For all the news out of Spain: tumbling sovereign bonds, bailed out banking sector, there really is just one driver of everything: the same one many have been warning about for years: the artificially inflated valuation of the Spanish housing sector. Because the only reason why banks are suddenly finding that their assets are worth much less than previously expected, is because it is now impossible for local banks to keep the real-estate "assets" on their books at marks-to-model (read par) as the bulk of them have long since become impaired, delinquent or outright defaulted.
The common theme of course is that they no longer generate cash inflows. What however is still there are bank liabilities, which most certainly generate cash outflows. And in the absence of retained earnings (but plenty of retained losses), there is just no more cash to mask the capital deficiency. That's the whole issue with not only Spain, but Europe in a nutshell, the same we have been banking the table on for the past year: the accelerating disappearance of money good and cash-flow generating assets. Furthermore, once the spigot has been turned on, there is no stopping it, and the marks-to-market start pouring in fast and furious.
Which is the worst news for holders of Spanish bonds, now that the entire banking sector is effectively pari passu with the sovereign debt courtesy of priming ESM debt: recall that every incremental dollar, or in this case, euro, of bank capital deficiency will be one more priming bailout euro behind. Effectively there is now an inverse relationship between the Spanish housing sector and the country's sovereign bonds. And for those who are still naively are clutching to Spanish bonds, even as they tumble to all time lows (that's the local law, as opposed to the legal arbitrage trade we have been promoting and which today is making even more money), we have some bad news: that perpetual of optimists, S&P, just said that the Spanish housing sector has, wait for it, another 25% to drop!
This means a comparable drop in store for Spanish bonds and all the related securities in Europe, which courtesy of the bailout are all now daisy-chained.
Spain's Housing Market May Need Four More Years To Rebalance
The unwinding has begun: House prices have dropped 22% in nominal terms between first-quarter 2008 and first-quarter 2012, according to the Organization for Economic Cooperation and Development. That's more than in any other eurozone country except for Ireland. However, the magnitude of the decline has to be juxtaposed against the 150% rise in prices in Spain between 2000 and the peak in 2008. We note that prices climbed 116% in Ireland and 60% in the eurozone on average over the same period.
- For Spain's housing market to recover, household debt, which is still high, needs to come down further, implying years of weak
- Because of the heavy weight of unsold housing stock, we believe that the correction in housing prices is likely to be deeper and
more prolonged than in the previous cycle, taking up to four more years for the market to absorb the glut.
- A look at fundamentals--price to income and price to rent ratios--leads us to expect a further 25% drop in housing prices.
- Investment and employment in the construction sector is now down to 12.7% and 6.8% of GDP, close to half of 2006 and 2007 levels, respectively.
- The bursting of the real estate bubble is visible in Spain's dire economic prospects: Standard & Poor's expects GDP to contract in real terms by 1.5% this year and by 0.5% in 2013.
There is a lot in the report, but here are the key points:
Market Fundamentals Also Point To A Further Decline In Prices
Price to income and price to rent ratios in Ireland and the U.S. now stand below or nearly below their long-term average--but that is not the case for Spain. The country's price to income ratio has dropped from its peak in fourth-quarter 2006 but is still higher than its long-term average, and the same observation can be made about the price-to-rent ratio (chart 3). Looking at just these measures, Spanish house prices still need to adjust by nearly 25% for them to return to their long-term averages.
The Sharp Rise In Unemployment Is Weighing On The Household Sector
We expect Spain's economy to contract by 1.5% in 2012 and 0.5% in 2013 because of deteriorating private consumption, fiscal retrenchment, and weak credit conditions--coupled with flimsy external demand for Spanish products. High unemployment has been a drag on private consumption since the reversal of the housing and construction boom. The construction sector's share of GDP climbed from 15% at the end of 1999 to 22% in 2006, compared with 6% on average in the eurozone over the same period. With the real estate bust, Spain's construction sector has shrunk, representing only 12.7% of GDP in 2012.
The contraction of the construction sector triggered a loss of 1.5 million jobs between 2008 and March 2012. Employment in the sector, which was one of the highest in the EU with 14% of total employment in 2007, declined to 6.8% in March 2012. In comparison, this sector in France accounted only for 6.5% of employment in 2007.
The surge in unemployment is reflected in higher doubtful loans, as households find it more difficult to service their mortgages (see chart 4). Yet low interest rates have provided some relief to borrowers. Spanish households are very sensitive to changes in interest rates, since variable-rate loans comprise 90% of mortgages in Spain. That compares with 40% in the eurozone. In February 2012, as the unemployment rate reached 24%, doubtful loans reached 2.8% of total housing loans, a ratio that appears still reasonably low. But as the economy continues to weaken, we will continue to watch that indicator carefully as a potential harbinger of additional financial difficulties in the household sector.
And there you have it. Remember: Greek bonds at 100% in September 2011 were a whopping buy. Until of course there were an even more whopping buy at 1000% a few months later.