Confidence in Spain goes mainly down the drain

Article by Gregory Butcher

Confidence has always been the key element in the financial markets. It’s often presented in the mainstream media as some kind of ephemeral concept based on little more than a whim of a select group. However in reality confidence is based on more concrete factors and is simply a term for the amalgamated outcome of diverse research, analytical study and emotional pre-disposition.

And once again Spain is faced with issues of confidence from the markets. The Bank of Spain has continually attempted to reveal just enough information to assuage fears and the next date looming large is 28th March, by which time financial entities must submit their viability plans as to how they intend to meet the new core capital requirements set by the Bank of Spain earlier this year. These must then be enacted by September (with an allowance for them to gain an extension until 2012 if they commit to listing shares).

On 17th March 2011 the ratings agency Fitch calculated that the Spanish banking system would need at least 38 billion euros to clean up their balance sheets, but alarmingly they also noted that if the pattern of losses experienced in the Irish system were followed then they may require as much as 96.7 billion euros. Goldman Sachs meanwhile put the figure at 22 to 59 billion euros whilst Morgan Stanley estimated it at 40 billion euros.

This analysis came on the back of the Bank of Spain’s assumption that the balance sheets required only 20 billion of funding, a figure viewed with scepticism by many commentators as it failed to take into account future impairment losses. Indeed the release of this figure came shortly after another agency, Moody’s, had raised the alarm over Spanish banking woes as it sliced Spain’s credit rating (to Aa2) and warned it may do so again. Moody’s had calculated the cost of cleansing the balance sheets at around 50 billion euros.

So where does the real figure lie? And what can the system do to avoid a meltdown that would have potentially disastrous consequences for the Eurozone as a whole.

The real reason for the differing figures seems to be once again the valuations placed by the banks on their exposure to real estate. Gregory Butcher, Chairman of property investment company Fairhomes, commented “It is extremely difficult to quantify the Spanish banks capitalisation needs with confidence given the inability to calculate accurately the actual fall in Spanish property prices since they peaked in early 2008”.

At present banks and saving banks in Spain hold 150 billion euros in problematic loans linked to real estate (equivalent to 15% of GDP). Bad loans in the Spanish financial system have risen steadily and are now nearly 10 times the level seen at the peak of the credit boom and the highest bad loan ratio since October 1995.

Added to this is the recently published data showing that Spanish house prices slipped for the 12th consecutive quarter in Q4 of 2010, rising unemployment and little prospect of growth and recovery in the economy as a whole.

Most real estate insiders estimate that property prices have already fallen by 50% from their peak values in 2007. However data used by the banks to value their assets has come from valuation agencies such as TINSA whose measurements have been widely derided as over optimistic and anachronistic as they detail only a 12% fall in prices.

This illusion of higher than market prices has also been sustained to a certain extent by the banks own property activities. In an attempt to raise capital the banks have now also become the county’s biggest estate agents, setting up real estate arms to promote and sell property to domestic and overseas buyers. The prices they have gained form this activity have been used to some extent to justify their own valuations of their assets and so hide the true level of their liabilities.

But to use these prices as a guide is incorrect in two ways. Firstly, many properties have been offered at above market price in conjunction with 100% finance deals which are effectively subsidised (i.e., the bank’s margin is as low as an eighth of the margin it normally charges for personal mortgages). The purpose of this huge subsidy, which will damage that funder’s profitability for every year in the future, is to sell the banks’ repossessed stock at a price which is higher than it would sell at in the normal market (i.e., without the subsidy the funder would have to sell at a LOWER price and realise a greater loss). This also allows the funder to value their remaining stock of re-possessions at a far higher value, which it needs to for events like the forthcoming second bout of EU-wide “stress testing”. Secondly, using these future-damaging subsided mortgages the real estate arms of the banks have achieved only a limited amount of success by cherry picking assets, such as selling a penthouse with sea views on a particular development. The trouble here is that this may well hinder future attempts to sell to bulk sell to investors or promote to an end user buyer. As market insiders know this is going on but cannot determine its precise scale, this ultimately self defeating exercise for it causes more uncertainty and uncertainty further erodes confidence.

Confidence must be restored and the imponderables on the balance sheets of the banks and cajas removed. Both of these can be alleviated by the accelerated sale of real estate assets held by the financial entities. This will prove difficult unless large discounts are offered as many of their assets are non-performing and illiquid, but large discounts mean large loan-loss provisions which the funders (and in all probability Spain’s financial system) cannot meet. Also the spread between property yields and government bond yields is around 80 basis points, which will be too small for most investors. So either bond yields have to drop, which is unlikely, or yields have to rise before appetite comes back, which means large discounts will have to be offered.

Gregory Butcher has previous experience tracking the course of property crashes in Asia, Germany and the UK and comments. “Here Spain has distinct parallels Ireland. In Ireland it was not a country issue, but a banking issue. There were entirely empty new ‘ghost’ estates in Ireland and a considerable surplus of private housing — as there is in Spain. The banks couldn’t take the loan loss provision in Ireland, nor can they in Spain. Ireland continued to deny it or that its banks needed a rescue, even past the date that the rescue was actually being covertly negotiated. Spain (and especially the Bank of Spain) denies that its banks need a large scale rescue and the real state of the banks balance sheets is being hidden by a lack of transparency which can only be clarified not by further “stress tests” but by exposure to the true market pricing.”

“The test is simple, if they don’t sell at the price they are offered to the market at, then that price is wrong — which gives you your answer. But now ask yourself how far would you have to lower the sales prices, to change a market which is currently absorbing around 250,000 homes a year, to absorb around 250,000 new builds and 180,000 predicted re-possessions for this year alone (in a situation of 20% unemployment and empty homes bought by speculators) and circa 600,000 new unsold empty homes and 300,000 part constructed homes and an estimated 1,100,000 homes on sale (and often owned by speculators who aren’t paying their mortgage) and an estimated circa 1,000,000 which are empty and not for sale as the owner either has lost hope in selling or awaits the bank re-possessing.” Gregory Butcher said.

“Just part of the price reduction needed above comes not to the 40 billion euros which Morgan Stanley estimates, but instead to more than the entire reserves of the Spanish banking system. And when you consider this you can’t help but deduce that what I’m thinking is extremely likely to happen.” Given Gregory Butcher’s impressive track record in predicting such property fluctuations we should all take note.

About the Author

Gregory Butcher, is CEO of the privately owned Gibraltar property investment company Fairhomes. Gregory’s modus operandi has been to buy assets at a discount in order to maximise gains, he follows crashes and has profited from being able to accurately read the property cycle.

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Tags: Confidence, down, drain, goes, mainly, Spain