Banks in Spain World's next Financial Drain

Spanish Housing market is much worse than people think. “Spanish banks are among the strongest in Europe,” reports Forbes Magazine.
The real estate crash in Spain is worse than widely is believed, while Spanish banks are hiding their losses.

Spain will be viewed much like subprime where all the banking results looked good, until they didn't. Spain has as many unsold houses as the U.S. but at only one-sixth of the population, and these homes are on the books of banks at full price

Spain's problem is tied in with the problem of the entire European community. The boom years following the adoption of the euro provided both; easy money via negative real interest rates, and an overvaluation of prices as measured by real effective exchange rates.

Spain, and the rest of the European community, can solve their problems either through massive productivity gains, which is highly unlikely during a recession, or through a reduction in wages and prices in the order of 20-30%, which is what will happen slowly and painfully. Such a reduction of wages and prices is effectively an "internal devaluation".

Such an internal devaluation will imply large losses to domestic banks and to external creditors. In the case of Eastern European countries, the damage will be bad, but not very large. In the case of Spain, writing off mortgage debt will be massive. It is estimated that Spanish real estate losses will be over €250 billion when all is said and done.

Clearly Spanish and foreign banks are unwilling to admit to the size of the problem and write off the debt. That is why the losses are being hidden.

The magnitude of the Spanish problem is staggering, and will overwhelm all the benefits of made provisioning. Spain has over 1,000,000 unsold new homes. Unfortunately, many of the homes are in the wrong place on the coast, and without a return of overleveraged British tourists, they are likely to remain unsold.

Spain's building stocks bubble looks very much like the US bubble and other classic bubbles. It went up 10x and then went down 90%. The consequences are simple to understand.

Spanish banks are now the largest real estate holders in Spain. They have come to own properties through many different ways. In order to hide from the effects of the real estate crash, Spanish banks have been buying properties before the loans on them turned bad and trying to dispose of them through their own real estate companies. They have also come to own dozens of thousands of homes through debt for equity swaps. Estimates put the value of property repossessed or swapped for debt by Spanish banks at about €16 billion.

Eastern Europe, Spain and Ireland are now experiencing the beginning of deflation. And there is much more deflation to come, which will have broad ramifications across the European banking sector. When a debtor can't pay, the creditor suffers. Germany, France and others will need to cope with recapitalizing above-mentioned countries. A deflationary spiral means that most of the debt will need to be written off, and the creditors will have to absorb the losses.

In a deflationary environment, servicing debt becomes even harder. Even when rates go to zero, prices and wages can go down faster and the real burden of debt can still go up. That is why deflation is such a terrible thing.

Spain's unemployment level is heading towards 25%. With a 25% unemployment rate and a debt deflationary dynamic, how exactly do the banks think they'll be paid back? Who will earn the money to pay the mortgage payments, and how will housing be affordable when wages have been deflated? Zapatero the Prime Minister assumes the worst is over in Spain, but that does not meet reality. Spanish politicians in general and international investors have grossly misjudged Spain, but events will force them to change their mind.

Inflation in Spain has been negative for the last three months in a row. Spain has not experienced a similar decline in inflation like this in over 47 years. However, the Bank of Spain and the government are behaving like ostriches with their heads in the sand.

Spain is not the only country facing deflation. It is a problem for the entire European community. Ireland, for example, has the highest rate of deflation in the world. Prices in Ireland are falling at an annual rate of 5.9%, well ahead of the drops in other countries - only Thailand, at 4.4%, comes close.

Ireland's experience is what Spain will see more of in the months ahead as the economy slowly adjusts to new realities. Almost all of Ireland's banks have been taken over by the government, and Ireland is struggling to decide how best to dispose of its bad assets. Spain looks like Ireland more than any of its European member nations.

Contrary, even though inflation is negative, and unemployment is high, Spanish unions are still winning pay rises. Most wage agreements in Spain are reached through collective bargaining on an industry level. So far, wage increases are happening above the ECB's 2% target inflation rate.

The rest of Europe financed Spain’s large growth in consumption. Spain's trade deficit was among the highest in the world in absolute and relative terms at around 10% of GDP in late 2007.
Spain will soon be faced with a number of very uncomfortable choices, but for now they appear in denial.

This next problem from the credit crisis is worldwide. To think they are not interconnected would be extremely naive. What happens in Japan and Spain and the US will affect every part of the world, some more than others.

Reference: Variant Perception Research