Financial Times (UK) 19/03/07

The Property "bubble."

Spain, Ireland, and threats to the property boom.

Published: March 19 2007 02:00

There are two phases in an asset price bubble that repeat themselves with clockwork regularity. The first is the phase of the bogus economic theory. I am sure you heard the one about the paradigm shift due to the more widespread sharing of credit risk; or the one about the profits/wages ratio rising indefinitely.

The second phase is a prolonged state of denial.

In the US subprime mortgage bubble, we are now in phase two. It is difficult to explain rationally why anyone would want to give out large mortgages to people with no credit rating, or why a bank would want to give out interest-only mortgages at more than 100 per cent of a property's value to anybody. Most of those products are based on irrational expectations by lenders and borrowers. The European Union is a little behind the US when it comes to such crazy financial innovation, but only a little. There is a subprime mortgage industry in some markets, such as the UK and Spain. You can also find interest-only mortgages. Unsurprisingly, these are also the markets that have seen the strongest increases in property prices over the past 10 years. The Europeans are still in phase one of their bubble. The bogus economic theory from Spain is that large immigration can maintain a construction boom indefinitely.

Let us just look at some statistics. In Spain, the construction and housing sector accounts for 18.5 per cent of gross domestic product, about twice as high as the eurozone average, according to the latest data from the EU's Ameco database. The comparable figure for Germany is 8.7 per cent. The justifications given for this increase are: a net inflow of immigrants, many from Latin America, who find it easier to purchase, rather than rent Spanish property; changes in the Spanish way of life, as young people leave their parental homes earlier than they used to; and Spain's continued popularity among sun-loving northern Europeans. In other words, the Spain-is-special-crowd argues this is a structural boom, not a bubble. They claim that Spain's property market can grow at faster rates for longer than most other European markets.

I do not want to dismiss all of these points. The trouble is that these merely tell us why the bubble happened in the first place, not why the path should be sustainable. In Spain, the average price of a square metre of residential property went up from about under €700 in 1997 to just under €2,000 at the end of last year - up threefold. House price growth has moderated more recently - from year-on-year growth of more than 15 per cent two years ago to more than 10 per cent now. It is true that Spain still has an extremely low level of mortgage defaults compared with the US. It is also true that Spanish mortgage banks are relatively flexible in terms of their willingness to refinance loans. Then again, Spain is in a different phase in the housing boom-bust cycle. Spain is today where the US was approximately a year ago. In Spain, most mortgages are variable-rate, so the rise in short-term market interest rates to more than 4 per cent is beginning to have an effect on the Spanish housing sector. Monetary statistics tell us that the boom in European mortgage lending is slowly receding but this process still has some way to go. If, as a likely consequence of the subprime mortgage crisis in the US, there is a global reappraisal of the price of risk, Spain would be hit by a double whammy - higher rates and higher spreads.

Now since 18.5 per cent of the Spanish economy is housing-related, a gradual convergence towards the eurozone average would seriously weigh on economic performance for a long period. Post-unification Germany experienced flat house prices for 15 years and a depression in the construction industry. Spain has one of the lowest rates of productivity growth in the EU. The rest of the economy may not be strong enough to fill the gap left open by construction. It does not take much imagination to see that a perfect storm is building up. The idea that Latin American immigrants will continue to jump on the property ladder under these circumstances and rescue the housing market is a little optimistic. While it is true that there has been a structural shift from a conservative to a more liberal society, such shifts end at some point. And German or British homebuyers may eventually find alternative and better priced homes in other parts of the Mediterranean. The explanations of the past cannot be extrapolated.

Another example is Ireland. In Ireland, the GDP share of construction and housing is even higher, at 20.7 per cent. While the performance of the Irish economy during the past few decades was remarkable, there are some deep underlying structural problems that are now surfacing. In particular, Ireland has been fast losing competitiveness within the eurozone - not a subject that has been talked about much outside Ireland recently. With interest rates rising and a slow return to sanity in the financial sector Ireland is going down the same route as Spain, perhaps only faster.

The US housing recession is not over yet. In the past the correlation between US and European property price movements has been extremely high. If the transatlantic tsunami comes, it is perhaps best to avoid some of Europe's western coastline states for a while.

The Financial Times Limited 2007

Spanish Alchemy: Debts, banks and funny money.

This note was prompted by reports that several Spanish banks and other firms are now buying many large overseas assets, outside the Euro zone, mainly in the UK ( Abbey Bank, Scottish power), Latin America, northern Africa and even in the USA - ASTROC for example. This while doing everything possible to protect large Spanish firms, notably Endessa-an issue that now has Spain being chased to the European Court of Justice by the EU's Commissioner for Competition. Reminds one of the Japanese rushing to buy anything in the USA back in the 1980's and 90's with a strong Yen propped up by inflated real estate valuations.

The following story which appeared in Información some weeks ago more or less demonstrates a point I have been making for some time about the big banks here being a large part of the problem as regards Spain's highly criticised urban "development". As you know, the UN's special rapporteur on housing Miloon Kothari, recently added to similar criticism in recent months from Greenpeace, Transparency Inernational , the WWF and of course the EU Parliament itself. (Plus countless media reports in the Economist, FT, Bloomberg, Standard and Poor, IHT, BBC etc.) This article speaks about four big concerns in Alicante, but from what I have read elsewhere in the Spanish "economic" press, this is ocurring in other areas too, notably Madrid and Andalucia. There are only about a dozen big construction and development outfits in the entire country, but they all seem to have huge debts to Spanish banks. I don't have copies of several articles I have read on this-eg. in financial pages of El País, but they shouldn't be hard to find.

If the banks weren't so cooperative, even the big constructors and developers firms wouldn't be able to do their rotten business. Easy loans are mainly granted on the basis of land "ceded" to developers- or bought for next to nothing. Then this new "urban" property is revalued upwards by ten times or more and used as collateral to secure loans. Dirt is turned into gold through this alchemy. This is the sort of racket that was very popular in Japan until the rest of the world caught on about a dozen years ago. Japan is only just now emerging from the financial meltdown and chaos that prevailed then. Japan, in that happy era was buying up movie studios (MGM), building complexes in the USA ( eg, the Rockefeller centre), production faclities elsewhere in Asia, probably realizing the days of the strong yen would be short lived. This is something akin to the banks and several big commercial concerns here who are buying assets as fast as they can to move the money out to spread their risk. It appears that the favorite target for take over bids is the UK, ie., out of the Euro zone and thus the control of the ECB.

It's interesting too how the Spanish banks actually use the "virtual" funds owing to them by large construction and promoters - shown on the books as accounts receivable - as collateral proof of their own wealth, which then translates into high share values. Then these are used as an exchange medium directly or indirectly, to purchase foreign banks, power companies, etc. (Abbey bank, Scottish Power, just being two recent examples-you may have seen the howl in the UK media, the Scotsman, for example, even if Scottish power has been essentially British held). So the land grab schemes and all that goes along with them, corruption, etc., here have serious implications beyond Spain's borders. In 2002-2003 (mid years) La Caixa reported that of the 800 million euros that went out of this region, nearly half went to fiscal paradises. I haven't been able to get newer data. I expect that the new rules and mechanisms designed to halt money laundering and tax evasion through offshore havens have made this more difficult. So, apart from parking money in €500 notes, the acquisition of foreign companies seems to be the new laundering mechanism and current focus of interest in order to use borrowings against property and possible future development schemes.

What should be worrying is the "house of cards" fact that the loans are pretty shaky and getting more so, extended against land that may in fact turn out to be not worth much more than it cost, rather than the artificially inflated values the land schemes in many regions allow, so that everyone can take a rich rakeoff. At the same time, it has been suggested that one of the reasons that Spain is so resistant to allowing the sale of their large concerns, such as Endessa, may well have as much to do with a reluctance to allow others who would buy in to check up on dodgey Spanish accounting and management practices as any strategic concerns. (Why would Spain not wish to attract foreign investment?)

What makes the loans more risky in this region is that some of the hundred and twenty plus large development projects approved in the last days of the LRAU have been stopped for a variety of reasons, by the regional superior and national supreme courts mainly because plannning and environmental rules have been breached. Others, to the dismay of the promoters who have seen the party in power as their ally, are now being held up by the Valencian Government and may never be approved. The new package of laws in Valencia, however still flawed, will greatly complicate the design and building of many of the schemes for which land has already been grabbed- and against which loans have been extended. I would venture that the cash cow of coastal construction in the Valencian "El Dorado" will continue to go dry. Apart from the aberration that there is an overhang of about 600,000 empty dwellings here, held mainly by speculators or as a way to hide black money, there is increasing talk of building only about half of the projected 800,000 dwellings envisaged just a few months ago. The market for resale housing is dropping sharply. First time sales to foreigners are off even more so- a complication for the entire Spanish economy, which has depended on such sales for about 20-25% of Foreign Direct Investment. No wonder the current account deficit is the largest per capita in the OECD (Economist sources). One serious worry just for the ordinary citizen and resident here is where those who lose jobs, legal or otherwise will get their money to live, since the social infrastructure is so weak and personal debt is already so high and increasing day by day.

The Spanish banks themselves send out mixed messages. Sometimes they express concern that they could be left holding an empty bag, if big developers can't service their loans. The chance is that they could be stuck with tracts of non developable land or houses that can't be sold-just as back in the 1980's and early 90's, without the convenient prospect of devaluing the currency and thus the debt- the Peseta was in constant decline, remember, through most of that era.

The question is how can the lid be lifted off this? A few more incisive articles in the UK (and perhaps German) press could start a process of enquiry. Maybe questions could then be raised in the EU Parliament, and that in turn could prompt some serious investigation or attract the interest of the ECB, OECD or the IMF. It remains to be seen if either higher interest rates or the new national land law will have much effect on this. The amount of credit outstanding to the developers is such that the banks' hands are tied. (The saying goes: If I owe a thousand bucks to the bank, paying it is my problem. If I owe a billion, then it's the bank's problem!)

The above isn't an article in itself, but it does contain the guts of one that could get a lot of attention- and perhaps some results. Perhaps more in depth reseach than I can do is needed. It wouldn't be for the article to suggest what those results might be and what changes of policy would be needed to achieve them. The hope is that exposure might prevent futher macro abuses - perhaps even major scams- and complicate the predatory practices of those who are committing the abuses that affect so many small property owners and wreck the environment at the same time.

Posted by Charles Svoboda

Thursday, April 05, 2007