Spain’s cost of borrowing from the markets is now more than the Portugese bailout rate. Have we finally reached the Citadel?

On the NAMA wine lakeblog, there is a page dedicated to providing an overview of bond rates for the so-called PIGS countries (Portugal, Ireland, Greece and Spain) together with up-to-date Moody’s ratings. The purpose of creating a dedicated page was to facilitate the monitoring of the bond market’s assessment of what were originally considered to be the EuroZone’s four most economically vulnerable countries after the 2007/8 financial crisis. Yes, Italy originally made it the “PIIGS” and Belgium and the UK have their own substantial debt problems, but it is the PIGS that have more or less fulfilled expectations.

All except Spain, which in the parlance of medieval castle defences is regarded as the citadel, the last redoubt because its economy dwarves the combined economies of PIG and may therefore exceed the limits of EU containment bailout funds if it runs into funding problems. The thing is, with its 10-year bonds trading at over 5.6% – slightly below the 5.68%/7.5 year money that Olli Rehn talked about for Portugal’s bailout on May 10th but certainly above the 5.1%/7.5 year money referred to in Minister Noonan’s statement two weeks ago when he said Portugal’s bailout was at a 0.6% discount to Ireland’s – does Spain really deserve its Moody’s Aa2 credit rating (third highest and seven ranks above Ireland)? Will it be feasible for Spain to repay or roll-over €660bn of debt that matures over the next two years?

First up, the whole topic “is Spain f*cked?” is deserving of a properly researched dissertation. This entry examines some of the headlines and poses some of the questions that seemed obvious inIrelandin the mid-2000s but which were rarely asked. The subject deserves 20,000 words, not 2,000 and it needs far more research. Which might be a challenge because on the face of it, Spaindoesn’t seem to have the same standard of statistical reporting as Ireland. Might one of our economics masters students, tutored by our able band of economists in academia, research in detail the topics below and produce a better-informed answer to the question? If they do, they might do worse than take a look at the following to help with producing a dissertation proposal.

Spain overview

Country with a population of 46m with a GDP of €1tn. Unemployment in April was 20.6%, by far the highest in the EU well ahead of Greece at 16.2%, Ireland at 14.1% and Portugal at 12.4% (Latvia, Lithuania also have elevated unemployment at around 17%). Take a look at the  EU Spring Forecast 2011 forSpain andIreland which covered the 2011-12 period:

The real difference between Ireland and Spain is the debt to GDP %. Ireland’s is horrendous, whilst Spain’s is uncomfortably higher than the 60% stipulated in the Stability and Growth Pact, that is to be adhered to by all EuroZone countries.Spain’s debt to GDP is well below Ireland’s. But Ireland is incurring some €70bn of debt to bail out its banks which represents 44% of Irish GDP. Strip that cost out andIreland’s debt to GDP is less than Spain’s. For all the accusations of economic idiocy hurled atIreland, we are confronting the true level of losses in our banks. We have had the most intrusive stress testing, oversight by the IMF and ECB plus NAMA which has done a pretty good job in valuing and crystallising property loan losses and we have an internal regulatory function in the Central Bank ofIrelandwhich now seems very impressive. All of this has meantIrelandhas crystallised losses in the banking system and consequentlyIrelandhas stumped up 44% of its GDP to support and capitalise that banking system. Now, what about Spain, does it have undisclosed banking losses which might also require enormous bailouts. Given the difference in GDP’s, Spainwould need see €400bn of State recapitalisation in its banking system to get it toIreland’s level of debt:GDP. Is that at all a possibility? If Irelandcould have a bank bailout cost of €70bn in a country with a population of 4.5m, could Spain have a €400bn hole in a country with a population of 46m?

Spanish residential property

I must admit to being truly puzzled by what seems like a modest price correction in the Spanish residential property market. Not an expert by any means, but I am familiar enough with the Costa Del Sol to have seen an immense construction boom over the last decade which seemed no less buccaneering than the Irish boom. New urbanizacions seemed to pop up like mushrooms every six months and from Estepona in the west to Nerja in the east the whole coastal area seemed to be a hotbed of cranes and construction for a decade and prices seemed to be increasing by 10-15% each year. This is highly anecdotal of course but still, take a look at actual price performance in Spainsince 2000, courtesy of the English-language Spanish Property Insight website which has extracted figures from the Spanish ministry of development.

Across Spain, prices are now down just 15% from the 2008 peak to Q1, 2011 and in Andalucia, home to the Costa Del Sol, by the same modest 16%, in fact the worst performing region was Alicantewhich is down by 21% from peak, while on a city basis Malagawas worst with a drop of 22%. Contrast that with an average fall of 41% in Ireland as a whole and 48% in Dublin. In Northern Ireland (sterling area with the Bank of England in charge), prices have dropped more than 44% from peak. So why on earth has the decline inSpain been so limited?

In Ireland, we have Ghost Estates, in Spain they have Ghost Towns, newly built modern housing constructed during the 2000s but today lying mostly empty – take a look at some of them here. Spain indeed did have a construction boom as illustrated by planning approvals (best approximation I can find to construction, even the Spanish ministry of development seems to monitor construction by reference to planning approvals) which show that in the years 2000-2007, there was approval for some 3.4m homes equating to just over 400,000 per annum whilst Spain’s population grew by 11% from 40.3m in 2000 to 44.9m in 2007. In 2001, Spain had some 21m homes and Spain has a high vacancy rate of 20% which presumably reflects the fact that many homes are holiday homes. In Ireland from 2000-2007 we constructed 558,285 (average of 69,786 see housing completion sections of reports here and here) whilst our population grew by 14% from 3.8m in 2000 to 4.3m in 2007. Here’s a summary.

So both Ireland and Spain had a construction boom in the 2000s, both saw prices spike during the 2000s with 10%+ annual price increases, both countries are now suffering economically with high unemployment and budget deficits. So why is Ireland perceived to be in a worse economic position compared to Spain?

Spanish banks

The obvious difference between Ireland and Spain is that our banking system has incurred huge losses, mostly on property lending in the 2000s. And thatIrelandhas taken major steps to support the banking sector. These have included the extraordinary State guarantee in September 2008, the subsequent recapitalisation of banks as losses were revealed, the establishment of the National Asset Management Agency (NAMA) to objectively value and remove certain property loans from the banking system, domestic stress tests including a €30m stress testing exercise in Q1, 2011 undertaken by BlackRock, Barclays Capital and the Boston Consulting Group overseen by external officials from the ECB and IMF, and by our own Central Bank of Ireland. The result of all of this is that the State will borrow an estimated €70bn to cover losses in the banks so thatIrelandpreserves a banking system grounded in existing banks.

What about Spain’s banks? One Spanish bank you hear a lot about here is Santander which bought AIB’s Bank Zachodni unit in Poland recently and which also bought the Abbey bank/building society in theUK. Banks on the acquisition trail during the present financial crisis certainly don’t indicate weakness. And whilst Ireland has been internationally lambasted for allowing mortgage credit to spiral in the 2000s, and changing rules to allow certain bank assets to be used to access credit on international markets which in turn stoked the credit boom even further, we are bored to death with tales about how the Spanish Central Bank intervened in that country’s banking sector to ensure the banks were sufficiently capitalised to weather any downturn. So the impression might be that Spanish banks are just fine.

Well take a look at the dark side of Spanish banking in this report on Spanish sub-prime mortgages in 2007 – 120% mortgages, no deposit, three month work history, sounds familiar in Ireland, in Spain at least 50,000 such mortgages were being reportedly handed out each year during the boom by just one subprime provider, CreditServices whose president thinks that one third of all Spanish mortgages (including subprime) will be in default in 2011. InIreland some 50-60,000 of the 790,000 mortgages are in arrears by more than 90 days and a further 30,000 have been restructured. We have a draconian bankruptcy regime and extensive mortgage company forbearance measures that sees less than 500 repossessions each year. Spain is not at all compassionate when it comes to such matters.

Last July 2010, the Committee of European Banking Supervisors (CEBS) published its now discredited stress tests; remember these were the stress tests that gave Bank of Ireland and AIB clean bills of health, despite recent stress tests identifying €5.2bn and €13.3bn additional capital needs respectively. Of the 91 banks stress tested, seven failed and five of these were Spanish – Diada, Espiga, Banca Civica, Unnim and Cajasur (in fact 27 of the 91 banks stress tested were Spanish). If it weren’t for the IMF and EU bailout,Ireland might never have confronted the true level of losses as uncovered by the latest stress testing. But if both ofIreland’s main banks could pass the stress tests then and need nearly €20bn now, what does that say for the Spanish banking sector now?

Spain’s banks were exposed to what we might call Land and Development to the tune of €445bn (yes billion) in December 2009. Irish banks have seen average haircuts on the value of their land and development (and associated lending) of 58%. Spain apparently has €40bn of loss provisions against its land and development loans. If its loans were to turn out to be as rotten as those inIreland there might be more than €200bn of land and development losses lurking around the Spanish banking system. Add in mortgage default in a stressed property market which would seem from an outsider’s point of view to have displayed miraculous resilience during the property downturn, and could we have €400bn of additional losses in the Spanish banking sector?

Conclusion

This entry didn’t set out to be a comprehensive study of Spain’s property and banking sectors. There is no examination of commercial property at all and little on Spain’s broader economy.Spain has an enormous banking sector and much research would be required to provide up to date estimates of losses. However for a fellow EuroZone country which plainly had a property boom in the 2000s, whose economy is suffering nearly as much as Ireland’s (on some bases like unemployment suffering more), it is puzzling that it still enjoys Moody’s third highest credit rating whilst Ireland is lifting its legs to avoid junk status.Spain is not in receipt of a bailout though it needs refinance €660bn of bonds in the next two years. Its 10-year bond rate is close to – indeed, arguably now above – the bailout rate offered to Portugal. How long before Spain succumbs and PIGS is incarnate?

I leave you with a warning from the chairman of the True Finns party in Finland Timo Soini who said “And so, unpurged, the gangrene spreads. The Spanish property sector is much bigger and more uncharted than that ofIreland. It is not just the cajas that are in trouble. There are major Spanish banks where what lies beneath the surface of the balance sheet may be a zombie, just as happened in Ireland for a while. The clock is ticking, and the problem is not going away.”

UPDATE: 5th August, 2011. Spain’s central bank has today issued its quarterly economic bulletin for Q2, 2011 (English language summary available here)  in which it notes that growth of the economy continues at a sluggish pace (0.2% quarter on quarter and 0.7% year on year), unemployment remains elevated at 20.9%, inflation is at 3%. House price declines have picked up (5.2% year on year in Q2, compared with 4.7% in Q1) which mean that prices are 17% down from peak in 2007 (22% in real terms).

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