Beware a Spanish fever

The unwinding of Spain’s property bubble is pushing its banking system to the brink, and writing a dangerous new chapter in Europe’s debt crisis.

PORTFOLIO POINT: Spain is facing a subprime mortgage crisis that could dwarf that of the United States (as a proportion of its total banking assets). And while we may look back at 2012 as a rare opportunity for equities, the fallout from the EU crisis is only just beginning.

It’s broadly known in ivory towers around the world that the European Central Bank’s long-term refinancing operations (LTRO) funds – those seen to have averted a complete collapse of Europe’s financial system by recapitalising the banks there – have not filtered into the real economy.

The ECB’s March 2012 Bulletin said: “[Money] and credit growth may remain subdued for some time, before strengthening as a result of the three year LTROs.” Exactly how long “some time” is, nobody knows, but investors are slowly realising that a recovery is not around the corner.

Further evidence of that conclusion was received this week, when Spain announced what anyone living there already knew – the country is in a recession. The background to this current situation is interesting and more importantly, not unique to Spain.

So let me give you a sneak peek into this one country that helps make up the European Union. Spain is a nation, like many others, banded together under the single currency and experiencing the unwinding of an asset bubble that is pushing the banking system to the brink.

One more point before I embark on this discussion: I believe that like the stockmarket rally that began in 1932, our market may just look back on 2012 as one of important and rare opportunity. There will be bumps along the way and the problems of the world are not solved, but awaiting a GFC-like decline in stockmarkets before wading back in may prove too pessimistic, and waiting for confirmation that all is rosy will be just as costly.

Source: Bloomberg

Back to Spain: From 1995 to 2001, Spanish and US house prices moved pretty much in lockstep, rising an impressive 50%. After 2001, however, something clearly changed and the next six to seven years shaped up very differently for each country in terms of property price appreciation. And we all know what happened in the US.

Both countries experienced a credit-fuelled housing boom and both were characterised by lax lending standards. In the US, NINJA (No Income No Jobs No Assets) loans, subprime mortgages and poor quality loans totalled 20% of the entire mortgage market. Subprime mortgages grew to $1.3 trillion of the total $6.8 trillion US mortgage market.

The boom in Spain, however, lasted much longer and was of a much greater magnitude. Spain’s property boom set that market up for an equally damaging correction that is now ripping through the financial fabric of its economy.

Source: Center for Responsible Lending/Inside Mortgage Finance

How exactly does Spain compare? In summary, Spain is the US on steroids. If the US was a bottle of beer, Spain is the whole brewery. While Spain’s mortgage market of €1.763 trillion is smaller in size (at about 34% of the US market), the proportion that the subprime issue represents dwarfs anything I have seen to date in terms of a country’s total banking assets.

It is estimated that 50% of all mortgages are tied to what is known as the 'Caja banking system’ (pronounced Ka-ha). For those not familiar with 'Caja’, it’s a banking system which was fuelled during the housing boom by demand from subprime and sub-subprime borrowers.

It’s also a banking system with zero transparency; a system which did not report LVRs, the quality of the lender, the quality of the collateral or anything that would help monitor risk in the highest risk sector of the mortgage market.

If Caja can be called a 'system’ at all, it was allowed to grow virtually unregulated along with a 'traditional’ regulated banking system until 2010-2011. And it’s a system that is said to be half of Spain’s entire banking assets, or around €881.5 billion.

With the US as our guide, experience tells us that delinquency rates on subprime lending have risen to around 25% of all subprime fixed and variable rate loans. If we assume a similar level JUST in Spain’s Caja banking system, bad debts in Spain could exceed €220 billion.

Add to this a current aggregate delinquency ratio of 8.16% (and climbing rapidly) – a level of bad debts not seen since October 1994 – and total banking system bad debts could approach €300 billion.

Source: Bloomberg

Under more recent Basel III regulations, banks worldwide must retain a total capital ratio no lower than 8% to withstand a large percentage of loans becoming delinquent in a short period. In Spain, with total banking assets of €1.763 trillion, €141 billion in total capital is required to support Spain’s mortgage market. One assumes that the collective banking system had at least this level of capital supporting loans to begin with – a big assumption!

Say goodbye to Kansas, Dorothy – Europe is about to write another significant chapter in its ongoing financial crisis. Forget about Greece being 'fixed’ (until this time next year at least). Without help, Spain’s banking system, which makes Greece look like a pimple, is facing a potential €300 billion in bad debts that would wipe out all its capital. Spain therefore appears to be grossly underfunded to deal with the train wreck slowly rolling towards it. And that train is the Midnight “Marked-to-Market”.

Indeed, I could even make the argument that the Spanish banking system is insolvent, based on my estimates of future delinquencies, and therefore is on the verge of collapse unless central banks again come to the rescue.

We have all heard recently that the ESM has been boosted and the IMF has replenished its war chest. If Spain has delinquencies anywhere near the rate that the US experienced in just 50% of its mortgage market, the country is going to need all the extra firepower it can get!

  • Caja potential delinquencies = €220 billion
  • Traditional banking delinquencies €72 billion
  • Total capital supporting mortgage market = €141 billion
  • Potential shortfall = €151 billion
  • Capital required to recapitalise Spain’s banking system in anticipation of delinquencies = €118 billion
  • Total unfunded = €269 billion

So stay tuned. I am generally bullish about our stockmarket, but these events provide the bumps of fear that long-term investors should take advantage of.

Roger Montgomery is an analyst at Montgomery Investment Management and author of, available exclusively at

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