1/ Euribor (12 months) - this is the interest rate most commonly used to calculate mortgage payments in Spain – rose to 5.361% in June, its highest level since the introduction of the Euro. The previous high was in August 2000, when Euribor reached 5.248%. Euribor is now 19% higher than it was a year ago, having risen 7.3% during June. Euribor is now one and a half times higher than it was in June 2004, when the Spanish property boom was in full swing, meaning that mortgage payments for people who bought then have more than doubled. It is important to be clear that this is NOT the pricipal driver of the Spanish slowdown (which is a shortage of bank funds for mortgage lending) , but clearly the shoe does pinch the foot of a Spanish consumer already hit by global rises in food and energy prices, so it does add to the problems as we go down. Further, since (see below) a large part of the mortgage lending during the boom was externally financed, it does make the external imbalance (current account deficit problem) worse, since a significant chunk of the increase goes directly to external investors. ie the income balance on the current account WILL continue to deteriorate. Long term this is going to become an important problem for Spain. The steady deterioration in the income balance can be seen in the chart below.
2/ Spain's budget surplus "cushion" is fast disappearing. Carlos Ocaña, Secretary of State for Housing, recently said that for the year to May the surplus in the government budget was €2.7 billion, 0.24 percent of GDP, down from €13.6 billion for the same period in 2007. The impact of the most recent 18 billion "crisis package" will now surely send Spain's public finances into deficit. The only real question is how far, and for how long?
3/. Since 1995 Spanish house prices have risen 200% in nominal terms (i.e. before inflation is factored in), and 110% in real terms (after inflation).
4/. Over the last decade, the share of property related loans has risen from 40% of total private non-financial sector loans to 60%, equivalent to a staggering €1 trillion in property loans, around 100% of Spanish GDP and a third of banks’ total assets.
5/. Whereas Irish house prices have been falling for some time, the Spanish numbers continued to show a small annual increase until very recently. One reason for this situation may be the way the numbers are calculated; the figures depend not on market prices, but on valuers, who may be cautious about cutting their estimates. There are a lot of numbers floating about offering estimates about how far Spanish property prices will fall. At this point I refuse to offer any such "guesstimate" since there are so many factors we simply cannot calculate yet, and they all tend to reinforce each other in "lose-lose" fashion (that is the process is definitely not linear, which is why the speed of the slowdown in the Spanish real economy has surprised many people). I would simply say that the correction in prices is likely to be substantial.
6/. Spain and Ireland stand out as the two eurozone countries whose economies have been dominated by housing. According to Goldman Sachs, construction and housing-related employment in both countries made up 13% of all private-sector jobs at the end of 2007, as compared with 9% in the US and 5% in Germany. Meanwhile, nominal residential investment was 11% of GDP in Ireland and 9% in Spain, against 6% in the US in 2007.
7/. More than 4 million Spanish dwellings have been built over the past decade, according to Britain's Royal Institution of Chartered Surveyors. Their 2008 survey of European property suggests that far more Spanish houses were being built last year than are likely to be needed in steady market conditions, let alone during a slump.
8/. While the countries most affected by the property-driven credit crunch in the EU are Spain, Ireland and the UK, the UK is rather different from the other two. Housebuilding grew by 187% in Spain between 1996 and 2006 (and 177% in Ireland), while the equivalent increase in the UK was just 12%. Planning restrictions in Britain meant fewer homes were built which may also explain why house prices in the country have almost doubled, in real terms, since 1999 despite the comparatively low percentage of new builds.
9/. In recent years the Spanish banking system has had one important structural characteristic: is has been characterised by particularly high intermediation margins. In fact the Spanish banking system has historically had some of the highest intermediation margins in Europe, since it has combined more costly loans with lower-yielding deposits than in the rest of Europe. Margins reached a historical high of 3.4% in 2001, then fell back to 1.7% in 2004. Average margin climbed again to around 2% in 2006, a level not far off that of the major Italian banks (2.08%). This compares with 0.77% in Germany, 0.98% in France and 1.61% in the United Kingdom. It is this historic margin which is currently enabling the Spanish banks to keep the wolf from the door to some extent, since they are able to raise short term funding by (for example) raising payments made on deposits and thus reducing the margins. This process does, of course, have its limits.
10/. As a result profitability has been comparatively high in the Spanish banking sector. Spanish credit institutions reported strong performances in both 2005 and 2006. Net interest incomes benefited from the generally strong economic performance reached over 55% of Net Operating Income in 2006. Commissions were stimulated by the positive performance of the Spanish stock markets (+21.6% and +24.5% respectively on IBEX 35). Despite the impact of the financial turbulence in the summer of 2007, and the subsequent loss of confidence, Spanish financial institutions recorded an increase in net results over the first nine months of 2007. The leading Spanish group, Santander, realised a net profit of 6.4 billion euros (+27% year on year). Banco Bilbao Vizcaya Argentaria (BBVA) published a net result of 4.9 billion euros (+7.2% year on year, with +15.5% in intermediation revenues). La Caixa and Caja Madrid also saw their after-tax profits leap up by 44% to 1.5 billion euros for La Caixa and 1.2 billion for Caja Madrid. Finally, the net income of Banco Popular was up 15%, reaching 986 million euros. In whole year BBVA increased its net attributable profit 29.4% to €6.1 billion, while Banco Santander's net attributable profit rose 19% to EUR 9.060 billion.
So the Spanish banks have been able to leverage high gross operating profits (25.5 billion euros in 2006) as a result of one structural characteristic of the banking system: very high intermediation margins. This situation, the high profits declared in recent years may mislead many observers into thinking that financial support for the banking sector will not be necessary as we move deeper into the crisis. This view would be a mistake in my opinion, since as I am saying, these margins can be rapidly eaten up by the need to pay higher interest rates to depositors or others in order to refinance the cedulas. Unless something is done to structurally alter the rate paid by borrowers this problem will probably continue and get worse. The high recent bank profits will only then serve as bad public relations material for a government which may need to explain to voters that they need to pay more for their existing home loans.
11/ The Spanish banks are, however, faced with two major challenges: the bursting of the property bubble and a liquidity crisis. The current paralysis of the relevant sections of the wholesale capital markets presents the Spanish Banks with two important risks at a time when they have been securitizing a significant proportion of their loans. The first, a direct risk, is a weakening of institutional bank balance sheets. The second, indirect, is a tightening of credit conditions, accelerating correction of the property market and increasing the counterpart risk by eroding borrowers’ ability to repay their loans.
Basically, and whatever the protests to the contrary from some quarters, the Spanish banks are having difficulty generating the funding they need. The principle evidence for this is the rapid slowdown in year on year bank lending. Since the knock-on negative feedback for the banks that this will produce via a recession (or worse) in the real economy means the banks would be avoiding this state of affairs if they possibly could. I think things have now come so far that there is no way back up the path we have come along, and the only way ahead is to move on downwards and through the eye of the storm.
12/ The second major risk issue in terms of the credit tightening is the refinancing of the cedulas themselves. The Madrid based consultancy Analystas Financeros Internacionales (AFI) estimate that during 2007 Spanish banks were raising approximately 40% of their funding requirements outside Spain, as compared with only 15% in 2000-2001. AFI estimate that around 40 billion euros in cedulas and other bank debt come up for refinancing in the second half of 2008, that in 2009 this number will rise to around 80 billion euros, and that the number will remain high through 2010 and 2011. That is to say my rule of thumb guess that we may be facing around 300 billion euros in rollover issues (or somewhere in the region of 25% - 30% of Spanish annual GDP) in the coming years does not seem to be too far off the mark. (And note that similar provision may need to be made for equivalent exposure to bankrupt builders, households, corporate entities etc).
The following chart (prepared by the bank itself as part of earlier promotional material) for the Spanish bank BBVA gives some rough and ready indication of the rollover issues which are coming up, and their temporal distribution.
13/. The proportion of mortgage-backed securities in the broader sense of the term (ie including cedulas and MBS) amount to around 37% of outstanding mortgage loans. Asset backed securities held by non-residents constitute may amount to as much as 81% of the total securities issued (according to a PNB Paribas estimate, this may be too high, but in any event the figure is very large).
14/ Loan quality has been pretty high in Spain: the ratio of doubtful loans to gross loans only stood at 0.8% in 2006 as against 1.6% in the United Kingdom, 2.9% in France, 3.7% in Germany and 5.8% in Italy. The coverage ratio of non-performing loans by the large institutions is 217%, against a particularly weak default rate (0.76% of the outstanding loans to the nonfinancial private sector in the second quarter of 2007), which reveals the extremely prudent provisioning rules operated by the Bank of Spain. The problem is that, in the first instance at least, the major risk to the Spanish banks does not come via this route.
15/ Outstanding home loans (for purchases and refis) represent a substantial percentage of the Spanish banking institutions’ balance sheets (21.5% of total assets and 35.6% of total loans to the non-financial private sector in the second quarter of 2007). In the second quarter of 2007, outstanding home loans amounted to 589 billion euros, 56.4% of which were distributed by cajas (29.8% of their assets), 37.2% by commercial banks (15.4%) and 6.4% by mutual institutions (30.9%).
15/ If we add together home loans and the financing of real estate sector (construction and property services), the overall exposure of Spanish credit institutions has increased significantly over the last decade (37% of assets in the second quarter of 2007, 61.5% of total loans to the non-financial private sector). Exposure of Spanish banks to the real estate sector exceeds, both in level and in growth rate, that of US, Japanese and British banks. In total, in the second quarter of 2007, cajas (49.7% of assets, 70.5% of loans) and mutual institutions (46% and 56.3% respectively) were almost twice as exposed as commercial banks (28% and 55.2% respectively).
16/ Securitization in the broader sense (i.e. including covered bonds) plays a fundamental role in the financing of Spanish mortgages. The proportion of resources which derive from issues on the mortgage market amounted to 37.3% of outstanding mortgage loans (residential or non) at the end of 2006 as against 35.3% at end 2005. At the end of 2006, total funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).
Bank liabilities represent an important underlying factor in Spanish securitizations: 27.7 billion euros in 2006, principally in the form of Cédulas hipotecarias (or covered bonds) (34.8% of new issues on the mortgage securities market). The direct securitization flow of mortgage debts (MBS) reached 48.5 billion euros in 2006 of which 38.9 billion was in the form of residential mortgagebacked securities (RMBS). In 2006, MBS’s represented 65.2% of new issues on the mortgage securities market. Outstanding amounts of residential mortgage loans constituted one of the principle supports of securitization in 2006, close to 41% of new issues taking the form of RMBS (38% of outstanding amounts). The growth of these latter has, nevertheless, significantly diminished (+31% of annual growth in 2006 compared to +57% in 2005), reflecting the slowdown in home loans and also the fact that an increasing number of loans no longer satisfyied the rule that loans should not exceed 80% of the estimated value of the property. Combining these two securitization techniques (covered bonds and MBS), mortgage loans (to households and other agents) represented, in 2006, the counterpart of close to 80% of new issues by securitization vehicles (and 83% of outstandings).
17/ Spanish households are now among the most indebted in Europe. While at the end of 2006 European households had debts amounting to some 80% of their gross disposable income, Spanish household debt reached 118% (against 67% at the end of 2000). In the third quarter of 2007, the global debt of Spanish households reached a record of 124% of GDP of which 92.2% was for home loans (as against 40% in 2000) and 31.8% for consumer and other loans (24.3%).
Household solvency has thus clearly deteriorated since the start of the century. Moreover, real household borrowing capacity has declined significantly. At the end of 2006, the average affordable surface area for a household with average disposable income who were likely to finance the purchase at the average lending rate and whose personal contribution rate remained stable was less than that the same family could have bought in 1993 or 2003 (reference years in which real solvency matched the 1987-2006 average).
Prices were about 20% above the level that would have enabled a representative household to purchase the same surface area as in 1993 or 2003. The Bank of Spain has estimated that, in September 2007, the price of a residential unit of 93.75 m2 represented, on average, a little over seven years of disposable income (as against five years in 2003), while the annuity of a standard home loan, equivalent to 80% of the value of the home purchased, reached close to 45.4% of the average household gross disposable income (as against 31.3% in 2003)
18/ The Spanish construction sector was one of the main growth drivers between 1996 and 2006. The value added from construction increased substantially (+5.8% on annual average at constant prices as against +3% for the whole economy). The weight of construction in GDP rose from 6.6% in 1996 to 10.8% in 2006. Employment in the construction sector rose rapidly (+7.7% year on year on average between 1996 and 2006 as compared with +3.5% for the whole economy). In 2006, the construction sector accounted for 13.6% of total employment as against 9% in 1996. The structure of (and significant increase in) outstanding corporate loans since the start of the century reflects the importance of these loans and real estate as growth drivers. The share of industry and services’ (excluding property services) in financing to productive activities has declined, and their market shares have also decreased, over the last decade in favour of construction and, above all, the property developers whose market share has multiplied by four. In the second quarter of 2007, the property sector still absorbed 49% of loans to non-financial corporations, of which 16.6% were for construction.
19/ Losses linked to a deterioration in the quality of Spanish debts would not be absorbed exclusively by Spanish institutions themselves, of course. In 2006, out of a total of 243.2 billion euros of securities issued by Spanish securitization vehicles, close to 197.2 billion were held by non-resident investors, bringing the proportion of securities in nonresidents’ portfolios to 81.1% (against 28.7% in 2000).
In Conclusion
Higher than eurozone average inflation which resulted in extremely low, and between the end of 2001 and the end of 2006 negative, real interest rates (see chart below) home loans were heavily stimulated in Spain, with an average annual growth rate close to 20% since 1998.
If you go back and look at the chart for house price increases (above) you will see that this period of negative interest rates correspoded to the fiercest period of house price rises in Spain, and of course the rate of increases first started to really slow in the second half of 2006 when interest rates moved into positive territory. This then began to produce a more or less orderly slowdown in the Spanish housing market, and this is what many observers still continue to expect. The difficulty is that this orderly correction was "severely disrupted" by the credit crunch shock which followed the sub-prime turmoil in the US in August 2007, a shock which has meant that the doors of the wholesale money markets have now become locked tight in the face of the Spanish banks.
House purchases were boosted by a variety of positive-feedback factors (strong headline GDP growth and high jobs creation) which together with the attraction of a strong positive wealth effect (higher value of household assets following the surge in house prices), brought the proportion of Spanish homeowners to 84% of the total in 2006 as against 71% in Great Britain, 58% in France and 42% in Germany. However, the rise in house prices has also been fuelled by a very tight rental market (approximately 10% of total residences) and the sharp rise in rents (which often made a given property more expensive to rent than to buy) was in part the product of pressure produced by a massive migrant worker inflow (almost 5 million people 2000-2008) chasing a very limited rental stock. The end product: a record household debt rate (124% of private gross disposable income in September 2007), and a real economy which now trembles under the growing impact of a shift from a strong positive feedback mechanism to a strong negative feedback one.
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