Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public.
Ben Bernanke, Deflation: Making Sure "It" Doesn't Happen Here
Many of the macro-economic fundamentals of Spain today are very different from those of ten or fifteen years ago...........A lot of factors look better this time around. Compared to its history, Spain has low interest rates, low unemployment and a strong fiscal position........the 2007 levels of government debt, unemployment and interest rates are about half the level of 1993. Equally, a lot of factors related to debt levels, housing and bank funding are worse versus the last downturn. For instance, the relative size of mortgage debt or total private sector debt to GDP, or the size of the construction sector to GDP, were all about 60% bigger in 2007 than in 1993. As was the bank system’s loan-to-deposit ratio. And the housing PE has expanded almost as much. So when Spanish bank management’s argue that the world today is not like the early 1990s, they are right: some things are better, but others are worse. As Mark Twain noted many years ago, history may not repeat itself but it does rhyme.
Spanish Banks, How Bad Can It Get? - Citigroup, September 2008
As I suggest in the title, the contents of this post resembles more an online training session about how the recent proposals to refloat and reinforce the Spanish banking sector may work out in practice than a conventional blog post, but still, this is the weekend, and at weekends, as well as all that interminable football, hiking and tapas snacks in bars, people are supposed to enjoy complementary and value-enhancing activites like going on courses, aren't they? So why don't we have a try. But remember, this topic is only for those with the sternest of stomachs, and the greatest of abilities to find - now what was the word Krugman recently used, ah yes, beauty - in that otherwise most arid of landscapes, the world of financial book-keeping.
So, as is the custom in all good training sessions, let's all start by watching a video, just to get us in the mood, and into the swing of things as it were. I think after the viewing what follows may be a lot more digestable, and certainly it should be more comprehennsible. (The version is conveniently supplied with substitles in Castellano the benefit of any Spanish speaking readers who might drop by).
Now For The Details
Well, we should now have all understood quite clearly what it is that extremely bright and intelligent investors do and don't do, but before we let ourselves forget the hard work that they all do we should not forget to offer a special vote of thanks to Moody's Investors Service, since thanks to them we now have, courtesy, of course, of the work of some of those aforementioned extremely bright and intelligent young people, a convenient summary of the principal measures contained in the recent Royal Decree Laws enacted in Spain.
Basically, the Spanish legislation follows the framework thrashed out in Paris on the October 12, and as such consists of four main components: 1) state guarantees of bank new debt issuance, 2) recapitalisation of banks, 3) coverage of the interbank lending market to increase liquidity, and 4) new temporary accounting rules.
The key measures agreed at the summit were: 1) a pledge to guarantee new bank debt issuance until the end of 2009; 2) permission for governments to shore-up banks by buying preferred shares; and 3) a commitment to recapitalize any "systemically" critical banks in distress. In particular, governments agreed to buy into banks to boost their finances and guarantee inter-bank lending. According to the substance of the agreement the guarantees should be offered on commercial terms, be available to banks of all nationalities (although national governments are to be allowed to attach their own conditions), and include assurances on providing credit to companies and households.
In terms of transnational agreement, the only truly "European" dimension to all this would seem to be the agreement to harmonise legislation and measures across countries. There are also reciprocal arrangements that each individual government will render assistance to bank outlets from other member country banks on their national territory. This could be considered as being structurally homologous to existing reciprocal social security agreements about access by citizines in one member state to health systems in another etc.
The only potentially important transnational decision which could potentially involve pooled financial support is the part of the agreement which commits member nations (implicitly although not explicitly) to collectively recapitalize any "systemically" critical banks which may find themselves in distress should the need arise, although even this commitment is not spelled out in detail, but since the system we are talking about here is the "eurosystem", and since the demise of Lehman Bros turned the term "counterparty risk" into an everyday household expression, then it is a committment which is likely to be acted on in the unfortunate circumstance that this should become necessary.
One interesting question which is raised here is who exactly the "we" are who are committed to the recapitalisation of any "systemically" critical bank which may find itself in distress in the event that the host country does not have the resources alone to carry out the resue left to its own devices. In principal, we would seem to be talking about the eurozone countries, since the evolution of the crisis in Hungary does suggest the eurozone is reluctant to intervene directly and come to the rescue of distressed systemic banks in the EU10 (in this case we would be talking about OTP, I think), although at the time of writing the ECB has extended a credit line to the Hungarian central bank to try to ease the shortage of foreign exchange there.
Of course, as we have seen in the case of German and French banks vis-a-vis the US sub-prime problem, in current account deficit countries, it isn't only the local banks who are affected when there is a sharp drop in property values, those banks who lend to the local market also take a hit.
Also, losses linked to depreciation of mortgage loans would not be exclusively supported by Spanish institutions. In fact, according to our estimates, the Spanish banks “export” close to 30% of the counterpart risks linked to mortgage loans.
Celine Choulet: Is the profitability of Spanish banks under threat? - PNB Paribas
And as PNB Paribas's Dominic Bryant points out, Spain's banks have been noticeably absent from the headlines surrounding the latest turmoil, since they have on net acted as intermediaries to bring money into Spain, rather than engaging in buying US (and other, Hypos activity in Delfa eg) sub-prime typeassets
Spanish banks have so far been conspicuously absent from much of the troubles that have struck banking systems over the past year. Of the EUR190bn that has been written off due to sub-prime related losses in Europe, little if any has come from Spanish banks. Consequently, the Spanish government has not felt the need to pledge capital injections in the way that the UK, Germany, France and some others have. The reason that Spanish banks have not suffered directly in the sub-prime debacle is that Spain has been a capital importer for many years e.g. Spanish banks have on net acted as intermediaries to bring money into Spain, rather than engage in buying US sub-prime assets.
Spain: A Matter of Time, Dominic Bryant, PNB Paribas, October 2008
However, even this vague commitment to support systemic banks could be turned into a rather undesireable blank cheque at some point, and could even become some form of moral hazard, since it could be considered to provide an incentive to allow a systemically important bank to arrive near to failure (and thus attract community wide support), possibly a preferable strategy for a national government heading under water than the idea of soldiering it out and single-handedly rescuing a whole string of medium-sized banks or bankrupt builders, who are obviously not going to be considered to be "systemic" in this sense, and would thus not attract community level support.
In the Spanish context, where the scale of the looming obligations far outweighs the ability of the national treasury to cope, this inbuilt weakness in the plan could turn out to be important, since there is little incentive to prepare a plan and close down "excess to requirement" builders (see below) when there is no funding available to support this, while it is possible under the rules to keep guaranteeing builders debts via support from systemically important banks till the cows come home, or at least until the bank (or the government) folds. It is possible, that is, for just as long as the ECB continues to accept Spanish government paper.
The Changes In The Spanish Law
The new Spanish Royal Decree Law implementing the Paris decisions follows behind (and is complementary to) Spain's announcement the earlier announcement of the creation of a EUR30 billion - EUR50 billion emergency fund to provide liquidity to the financial system and the increase of bank deposit guarantees to EUR100,000 (as underwitten by the Spanish Deposit Guarantee Fund, then Fondo de Garantía de Depósitos).
The Royal Decree Law 7/2008 of October 13 comprises the following elements:
- The approval of up to EUR100 billion worth of state guarantees for new financing made since 14 October 2008 by credit entities based in Spain. The Royal Decree specifies that the funding instruments that will be covered are commercial paper and bonds traded in the official secondary markets in Spain, but also mentions the possibility of extending the guarantee to other instruments such as interbank deposits. The maximum maturity of the above-mentioned instruments is limited to five years and the granting of state guarantees will be finalised on 31 December 2009.
- The authorisation, on an exceptional basis and until 31 December 2009, for the Ministry of Economy and Finance to acquire instruments issued by credit institutions based in Spain in order to strengthen these institutions' equity. The instruments mentioned by the Decree Law include preferred shares and participation certificates ('cuotas participativas').
On the same day as they published the above-mentioned Royal Decree Law, the Spanish government also published a Royal-Decree Law 6/2008 October 10, which offers more information about how the above mentioend EUR30 billion - EUR50 billion emergency fund will operate. This second Royal Decree Law states that the 'healthy assets' bought by the emergency fund will be purchased at market prices. The law defines as 'healthy assets' those financial instruments that are issued by credit entities and securitisation funds and are backed by loans granted to individuals, corporates and non-financial entities. In the preamble, the Royal Decree Law specifies that assets acquired by the fund should be domestic and that the fund will favour the acquisition of assets backed by loans granted after 7 October 2008 in an attempt to promote new lending activity to individuals and corporates.
Moody's evidently welcome the new measures, but they do add this caveat:
Moreover, Moody's notes that, although the proposed government measures should help to ease the pressure on current liquidity constrains, Spanish banks are also experiencing a very rapid deterioration in asset quality driven (i) by their exposure to the real estate and construction sectors, which are undergoing a more pronounced and rapid correction than initially anticipated; and (ii) by an increasing decline in households' debt-servicing capacity as a result of both rising interest rates, growing unemployment, in some instances, aggressive growth strategies. Although Spanish banks display a relatively high risk-absorption capacity as a result of excess provisioning, Moody's notes that excess coverage is nevertheless rapidly declining and the fundamental credit trends in the system remain negative - and these factors underpin the likelihood of further downward rating adjustments.
Basically, the measures seem straightforward enough, but what we have little information about at this point is how they are to be financed, and what the implications over the short term are for the Spanish government's total debt to GDP ratio.
If we go back to the measures specified in Royal-Decree Law 6/2008 (the suplementary EUR30 billion - EUR50 billion ) then it seems that basically the government will be purchasing securitised instruments of some form or another (most probably Cédulas hipotecarias - see below) which the private sector now consider too risky to buy, or are only willing to buy with a considerable markdown. It should not escape our notice that the law entails the government creating a special emergency fund, and despite the fact that the fund is only going to buy the "very best assets", since these assets are likely to be so good that no one else wants them, we might like to dig down a bit below the surface and think about what is happening here. The Spanish state is creating a special fund to acquire rather risky (in the sense that they are backed by Spanish mortgages whose value is likely to fall as the houses which support the mortgages fall in value, and as the mortgagees steadily find themselves unemployed, and unable to maintain their payments) even though the law assures us the government is only going to buy very 'healthy assets' (what was it Bear Stearn's called their extremely leveraged "enhanced" funds - oh yes, "the unemployed Afro American shanty-dweller sitting out on the veranda in a string vest fund" - of course, you will always recognise the healthiest of assets precisely because they have the word "healthy" stuck at the front of them: evidently you only need to worry when they become "very healthy".
Now humour aside here, while we don't know what exactly will be done with the money which is to be raised by selling the post October 2008 securities to the government, it is quite likely that much of it will go in refinancing Cédulas (and other RMBS) which come up for renewal this autumn. Indeed, while it is quite possible for the banks to generate additional securities in order to finance the acquisition of new properties, it is not at all clear that it would be wise for the Spanish state to be getting itself into debt simply to allow Spanish citizens and corporates for their part to get themselves into more debt, since as I explained in a previous post, Spain Incorporated (with its 10% of GDP current account deficit) is already far too leveraged, thank you very much indeed:
Back in the good old days of Q2 2007, when Spain's economy was busy growing at a rate of about 4% per annum, corporate and household debts were increasing at a rate of about 20% per annum. 4% growth for a 20% rise in indebtedness (or an increase of about 30% in debts to GDP) doesn't seem like that good value for money when you come to think about it - and in the meantime Spain Incorporated's indebtedness to the rest of the world (via the current account deficit) was growing at a rate of 10% per annum. Fast forward to Q2 2008, and household and corporate debts were rising at a mere 10% per annum (and government debt had also started to rise, at this point at a rate of around 2% of GDP per annum, or 4% of accumulated debt), but Spain's economy had reached a virtual standstill (true it was still growing at 1% rate year on year, but quarter on quarter it was virtually stationary). So not only is this a horrible "bang for the buck" ratio, it is also totally unsustainable. Indebtedness has to be reduced, not increased, and this can be done in one of two ways, either by ramping up GDP growth (which in the present environment is out of the question in the short term) or by burning down the debt by paying (or writing) it off.
In this sense Moody's offer us a very important warning. Basically they say that while in general the deterioration in the banks asset quality will increase the likelihood of further downward rating adjustments, in the case of those debts guaranteed by the government, it will be the appropriate government rating which conditions the level of the risk assessment:
The exception will be bank obligations for which a clear substitution of risk will be made by the government for that of the bank, as in the case of explicit guarantees. In such cases, Moody's is anticipated to de-link the risk assessment from the bank and apply the appropriate government rating to the specific obligations, upon detailed review of the guarantee terms.
Now excuse me, but wasn't this just how "we" got into this mess in the first place (with the we here being the banking system), by providing investment grade ratings to products where the quality of the underlying asset (you know, that guy sitting out on the veranda in his string vest) didn't justify the awarding of invesment grade. So now that the Spanish banks cannot sell their products at the investment grade price (since someone has been "stupid" enough to ask what the underlying assets - the houses - are really worth), then the government is coming in to guarantee the assets using its investment grade as a kind of trump card.
Well frankly, this works until the day it doesn't, as Bear Stearns found out to their cost, but then, as John Bird says at the end of the video, the main thing at risk here is your pension fund.
Buying Bank Equities
Bank mergers are likely in Spain and other European countries due to the international financial crisis, Spanish Prime Minister Jose Luis Rodriguez Zapatero said on Wednesday."During a serious crisis like this, it's likely that not only in Spain but also in other European countries, you will see mergers or restructurings," Zapatero said during a session of Congress.
Now, according to José Luis Rodriguez Zapatero, Spain has absolutely no intention whatsoever of nationalising any part of the banking sector. Despite this commitment his government has, nonetheless, taken legalislative action to make this possible should it prove necessary. Like Hank Paulson's Bazooka, which was armed up so it didn't need to be used, but of course, at the end of the day it may have to be. Earnings reporting season is coming up this week, and a number of Spain's larger banks have already been taking a beating on their earnings, like Banco Popular Espanol who's stock has already fallen around 28 percent this year and which is highly reliant on wholesale funding (about 40% of total funding), with historically weak deposit growth, which is why their shares shot up 5.5 percent on Sept. 16 following speculation it might merge with the better provisioned Banco Pastor . Or Banco de Sabadell, Spain's fourth-largest bank, which was place on a list of banks that are "remotely at risk'' of having to raise capital or rely on wholesale funding by UBS's Philip Finch in September. Along with Sabadell were mentioned Anglo Irish Bank Corp, Plc, Danske Bank A/S and Lloyds TSB, all of them in the "usual suspects" group.
Santander is little affected from an earnings or capital perspective should Spain have a repeat of 1985 or 1993 peak provisioning. BBVA appears more affected than Santander due its greater Spanish-gearing but this is neutralised by its higher generic provision buffer. The mid-caps (Banco Popular, Sabadell, Bankinter and Banesto) see their 2009E earnings wiped out if we see a repeat of an average of 1985 and 1993 peaks. But the benefit of generic provisions may allow them to ride out a repeat of 1993-1994 in 2009-10 but a repeat of 1985-86 would lead to capital challenges.
Spanish Banks, How Bad Can It Get? - Citigroup, September 2008
In the short term, what is more likely is an intervention by the Spanish government to try to force the marriage of some of the regional cajas, although this process is, as local newspaper Expansion reported last week, meeting with strong resistence form the cajas principal clientele, the regional Spanish governments.
One interesting side issue here, raised by Jaime Ponzuelo-Monfort on the RGE Europe Econ Monitor, is that Standard and Poor's announced to it would consider downgrading the credit ratings of four Spanish regions if they did not moderate spending in an environment where revenues have shrunk because of the construction slump.
The regions under credit warning included Madrid, Valencia and Catalonia. Valencia is the most indebted per-capita region in Spain. The region has been ruled by the Popular Party since 1995, when Benidorm Mayor Eduardo Zaplana became President of the Generalitat Valenciana, the regional government......The region’s strategy has been to finance large infrastructure projects increasing the region’s debt to an extent that it is now the most indebted in the whole of Spain. The vision of grand projects has recently continued with the America’s Cup and the grand prix of Formula One.
This problem of regional administrative debt and caja autonomy may well go hand in hand, hence the problem with "rationalising" the sector. Of course, we also might not like it to escape our attention that the key banking institutions whose problems lead to the recent hasty summit - Dexia, Fortis, and Hypo's Irish subsidiary Delfa - were all in some way involved in financing local authorities.
Absolutely No Idea At All
Then of course we have the builders. Like Jesualdo Ros, general secretary of Provia (the Alicante property developers association) who told the Spanish press recently that the situation “can’t get any worse.” “We’ve touched bottom" he said, "and from now on things will start improving, though the future still looks pretty bleak". Ros argues he sees a glimmer of hope in the fact that sales declines appear to be bottoming out. Sales over the 4 months between May and August were 15% lower than sales in the first 4 months of the year. The collapse in sales at the same time last year was 51%, which of course makes the recent 15% fall look great in comparison, but he is forgetting something pretty important here, the so called "low base" effect. I mean if sales in Alicante were already down 51% y-o-y one year ago, then the further fall of 15% puts them at an even lower level, the rate of decline has slowed, that is all. You simply cannot have exponential downward momentum in sales, economics simply does not work like that. But from here to a "bottoming" in the market there is a long way to go, we haven't even officially entered recession yet.
In 2006, housing starts increased to 760,000 units, i.e. a rise of 6.2% compared to 2005, while the number of new homes built reached 658,000 (+11.5%). Due to these considerable stocks and the rise in the market for second homes (the Spanish coasts attract numerous foreign investors, particularly British), the number of residences per household exceeds 1.5 in Spain. The acceleration in housing starts, which has coincided with a fall in the number of new households formed, has pushed up the ratio of the change in residential construction to the change in the number of households to 1.53 in 2006 as against 1.33 in 2005.
Celine Choulet: Is the profitability of Spanish banks under threat? - PNB Paribas
Then there is Guillermo Chicote, president of Spain’s Association of Constructors and Developers (APCE), who argues that the price of newly built properties in Spain will not fall any further because they have already fallen enough. “Don’t anyone expect prices to fall 30% to 40%, because I’ll give them to the bank before that,” Chicote told a property conference recently. Actually these people are very special, since they obviously live on a different planet from the rest of us. But what worries me is that these sort of arguments may be influencing the Spanish governments current policies, which would then seem to be expecting a property upturn sometime in 2009 or early 2010, an upturn which will, of course, simply not arrive.
And in the "bailing out the builders" case, the position is even more scandalous, since what we really need on the table at this point is a plan to downsize the sector, and close down at least half the industry (compensating on the way the banks for some of their losses, since if not...), not a lease of life to what are already effectively the living dead. Spanish construction currently represent 11% of GDP. On any rational criteria, the most that can be hoped for 3 years from now is 5.5 % - 6%, and it is not unlikely given the excess of building we have had recently that we may be down to 3.5% to 4% (which is the level to be found, for example, in Germany).So my big point is that in the absence of a structural transformation plan for the Spanish economy, and a massive downsizing plan for the Spanish construction sector, all of this is highly irresponsible. And of course it is precisely this kind of macroeconomic perspective we are lacking at the moment. So this isn't just the "blind leading the blind" - it is the man in the Moncloa Palace stretched out on his bed with a blanket over his head and fearing to look in the mirror before him leading the rest of us. Cannons to the right of us, cannons to the left of us, and into the valley of death rode the 45 million.
No Gentlemen Sitting On The Veranda Wearing String Vests In Spain
Well, fortunately we dodn't have too many unemployed gentlemen sitting out on the veranda in their string vests here in spain, but we did have plenty of people like Fanny Palacios. Here she is:
And here you can find a Bloomberg link to a video of her explaining her determination not to "let them take my home" (see "Migrants in Spain Work 20-hour Days To Keep Their Homes" link under video and graphics over on the right).
Immigrants like Fanny Palacios, drawn by Spain's once-booming construction and service industries, helped sustain the decade- long surge in house prices by scrimping and sometimes lying to qualify for mortgages. Now those last on the property ladder are losing the lives they built as the global credit shortage pushes interest rates higher. The single mother of two from Ecuador worked 12-hour night shifts caring for an elderly woman on top of her day job at a nursing home to meet her bank's deadline for 3,000 euros ($4,720) in mortgage arrears. "This is desperation," says Palacios, 30. "I have to pay whatever it takes. I won't let them take my home."
As I say, we don't have too many string vested gentlemen here in Spain, but we do have a lot of women who have come here to work as domestic care workers, who earn salaries in the 600-800 euros range, who have morgtage repayments which now exceed 900 euros a month, and whose husbands used to work in construction, before the "bust" came.
And we do also have numerous trances of debt issued by the Spanish bank conduits - like Santander's Hipotecario 4, Caja Madrid's RMBS III FTA etc - funds which were doubtless sold in their day as "high powered" and "enhanced" but which are now busily being scrutinised by the Moody's, S&P's and Fitch's of this world to see just where the scalpel has to be inserted.
The RMBS III FTA bonds are part of a 3 billion-euro transaction Caja Madrid sold in July 2007 - pooling mortgages with a loan-to-value ratio of an estimated 92 percent (you know, that pooling into tranches that most people thought hadn't been going on in Spain, since under the cedula system it is the whole stock of mortgages in the morgage book which back the bonds). The notes are among portions of debt from 13 separate transactions that Moody's Investors Service said it was reviewing for downgrade after a change in the way it assesses house price declines and risks of default for some Spanish mortgage bonds. Caja Madrid's loan default rate more than tripled to 1.89 percent of its total loans by the end of the second quarter from a year earlier.
Caja de Ahorros de Gipuzkoa y San Sebastian SA - a savings bank in northern Spain popularly known as La Kutxa - has sold 2.5 billion euros of mortgage-backed bonds since the end of 2005. Kutxa also gained a certain notoriety inside Spain when it became the first domestic bank to offer mortgages with fifty year terms - you know, the ones you can pass on to your children, now that is what I call leveraging! Purchasers of Kutxa bonds have included investment wholesalers like Newport Beach, California, based Pimco and Pioneer Investments, based in Boston Massachusetts, who both bought the bonds for their funds which are sold to investors around the world.
Pimco's Euro Bond Fund, sold to savers in Hong Kong, is the biggest investor in Kutxa's 2007 bond issue with a 20.6 million-euro holding, according to a March 31 regulatory filing. Pioneer Investments' CIM Euro Fixed Income Fund, which is sold to Italian savers, holds 11 million euros of the bonds. Pimco, majority-owned by Munich-based Allianz SE, runs the world's largest bond fund and has $829.5 billion under management on behalf of corporate pension plans, public retirement funds and foundations. Pioneer Investments is the fund-management arm of Italy's largest bank, Milan-based UniCredit SpA (oh, oh, not them again), which oversees 190.5 billion euros for 40 million customers in 23 countries. Kutxa's 2007 bond has lost 8 percent since it was issued in February last year. That contributed to the Pioneer fund underperforming the JPMorgan EMU Bond Index by 2.7 percentage points over the past 12 months.
Securitization, in the broader sense (i.e. including covered bonds), plays a fundamental role in the financing of Spanish mortgages. According to Celine Choulet of PNB Paribas, the proportion of resources deriving 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 mortgage market reached 201.3 billion euros, of which 88.3 billion was in covered bonds (or Cédulas hipotecarias, which represented 43.9% of the total of mortgage securities market) and 113.0 billion in more conventional mortgage-backed securities. According to the Bank of Spain (November 2007 bi-annual report), Spanish institutions have developed a less complex securitization model than their British and American counterparts, have securitized only what are (in theory) good quality assets (94% have triple A rating) and have favoured the maintenance of some part of the risk within their balance sheets. This, it is argued, has lead them to pursue a more rigorous credit policy than the British or US banks, but when we look at the rate at which the Spanish loan portfolio has expanded, we might like to raise an eyebrow or two in the face of this argument. In the strict sense of securitization, 20.9% of mortgage loans were securitized in 2006 (in the form of MBS). Combining the two securitization techniques (MBS and covered bonds), this proportion reached 37.3%.
Covered bonds (Cédulas hipotecarias in the Spanish context) are debt instruments which are distinguished from standard RMBS in two ways. In the first place they are secured by a cover pool which is not discrete and parcelled up into tranches as in the case of RMBS, but includes all the mortgage loans or public sector debt on the issuing banks books, and to which investors have a preferential claim in the event of default. In the second place they do not constitute securitization, in the strict sense of the term, since the risk remains on the balance sheet of the issuing institutions. However, the great advantage of doing things this way was, of course, that the issuance of covered bonds enabled credit institutions to obtain lower cost of funding in order to grant mortgage loans.
Asset-backed securities (ABS) in the stricter meaning of the term are bonds issued by securitization vehicles (Santander's Hipotecario 4, Caja Madrid's RMBS III FTA) established by parent banks in order to finance the purchase of assets, for example customer debts. According to the nature of the underlying asset, such securities can take the form of mortgage-backed securities (MBS) (which are then broken down into residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) …), collateralised debt obligations (CDO), collateralised loan obligations (CLO) and various others. These classes of securitization facilitate the partial ( the case of MBS) or total (in the case of CDOs or CLOs) removal of assets from bank balance sheets.
In their post August 2007 turmoil publication "Structured Investment Vehicle Ratings Are Weathering The Current Market Disruptions" (15 August 2007), Standard and Poor's clarified the distinction between MBS on the one hand and CDO/CLO on the other, as being one between "traditional" and "non-traditional" asset-backed commercial paper, with the MBS being counted as traditional.
Traditional asset-backed Commercial Paper (ABCP) conduits are often viewed as those that are supported by liquidity facilities, where the ratings are linked to the liquidity provider's rating because the investor relies on the liquidity provider to pay in the event of a market disruption.
Thus the quite important distinction here is that Spanish conduits are not entirely off-balance-sheet, since their is a direct liquidity enhancing responsibility for the parent bank. In theory this means that the lending should be less risky, however Santander's Hipotecario 3 and Hipotecario 4 bonds would hardly seem to be in the "less risky" class since as Fitch Ratings reported back in May these two conduits had a combined 13 million euros ($20.4 million) of mortgage defaults in January and April and these ate into the reserves set aside to protect the bondholders. Indeed both funds were reported to be incurring losses earlier than expected and had been "forced to tap-into their reserve funds,'' according to the Fitch report. The rating firm lowered the outlook on 154 million euros of junior notes to negative from stable, citing the drop in reserves. And Fitch are not the only ones to be worried, since around the same time Moody's Investors Service put about 16.9 billion euros ($26.6 billion) of Spanish residential mortgage-backed securities under review for possible downgrades after adjusting for rising default rates and slowing house price growth. The rating agency said at the time it was reviewing 68 tranches of 13 deals after updating its assessment model.
Beyond the expansion of this type of financing, breakdowns between the two securitization techniques remain fairly close in terms of outstandings and flows. Banks’ liabilities constitute 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 in the form of residential mortgagebacked securities (RMBS). In 2006, MBS’s represented65.2% of new issues on the mortgage securities market.
Celine Choulet: Is the profitability of Spanish banks under threat? - PNB Paribas
Choulet adrgues that the current paralysis in the commercial paper market could turn out to be particularly costly for the Spanish credit institutions since losses incurred by conduits could end up being reported in bank balance sheets. In fact, in the case where the conduits are short of liquidity or going bankrupt, the Spanish institutions themselves would be constrained to refinance the vehicles they created, as the British groups have had to do. There would then be a forced reintermediation, and the banks would be obliged to show these losses in their balance sheets. The back-up lines destined for the securitization vehicles, reached 4 billion euros in 2006 as in 2005, but they were probably significantly higher in 2007. The problem is that it is difficult to identify with precision the institutions that are most at risk and the amount of liquidity lines engaged in the conduits since as of September 2007 the affected institutions not proving to be especially forthcoming on this point.
Although they are not directly exposed to the American subprime crisis and have not encountered liquidity problems for the time being , the Spanish credit institutions are among the first to be affected by the sudden drying up of securitizations in Europe. On the one hand, the reversal of the asset securitization market and the interruptions in interbank transactions on covered bonds are forcing them to seek refinancing on the interbank loan market, which is expensive. On the other hand, Spanish securitization vehicles, victims of the paralysis of certain capital market segments and that may hold American subprime-related securities, could withdraw money from the back-up lines put at their disposal by the banks. This might then induce a forced reintermediation, the Spanish banks being constrained to absorb the losses from conduits that they are sponsoring off balance sheet.
Over recent years, the spectacular growth of securitization, that has placed Spain in second position in Europe just behind the United Kingdom, continued in 2006. New issues grew again by 36.1% to 93.8 billion euros (as against +31.2% in 2005 and +33.5% in 2004), bringing outstanding amounts issued by Spanish securitization vehicles to 243.2 billion euros by the end of the year. ..........In the first quarter of 2007, new issues amounted to 40 billion euros of which more than half were in the form of mortgage-backed securities (MBS).
Celine Choulet: Is the profitability of Spanish banks under threat? - PNB Paribas
Falling Property Prices In Spain, I See No Falling Property Prices In Spain
Then we have the Spanish Ministerio de la Vivienda (Housing Ministry), with their notorious property price index. Now according to the latest data, out last week, average Spanish property prices actually rose over the 12 months to the end of September by 0.4%. The Ministry do however admit that prices fell in the third quarter, by 1.3% over the second quarter. Obviously these numbers come from another planet, possibly the same one where Jesualdo Ros and Guillermo Chicote live.
To put this in perspective, Spain has had a far more dramatic slowdown than either the US or the UK have had, and the pace has been at least equally as rapid that in Ireland, yet according to the much more reliable housing market statistics we get from these countries, all of them have property prices down by double digit percentages.
One of the arguments in defence of the Housing Ministry statistics used to be that they were based on valuation prices, not selling ones (that is, using today's accounting terminology, they were not "mark to market" ones).
Which is strange, because according to the latetst data to be released by TINSA (Tasaciones Inmobiliarias, S.A.), the largest property valuation company in Spain, Spanish property prices fell by 4.9% over the 12 month period up to the end of September, and by 5.9% in the first 9 months of 2008. As with the government’s figures, resale prices fell more than newly built prices, possibly because private vendors have more room for manoeuvre on price than developers.
According to Tinsa, 75,000 new properties were sold in the second quarter of this year, 41% of the total number of homes completed during the period, which meant the inventory of unsold new homes rose to 680,000.
Tinsa estimates there will no more than 300,000 transactions in all 2008, implying that the stock of unsold new homes will rise to 930,000 by year end. Unlike Jesualdo Ros and Guillermo Chicote, Tinsa expect the inventory of new homes to keep rising into 2009, as construction on current housing developments finishes, and argue that it will take at least 2 years for the market to digest the existing housing overhang, and that is, of course, if few more houses are built in the meantime, but this is precisely what the developers associations want the government to provide money to change, since they are anxious to start building again, and as soon as posible.
Change In The Accounting Rules
The fourth item agreed to at the October 12 summit was an ammenment to the EU's accounting procedures and the European Commission duly changed the rules (on Wednesday 15, just to show how fast they can act when they really want to). The objective of the change is to try to help banks (and now of course governments) avoid sharp drops in the value of their assets at times of market volatility, such as the present financial crisis. The adjustment of what is known as the "mark-to-market" accounting system will be applied as of the third quarter of 2008, that is to the bank results which are about to start being published in Spain as of next week. So it really was a pretty close shave.
Under the previous mark-to-market accounting rules, company assets were valued on the basis of the price they would fetch if they were offered for sale on the market immediately and not what they would be valued were the company to hold on to them until maturity. During the current crisis, banks in particular have seen their assets plunge in value because of mark-to-market valuation of "sub-prime securities" - financial assets based on loans to borrowers deemed to be at risk of defaulting - with experts saying the banks' losses would have been much lower if they were valued on the maturation date basis. The current practice can create a downward spiral in which companies seem to be insolvent.
So how bad will it get? The head of the association of Spain's savings banks, the Cajas, has said that their NPL ratio could rise to 3% by end 2008 and 4% for 2009. Note the Caja's NPL ratio was 0.64% in June 2007 and has already trebled to 1.91% by June 2008. The commercial banks’ NPL ratio is lower at 1.28% in June 2008, but this is more than double the level of 0.49% a year ago. Banks have lower NPL ratios versus the Cajas as usually they did not expand as fast in the boom years and have greater geographic and client diversity (for instance, they have less exposure to developers). However, even if the banks' NPL ratios are lower than Cajas, and are low in absolute terms compared to European banks, there is no room for complacency. The banks' NPL ratio has increased dramatically: the four quoted mid-cap banks we follow (Banco Popular, Sabadell, Bankinter and Banesto) posted an almost 50% increase in their absolute NPL levels in just the last reported quarter (end 2Q08 versus end 1Q08). And their bad debt coverage ratios (Provisions/NPLs), while still high versus European peers due to generic provisions, also dropped dramatically.
Spanish Banks, How Bad Can It Get? - Citigroup, September 2008
Under the commission's new proposals, banks and other companies can optionally reclassify assets from the "held-for-trading" category to the "held-to-maturity" category, and thus avoid this particular problem. No I would stress at this point that I am not an accountant, but I would also stress that in the world of economics and finance, there are not, as a matter of fact, free lunches. So this move must have both advantages and disadvantages.
Now, if we want to see what mught be one of the disadvantages of the new system, we would do well to think about the distinction which is frequently drawn these days between insolvency and illiquidity. Piling up dodgy securities and locking them away in a special box marked "held-to-maturity" has the effect, I would think, apart from providing the analysts with a convenient tool to identify what might be the dodgy assets in the portfolio at a glance, of reducing the short term liquidity of the entity in question, and since one of the big advantages of having trading in just these classes of derivitives was to give banks and companies interest bearing alternatives to holding cash, then I think we can see that one of the consequences here for any company having liquidity problems may well be to make the problem worse.
Which brings us back to the governments, who will undoubtedly avail themselves of this new classificatory category to shore up their deteriorating balance sheets as they start to buy up debt from the banks, but again, this will only mean that the governments in question will not be able to use the instruments in question to regulate their short term financing fluctuations (as the Spanish government, for example, had been doing during the recent times of surplus by buying instruments from Spain's banks with surplus cash in hand. Basically, if any of the sovereign governments come under stress at some point, then the detail of having moved these securities over into the "held to maturity" class will show up in the conventional stress and robustness tests, and if anyone rapidly needs to move them over into the mark to market category to raise liquidity, then, of course, they can expect substantial downward revisions in their value. It is never a good idea to move assets over into the "for sale" category at precisely the moment that everyone knows you have to sell, as many Spanish corporates are discovering with their equity and property holdings at just this very time.
Down The Bottom Of An Old Mineshaft
Well, returning to the quote from Keynes that I cite at the start of this post, we might say that the Spanish taxpayer is being sent off to the bottom of a deep mineshaft in search of a bankrupt builder, that is to say s/he is being sent off on a wild goose chase in the cause of a worthless objective. Better than sending them down the mineshaft to try to recover their money from a bankrupt builder, maybe the government should be paying unemployed migrants to dismantle newly constructed houses brick by brick and transport the remains down to the bottom of a very deep mineshaft to be buried (remember, Keynes once also suggested that it was better to pay unemployed people to dig holes and then to fill them in again than to pay them to stand idly around), at least this solution would have the advantage of paying people to take the excess housees off the market, in order that the system can restart again at some point.
But what the Spanish government should not be doing at this point in time is to in any way aid, abet or encourage these same builders to build yet more houses. Instead of firing pointless blanks off into the air they need to keep their powder dry, spend some time taking decisions on who is to die and who is to live, and then get on with the mass exectution. There is, at this stage, little alternative. And the money that they are effectively having guaranteed by the other member states of the Union after last weekend's summit, well that should be being put to good use helping the banks write down their debt to the aforementioned now non-existent builders, subsidising useful new employment generating investments in the export sector, and helping young people generate the mortgages needed for them to buy up some of those ever so surplus-to-requirement houses.
But saying this right now in Spain is like being a lone voice, crying, in the widerness, show me, where the hell is the track that leads to the oasis.
Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.
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