Shaky foundations Government and bank indebtedness in Spain

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1 For professional investors only Not for public distribution January 2011 Government and bank indebtedness in Spain The potential cost of bailing out Spain is one of the main causes of anxiety about the euro s survival. Government debt levels are not terribly high. But there is a substantial contingent liability in the banking sector and the fallout from a collapsing property price and lending bubble has yet to be fully felt. Dan Morris Vice President Market Strategist Reasonable doubt Spain s government is not as indebted or as profligate as Greece, nor are its banks as troubled as those in Ireland, but uniquely it shares the problem of each country. Spreads of Spanish government debt have risen inexorably over the last year as investors worry not only about the ability of the Spanish government to reduce its budget deficit and to obtain funding, but also about the cost of further support for the country s savings banks (cajas de ahorro). As has been the case elsewhere, vehement denials of vulnerability only serve to increase investors anxiety. Exhibit 1: Government bond spreads over Germany Despite two bailouts and Europe-wide bank stress tests, peripheral country bond spreads have continued to climb. On one hand this is rational as investors are simply taking country risk into account once again. 700 bps Greek bailout / Eurozone stabilisation fund Ireland Portugal Spain Stress tests Irish bailout 0 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Source: Bloomberg, J.P. Morgan. 1

2 Spain s budget surpluses were the result of the housing and construction boom. They will be difficult to repeat. The central government s debt burden is low compared to the rest of Europe at around 50% of GDP versus over 70% for Germany and France and more than 100% in Italy. The budget deficit for 2009 was 11% of GDP, but prior to the crisis it had been in surplus for several years. Since much of the revenue in earlier years was thanks to the booming housing and construction industries it is doubtful that tax receipts will be equally strong from now on. The central government is only part of the picture, however. The regions of Spain have a high degree of fiscal autonomy and account for half of public sector spending. Still, the most recent government reports suggest that the regions are on target to reduce their budget deficits in The biggest worry is the financial sector and the cost of recapitalisation of the banks if real estate and housing loans continue to sour. Spain experienced one of the largest property bubbles in the developed world over the last decade. Low interest rates following the introduction of the euro helped fuel a boom in house prices, which increased 2.8 times from 1999 to The US increase was just over two times. It is important to realise that an increase in property values does not by itself signal a bubble. If the broad economy is expanding vigorously, the increase in the price of land and buildings could simply be reflecting this growth in GDP. In Japan from 1955 to 1973, land prices increased by 13 times, but so did GDP so the ratio of the two stayed roughly in line. During the subsequent bubble, though, land prices went up a further 600% whereas GDP expanded by just under 300%, leading to the famous situation where the land under Japan s Imperial Palace was It is important to put property price increases in the context of the broader economy Both Spain and Japan are notable for having property prices that rose far more quickly than economic growth apparently warranted Exhibit 2: Real estate values relative to GDP 6 Spain Japan (+17 yrs) 5 Ireland 4 US Note: Japan data shifted forward 17 years so peak corresponds with other countries. Japan: Land Underlying Buildings and Structures; US: Household Real Estate Assets; Spain: Residential Household Wealth; Ireland: Dwellings. Source: OECD, Japan Land and Water Bureau, Ministry of Land, Infrastructure and Transport, Cabinet Office (Government of Japan), US Federal Reserve, S&P/Case- Shiller, OFHEO, Bank of Spain, Ireland Central Statistics Office, Permanent TSB/ESRI, J.P. Morgan. 2

3 worth more than the entire state of California. Twenty years later, land values are still declining. In Spain s case, property values similarly increased much faster than GDP. As Exhibit 2 illustrates, the ratio of household real estate wealth relative to GDP rose just as far as it did in Japan during its boom, and further even than in the US or Ireland. And whereas levels have already declined markedly in the US, there has been little adjustment in Spain.* How much will you give me? A notable contributor to anxiety about Spain is scepticism about house prices. After such a meteoric rise, it is hard to believe that they have fallen by just 12% over the last two years. Since the peak in Spanish house prices in early 2008, most indices show a fall of around 12%, compared to a 30% drop in the US. There are numerous doubts, however, about the accuracy of these figures. Anecdotal evidence from Spanish real estate agents suggests prices are down perhaps as much as 30-40%. The explanation for the discrepancy is that the published indices are based on appraised values and not on sales. Since appraisals reflect asking prices and sales are slow, the asking price likely does not reflect a home s true market value. Consequently, it is difficult for investors to estimate the true state of the market and they are therefore reluctant to invest in it. Unreliable house price indices also call into question the value of mortgage assets on banks balance sheets and whether reserves and write-offs are sufficient. Profitability for both the banks and cajas de ahorro has remained strong. Though they have declined from the peak of 2007, this year s results are on par with those of But if bank reserves and write-offs are understated, this apparent robustness is unlikely to last. Delinquencies in Spain have surged over the last two years, but relative to the experience in the US they appear to still be too low. Though home mortgages in Spain may be guaranteed, property developers will more easily default on their loans. Exhibit 3: Delinquency rates 9 % 6 3 Residential Mortgages: % of Balance 90+ Days Delinquent US Doubtful Real Estate Loans as % of Loans Outstanding Spain 0 Dec-04 Dec-06 Dec-08 Dec-10 Source: Bank of Spain, Federal Reserve Bank of New York, J.P. Morgan. *Note that it is the change in the ratio that is comparable across the different countries not the ratio itself as the numerator is not identical across the countries (see footnote to chart). 3

4 The forecast for Spain for the next several years is for continued weak growth, suggesting more and more loans will go bad. Given the economic challenges facing the country, we expect that delinquencies will rise significantly. The Spanish economy is expected to expand by just 0.6% next year versus 2.6% for the US (in 2010 Spanish growth is forecasted to be -0.3% compared to 2.8% for the US according to estimates compiled by Bloomberg); official unemployment is twice that in the US, yet delinquencies have trailed those in America (see Exhibit 3). One reason for this is that mortgages are unsecured in the US whereas homeowners are personally liable for them in Spain, increasing the incentive for the borrower to continue paying on the mortgage even if they no longer own the property. We nonetheless anticipate that Spanish homeowners will find it increasingly difficult to stay current on their loans. More importantly, property developers are likely to be forced to either default or restructure their loans as they are unable to sell their properties at the prices they had initially hoped for, if at all. Of total real estate lending in Spain, over 40% was for construction and property development. If delinquencies rise, leading to further losses on property lending, have Spain s banks reserved enough against these anticipated losses? The evidence suggests not. The banks and cajas currently have loan loss reserves for their real estate portfolios of 2.7%, up from a range of % during the beginning of the decade. While this is a significant increase over historical levels, the main mortgage lenders in the US have reserves over 4%, and they surpass 7% for secondary mortgages that might be comparable in risk to the property developers. Write-offs to date are running below rates in the US despite an arguably bigger bubble. The low level of Spanish bank reserves seems inadequate given the increase in doubtful loans already realised and against the level they are likely to reach as prices fall further and banks are forced to recognise the true value of their portfolios. Over the last two years write-offs have been fairly stable at roughly 8-12 billion per quarter even while doubtful loans have soared. Following the peak of prices in the US, cumulative write offs of just single family residential mortgages totalled $113 billion out of a portfolio that peaked in value at $2.1 trillion, for a loss rate of 5.3%. Spain s experience so far has seen write offs reach 45 billion out of a lending portfolio of 1 trillion for a loss rate of 4.2%. But given that property prices in Spain increased by over 30% more than in the US and have only fallen by 12% so far, and that lending to property developers is less secure than primary mortgage loans, we believe this loss rate will increase and that the cajas in particular have inadequate reserves. In fact, while loan loss reserves at the banks have continued to increase against future losses, the cajas have seen reserves fall by 8% since the end of March; caja reserves are now smaller than those at the banks even though total real estate lending by the cajas is 133 billion greater. 4

5 To the rescue Since the cajas are not publically traded, they are not obligated to disclose financial results. This only increases investor scepticism. The government s Fund for Orderly Bank Restructuring (FROB) has recourse to up to 90 billion, which is intended to promote consolidation in the sector and to help shore up balance sheets if losses overwhelm the cajas ability to absorb them. The question is whether or not this fund is large enough. Given that 45 billion has already been written off by both the banks and the cajas following a negligible fall in prices, it is not difficult to imagine a steeper decline leading to much more substantial losses. The amount that might be needed is difficult to estimate because the cajas are not publically traded and hence there is little information available about individual cajas finances, though there have been hints that the government may try to increase disclosure. Several investment banks have nonetheless made attempts to estimate potential losses. One bank, UBS, put the amount of capital needed to adequately strengthen capital at 70 to 120 billion. It is this combination of inadequate information and potentially large shortfalls that have made markets so sceptical towards Spain s ability to ride out the crisis. We believe the time has passed where investors are willing to accept on faith the protestations of fiscal probity by governments. We believe only disclosure from the government about the true state of the cajas financing, and a realistic assessment of property values across the country, are likely to restore confidence in the government s ability to manage the crisis. Assuming, that is, that the new information does not simply confirm the market s worst fears. In the meantime, confidence in the euro is likely to remain shaky while investors await the denouement of the broader crisis: either closer fiscal union or breakup of the eurozone. 5

6 Dan Morris, vice president, is a strategist responsible for delivering market analysis and insight to clients in Europe. Prior to joining J.P. Morgan Asset Management, Dan was the Senior Equity Strategist at Lombard Street Research and before that part of the Institutional Investor-ranked portfolio strategy team at Banc of America Securities in New York. Dan began his career covering Latin American equity markets at BT Alex. Brown and Dresdner Kleinwort Benson. He holds an MBA from the Wharton School and a Masters in International Relations from Johns Hopkins' School of Advanced International Studies. His undergraduate degree is in Mathematics from Pomona College and he is a CFA charterholder. FOR PROFESSIONAL INVESTORS ONLY. NOT FOR PUBLIC DISTRIBUTION. Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are J.P. Morgan Asset Management s own as at the date of the document. They are considered to be accurate at the time of writing. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. Changes in exchange rate may have an adverse effect on the value price or income of the product. Investments in smaller companies may involve a higher degree of risk as they are usually more sensitive to market movements. Investments in emerging markets may be more volatile and therefore the risk to your capital could be greater. Further, the economic and political situations in emerging markets may be more volatile than in established economies and these may adversely influence the value of investments made. You should also note that if you contact J.P. Morgan Asset Management by telephone those lines could be recorded and may be monitored for security and training purposes. J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. Products may not be authorised or its offering may be restricted in your jurisdiction. Issued by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR Material issued in the United Kingdom are approved for use by JPMorgan Asset Management (UK) Limited, 125 London Wall, London EC2Y 5AJ, England. JPMorgan Asset Management (UK) Limited is authorised and regulated by the Financial Services Authority. Registered in England No Registered address: 125 London Wall, London EC2Y 5AJ. 6