The Spanish Banks' Growing War Chest

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.


Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.



During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?


Update

Geert asked me a question in comments, possibly reflecting some of the difficulties people may be having with this post.


"I must confess that I don't really fully understand this post."


Since I have tried to answer at length, I though it might be useful if I reproduced my explanation above the fold.

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think,though, that to get the background here you need to go through the posts on my Spanish blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

Toshihiko Fukui's Term At The BoJ

Toshihiko Fukui will retire as governor, after five years at the helm of the Bank of Japan, on the 19th March. His successor may well be announced this week. This morning in the Financial Times David Pilling has a long, and very "fair and balanced" asseessment of Fukui's time at the BoJ, which is more than worthwhile reading for those of you who would like to understand the workings of this venerable institution just a little better. As Pilling's concluding paragraphs make clear, what would seem to matter most in this case isn't so much what just happened, as what gets to happen next:

“Fukui has often been portrayed as chomping at the bit to raise rates,” says Ben Eldred of Daiwa Securities “The truth is that Fukui’s BoJ has been fairly pragmatic – waiting until relatively late in the economic cycle before raising rates, doing so only very gradually and pausing as soon as it became clear that the global economic outlook had worsened in 2007.”

The pause to which Mr Eldred refers has lasted a year. As well as a response to international circumstances, the delay also reflects the failure of the domestic economy to click into gear as Mr Fukui has long predicted. The governor has continually stressed his belief that record corporate profits will feed through into higher wages and consumer demand – a “virtuous circle” that might have been a good justification for the bank’s forward-looking policy.

Unfortunately, it has not panned out. Wages have stalled or even fallen as global competition, coupled with labour market and demographic changes, has short-circuited the normal mechanism by which profits flow into remuneration.

This has left Japan’s economy running on only one, export-led engine and flying too close to the deflationary ground for comfort. What headline inflation there has been is due almost entirely to higher oil and commodity prices. If commodity-led inflation fades – as many predict if the global economy slows – Japan could yet crash-land back into deflation.

Markets are factoring in the possibility that the BoJ’s next rate move will be down – not up as the governor has long intimated. It would be a severe blow indeed for the bank to put hard-won interest rate rises into reverse. But if the day for such a decision arrives, at least it will not be Mr Fukui’s to make.

Basically I think Fukui's big bet was that domestic consumption would prove strong enough to provide a second leg (in tandem with exports) for the Japanese economy. As Claus Vistesen details at great length here (and here) - and as Pilling also seems to accept -this view seems to be inadequate, and fails to get to grips with the malaise which is affecting the Japanese economy. And as if to give just one last kick to this now thoroughly wobbly perspective, todays index for December services has just been published by the Japanese Trade Ministry. The tertiary index, which is a measure of the money households and businesses spend on things like phone calls, power and transportation, declined 0.6 percent from November. The Ministry listed the following sectors as having declined:

1. Finance and Insurance, 2. Services, 3. Compound Services, 4. Wholesale and Retail Trade. Industries that contributed to the increase are as follows:1. Eating and Drinking Places, Accommodations, 2. Real Estate, 3. Learning Support, 4. Electricity, Gas, Heat Supply and Water, 5. Medical, Health Care and Welfare.

Although the index actually rose some 0.2 percent over the fourth quarter, this latest sign of weakening will certainly not come as good news for Fukui as he prepares to clear up his desk.

Turning The Screw on Hungary; Three Possible Tipping Points

Hungary's forint firmed slightly today after standing up to several waves of pressure, settling around what still amounts to a one-week low against the euro. The mildly favourable retail sales data that came out in the US during the afternoon eased some of the pressures on emerging market economies and in the collective upswing the forint managed to get back below the 262 to the euro level. Just enough to knock out stop-loss levels, but hardly anything to get excited about. The forint had been as far down as 266 to the euro earlier last week - amid a spate of rumours which included the idea that the prime minister was about to resign, and that the central bank was about to announce an emergency rate cut (or was that increase, I never was sure which possibility was most in people's minds at that point). Indeed it was clear that a general downturn in global risk appetite which struck all across emerging market instruments was hitting Hungary's long-unsteady markets the hardest.

Hungary's economy has slumped to decade-low in growth following a government belt-tightening campaign aimed at straightening out its public finances.







Danske Bank Analysis


Portfolio Hungary reports this morning on the view of Danske Bank analyst Lars Christensen. Christensen's argument is that it is only a matter of time before the forint follows the leu, the kronur and the rand in weakening significantly. In particular he argued that the forint is not sufficiently protected by adequately high interest rates.

Since the outbreak of the global credit crunch in August 2007 many currencies in the EMEA countries which have been running large current account deficits and/or have accumulated large ratios of foreign debt have been under significant selling pressures. According to Christiansen:

“Most notable has been the weakening of the Romanian leu, Icelandic kronur and the South African rand, which have all weakened around 15% since the beginning of August. The lira has more or less been flat against the euro since early August and the forint has “only" weakened around 5%".


“While we clearly see a risk that these currencies can weaken significantly more, there is also a risk that this weakening will spread to other EMEA economies with similar problems. In particular, the Turkish lira and the Hungarian forint stand out,"

“While high interest rates in Turkey give some protection, it is hard to use the same argument for the forint and hence we believe that it is only a matter of time before the forint follows the leu, the kronur and the rand and weakens significantly."

(The base rate is currently 13.75% in Iceland, 11.00% in South Africa, 9.00% in Romania, 15.75% in Turkey and 7.50% in Hungary.)

As he points out, imbalances have been reduced in the Hungarian economy on the back of last year's tightening of fiscal policy, but the markets have also 'rewarded' the Hungarian government for this by not selling the forint as much as the continued large imbalances and large foreign debt could 'dictate'.

Also, as the global credit crisis drags on there is an “increasing risk that we will have a repeat of the forint 'crisis' of 2006", where the HUF fell sharply from around 250 against the euro to 285 in a comparatively short space of time. And the global financial environment at that time was significantly more benign than is the case at the moment. So a forint at 280 or below to the euro hardly seems an unlikely level at this point in time, and indeed Lucy Bethell from RBS was arguing exactly this earlier in the week.

In particular, Christiansen stressed that any “slippage" on fiscal policy in Hungary would hit investor confidence hard and this would also “likely lead to downgrades of Hungary's credit ratings". And this is just why tomorrows Q4 2007 preliminary GDP data will be so important, since if the figure slips to any great extent on the downside this is bound to place strong question marks around Hungary's 2008 budget targets which are - let us remember - based on government estimates of GDP growth in the 2.8 to 3% range.

And before we leave Christiansen's analysis, I would like to draw attention to one point: the comparison with Turkey. Back in August 2007, just after the credit market crunch started to close its grip, I wrote a long post (and an even longer analysis) of Turkey, where I tried to argue that even though Turkey's economy would come under pressure just like those of its East European neighbours, the underlying soundness of Turkey's demography, and hence the element of homeostatic regulation which it would enjoy following from any significant downward correction, meant that it could well emerge with a lot less medium term damage from the coming global storm than the rest of Eastern Europe. This view is now about to be tested, as indeed is the whole thesis that demography and fertility don't matter to economics. As I wrote at the time:

There are good theoretical reasons - at least if you take demography seriously there are - for imagining that the Turkish economy might well prove to be more robust than some of the Eastern European ones will under the strains the various economies are under and about to receive. These latter economies, despite their apparent vibrance are actually much more fragile under the surface, and it is for this very reason that the observed response differences bear examination day by day.

I Suppose That's The Hill Sergeant, and I Guess You Are Going To Make Me Climb It.


The most probable scenario we now face is for the forint to experience a succession of waves of attack, and a systematic attempt to knock it of the perch on which it is so delicately poised. All free-market economists of course believe in the workings of financial markets as a regulatory mechanism, but we don't have to believe they are fair, kind or forgiving.

There seem to be three critical tests facing the forint in the short term. The first is the GDP and inflation data coming tomorrow. Starting with the Q4 2007 GDP data, my opinion is that this will surprise on the downside, and possibly give every indication of just how unrealistic most of the 2008 GDP forecasts for Hungary currently are. The second is the inflation data, and here the Hungarian central bank is now almost certainly in a heads I lose, tails I lose situation. If the CPI - Hungarian inflation was running at an annual rate of 7.4% in December - surprises on the downside this may encourage currency dealers to feel that the central bank will bow to political pressures and reduce interest rates - a move which the collapse in Hungarian internal demand suggests is badly needed.







But the reduction in yield differential would make forint denominated assets less attractive, suggesting that the foring would face a more testing toime and that an acceleration in capital exit would probably occur. If, on the other hand, the data surprises on the upside - which after today's December agricultural PPI data (38.1% y-o-y) seems more likely, then this may lead people to feel that the central bank will have no alternative but to increase rates. Indeed many market analysts have now reached the conclusion that such rate rises are more or less inevtiable. The latest of these has been Gillian Edgeworth of Deutsche Bank, who today projected a total of 100-bp rate hikes in the next six months (over the course of the next six policy meetings.), and in this she has joined a fine galaxy of observers including Goldman Sachs and Citigroup - who are projecting a 50-bp hike at the 25 February policy meeting, while Citibank analyst Eszter Gárgyán is on record as saying she does not believe that even a 50-bp hike could be enough to stop the weakening of the forint. I am not sure how much of the macro-economics of what is involved in all this these forecasters understand, but I am quite happy to say that the sort of monetary tightening that Gillian Edgeworth is contemplating is just not posible at this point in the game, since, apart from the fact that it would send Hungary off into one whopping and unholy recession (especially if it was accompanied - as it would have to be - by a continuing tightening of the loan conditions on Swiss Franc mortgages, due to the hightened currency risk default issues), the political dynamics would not accept it. You can only ask people to accept so much belt tightening before they rebel, and we are already over 18 months into this round, so tolerance must be wearing thin, and another year of monetary tightening is most definitely out at this point. If you have any doubt whatsoever on this, look at what has happened in other countries in other epochs.

So, given that not all market analysts are competely devoid of foresight, any move to press the tightening trigger can alos lead to a similar conclusion to a rate cut about the desireability ditching Hungarian assets, since more monetary tightening would only close even further the noose which is currently extending its grip over the internal economy. Such are the difficulties when you back yourself so tightly into a monetary and fiscal corner.

The second hurdle, or critical point, the forint will have to get over - assuming it survives tomorrow - will them be the meeting of the central bank itself on the 25 February, and again rate policy decisions either way can have unpredictable effects, and once more it is likely that an attack will be mounted, regardless of the decision taken, given (as I argue above) there are sufficient reasons for doubting that either policy option is a good one. What all this amounts to is that the Hungarian central bank has now run out of policy options, and it is just a question of time before we get to see what the financial market participants decide to do about the situation.

Finally, and assuming that the currency passes muster relatively unscathed in the first two initial skirmishes, the cherry is most decidedly and firmly likely to be planted on the top of the cake if the proposed referendum on some of the more controversial measures in Hungary's adjustment programme actually gets to be held on March 9th. Since a vote to abandon the contested education and health service charges - which seems on the face of it to be the most probable outcome - would virtually present a frontal challenge to the whole "adjustment" process, it is hard to see how the Gyurcsany government could continue under the circumstances (even if there would be no formal obligation to resign). This kind of situation is, of course, "more power to my elbow material" for those market participants with an acquired taste for warm, freshly-spilled blood, and really if we got through to this point, without anyone having the presence of mind to take the bull by the horns first (by which I mean making a virtue out of a necessity, and openly accepting that policy is now in a no-exit bind, and that a significant drop in the value of the forint is both inevitable and desireable, depite the fact that there will be a lot of renegotiating and cleaning up to do in the aftermath), then the outcome may well not be a pleasant sight to watch.

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.