Are Spain's Banks Likely To Be Spared Global Financial Pain?

So are Spains banks likely to escape the pain associated with the global financial turmoil? Well the Financial Times' Gillian Tett obviously thinks they are, and she has been argueing her case in two interesting and valuable pieces in the Financial Times - "Spanish banks spared huge writedowns" (Feb4 2008), and "Why the pain in Spain has mainly been contained" (Feb1 2008). In support of her Tett makes the important and valid point that:

"In the past few years, the Bank of Spain, which acts as financial regulator, has prevented banks from holding any kind of special purpose vehicles off balance sheet."

But could it be that in the Spanish case the financial pain, likely the proverbial rain, falls mainly in the plane? Namely, and as I try to explore in this post, could it be that the large Spanish banks have largely weathered (and may well continue to weather) the storm that is brewing in Spain's troubled domestic mortgage market due to the fact that they stayed to some considerable extent on the sidelines in the massive cedula hipotecaria (covered bond) boom market, leaving most of the risk - and comparatively little of the return - to be shouldered by the smaller players, like the regional cajas.

Certainly I would argue that the little model which I present in the diagram in the above linked post of mine probably has some sort of general validity, and may help us to see how things will pan out here.

The argument Tett advances, which is pretty much common currency here in Spain at the present moment is technically correct:

When the subprime crisis exploded in the US last year, a majority of analysts predicted the contagion would soon spread to Spain. Spain, like the US, had an overheated housing market and banks that had lent freely into the construction boom. Six months on, part of this prediction has played out, in the sense that Iberian banks are suffering from the effects of the liquidity squeeze, like the rest of the global banking system. However, many analysts have been surprised to discover that Spain’s financial groups have had no exposure to the kind of mortgage-linked investment vehicles that have wreaked so much havoc in the US and Europe.

It is technically correct in that while the Spanish banks are - as she admits - experiencing liquidity problems, these problems are not essentially connected to the subprime problem in the US, but they are connected with the ensuing credit crunch which has followed in its wake, as I explain here. Indeed Tett also accepts this:

Spanish lenders are now furtively turning their mortgage loans into privately placed bonds to use these as collateral to get access to liquidity from the European Central Bank. Meanwhile, the cost of buying insurance against default for medium Spanish lenders, via the credit default swap market, has recently soared, amid rumours that hedge funds can smell blood.

So not everything in the garden is completely rosy. The Spanish financial sector is essentially having to swallow its own bonds in order to be able to raise day to day liquidity at the ECB, and there is a huge problem looming after 2010 as the 10 year term cedulas need to be rolled over. The problem has assumed a particularly acute form since noone at this point in time has any real ideal what the pool of properties which back Spanish covered bonds is going to be worth in both the near and the longer term future.

Gillian Tett notes that something is afoot in Spain:

Twice a year I travel down to Spain to visit my relatives - and almost always return feeling worried about financial risk. For nobody can fly over the Spanish coastline these days without noticing that the country has recently been in the grip of a construction boom. And that, unsurprisingly, has led to an explosion in the balance sheets of banks, with a corresponding boom in the Spanish residential mortgage bond securitisation (RMBS) market. It is a fair bet that this credit party will produce plenty of hangovers in the coming years. Indeed, where my relatives live in southern Spain, house prices are already tumbling and flats stand empty (albeit, on a scale that still looks modest compared with the subprime-scarred areas of Los Angeles, say.)

Well, Gillian, I don't know what you consider modest, but according to Leslie Crawford writing in the FT last week the IPE business school are suggesting that by March there may be 500,000 unsold homes in Spain - more or less one year's residential construction output at the old pace. And that was the old pace. If we assume that one of the impacts of the current correction may well be a slimming down of Spain's construction industry, then this may turn out to mean that we already have an inventory which is nearer to two years supply, and growing.

From here on in financial market calculations may well take the back seat while the real economy takes over. Most calculations of what we can expect going forward depend on what is going to happen to Spain's economy as a result of this correction, since that will be the factor which ultimately determines where Spanish housing prices finally settle, and since the correction has hardly begun let alone ended most calculations on this front should be treated with a very strong measure of caution.

One problem though is puzzling me, Spain's external deficit. Basically Spain runs a very large balance of trade deficit, and one of the principal factors sheilding Spain from difficulties on this front has been the steady inflow of funds associated with foreign investors purchasing the cedulas. These flows have now virtually stopped so the deficit will either have to be financed in some other way, or turned round. Both of these, given the magnitude of the issue, seem very complicated indeed. To give some idea what I am getting at, and on an off the top of my head basis, we could note that a large part of the trade deficit is to pay for oil and natural gas imports - all that central heating and air conditioning for all those extra houses - and that most of the money to pay for these imports has been indirectly borrowed via the mortgage demand from would be householders. It may even be the case that Spain has not yet paid for a drop (let alone a barrel) of all that oil which has been used since 2000. Whether or not this is exactly the case the problem clearly exists, and Spanish consumption is going to be reduced on an ongoing basis, and over a number of years, to pay down the accumulated debt, at just the same moment as Spain will have to reinvent a new driver for economic growth, since construction as the principal driver is clearly finished. In that sense comparisons with the United States may not be so far from the mark, and even more so, since proportionately Spain's boom has been much larger.