...is in real estate. Can the Eurozone cope with the looming loss of value...?
THE SPANISH ECONOMY is bankrupt, writes Dan Amoss, editor of Agora Financial's Strategic Short Report.
A veneer of freshly printed Euros is all that's holding it together. Within a matter of weeks, more printing will be seen as crucial to prop up banks and sovereign debt.
Like a zombie in a horror movie, this is the crisis that just won't die. Spanish government bond yields are rising yet again, wiping out any "carry trade" profits that Spanish banks were hoping to generate by borrowing from the European Central Bank (ECB) at 1%.
The ECB's three-year long-term refinancing operation loans bought Europe a few short months of tranquility. The Bank of Spain announced that during the month of March, Spanish bank borrowings from the ECB soared from €152 billion to €227 billion.
Spanish banks are in big trouble. They must pay out depositors looking to move to safer banks and foreign institutional lenders pulling money out of the country. The only place Spanish banks can turn to replace this lost funding is the ECB. Spanish banks have taken up 30% of the LTRO loans issued thus far.
Spanish banks are propping up the Spanish government by parking these loan proceeds in the bond market. But this is just temporary, and it makes the situation even more fragile by tying the fortunes of the government and the banks even closer together. Ultimately, the funds borrowed from the ECB must be used to satisfy deposits and bonds maturing later this year.
"Weaker lenders are merely parking the ECB's ultra-cheap funds in [Spanish government] bonds until they need the money to roll over their own debts," writes Ambrose Evans-Pritchard in his Telegraph column. "That is coming due since European banks have €600 billion in redemptions over the rest of the year. Many are now stuck with losses that they cannot afford to crystallize." Considering the turmoil we'll surely see in the Spanish economy, €600 billion in maturing debt is going to be a huge challenge for the European banks.
The Spanish economy is fraying at the edges. It has many unresolved issues. A backlog of mortgage-related losses lurks unrecognized on the balance sheets of Spanish banks. The restructuring of the Spanish housing bubble has yet to begin. Housing prices remain at levels far above what would be justified by Spanish incomes. In a recent presentation, Carmel Asset Management makes an excellent case that the Spanish housing price index needs to fall another 30% to realign itself with the trend in household wages.
I'll highlight a shocking figure from Carmel's analysis: 80% of Spanish household wealth is in real estate. And 24% of households own second homes. So when (not if) housing prices fall further, this will crush the rest of the Spanish economy.
There are no identifiable demand-side catalysts to keep the Spanish housing market from falling much further. Spain's population is aging, and its youth, living with a 50% unemployment rate, is in no position to buy houses – especially at today's asking prices. The "bid" side of the market is well aware that it's a buyer's market. Buyers know that there are plenty of excess vacant housing units.
It's hard to argue that the Spanish banking system – or even the Spanish economy itself – is solvent. Its liabilities exceed its assets.
The new government can make heroic efforts to cut spending. It can also push to reform the highly rigid labor markets. But these efforts will fail to get the country out of its hole. Support from the European Central Bank is the only force propping up the tottering pyramid of debt in Spain.
Carmel estimates Spanish banks are undercapitalized by €200 billion, or 20% of Spanish GDP. To give you a frame of reference, this is equivalent to US banks being undercapitalized by $3 trillion (or four times the amount of money that Treasury Secretary Hank Paulson requested from Congress for TARP in late 2008).
Spain will need "four TARPs" to recapitalize its banks, yet ironically, the very act of raising this huge pile of money to inject into the banks would undermine the very assets sitting on bank balance sheets (government bonds and loans). Twenty percent of GDP is simply too much capital for Spain to support its banks, so it will have to beg for the money from the EU/EFSF. International private-sector investors will keep fleeing Spanish markets.
This situation is screaming for a bankruptcy and restructuring. Putting this off will result only in larger losses in the future. The Spanish economy will not rebound until debt is restructured.
Deficit targets that Spanish politicians are promising to EU paymasters are unreachable. The layers of bureaucracy are thick. Each level of government in Spain – central, regional, provincial and municipal – will fight for its turf and its budget. Bureaucracy has made the labor market very inflexible. According to a Word Bank index of wage rigidity, the Spanish work force ranks as the least flexible among developed economies – worse than even France, with its legendary socialist labor policies.
The policies of the regional governments are frequently at odds with those of the central government. For instance, the regional governments fund and administer Spain's health care system. So Prime Minister Mariano Rajoy, desperate to show progress in cutting Spain's deficit, this week signed a new budgetary stability law.
The central government is seeking more control over the budgets of regional government. "[Popular Party] leaders under Mariano Rajoy, prime minister, have rushed through the new law, which allows the central government to intervene in errant regions to ensure compliance," reports the Financial Times. Regional and municipal governments have racked up €35 billion in unpaid bills to service providers, including drug companies and trash collectors. The central government has launched a plan to pay down these bills through the banking system. No doubt it will seek more budgetary influence after this bailout.
Austerity in a country so reliant on government spending and employment would be self-defeating, as it was in Greece. Even if government spending falls, GDP would fall as fast, or even faster. Business lobbying group Circulo de Empresarios points out that since 1996, the number of Spanish public employees has grown from 2.2 million to 3.2 million.
What does this mountain of evidence mean for the future twists and turns of the Euro crisis? It means that the EU, if it's going to have a chance to hold things together, is "going to need a bigger boat" – as Roy Scheider's Chief Martin Brody says in Jaws. Take Portugal, Italy, Ireland, Greece and Spain out of the list of contributors to the EFSF bailout fund and its size falls considerably.
The EFSF is not a viable solution for this mess. The political will of countries like Germany to increase their funded financial commitments to the EFSF is fading. More European politicians will wake to the fact that Spain's official 60% debt-to-GDP ratio rises closer to 90% if you adjust for regional government debts, loan guarantees and state-run businesses. The picture gets much worse if you project how insolvent the banks will be when they finally deal with their backlog of mortgage and construction loan losses.
The sugar rush from the ECB's LTRO is wearing off. More pressure will fall on the ECB to resume its direct purchases of PIIGS debt.
Gold and other tangible stores of value have been rather dormant over the past six months. Considering the explosive nature of this situation, this is puzzling. Perhaps most investors will wait to act until the gravity of this situation in Spain is staring them in the face. Perhaps the "gold bugs" should be the ones belittling the "paper bugs" for holding rapidly spoiling Euros, Dollars and sovereign bonds in this unstable environment!
It's only a matter of time, I believe, before a broader group of central banks and institutional investors rushes to start Buying Gold...