More Comedy From The Spanish Banking System

Going through the Variant Perception report on the parlous state of Spain's banking system, I couldn't help stopping and thinking hard about this point from the Spanish newspaper Expansion.

The valuation of the guarantees of the mortgage book of the cajas and banks and of its real estate gains importance. The thirteen companies tied to financial entities represented 47% of all real estate appraisals in 2007. The valuation of these real estate assets has taken on new importance for banks in the context of the current economic recession. The valuation of the mortgage guarantees and of the real estate assets they are taking on through the courts and debt for equity swaps is key to calibrate the solvency of the financial system. 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.

And then scratching my head, and scratching my head.

Now to put all this in plain English, we are talking here about the valuation of properties that are repossesed by the banks, and that the banks then have as part of their asset side, as goods awaiting sale. Now, Expansion raises the question: "how can we know that these assets are being fairly valued (that is how can we assess the quality of part of the asset side in the bank balance sheet) when the banks themselves own (directly or indirectly) nearly half of the companies doing the valuing.

Well, this is an issue, but in fact the problem is much worse than the Expansion writer seems to realise, since there is a technical (matter of fact detail) that they seem to miss here, and that is how the valuation of property which is repossed by the bank actually takes place.

The issue is fairly complicated, but please bear with me, since if you follow me through to the end you will see why all the rigmorole is important. Basically Spanish “escrituras de hipoteca” (or mortgage agreements) require that the “valor de tasacion” as well as the amount secured is specified in the deed. The “valor de tasacion” is in effect the valuation of the property and it is put in the deed so that the amount of the debt can never actually exceed the value of the assets being mortgaged.


However since the bank don’t know when they might need to "exercise" (or recover) the mortgage, they don’t really want to compromise themselves in advance, and the typical way of handling the problem legally is to state in the "escritura" (or title deed) that it is agreed that the "valor de tasacion" for purposes of "exercising" the mortgage will be equal to the total amount of the debt outstanding plus the rolled-up interest.

This is a very convenient solution for the banks, since it gives outsiders the impression that there is what one might call a valuation in the UK or US sense, when what is really involved is simply a formula applied in order to structure legal documentation.

The same thing happens when it comes to the time to “ejecutar una hipoteca” by auction, there being no other way in Spain. Since judges tend to give banks a really hard time if the asset is valued below the amount of the mortgage debt (ie the individual who owes the money has a debt even after the auction) banks normally take the easy way out and value the property at the amount of the debt rather than have the judge cancel the auction. Banks then theoretically have to pay tax on the transfer price to the registry (assuming they end up “adjudicando” the asset to themselves, i.e. taking possession), and the tax office - Hacienda - won’t accept anything other than the price at which the asset has been “adjudicado”.

The whole point here is that it ends up being very difficult for a bank to transfer an asset to itself in settlement of a debt at a figure which is substantially different from the amount of the debt unless there is a real possibility of getting the borrower to pay the balance.

So........ “valuations” in Spain effectively result from this complex and machine-like calculating process and are in no way comparable to what are known as valuations in - say - the UK market, nor does anyone involved in the process really think that such "values" really reflect what someone would pay for the property. Having got themselves into this position as a result of what is in the end for them a necessary procedure the banks basically just leave the figures exacty as they are. In simple Spanish a property valuation is an estimate of the property's “value”, whatever that might mean!

Which brings us right back to the Expansion article, and this quote:

"The valuation of the mortgage guarantees and of the real estate assets they are taking on through the courts and debt for equity swaps is key to calibrate the solvency of the financial system."

Well if this proces I have descibed above is the "key" to calibrating the solvency of the Spanish financial system, then the calibration process that results is going to be just as ad hoc and inadequate as the valuation process that gave rise to it. In a way all of this reminds me of the structured CDOs in the US case. Most of these got valued by computer programme simply because they were never traded. No-one ever really thought the valuations represented what they could be sold for even if that’s what hedge fund investors were told they were worth. Hence many were in the uncomfortable position of having them valued at 99.98 one minute and getting a bid at 30 the next.

Which again brings us back to Jonathan Tepper, and his Variant Perception report. As I undersand Jonathan, what he is arguing is that the situation in Spain now has certain structural similarities with the situation in the US before the sub-prime crisis broke out. The similarity is partly becuase there is little in the way of an early warning system available. The fact that the Bank of Spain's foreign exchange reserves are merely academic means that many professional bank analysts lack the early warning signs of an imminent balance of payments type crisis, and the mechanical and artificial system for valuing the growing number of homes accumulating in the banks' real estate portfolio means there may well be no small amber flashing light to watch for before all the dials suddenly luch over to red.

Has Spanish Unemployment Really Been Falling Recently?

In this post I would just like to ask a very simple question. What is the real rate of growth of unemployment in Spain? Are things improving, getting worse, or simply staying the same? Now, before you jump to too many conclusions on this it is important to remember that in the world of economic analysis there are lies, damn lies, and then there are press releases.

So if you read in the headlines in your paper recently that the number of jobless in Spain fell by 20,794 in July after a 55,250 decline in June (cutting the total number of unemployment benefit claimants to 3.54 million), you might like - bearing in mind what I have just said - to ask yourself what else could lie behind such statistics?



Well, if you look at some of the more informed commentary - say Reuters writer Paul Day - you will also note the little detail that "A huge public works programme in Spain slowed further layoffs in the beleaguered construction sector and helped unemployment claims to fall for the third straight month" - as a result of which the picture you have in your head may start change.

In fact, in the first six months of 2009, the Spanish government poured some 5 billion euros into local infrastructure projects as part of a total state-funded public works package worth up to 11 billion euros. Then you might notice the quote from PNB Paribas's Diego Fernandez -"'Keep in mind these figures are distorted by the fact that people taking state funded, back-to-work training courses are not counted"

But there is another little detail you should never forget, particularly in a country that has a lots of seasonally related employment, like construction, agricultur and tourism, and that is the lack of seasonal adjustment in the data. It is normal for unemployment to weaken somewhat in the summer. So if we look at the Eurostat data - scandalously Spain doesn't give a monthly unemployment rate to the public, and much less a seasonally adjusted one - we find that unemployment has gone up steadily from month to month, even if the rate of increase has weakened. The number of unemployed has now gone up every month since May 2007 in my Eurostat datasheet. That is 27 consecutive months of increase. And just wait till we get to the autumn!



All of this is very curious, since the way the Spanish National Statistics agency report data to Eurostat, and how they adjust it, remains something of a mystery to me. The June published rate of unemployment is 18.1%. In fact the unemployment number shot up rapidly in the employment survey in March - to a then published 17.4% (source Reuters). This surge surprised me greatly at the time, since I could see no reaon why it should exist looking at the underlying speed of the economic contraction. I even contacted reseachers in the Bank of Spain -via a friend - to ask whether there had been some seasonal correction or something, and received the following reply:

"Los datos de la EPA no se revisan. El INE hace una encuesta posterior para evaluar la calidad de la EPA, pero no hay revisiones. El incremento de las cifras del paro es muy preocupante, sobre todo porque pasaran varios trimestres hasta que se estabilicen. Y las cifras de paro registrado no contradicen en nada a las de la EPA." (Basically, the survey data is not subsequently revised).

Which is very very strange, since the data which are supplied monthly to Eurostat are being continually revised with every passing month at the moment (first up in March, and then down again, the current March reading is 17.2%), which is very acceptable, since seasonal corrections must be difficult at the moment, but it would be nice to have an explanation, since otherwise we might be lead to think that the EPA numbers shot up in March so the INEM numbers for April and May would come down, which they did. And those of us with really bad minds would remember that there were European elections in June. It would be ridiculous to suggest that these numbers were being massaged simply to give the impression unemployment was coming down, wouldn't it?



But as I say, the underlying seasonal trend as reported to Eurostat (but not revealed to voters in Spain) have continued to climb. Only in a country where the generally understanding of statistics is low could this happen, and pass un-noticed.

On the other hand, the rate of annual increase in the INEM numbers is definitely slowing - or if you prefer the second derivative has turned south, and the annual rate of increase has fallen back from a peak of 56.69 in March to 46% in July - which is hardly surprising since unemployment cannot go up exponentiallly (or there would soon be no one left working) and is also what you would expect to find when manufacturing is contracting less slowly, and significant numbers of people are being employed on public works or going on training courses.



So the fact of the matter is, that the latest good data we have for Spain are the June unemployment data (supplied to Eurostat based on the EPA) which showed 4.186 million out of work, and an unemployment rate of 18.1%. And unemployment is rising every month, and that is the sorry and woeful tale of Spanish unemployment at the moment. That and my forecast that, if nothing is done to stop the runaway contraction, unemployment could be up and hitting the 30% mark come December 2010. 25% before Easter 2010 is now a done deal as far as I am concerned, and we will probably break the 20% psychological threshold in October or November of this year.

My Name Is Edward Hugh, And I Am Here To Recruit You....

The above quote is, of course, a straight parody of Harvey Milk, the businessman based in the Castro district of San Francisco. Now, the point is, Spain is living a lie. Everything is being "massaged" in a way that those of us who have lived here long enough had grown used to, but had hoped now belonged to the past.

Some of us are trying to put together a detailed, but non sensationalist, account of the actual state of play in the Spanish banking system. I think we owe this to our families, our friends, and our loved ones. So....

So, if you work in the Spanish banking system, and have valid knowledge of current practices and accounting positions, please get in touch with me. Insiders have to explode this, before "this" explodes all of us. With unforseeable consequences, not only for the Eurozone, but for the whole global financial system.

One example of what can be done is show in this presentation from José Contreras, which you should all read.






I might differ on some of the details, but José gets right through to the core points, which are:

i) the significance of the foreign debt
ii) the importance of rising unemployment
iii) the impact of price deflation

More examples of what needs to be said can be seen in this interesting exchange in Afoe comments.

José

Edward, thanks for your comments. I am more inclined to believe that if banks sell a particular product strongly enough, clients end up buying it. In this particular example, in my view, the burden of gilt is more with banks than with clients. I am a spanish citizen with a mortgage and have I worked in a spanish Caja, so I can claim to have seen both sides of the picture. My general impression is that financial ignorance by clients has been used by banks to make money, which obviously is not illegal but certainly questionable.

Mark:

That is a great summary! Re Spanish banks dubious advising of clients (= out and out selling), the latest scam has been to sell prefeence shares as to retail clients as if they were deposits. Someone (the OCU?) should be taking out legal action about this.

José

Thanks Mark. By the way those preference shares are a perfect example of what I am talking about. Round about the time the banks were selling them (Jan 09-Jun09), the institutional market was pricing identical transactions by the same issuers in the secondary market at 25%-40% of nominal value. The preference shares being sold in the retail branches were sold at 100% of nominal value (as you would expect with any normal fixed income product). As I said before, it is not illegal but clearly questionable.

Also, this comment from the thread in Expansion on the recent Variant Perception report.

1. broker (Autor sin e-mail publico) el 23 de Agosto de 2009 a las 10:50

Trabajo en un Banco, en uno de los Grandes, en junio se nos dio oreden con prioridad absoluta de refinanciar todos los préstamos impagados, esta semana le di un vistazo a las primeras refinanciaciones y vuelven a estar la mayoria de ellas en situación crítica. Estamos aplazando el problema y esta Bola de Nieve pronto rompera. La mora real bancaria sin trucos, esta por el 10%, OJO QUE ESTO ES SERIO.

He is saying that distressed loans are already more like 10%, and that in June (when Salgado raised another 90 billion in debt, and just before the ECB "wheelbarrow") bank staff were advised to refinance all loans, whatever.

Basically, in the face of so much official silence and hypocracy, my feeling is all of this is going to fall apart when people who have been working on the inside finally come out in the open and admit the reality. They two have childre, loved ones and elderly parents. No family will remain untouched.

Finally, this comment from José, which is 100% to the point as to where we are now.

Edward, my reading of Blanco´s comments regarding higher future taxes is that the EU has privately held talks with the govt. and announced to them the maximum level of deficit that they are prepared to tolerate. Since Maastricht no longer applies and deficits have theoretically no limits in the EU, these issues are being held case by case behind closed doors. Spain is clearly the most worrying partner for its size and problems. My open question is simply; What is the limit that the EU has informally impossed the Spanish govt. regarding the public deficit? Once we have an answer to that question we can make our own calculations as to how long the govt. can sustain the financial system, new unemployment benefits and public works (among others).

Absolutely. The game is over. The future is already being decided behind closed doors, and once we know what next years spending limit will be we can start to calibrate.

Crickey, Harvey Milk ended up badly, didn't he. I certainly hope nothing like that happens to me :).

Raising Taxes In Spain Is Not A Solution!

Victor Mallet had a piece on public works minister José Blanco's Thursday speech in the FT yesterday. My feeling is that the Spain of Zapatero looks more and more like the Hungary of Gyurcsany with every passing day, and I say this more from the point of view of the twin deficit problem, and the impression the administration gives of things being totally out of control and no one knowing what to do, than anything else.

I am not at all party political, and my observation should in no way be read in that sense. The situation has only deteriorated since Solbes and Vergara were ousted, and the only mystery for me is why exactly they were replaced with a team who have no understanding of macro economics whatsoever. For the record, I predict the IMF will have a permanent delegation in Madrid before 2011 is out. My long promised piece on the current situation will finally appear this weekend and will attempt to justify this view.

As the following chart - from Dominic Bryant at PNB Paribas - makes clear, while Spain's households and corporates are busily deleveraging, government finances are deteriorating in a totally unsustainable fashion.



On the details of Blanco's statement, I would simply make three points.

Firstly, it is far from clear that this is a serious proposal. There must be a battle royal going on inside the PSOE even as I write, and this proposal may well have more to do with internal party debates than anything more substantial. Economy Minister Elena Salgado has been notably silent, so one possibility is that Blanco made the speech simply to "test the ground".

Basically, the current Spanish administration want to hear nothing of internal devaluation, and will try anything to avoid that going down road. The biggest issue they have is growing deflation, and falling revenue as prices drop. This has been a common picture across Eastern Europe, it is just that the states in the South of Europe are rather richer, so there was more flesh on the bone when the crisis broke. They have a salary increase for public servants pencilled in for next year, and this, of course, is a commitment which it will be impossible to honour in the present climate.

Secondly, the biggest unspoken issue we are seeing in one economy after another is the retreat of a lot of activity back into the informal sector. So called economic "greying". Just look what is happening to revenue in Italy. Again, we have seen this happening throughout the East. The contractions in the Baltics are nowhere near 20% in my view (although they are, of course, very large), people simply are declaring less and less. This is a problem the IMF are struggling with day in and day out in Latvia. But this whole process makes things very difficult for government finances, as we are seeing. More tax increases on the very rich and professional middle classes will be entirely unproductive as they will only accelerate this process.

Lastly, increases in VAT. These are again very counterproductive, since they hit consumption directly, at a time when consumption is declining anyway. All such increases do is accelerate the contraction (IMHO the IMF is wrong to be advocating this in the East, but undoubtedly they feel they have little alternative if they wish to preserve some minimal semblance of social services, which they need to do to get the population to agree to their packages in the first place). I wouldn't even mind betting that a VAT hike would be nearly revenue negative, for the consumption drop it would produce and the retreat into the informal economy it would accelerate.

Twenty Percent of Spanish Mortgages Now Considered To Be High Risk

Hello, and sorry I have been away for so long. Basically I have been busy with holidays, and economic problems out in the Baltics and across Eastern Europe. I have however been posting regularly in Facebook, and basically those of you who haven't taken advantage of my offer to join my friends don't know what you have been missing.

I break radio silence this morning to cover a story which appeared today in the Spanish newspaper Expansion. According to that article, one in five Spanish mortgages is now considered as being high risk and liable to become "non performing".

The mortgages at greatest risk are naturally those contracted after 2005 where the loan to valuation was over 80% of the total. In 2006 and 2007, according to data from the bank of Spain, LtVs were over 80% in 17.7% of the mortgages granted.

Prior to 2006, the main source of data comes from a study by Genworth Financial, who show that loans with +80% LtV rose from 12.2% in 1996 to 26.4% in 2005 (see chart below which comes from Expansion). These loans were especially popular between 2003 and 2006, but then started to decline as the decision of the ECB to raise interest rates made the likelihood of a price correction rise sharply.



The other key indicator for risk of mortgage default is, of course, the proportion of income devoted to servicing the loan. This has risen, according to Bank of Spain data for the second quarter of 2009 to an average of 38.6% of disposable income.

This figure is down sharply from the 46% reached between 2006 and 2008 largely as a result of the drop in interest rates. This is the plus side of over 90% of Spanish mortgages being variable interest. The boost to families with mortgages has been significant, and this is evident in the consumer confidence surveys.

But there is a downside here. Spanish households are now extraordinarily vulnerable to any rise in interest rates.

Secondly, people feel better because of the improved cash flow situation, but are probably not looking at the capital account side of their personal balance sheet. People with large mortgages and very high LtVs may well be better off by a few hundred euros a month, but the capital value of their investment may be sinking like a stone. In other words they are bleeding out money through the rear window. One day they will wake up to this, and find they are paying interest on a loan which is worth far more than the property they hold. Then, if there is no change in the bankruptcy law it is off to Australia, Canada or Brazil for many highly educated but heaviliy indebted young people, since as the Spanish law stands there is simply no way out from underneath this for them, ever. That is what those awkward little words "full recovery" mean.

Thirdly, Spain is now in deflation. This means that incomes will go down (over several year probably, if there is not one dramatic year of fall), and property values (which will remember correct against the general price index, that is they will also be further sucked down by the general level of prices) will also continue to fall. So the LtV will rise even as the proportion of income which needs to be paid to service a debt of which so many people were once so proud, but which they now find the be a millstone round their necks, will go up and up an up.


Meanwhile Bad loans as a proportion of total credit at Spanish lenders fell the first time in two years in June as savings banks reported a decline in defaults. The ratio fell to 4.6 percent from 4.66 percent in May and compared with a rate of 1.7 percent a year ago, the Bank of Spain said today on its Web site. Bad loans at Spain's banks slipped to 85.6 billion euros in June from 86.7 billion euros in May and 31.2 billion euros a year earlier.

But to put this in perspective, the ratio of bad loans to the total has still tripled to 4.6% over the past 12 months. And the situation is worse than it seems, since according to a study by UBS Spanish commercial banks have clawed back about €10 billion in debt-for-property swaps. And this number does not include Spain’s savings banks who do not disclose the relevant figure. If the position is similar to their commercial peers and we reclassify all these property purchases as bad loans, then the non-performing loan ratio would be 5.7% (before making any further adjustments for the loan restructuring which has been going on thanks to the availability of generous government and ECB funding).

In addition the central bank recently circulated new guidance relaxing the provisioning rules on risky mortgages. Until now, banks had to make provision for the full value of high-risk loans - those above 80% of the property’s value—after two years of arrears. That was obviously far too demanding, since property values rarely fall to zero. However the timing of the change was far from inpeccable, and the new rules, which mean banks only have to allow for the difference between the value of the loan and 70% of the property’s market value, give the impression of massaging rend results.

Iñigo Vega, an analyst at Iberian Equities, estimates that the new rules would relieve banks of the need to make provisions of about €22 billion in coming months (assuming non-performing loans only reach 8% by the end of 2010). To put that into context, Spain’s savings banks, which are heavily exposed to developers, are expected to make profits of only €16 billion before provisions this year.

As the Economist said, deferring losses to mañana doesn't change the extent of the difficulties facing Spain’s financial system.

And just to confirm that Spain really is different, surreal almost, this article (in Catalan) explains that the majority of the long term unemployed who have gone to the employment offices to claim the 420 euro monthly payment they thought they had been promised have discovered ...... that they are not in fact entitled. Apparently, according to the small print, you need to have run out of benefit and been declared unemployed AFTER 1 August 2009. This is Monty Python stuff, isn't it?

Incidentally, I have a much longer and more thorough post now in the works, sometime tomorrow for publication probably.