will either have to be financed in some other way, or turned round. Both of these, given the magnitude of the issue, seem very complicated indeed. To give some idea what I am getting at, and on an off the top of my head basis, we could note that a large part of the trade deficit is to pay for oil and natural gas imports - all that central heating and air conditioning for all those extra houses - and that most of the money to pay for these imports has been indirectly borrowed via the mortgage demand from would be householders. It may even be the case that Spain has not yet paid for a drop (let alone a barrel) of all that oil which has been used since 2000. Whether or not this is exactly the case the problem clearly exists, and Spanish consumption is going to be reduced on an ongoing basis, and over a number of years, to pay down the accumulated debt, at just the same moment as Spain will have to reinvent a new driver for economic growth, since construction as the principal driver is clearly finished. In that sense comparisons with the United States may not be so far from the mark, and even more so, since proportionately Spain's boom has been much larger.

Thursday, February 07, 2008

Spain's Election Hubris

Leslie Crawford has a reasonably balanced contribution to an opinion editorial in the Financial Times today, where he raises the issue of the excessive optimism of the Spanish government in the face of the growing crisis here. As he notes ...."Only the government predicts Spain will grow by as much as 3.1 per cent in 2008." This view is evidently ridiculous, as far as I can see from the current data Spain may well have entered recession (being defined in this case as having the first of two consecutive quarters of negative economic growth) in Q1 2008. And even allowing for some sort of rebound later in the year annual GDP growth in 2008 is hardly going to be above the 0.5% - 1% range, and may well be lower. What is so striking about Spain at the present moment is the speed with which it is slowing, like an airplane that is losing velocity fast, as if someone punctured an air cushion.

Another interesting point contained in his piece is the estimate from the IPE business school that by March there may be 500,000 unsold homes in Spain - more or less one year's residential construction output at the old pace. This is going to need a long time to correct and work out of the system. Of course, Zapatero is right when he mentions that Spain is running a 2% of GDP fiscal surplus, and so fiscal policy is available to correct the problem to some extent. But as we have learnt in the previous case of Japan - which went into a major economic crisis in 1992 following a significant housing bust - this strategy can only be a short term holding operation, the Spanish economy needs to "reinvent itself" and quickly.

(of course, the other lesson we were supposed to have learned from the Japanese experience is that to prevent a country in this situation - where they may be a major and severe correction in housing prices, and a "wealth effect" motivated deflation in demand, is that a rapid and decisive loosening of monetary policy is called for to ward off the risk of price deflation - constinuing strong price inflation in Spain is very unlikely if we look at what is happening to domestic demand - but the ECB seems to be light years away from waking up to this danger at the present time. Of course, since what we have is inpart a credit crunch, even traditional monetary policy measures like lowering short term interest rates may have little effect, but that is no excuse for not doing so).

Since in terms of the demographics of the time and the general profile of the problem Japan 1992 and Spain today are so strikingly similar it is hard to resist the comparison (it may be the only relevant one we have to go by) and it is interesting to note that one of the first people to dismiss out of hand Dominique Strauss Kahn's recent proposal to have a concerted G7 fiscal response to the weakening in global demand was Fukushiro Nukaga, Japan's finance minister, who reportedly responded to the proposal by saying: "We have learned what such fiscal spending could mean from our experience after the burst of the bubble," referring to attempts to spend Japan out of recession and deflation in the 1990s. I think Spain's next government really needs to take note of this experience. Short term fiscal stimulus is fine, but you need to get to the root of the problem.

Crawford also points to the growing global presence and importance of Spain's major companies, and this is important, but as Japan has gradually learnt to its cost, in macroeconomic terms it is hard to substitute global corporate prowess for local domestic demand. Spain's economy has been largely driven by domestic consumption and increasing consumer credit in recent years. This is now done. Finished. The situation in this sense - if we look at the comparative demographics - is much more severe than in the United States. Worse, people are going to have to start paying back what they have borrowed, both individually and collectively. The recent boom was not financed by Spanish savings but by a steady and sustained inflow of funds made possible by the eurosystem. Some 60% of the investment which went to finance the Cedulas Hipotecarias came from outside Spain, and these capital flows now have to reverse to some extent. So all of this will be a negative are far as medium term consumption in Spain is concerned. Spain now needs to become an export driven economy, and this is a huge change, and is obviously going to need some years to achieve.

My only real doubts at the present time relate to what is actually going to happen to the immigrants and what will happen to inflation. Maintaining the roughly 5 million recent immigrants who currently live and work in Spain is important to the country's demographic future, given the long term very low fertility that the country has been experiencing. These "replacement migrants" make up for the missing births produced by the birth postponement process (as I explain here). So holding onto these migrants is going to be critical, if hard, since many will be without work in the not too distant future, and with little in the way of formal financial support from the Spanish authorities. Again, this is going to be another of the major items on the "to do" list of the incoming government.

Lastly inflation. Basically the accelerating inflation we are currently seeing is unsustainable in the light of the collapse in internal demand. So the process will reverse, indeed if it doesn't - and the euro stays near current levels - it is hard to see where Spain will get the competitivity from to begin the long march to an export driven nation. The German experience post the collapse of their 1995 construction boom might be instructive: ten years of almost constant wage deflation as relative prices come back into line. This may be hard to contemplate in Spain at this point, but my best guess is that this is where we are headed. Oil prices are unlikely to increase in 2008, and may well drop back if there is a significant decline in global demand - although even this isn't guaranteed, since whatever happens in the US and Europe some countries (like India) will keep growing, and they will be energy guzzlers. Also Spanish property and land prices may start to fall drastically at some point - looking at the one years supply of unsold homes (and remember this is one years supply at the old level, it may well be two years supply at the new one) - so a sharp correction downwards may well take place at some point as bankruptcies start to occur. If this were to happen, then rather than moderate but long term wage deflation, Spain might face outright and straightforwad price deflation, Japanese style. At this point it is too early to say, but this is the other factor to watch for as we move forward.

And now for Leslie Crawford:

Eurostat, the European Union’s data compiler, in December published a dry table that revealed a remarkable fact: Spaniards had become richer per head than Italians, writes Leslie Crawford.

Anyone who knew Spain in the 1970s – when it was a byword for backwardness and governed by an ageing dictator – can only marvel at its political and economic transformation. Along with Ireland, Spain has been one of the unequivocal success stories of the EU, which it joined in 1986. The new member states of central and eastern Europe regard Spain as their role model, for the skill with which it used EU funds to spearhead its development.

But never did Spaniards think they would one day overtake in terms of per capita income one of the founding members of the EU. José Luis Rodríguez Zapatero (pictured), the Spanish prime minister who faces a general election next month, boasts that overtaking France and even Germany by that measure is possible within five years.

Mr Zapatero’s grandstanding, however, has been obscured by doubts. The end of a 10-year housing boom, coupled with financial turmoil abroad, is leading Spaniards to question the foundations of their leap forward. The Spanish sorpasso took place just as the country’s growth was peaking. Might it prove as fleeting as Italy’s famous overtaking of the British economy in the 1980s?

Moreover, its economy is now big enough to affect Europe’s performance as a whole. “If residential construction in Spain contracts in 2008 as sharply as it did in the US in 2007, it could shave 0.2 percentage points off eurozone economic growth,” Holger Schmieding of Bank of America wrote in the Financial Times last month.

During the peak of the construction frenzy two years ago, economists described the Spanish economy as a “monoculture” of bricks and mortar and worried that there was nothing to take its place if the building boom came to an end. Construction employed 13 per cent of the workforce. The banking system channelled 60 per cent of all credit to housing-related activities.

Spain was building more homes than France, Germany and the Benelux countries combined. It was consuming half of all the cement in the Europe and it was borrowing massively abroad. Economists agreed that Spain’s credit-fuelled property boom accounted for most of the country’s growth differential with the EU.

The credit squeeze hit Spain at its most vulnerable point in the economic cycle, with an overpriced and oversupplied housing market and families and companies deep in debt. As a result, the country is on the brink of a property slump that will affect employment, consumer confidence, bank earnings and the economy as a whole, according to a number of recently published reports.

IPE, a business school that specialises in urban planning and property, estimates that there will be 500,000 unsold new homes by the end of March – roughly the number built in an average year. Given government forecasts that 500,000 more were to be built this year, the unsold stock is worrying. About half the country’s estate agents are already out of business, according to their trade association.

One consequence of the building slowdown is that unemployment has shot above the 2m mark. January’s 6 per cent increase in the number of unemployed was the highest monthly rise in 10 years. Immigrants and temporary workers are feeling the brunt of the cuts. The end of the property boom is also worrying for Spanish commercial and savings banks, which have €290bn ($425bn, £217bn) in outstanding loans to property developers and are trying to cut their exposure to the sector.

Not everyone shares the gloom, however. Mr Zapatero is unabashedly confident about his country’s economic prospects, on which his re-election prospects also depend.

“I am an optimist,” he tells business. He expects the economy to grow by “at least” 3 per cent in 2008. Mr Zapatero’s Socialist party is promising to create 2m jobs over the next four years and to raise minimum pensions and wages. If the economy fails to grow at the predicted rate, Mr Zapatero thinks old-fashioned fiscal stimulation should do the trick. The government has a “comfortable” budget surplus of 2 per cent of GDP, he says, to get things moving.

Another reason for optimism is that Spain’s big companies have used the profit windfalls of the past several years to diversify out of Spain. Joaquín Ayuso, chief executive of Ferrovial, the company that in 2006 bought BAA, the British airports operator, says: “Back in 1992, construction – mainly public works – was 90 per cent of our business and it was all in Spain. Then there was a devaluation and a recession.

“We had four horrible years. I was the director for
construction then and I was convinced I would be fired. Those years taught us a lesson: that we couldn’t depend on just one country, one business and one client, the government.”

Today, 90 per cent of Ferrovial’s assets are in the UK, Canada and the US; they include toll roads, airports and baggage handling. Less than 15 per cent of Ferrovial’s income comes from construction.

Santander and BBVA, Spain’s two big banks, have expanded abroad so that a big part of their business is based in Latin America and the UK, where Santander owns Abbey National. Telefónica, the former telecommunications monopoly, has also become world-scale.

Diversification means that even if Spain starts to flag, some companies will be able to cushion the blow with income from other parts of the world. Tighter credit conditions, however, will make it much harder for them to continue an acquisition spree that has included investments of more than €60bn in the UK alone.

In this jittery environment, resilience is a big advantage. What frightens some is the hubris that appears to have taken hold of Mr Zapatero and some of the business establishment. Only the government predicts Spain will grow by as much as 3.1 per cent in 2008. The International Monetary Fund estimate is 2.7 per cent. The Organisation for Economic Co-operation and Development forecasts Spain will grow by 2.5 per cent.

“To draw up economic policy on the basis that we are going to grow by 3 per cent this year is unrealistic, even irresponsible. Not to recognise a problem is the first step to not solving it,” says Lorenzo Bernaldo de Quiróz, of Freemarket, an economic consultancy in Madrid.

Complacency is also frightening because Spain could easily slip into Italy’s “do nothing” malaise. For the moment, Europeans prefer to shop at Zara rather than Benetton. Iberia is a going concern whereas Alitalia is bust. Telefónica is a big shareholder in Telecom Italia rather than the other way around.

“Spain has undergone such a tremendous transformation in the past two decades. Now it has to take the next step,” says Stefan Bergheim, a senior economist at Deutsche Bank. An inflation differential with the EU needs to be tackled. Productivity, which is low, has to be addressed and Spain must move on from bricks and mortar to find a more sustainable route to prosperity.

Wednesday, February 06, 2008

Spain Unemployment January 2008

Spanish unemployment continued its upward march in January 2008, according to the latest set of figures from the employment office INEM. The total number of unemployed was up by 132,378 in comparison with December. This was an annual increase of 8.62% over January 2007 to put things in perspective.

If you look at the inter-annual comparisons, it is clear that this is now a sharp increase. Really at this point I don't mind sticking my neck out, Spain is entering recession (negative Q-o-Q growth) in Q1 2008 for the first time since 1992. Now lets wait and see where we go from here.

Just for good measure here are the y-o-y changes in unemployment for 2007. The line of evolution is clear, it's a long swing, and not simply a by product of the financial turmoil of last August. So we have entered, but I have no idea at all when we will exit.

Tuesday, February 05, 2008

Spain Services PMI January 2008

Well, this really is a shocker. Spains services sector had a significant contraction in January according to the latest PMI. This makes it very probable that the Spanish economy is entering recession (negative growth) in Q1 2008. I would like to see a bit more data before reaching a final conclusion (the next industrial output release should settle it) and I will try and justify this view when I do my monthly report at that stage.

The Spanish services sector purchasing managers' index (PMI) stood at 44.2 in January, down from 51.0 in December, according to market research group NTC. A reading above 50 indicates the sector is generally expanding, while a reading below 50 suggests general contraction. The PMI value is the lowest since the series began nine years ago. January's service PMI slowdown was much sharper than expected, Nathan Carroll at NTC Economics noted. 'While employment growth continued, service sector companies could be expected to reduce their workforce in the next few months to cut costs,' he said.

Spain Consumer Confidence January 2007

Spain's Instituto de Credito Oficial today published the results of the January consumer confidence survey. The only real surprise was the fact that it took about a week longer than usual to appear on the Insitute's website (the pre-election atmosphere I imagine). As was to be anticipated, the index was down for the eighth month in a row, to yet another historic minimum, although it should be noted that this months decline was less dramatic than in previous months - only 1.4 points from 72.3 to 70.9 - since the expectations component rebounded slightly. Possibly consumers feel slightly better times are coming, although what the basis for such an improvement in expectations could be at this point is far from clear.

We also have the January results of the EU commission European Confidence Index. As can be seen in the chart, while there is some rebound in Ireland (the decline in previous months had been very steep), Spain continues its downward trajectory.

Also the general movement in the index across eurozone countries is also clearly downwards.

Saturday, February 02, 2008

Spain Retail Sales December Mortages November 2007 and Inflation January 2008

Unsurprisingly the downward trend in mortgages continues. According to data from the Spanish INE, during November, the average value of contracted mortgages stood at 158,994 euros, 0.1% less than the same November 2006 and 7% less than October 2007. In the case of housing mortgages, the average value was 147,018 euros, 1.9% more than November 2006, and 2.5% less than the figure registered in October 2007.

The total value of mortgages created on urban buildings exceeded 21,300 million euros in November, representing an interannual decrease of 9.3%. In housing, the capital loaned reached almost 13,802 million euros, 13.3% less than in November 2006.

The average interest rate of savings bank mortgage loans was 4.9% and the average term was 27 years. For banks, the average interest rate for mortgage loans was 5.0% and the average term was 25 years. 98.5% of the mortgages constituted in November used a variable interest rate, as opposed to the 1.5% that used a fixed rate. Within the variables, the Euribor was the reference interest rate most used in constituting mortgages, specifically in 87.7% of new contracts.

Retail sales in Spain are now in complete retreat, and on a seasonally adjusted basis have now declined for four consecutive months.

If we look at the year on year tendency, this turned negative in December 2007 for the first time - falling by 1.9% over December 2006 - and if you look at the chart you will see that they have been losing momentum since 2006.

The HICP annual inflation rate is expected by the INE to be 4.4% in January 2008, according to the flash estimate. This estimate provides a preview of Spanish inflation which, if confirmed, implies a slight increase in the monthly annual rate, since in December this HICP was at 4.3%.