Tuesday, 14 August 2007

The largest scam in modern history- Real Estate Fiesta in Spain (I)

I moved back to Spain from the USA in March 2003- over four years ago- with a view to buying a house and putting a foot in a country that I enjoy living in tremendously. Back then, I was shocked to find that prices per square metre were around EUR 6,000 in good areas of Madrid (Chamberí, Chamartín, Centro, etc.) and even more in the exclusive neighbourhoods of Salamanca, El Viso and La Moraleja.

In any case, I had a good job working for a bank, had saved some money after ten years working, and thought that I needed to settle down. I purchased a 60 year old 55 sq.m. apartment in the Chamartín area of Madrid for EUR 300k (of which only 250k was declared- the rest was paid in cash). At current exchange rates that was c. USD 450k for an apartment in Madrid! Not London, nor New York, nor Tokyo!

Anyway, I had just landed in Spain and was fairly naive as to how the Spanish economic miracle was being wrought. Gradually, and mostly due to my work (large corporate banking) I was able to gain some insight as to how some of the real estate and construction companies were performing the largest scam in Spanish economic history with the connivance of politicians and political parties.

It works like this, you see. Spain is a "democracy" which is run by political parties, not individual politicians. The latter's influence is solely determined by the extent to which they are able to influence the party they adhere to. It is normal, therefore, that once a politician comes to power he or she owes a debt of allegiance to the party that placed them there. Elections are, after all, expensive to run, and their success is largely driven by spending power.

Since legal funding for parties is limited by law, alternative (illegal) funding sources have to be found. An easy route is to use political power to change the zoning for certain plots of land. By decree, a local council can change an almost worthless plot of agricultural land into an urban plot worth exponentially more. This, of course, comes at a cost (bribes) which is paid to the politicians who in turn use the funds to pay their debts to the parties (and skim something along the way).

An extension of this little trick is the concession regime for public private partnerships, whereby a certain consortium gains the right to exploit a public good (motorway, waste treatment, airports, etc.) for a limited amount of time- in exchange for a "contribution" of course. This was particularly poignant in the Catalan region, where a 3% fee was the standard ticket.

Coming back to real estate; you may ask: how do the beneficiaries of the new zoning come by the large wads of cash (the EUR 500 notes which are notoriously abundant in Spain)? Well, the owners develop the land and sell the finished product (usually flats) for inflated prices, a part of which is settled in cash, outside legal settlement procedures. This whole game explains why buildable residential land in prime areas can cost up to EUR 12,000 per square metre- in a country with a low density of population and in some cases, like Madrid, with ample geographical expansion space.

On the demand side, the Spanish population has been blinded by the artificially low interest rates that were available during the 2003-2005 period, mostly due to the slump in Germany. Most mortgage loan borrowers only look at the monthly payment, regardless of how much they pay. Thus, they sign up for mortgages and happily take up to 40-year debts which they will pay when they are in retirement homes or pass on to their children as an inheritance.

Therein, lies the scam; millions of Spaniards taking on billions of mortgage debt to pay for artificially high residential real estate which is to be repaid over decades while being egged on by the retail banks, low interest rates, and greed fuelled by an irrational belief that house prices will increase indefinitely.

The reason why this scam has not reached public awareness is that there is limited interest in disclosing this. Think for a minute- the state collects taxes from the real estate transactions (barring the cash part of the transaction), politicians become immensely wealthy, parties are able to fund increasingly expensive elections, a belief sets in that real estate will increase forever, and consumer good providers prosper. Meanwhile the poor mortgagee doesn't realise that he or she is funding this corruption because the bribes implicit in the inflated purchase price of the house are spread over 25-35 year periods

Maybe the above will also provide some insight into the following questions
1. Why is Spain the EU member with the largest amount (in absolute and per capita terms) of EUR 500 notes in circulation?
2. Why do you see so many new BMW, Aston Martins, Mercedes Benz, Bentleys in large urban areas of Spain?
3. Why are Spanish companies in the construction sector purchasing electric utilities and other utility type companies outside of Spain?
4. Why are Spanish real estate speculators landing in droves in Romania, Poland and Bulgaria?
5. Why is a normal dinner EUR 60 in Madrid, which is more expensive than New York City?

As you reflect, keep this in mind. In 2006, a 30 year Ponzi scheme consisting of investments in postage stamps finally collapsed (Forum Filatélico Group). This time around the damage will be far more serious.

Interested in 100 sq.m. flat in a reasonably good area of Madrid for EUR 600k (USD 800k), anyone?