Expect more panic in Europe as Spanish house prices tumble

The effects of Spain's burst property bubble remain largely hidden for now. But that can't last. And the next phase of the bust will mean another bout of panic in the eurozone, says John Stepek.

"Mortgages get paid in good times and bad. Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid."

So said Alfredo Saenz, chief executive of Spanish bank Banco Santander, on Friday.

That's the kind of quote you can't help thinking will go down in history alongside credit crunch classics such as this 2007 line from Ben Bernanke: "we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited."

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So will Saenz's words come back to haunt him? We suspect so

Spain is like Ireland magnified

On Thursday, Spain's credit rating was cut by two notches to BBB+, which is the same as Italy's. Standard & Poor's wasn't telling us anything we didn't know. You only have to look at Spain's cost of borrowing hovering around the 6% mark - to see that it's a troubled economy.

What's bothering S&P in particular is the risk that Spain's banks will need more support from the government. S&P's Mortiz Kraemer told Reuters: "It's not going to be an easy job for most Spanish banks to find funding in the market. So the state may be called for."

When you look at Spain's public debt-to-GDP figure, you wonder why it's in trouble. As a proportion of GDP, the national debt is only 68% (as of the end of 2011).

Yes, it's hardly anything to be proud of. But compared to its troubled peers, Greece (165%), Italy (120%), Portugal and Ireland (108% each), it's positively frugal. And Britain and France are both on 86%.

But if you're confused, it's only because you're looking in the wrong place. Spain's problem lies in its private sector lending. In terms of its problems, you can think of Spain as being a big version of Ireland. Easy credit drove a massive bubble in the property market. That bubble has burst.

So the fear is that the banks will be left in such a bad state, that the government will end up needing to bail them out. As a result, that dodgy private sector debt will end up on the government's balance sheet. And as happened with Ireland, foreign lenders will no longer be willing to fund Spain's spending.

As Vincent Cignarella put it in the Wall Street Journal last month: "It's not hard to imagine a transfer from private to public sector debt rapidly blowing the sovereign debt ratio toward 100% of GDP in the next few years. Does Spain then become the next Greece?"

Spain's suspiciously healthy housing market

The Spanish government hasn't been sitting on its hands. It has already rescued several of the smaller lenders in fact, there have been "three rounds of forced clean-ups and consolidations" so far, notes Reuters.

As a result of all this, the banks have put aside enough to protect themselves against any losses on loans to property developers, notes The Economist.

Trouble is, "there are almost no provisions" for all the other loans on the banks' balance sheets. This includes residential mortgages, of which there are more than e600bn outstanding. The Bank of Spain says that less than 3% of these loans are in trouble.

To put it gently, that seems odd. The optimistic argument on Spanish property is that Spanish banks were more cautious lenders than banks in the US, for example.

But as the New York Times put it last week, when you've got unemployment above 24%, "the distinction between a prime and subprime borrower can be hazy."

And given that, as a whole, dud loans are at their highest level since 1994, it seems particularly unlikely that the mortgage sector has escaped unscathed.

What's more likely is that Spanish banks have done just what British banks have done. The strategy is extend and pretend.' Shift people to interest-only home loans, to cut their payments. Try to avoid repossessing homes. If you do repossess, keep them off the market where possible, in the hope that better times will come.

But as the economy continues to deteriorate, and inventory builds up, it'll get harder and harder to continue with this line. As analysts at JP Morgan tell Bloomberg, mortgages may be the "next leg downward in a prolonged banking crisis where solvency remains a risk."

What's the solution? Well, temporary money printing by the European Central Bank (ECB) certainly didn't do it. My colleague Tim Bennett explains why in this video. But in essence, it's because the LTRO was temporary.

The ECB gave money to Spanish banks to buy Spanish government debt. The money ran out. So now banks of questionable solvency hold even more debt owed by a government of questionable solvency. Why would anyone sane give either party more money?

The fate of the euro will be decided by voters

The likely end result of all this is that Spain needs some sort of bail-out. But Spain would be very expensive to bail out. Whatever funds exist are probably not sufficient.

So once again we'll end up going to the wire. As Jeremy Batstone-Carr of Charles Stanley notes, we may have to see Spanish 10-year bond yields above 7% before we get the next panicky move to settle the eurozone down.

What'll that mean for the euro? One thing that's become clear about this crisis is that the euro comes down to politics. As long as there is the political will in other words, as long as people want it the euro will be around.

For all that the populations of many European countries are suffering, they don't so far seem to blame the euro currency itself for their woes. The idea of going back to their old currencies is a frightening step into the unknown.

If they blame anything, they're angry with Germany for not sanctioning money printing and fiscal transfers.

In the long run, the euro can't survive. There are too many countries, with too many different needs. But it may take a larger, more self-confident nation, declaring that it's had enough of the currency and can go its own way.

Perhaps Germany will get fed up subsidising the others and leave. Or post-election, perhaps France will be next to be targeted by the markets and stomp off in a huff. My gut feeling is that the ECB will eventually be persuaded to print money, and that a formal break up will remain further off in the future. But the final decision will be down to voters, rather than markets.

Whatever happens, there's a lot of ruin left in the single currency. If you're interested in playing the currency markets, you should sign up for our free email on spreadbetting, MoneyWeek Trader. That'll give you an idea of the risks involved and how to minimise them.

As for bargain stocks in Spain we've been keeping an eye out, but there's nothing that catches our eye as being quite tempting enough to be worth the risk, given the state of the economy. We'll let you know when and if that changes.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.