And Variant Perception Respond to Iberian Equities

Well, Jonathan Tepper has now written a reply to Iñigo Vega, of Iberian Equities, Izabella Kaminska covers the reply here, on FT Alphaville, and Claus Vistesen has a summary of the whole affair here, on his Alpha Sources blog.

And may I remind everyone of a recent quote from the Economist:

The new accounting guidelines will help Spanish lenders smooth out the effects of the property bust over time. But the risk is that the problems are merely postponed. The ratio of bad loans to the total, property included, has tripled to 4.6% over the past 12 months as unemployment appears to head inexorably towards 20%.

The true picture is worse still. Commercial banks have bought about €10 billion in debt-for-property swaps, according to UBS. Spain’s savings banks do not disclose the figure. Assume it is similar to their commercial peers and reclassify all these property purchases as bad loans, and then the non-performing loan ratio would be 5.7% (before any further adjustments for loan restructuring). Deferring losses to mañana doesn't change the extent of the difficulties facing Spain’s financial system.

The sad fact of the matter is, as the Economist says, that we really don't know what the real level of Non-performing Loans in the Spanish banking system is at this point, mainly because the system itself is not providing enough high-quality, detailed, credible information for us to make the necessary judgement.

That is partly why Jonathan Tepper is, I imagine, reduced to popular press articles and testimonials from insiders. And one last question, after reading Iñagi and Jonathan's latest exchange, is there really anyone still left out there who continues to believe that the ratio of bad loans actually fell to 4.6 percent in June from 4.66 percent in May? Whatever you make of the crossing the "t"s and dotting the "i"s part of the argument (or even if most of it is quite simply "beyond your ken"), all that is necessary for Jonathan's point - that Spain's banks are going to some considerable effort to cover up the extent of their growing bad loan problem - to be valid is that the former claim is untrue. This part I think is now clear enough. So c'mon gentlemen, try offering some credible numbers and then people may start to believe you. Have you never heard of getting the bad news all out in order to be able to get on with the job? But isn't this just Spain's problem at the moment, people are going to any length not to get on with that badly needed economic correction.

Variant Perception's Reply To Iberian Equities
by Jonathan Tepper

Variant Perception is very reluctant to get into public argument with someone we don’t know, but the issues facing Spain are large and serious.

We find it amusing that Iñigo Vega and Iberian Securities felt the need to issue a counter to our report. Variant Perception has written repeatedly about Spain for the last year and a half. Its conclusions have been far more accurate than those of Spanish analysts. We are an independent research house and express our views as we see things. What is interesting is that since the report came out, Spanish bank managers, surveyors, and developers have sent emails and come out of the woodwork to agree with us.

The report has struck a chord with readers because they know the emperor has no clothes. It seems only Spanish banking analysts are still blind. Interestingly, Iñigo Vega and Iberian Securities make few macroeconomic observations. We would be curious to know if Iñigo really thinks his loan loss assumptions make sense. Does he think this downturn is a normal downturn and does he feel he really has a grasp of the problems? How does he think the more than one million empty homes will be sold in a slow and orderly basis over the next few years? Who will buy them when affordability in Spain is so terrible and unemployment is above 20%?

Tellingly, he doesn’t even comment on the macro questions facing Spain. Sell side analysts engage in steady state thinking, but the world doesn’t stay the same. US housing analysts had very little macro understanding. They didn’t realize that house prices can go down, and they can go down a lot. In the case of Spain, he doesn’t once mention deflation, unemployment or why Spain will not suffer horrendous pains as it can’t simply devalue the peseta to get out of this crisis. That is why equity analysts have been so useless for the last two and a half years.

Spanish banks are sitting pretty, with high interest margins. Analysts must ask themselves how much of this is due to the fact that many commercial and residential loans were tied to Euribor with 12 month resets. Borrowers have been paying in at 2008 rates with high Euribor, while banks have been able to fund themselves for next to nothing. What will happen now that borrowers will get lower rates with a lag, and if the global green shoots rebound happens, Spanish banks might have to fund themselves at higher rates. The mind boggles.

This will be the last response, as Iñigo Vega and Iberian Securities aer not Paul Krugman and we are not Niall Ferguson.

And on a point by point basis:

Spain is Japan 2.0 - Not a bad start

We’re not sure what his point is here. He says that comparing Spain to Japan is “not a bad start,” but then goes on to make the very brave and foolish statement that Spanish banks have higher cumulative new NPLs than other developed markets. True, but beside the point. The question isn’t whether Spanish NPLs are high relative to other developed countries, but whether Spanish banks are indeed recognizing losses relative to what losses really are in Spain.

Loan loss ratios are being under-declared.

ADICAE, the Spanish banking consumer watchdog, agrees with me and explains how they do it. They are highly credible, independent and respected in Spain. They’ve done a far better job on tracking down ponzi schemes, abuses in the banking sector than the Bank of Spain or the CNMV have done. ADICAE highlights a variety of practices, not least the debt-equity swap. If he cares to read the article and speak to them, he might find it illuminating.

The president of the Association of Users of Banks, Cajas and Insures (ADICAE), Manuel Pardos, affirmed today that the data offered by the Bank of Spain on delinquencies of the Spanish credit institutions “are very distant” from reality, since banks are resorting to all sorts of “tricks and cons” to “put makeup” on thier accounts and reduce their non performing loans.

Source: Adicae duda de la fiabilidad de los datos de mora del Banco de España ante las "artimañas" de bancos y cajas

The argument that Spanish banks are like Japan is not only that Spanish banks are not recognizing all their losses. It is also that by providing capital to the weak, Spanish banks are not providing capital to other companies that desperately need it. That is how businesses are choked by lack of liquidity and financing. Also, by owning large amounts of property, which is by its very nature illiquid, Spanish banks are constraining their balance sheets. If he wants to understand the loss of liquidity caused by lending to zombie companies and keeping illiquid securities on a bank's balance sheet, he can read the following editorial in Spanish by Daniel Villalba, an economics professor in Madrid at the Universidad Autónoma.

¿Dónde está el crédito que "no aparece"?

470 billion euros in loans could go bad

We take his point on infrastructure spending. However, he states, “The report forgets to mention- however- that a chunk of the €323bn in outstanding loans to developers does not necessarily involve residential lending but commercial lending(which is relatively safe in Spain , in our view).” Really? How does he know? How does he think deflation, unemployment will not affect commercial lending?


His loan loss assumptions for residential mortgages are not dire enough. According to Expansion and the Bank of Apin 1 in 5 mortgages is at danger of becoming delinquent. We are curious: would he agree with that?

Source: Una de cada cinco hipotecas tiene alto riesgo de morosidad


Iñigo states in the introduction to the piece that residential real estate prices can go down 40%, but he thinks 50-60% Loan to Value (LTV ratios) are good. Does he not think banks may be forced to dispose of residential real estate at levels belowtheir fair value in order to move inventory?

Iñigo states that LTV ratios are fine for builders at 50-65%. That would be news to many smaller builders with political connections in the regional cajas. Even public builders had higher ratios than that. Colonial’s were closer to 75% before it went bust. Taking comfort in 50% LTV ratios is ridiculous. Martinsa Fadesa was 50% when it went bust. Its books had many irregularities, so its values were bogus. As values go down, LTVs deteriorate very quickly. Metrovacesa is a classic case in point after banks took it over, LTVs suddenly shot up. Loans are known and fixed; values are a moving target. Welcome to deflation.

Getting a boost from accounting provisions

n his piece, he writes, "Yes, the Bank of Spain changed last July the interpretation of the provisioning rule on some mortgage loans. Now the rule is more in line with the rules applied by most European/US banks (where provisions tend to match the expected loss as opposed to the frequency of losses). However, the measure has had zero impact on the system’s P&L hitherto."

He is also on the record in The Economist:

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 ($31 billion) in coming months (assuming non-performing loans 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.

Anyone who is slightly critical could be pardoned for asking: why would the Bank of Spain bother, if there is no P&L impact? Perhaps Iñigo would care to clarify his own statements and why the Bank of Spain would do something like that at this juncture.

Dynamic Provisioning

Iñigo makes a point that dynamic provisioning didn't start in 2000 and states this our summary is inaccurate. It is true that since time immemorial banks have set aside losses, and they did before 2000. However, central bankers all agree that Spanish Dynamic Provisioning started in 2000.

Perhaps he wants to disagree with the Bank of Spain:

The Bank of Spain is empowered to issue accounting ordinances to banks under its supervision. In this condition it regulates the solvency provisions that cover credit risk. Up to 1999, the main solvency provisions affect impaired assets. There is also a general flat 1% provision on non-impaired assets (0,5% on some mortgage guaranteed loans). In June 2000 the Banco de España introduced a new statistical (or dynamic) provision for Spanish credit institutions.

and the World Bank:

Banco de España, Spain’s central bank and its banking supervisor, put dynamic—or statistical— provisions into place in July 2000, to cope with a sharp increase in credit risk on Spanish banks’ balance sheets following a period of significant credit growth.

and the Bank of England:

The favourable economic environment in Spain over recent years has led to an improvement in banks’ asset quality and, in most cases, this has resulted in a reduction in loan loss provisions. The Bank of Spain was concerned that as banks’ loan portfolios continued to expand, partly because of a low interest rate environment, loan loss provisions were not keeping pace with potential credit losses latent in new lending. Consequently, the Bank of Spain introduced a new ‘statistical’ provisioning method which came into effect in July 20001.

We could go on, but it would bore the reader senseless.

Perhaps we're talking semantics when we refer to what "Dynamic Provisioning" is, but if so, we have no idea what his point is. In fact, we are not not sure he knows what his point is.

He states that the US would be better if it adopted dynamic provisioning. Greenland would be warmer if it were closer to the equator. That is a rather obvious, non controversial point. The question is: are Spanish reserves enough to absorb losses. Much like the US, loan losses in Spain have been much higher than has been anticipated. Does he really think that the provisions of Spanish banks are enough?

Iñigo Vega states, "In fact, Spanish Banks added €12.3bn in excess provisions over the last five years (end ’03-end’08) or 12% of its reported pre-tax profits (0.7% of loans)." Bravo! CCM, the only bank taken over so far by the government, was estimated to need almost 2.7 billion euros to be recapitalized. It has since reported over one billion in losses. Mr Vega is a brave analyst if he thinks that there aren't others out there that will have similar requirements. If provisioning is adequate, then perhaps he should let the government know. The government is setting up a fund with 9 billion euros and will have the capacity to raise an additional 90 billion euros in debt. Obviously the government thinks dymanic provisioning isn't enough.

Source: Spain Says Bank Aid Fund May Reach 99 Billion Euros

A simple back of the envelope calculation shows that provisionings aren't high enough. If there are 1,000,000 unsold homes, and the average mortgage on a home is 120,000 euros, if you assume a 30% loss on that (we think it will be higher), that is 36 billion euros. That is three times as much as the excess provisions. Many of the loans are developer loans and not mortgages, but run a similar back of the envelope calculation gets you to the same place.


Not marking loans to market

He should see my point above from ADICAE about banks not marking their loans to market. If a loan is non-performing, it should be marked as such.

Source: Adicae duda de la fiabilidad de los datos de mora del Banco de España ante las "artimañas" de bancos y cajas

He should also speak to bank managers. Non-performing loans are being passed off as current, vacuumed up and rolled ito cedulas to deposit at the ECB's repo window. (Incidentally, that is the only way many Spanish banks are finding any semblance of liquidity right now. Without the ECB, some Spanish banks would have the same liquidity problems that subprime mortgage originators had. The ECB is a mega warehouse, effectively, for the Spanish banking system. This is intimately tied in to the question of funding excess consumption in Spain, which we discussed.)


Not marking assets swaps to market given conflict of interest- Additional comments are required

He agrees that there is a problem with appraisals. We're glad. Appraisers, too, think there is a problem. He states, "Yes we agree that there could be some downside in some properties given the poor environment but the difference should not be huge from current levels." Variant Perception could not disagree more. The anecdotal evidence that property prices are far below appraised values is overwhelming. He should get out and meet people and see what things are like in neighborhoods around Madrid and on the coast of Spain. There is a vast gap between official statistics and what prices properties are transacting at.

Source: On 'Foreclosure Road' in Spain, Bargains Abound

Spanish property statistics are notoriously bad at capturing what is actually happening in the markets. Spanish homes are often bought with laundered money or non-declared money. This leads to massive distortions of data series. He can read more here:

Source: Beware Property Statistics - is the market worse than it appears?

As one surveyor put it to me, Spanish homebuyers under-report purchase prices, typically by around 30%. However, over the last three or four years under declaration has been brought into the money-laundering field and as a result is much less prevalent. The result of this in a level market would be the Registries showing higher prices being paid for properties, which were in fact only being sold at the same total price. However, prices dropped substantially, in many cases by more than 30%. So the net effect would be that prices haven't changed. Anecdotal evidence shows that many properties have declined by 50% in value or more. In some places,homes aren't trading at any price, given total lack of liquidity.


Offering 100% 40 years LTV loans.

Banks aren't offering 40 year mortgages willy nilly. They're offering them to clients who would otherwise be foreclosed, i.e. zombie customers, or to customers who might buy houses sitting on banks' balance sheets. If he doubts the number and prevalance of 40 year mortgages, he should ask around. He can also check here and count the number of 40 year mortgages still on offer.

Why are 40 year mortgages being offered? The math is fairly simple. Homes are too expensive for the average Spaniard to afford, and it is much, much cheaper to rent than to buy. According to the financial news portal Facilisimo.com the average citizen would have to dedicate 61 years to pay off a mortgage of a 70 square meter house if he does not go above 30% of his salary. For couples it goes down to 19 years, but that assumes they earn far above the national average. Rental yields are very low in Spain and far below the average mortgage payment. Renting in Spain right now means saving around 37.5% relative to buying. That is why no one is going to buy any homes at current prices.

Source: Un ciudadano medio en España tarda 61 años en pagar su hipoteca

We wish Iñigo all the best and hope he's renting and hasn't bought.