OK, if you've read the first blog you are probably wondering how and who is paying for the "Fiesta". After all, Spain was a relatively underdeveloped country in the 1980s and now it boasts a AAA/Aaa3 rating from the rating agencies (more about these later) while the BMWs and €500 notes are prominently in display.
The simple fact is that Spain as a country is addicted to debt. It has been running a current account deficit for years, as large in percentage terms as that of the US economy. The rest of the world, especially those countries with ageing populations, has been financing that deficit, as retirees and their trustees (pension funds and other institutional investors) look for places to invest their money. Individual Spaniards cannot, of course, borrow money from the Netherlands or Germany...this is conducted through the "oil that greases the economy"; domestic financial institutions.
The growth in assets of the Spanish banking system over the last ten years has been astonishing but more so has been the net production of loans. What do I imply by this? Not all loans, and especially mortgage loans, are kept on the balance sheet of banks. Most are packaged and on-sold to the trustees of those Dutch and German savers in the form of residential mortgage backed securities or covered bonds. In effect, Spanish financial institutions act as a mere conduit between non-resident savers and domestic borrowers. The lenders, via their trustees, are happy to buy these financial assets because the are highly rated by rating agencies- above investment grade in their jargon. This rating relies primarily on two aspects: (i) loan to value; i.e. how much debt to the appraised value of the property and (ii) debt servicing ratio; i.e. how much of the family income is consumed by the service of such debt. But, if you believe, as I do, that the "value" has been artificially inflated and that a great deal of the income of Spanish families is directly and indirectly derived from the construction and real estate sectors, themselves fuelled by cheap debt, then doubts begin to emerge about the credit quality of such financial instruments.
So why have investors not shunned Spain and taken their money while they can? For one, Spain is now within the Euro-zone. Prior to the introduction of the Euro, investors did just that on a regular basis; witness the devaluation of the peseta in 1994 after the previous real estate fiesta finished. Another important point is that the world is looking for borrowers; many countries are net savers and debt addicts such as the US and Spain are in high demand. Savings, after all, have to be invested.
Yet the chickens are coming home to roost. In the US, investors have finally realised that, as interest rates have risen, the value of the paper they were financing was not what they thought, given that an increasing amount of borrowers were now facing difficulties to service their debt. As a result, they have sold these assets and their price has come down. As the price falls, the loan to value covenants in many of the vehicles which finance these residential mortgage backed securities have triggering further selling. And so the cycle goes on. Furthermore, many of these vehicles were also funded by short term renewable money market loans also known as asset backed commercial paper. Of course, investors have also shunned this type of investment, leading to draw-downs under liquidity facilities provided by banks which were in place precisely to face this situation. But no one expected that they would be drawn all at the same time...which is what has been happening lately in financial markets.
So, remember those loans which the banks happily offloaded via securitisation? They are now back on the balance sheet of banks who had long forgotten about them. And yes, the banks need money to fund those drawn liquidity facilities. Yet, as the whole system faces increased liquidity requirements, few banks are willing to lend to each other, either because they expect to need the liquidity themselves or because they know that the assets which have been recently reacquired are not of good credit quality.
What does this mean for Spain? Well, everyone is focusing on the US and some of those German investors at the moment, but it is just a question of time before someone starts pointing a the "little US"- Spain. Unlike the much larger and monetarily independent Americans, Spain cannot devalue its currency to share the pain with its lenders (note what the US dollar has been doing lately). My prediction is that there will be a strong credit crunch in Spain over the coming years as banks try to sort out the mess implicit in those mortgage portfolios of recent vintages (aged mortgages usually have much lower LTVs). And then it will be time to pay for the fiesta, not with additional debt, but will real income...time to turn in those €500 notes and sell the BMWs.
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