spanish housing bubble jul09

8/14/2019 Spanish Housing Bubble Jul09

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July 2009

The Spanish housing bubble:A simple approach to gauge the

extent of the problem


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Index

Inflation: Public enemy number one..

House prices vs CPI

Inflation out of control...

Where is the money coming from?..

Where has it gone?..........................................................

Say nothing, do nothing..

Securitisation: Leverage in aeternum.

Summer 2007: La Fiesta is over....Deficit silver medal...

Bubble correction..

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5

6

7

8

9

1011

12


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Inflation: Public enemy number one

In a hypothetical desert island where you can only find 100coconuts and 100 euros, each coconut would be worth 1 euro. If themoney supply doubled (to 200 euros) each coconut would double inprice (to 2 euros). This is inflation. The money supply buys thegoods and services available.The temptation exists by the government to increase the moneysupply in order to increase its purchasing power. However, wheneconomic agents perceive this, the currency loses credibility and itdevalues.After multiple events of hyperinflation the lesson has been learned;inflation is the principal culprit of the loss of confidence in acurrency.The main mandate of the ECB is to maintain the purchasing powerof the single currency and therefore the stability of prices in theEuro zone. (Source: www.ecb.int )

CPI (IPC in Spain) is the principal instrument that measuresinflation in Spain. It tracks the increase of general prices bymonitoring the price movements of an average basket of goods andservices.It does not, however, capture increases in the price of housingbecause housing is perceived as an investment rather than anexpense.
http://www.ecb.int/http://www.ecb.int/


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Housing vs IPC (CPI)According to Asociacion Hipotecaria de Espaa (www.ahe.es), theaverage size of a mortgage has increased from 55.887 in 1998 to140.845 in 2008. The annual mortgage outlay (interest plusprincipal) of a typical household has increased from 4.671 to10.119.The average household consumption expenditure per year reached32.001 in 2008. (Source: Instituto Nacional de Estadistica).Therefore the amount required to service a mortgage loan in Spain

represents 32% of the annual expenditures of the averagehousehold.In contrast, the expenses associated to housing that are capturedby IPC methodology (CPI) such as house rent, house repairs, water,gas, electricity etc. represent 26,5% (or 8.201) of the averageannual expenditures of a typical household.Therefore the mortgage payment (interest and principal) representsby far the largest single item of expenditure for an average Spanishfamily.This item is excluded from IPC (CPI) methodology because it is notconsidered an expense and thus increases in the prices of housesdo not impact headline inflation figures.


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Inflation out of controlInflation figures can be misleading if a leading expenditureitem, such as housing, is excluded.

IPC (CPI) has increased 30,2% in the period from 1998 to2007. in the same period, the price of houses has increased176%.The price of housing has remained outside the control orscrutiny of economic agents because it has remained outsidethe IPC methodology. Not being part of IPC means thisexpenditure item is ignored. Real inflation was thereforehigher than reported by official statistics and the purchasingpower of households was lower.

Precio vivienda /m2

0

500

1000

1500

2000

2500

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Ministerio de Vivienda


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Where is the money coming from?Spanish banks have been able to tap hitherto unknownsources of financing since the inception of the Euro market(Jan 1998). They have used this capacity to the full.

Euro denominated bonds, securitization, cedulas hipotecariasHybrid capital instruments that reduce the quality of capitalOff-balance sheets financing vehiclesDiscounting bonds and cedulas hipotecarias in the ECBReduction of minimum reserve requirements of financial institutionsin the ECBReduction in the core capital base (increased leverage). One of thelargest spanish Cajas for example had a balance sheet totalling Euro5bn in 1993. 15 years later, it has multiplied that by a factor of 20.

BCE

Private bank Private bank

Investors Investors


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Where has it gone?

Source: Ministerio de Vivienda

19.000.000

20.000.000

21.000.000

22.000.000

23.000.000

24.000.000

25.000.000

2001 2002 2003 2004 2005 2006 2007

Residential housing stock in Spain (units)

Looking at spanish banks balance sheets one would inferthat a lot of that money is parked in real estate assets. Since

2001, the stock of residential properties has increased by 3,5million units and the price per sqm has increased from992/m2 to 2.085/m2. The average size per residential unitis 98,6sqm and therefore there is more than 373.000 Mill of additional wealth parked in this asset class alone.([2.085/sqm- 992/sqm]*3,5mill*98,6sqm).The limitless liquidity in the new Euro market (coupled withlax regulation) was directed to the point of least resistance:Housing.


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Say nothing, do nothingThe paralysis which has afflicted the Spanish govt since theinception of the crisis is proverbial. Mr Zapatero went as faras promising full employment upon gaining reelection. Othermemorable highlights was his promise to overtake France inper capita GDP and his stuborn rejection as late as end-2008that there was even a crisis looming.He is still sticking to his famous quote that Spain enjoys thestrongest financial system in the world because so far no big

banks have been bailed out yet. We prefer to tip-toe over thesignificant measures to support banks through liquidity andguarantee schemes as if that didnt constitute a covertrescue already.Meanwhile the govt. replicates successful measures testedelsewhere or otherwise does nothing.As the crisis gathered momentum economic and social agentskept a suspiciously unanimous positive message:

Property owners saw prices rise.The govt. saw tax recepits increase and less unemployment.Banks and the construction industry made a lot of money.House seekers were concerned with price rises but they had a joband a mortgage that allowed them to have access to housing.

The authors view is that everybody in Spain was happybecause ultimately foreigners were paying for this fiesta.


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Securitisation: Leverage inaeternum

4. Bank grantsmore mortgages

950Mill

2. Bank securitises mortgages950Mill

3. Investors buysecuritized

assets 950Mill

1. Bank grants mortgages1.000Mill

A bank grants mortgages for 1.000Mill to its clients.Keeping approximately 5% of equity, the rest (950Mill) issecuritized and sold to institutional investors. The proceedsare again used to grant more mortgages.After 3 iterations of this process, the bank will have granted2.852Mill worth of mortgages from an original 1.000Mill of liquidity.Where is the limit? The limit is set by institutional investors

when they stop purchasing the securitised assets.


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Summer 2007: La Fiesta is overIn August 2007 the capital markets shut completely.The system was so rotten that US banks were grantingmortgages to NINJA (No Income, No Jobs or Assets) for100% of the value of the property with 2 year grace period oninterest and principal. Essentially anyone could buy a housewithout putting a cent of his own money.Spanish banks were second only to the UK in securitisationissuance in Europe (first in uroland) from 2004 to 2007.

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50.000

100.000

150.000

200.000

250.000

300.000

350.000

2000 2001 2002 2003 2004 2005 2006 2007

Stock of spanish securitizations (Mill)

Source: Banco de Espaa


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Deficit silver medalOne of the more aggravating characteristics of the record

current account deficit, second only to the US in absoluteterms, is that it has financed principally a housing bubble,thus doing nothing to increase productivity or the exportpotential of the country.In an economic situation where Spain cannot:

Devalue its currency (uro)Change monetary policy (interest rates)

It is not competitive on price in export marketsIt has a low productivity based on its construction and tourismeconomic model (both sectors accounting for more than 20% of GDP)

The adjustment can only come through a progressive andpersistent reduction in real prices (deflation) that can restorecompetitiveness and attract investment.


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Bubble correctionIf we agree that housing prices have overshot then a goodpart of the adjustment must come through the reduction inthe price of this asset.The real price of housing can be estimated in many ways. Onepossible approximation could be to take the price per sqm in1998 (757/sqm), before the current bubble started, and toincrease it by the average increase in prices since then (IPCof 30,7% in that period). The rationale behind this is thathousing should not have increased its prices more than the

average of the rest of goods and services in the economy.The correct price would then be 989/sqm, less than half of the average price observed at the peak (2007, 2.085/sqm).

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1.000.000

2.000.000

3.000.000

4.000.0005.000.000

6.000.000

2001 2002 2003 2004 2005 2006 2007

Valor estimado parque vivienda Espaa ( Mill)

Burbuja

Precio IPC


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Bubble correction II

Using the previous rationale, the estimated size of the bubble

is of the order of 2,695,000Mill. This is more than double theSpanish GDP (1,215,000Mill in 2008).This bubble needs to be corrected before foreign investmentreturns to Spain. Foreign Direct Investment (FDI) is the keyfactor that will cure the deficit and signal a turnaround.This exercise to revalue real estate assets must be led by thedomestic banks (who incidentally control the independentappraisal market). The balance sheets of banks comprisemore than 50% of real estate exposure in certain Cajas deAhorro.In the US and the UK the largest banks were rescued withpublic funds to ensure an orderly process in theirrecapitalizations. This has not happened in Spain becauseassets have not been marked-to-market.Unfortunately if this exercise of revaluation were to beimplemented in Spain today, the authors opinion is that thefinancial system as a whole would be technically bankrupt(i.e. equity


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Bubble correction IIIIn the absence of shock therapy spanish banks haveovercome the first hurdle, the lack of liquidity, by appealing

to the ECB and the spanish govt. The spanish govt. used twoprograms (apart from guaranteing deposits up to 100,000per account); one granting guarantees to bonds issued andanother buying debt directly from banks.The second hurdle, solvency, is more complicated because, inthe absence of massive recapitalizations with public funds,spanish banks need to provision losses slowly to preservecapital. They are doing this as follows:

During 2007 and 2008 realizing the capital gains from their equityholdings.During 2009 by using generic reserves and counterciclical reserves(the last one specific to Spain and used as a recurrent example of the strength of the spanish system vis a vis other countries).From 2010 onwards using retained earnings.

In the meantime, to support the prices of real estate assetsand therefore delay the day of reckoning, the banks (with thesupport of the govt) are doing the following:

Debt for property swaps (Daciones de pago). Banks hoard realestate and clients reduce debtDirect purchase of real estate assets from clientsRefinancing and renegotiations on existing loans


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Bubble correction IV

Unfortunately this half-baked and improvised approach is

producing:Deflation: Spain is the first EU state to suffer it and it is the firsttime, since official IPC (CPI) statistics started in 1961 that Spainsuffers this phenomenon.Unemployment: An unpredented rise in absolute terms (reaching17,3% in H1 2009) destroying more than 800,000 jobs in T1 2009alone.

The gravity of the situation, however, does not reside withthe worrying statistics but rather in the deterioratingexpectations of a recovery.The author does not get the feeling that Spain is taking thepainful medicine that it needs and yet the symptoms that it isdisplaying denote a very significant ailment already.

spanish housing bubble jul09

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