Spain: One side of the European domino

Foreign banks flee Spanish property debt

By Ambrose Evans-Pritchard in Madrid

Last Updated: 1:28am BST 05/04/2008

International banks are scrambling to sell their holdings of Spanish mortgage debt at a steep discount, fearing that the country may be sliding into the worst economic downturn in its modern history.

A blizzard of grim data has soured the mood, capped yesterday by a plunge in PMI purchasing managers’ index to an all-time low of 40.9. Car sales fell 28pc in March, and even Madrid’s legendary tapas bars seem to have lost their late-night sparkle.

Inmobiliaria Colonial - once the country’s biggest property group –is in emergency talks with banks after Dubai’s Investment Corporation pulled out of a rescue deal.

Developer Martinsa Fadesa is struggling to restructure €5bn of debt to stave off insolvency.

Traders says the market price for Spanish mortgage securities has begun to slide abruptly, replicating the pattern seen in the US last year. Large French and German funds and insurers appear to be liquidating assets in a pre-emptive move, afraid being caught yet again in a violent downturn.

Ismael Clemente, head of Deutsche Bank’s property arm RREEF in Spain, told a panel of experts in Madrid that foreign banks were now dumping Spansih mortgaged debt at a 40pc discount.

Mikel Echavarren, director of the property consultancy Irea, said Spain’s housing market was far weaker than the official statistics suggest, warning that prices could fall 20pc to 25pc.

“All kinds of ploys have been used to disguise the true extent of the price falls, which we think are 5pc to 7pc already. Buyers have totally abandoned the market. We’ve had a wave of negative sales as people pull out of commitments already made,” he said.

“We have a very worrying situation. The developers simply cannot refinance their debts. We need to cut interest rates by 2pc, which is obviously not going to happen,” he said, adding that the crash could be sharper than the property crisis in the early 1990s.

Santiago Baena, head of Spain’s estate agents lobby API, said the downturn had already forced 40,000 agents to close their doors, laying off 120,000 staff.

The Bank of Spain said default rates would rise but insisted that the Spanish banking system remains in good health, without much exposure to the US subprime debacle. The loan-to-value ratio on mortgages was kept to 70pc - although a report in Germany’s Die Welt newspaper today alleges that false pricing was often used to circumvent the rule.

The authorities said that a crisis comparable to the early 1990s (when bad debts reached 13.1pc) would erode the capital base of the banking system by 63pc, a manageable level. The developers owe €290bn to the banks and lenders, known as “cajas”.

The government is preparing a €20bn spending blitz on high speed railways and other mega-projects to cushion the downturn. Spain’s trump card is a budget surplus of 2pc of GDP last year, leaving in ample scope for fiscal stimulus - in sharp contrast to Italy, France, and Britain.

The root cause of the crisis is in a sense Europe’s monetary union. The euro effect halved Spain’s interest rates almost overnight. Rates then fell below Spain’s inflation rate for several years, fuelling an explosive credit boom. The country’s current account deficit has reached 10pc of GDP, the highest of any major economy.

The process has now kicked into reverse. Mortgage rates - priced off three-month Euribor - have nearly doubled since late 2005.

David Owen, Europe economists at Dresdner Kleinwort, said Spain was waking up to the reality that there will be no quick-fix. “They are no longer arguing about whether there will be a recession, but about how deep it will be,” he said.

“Spain is no longer able to set monetary policy for its own needs. It could face zero-growth for five years,” he said.

ABC newspaper reported that the Bank of Spain rushed its Financial Stability Report into print two months early in order to refute “tendentious” claims in the British media that Spain’s banks had become reliant on emergency funding from the ECB after the capital markets seized up.

The banks have been issuing mortgage bonds on a large scale to use a collateral at the ECB’s lending window, raising concerns that they are becoming dependent on taxpayer funding. The Bank of Spain said they had borrowed €44bn from the ECB, insisting that this was “fully consistent” with EU rules.

The ECB said its latest €25bn auction of six-month funding this week was heavily over-subscribed, with €103bn of bids from 177 banks at rates as high as 4.88 pc. It did not reveal how much of the bidding came from Spain.

Deutsche Bank expects house prices to fall 8pc this year as the market struggles to clear a glut of unsold homes. Construction peaked in 2006 when last year when 740,000 new housing units were built - more than in Germany and Britain combined.

Standard & Poor’s said Spain risked a “major collapse” in construction after a 40pc fall in housing permits. Building has accounted on a fifth of all jobs created in Spain since 2000. It said the country faced a “major and likely painful adjstment”.

Did Evans-Pritchard write this at a tapas bar? I just corrected about 15 blatant typos. Anyway …

The over-leveraged European countries (and the euro by extension) are the countries to watch.

The US has flooded its banking system with enough paper to put off problems for a while. I think John Mauldin is exactly right in his assessment, that the Fed will turn a blind eye to banks’ technical insolvency as they rebuild their balance sheets and write off their debts over the next five or so years.

Europe, however, is a different matter. The ECB was taking on lots of garbage debt, especially from Spain, but perhaps there’s a limit to what Trichet is willing to do for Spain’s banking sector.