Going Through Denial, Spain Suffers Painful Housing Hangover

Unlike the U.S. and U.K., Spain has been agonizingly slow to accept the fact it got drunk on a massive real-estate bubble, exacerbating and prolonging the hangover now reeling through its financial sector.

While it has begun to make amends with new measures aimed at cleaning up the mess, Spain and its troubled regional banks have yet to recognize the depths of their dilemma by taking the necessary painful writedowns.

“Like any psychological problem, first you’ve got to admit you have the problem,” said Jan Randolph, director of sovereign risk at IHS Global Insight. “Writedowns have been insufficient. They need to bite the bullet harder.”

As eurozone leaders debate pushing Greece out of the monetary union, the markets are expressing serious concern about Spain, which because of its size and troubles remains the most important country in this never-ending debt crisis.

Bubble Bleeds Banks

Spain’s stock market, the IBEX 35, plummeted another 2.66% on Monday, landing at levels unseen since October 2003. The country’s 10-year bond yields, which move in the opposite direction of prices, spiked above 6.3% and the cost to insure its debt hit a fresh all-time record.

“The past four years have witnessed a crisis of unprecedented proportion in the Spanish financial sector in its history,” the International Monetary Fund said in a report released on April 25 about Spain.

Reminiscent of the crises that crippled the U.S., Ireland and U.K., the story in Spain is of a real estate boom-and-bust cycle that is now causing banking trouble and bloating the government’s balance sheet.

Home prices have tumbled about 30% in Spain, compared with 35% in the U.S. and 50% in Ireland. However, unlike in the U.S., prices are projected to continue to decline in Spain, which reportedly has some two million vacant homes.

Reluctant Writedowns Slow Healing Process

Critically, Spain has been much slower to recognize the financial damage by lowering the value of mortgages held on the books of its banks to realistic levels.

That may help explain why the markets have widely panned new measures unveiled late last week by Prime Minister Mariano Rajoy forcing banks to increase loan-loss provisions on real-estate loans by 30 billion euros, up from 54 billion euros previously.

The combined 84 billion euros in mandated provisions pales in comparison with private-sector forecasts for eventual damage from the bursting of the real-estate bubble.

Moody’s (NYSE:MCO) has warned Spanish banks could suffer losses of about 305 billion euros, compared with a rough estimate of 380 billion euros from the Center for European Policy Studies, which is a Brussels-based think tank.

“The key weakness of the earlier plans has not [been] addressed.  Like them, the new plan appears to under-estimate the potential bank losses,” Marc Chandler, global head of currency strategy at Brown Brothers Harriman, wrote in a note on Friday.

In another sign of banks’ unwillingness to take writedowns, Fitch said in a note on Monday that banks typically marked repossessed properties down by about 25% before sales, but the price achieved was actually often 50% lower than the original loan valuation.

While private forecasts for loan-losses dwarf loan-loss provisions being mandated, construction activity is incredibly continuing to expand in Spain, further complicating the situation.

“If construction were to continue at the still relatively high rate of today, the process of absorption of the bubble would take more than 30 years,” CEPS researchers wrote in a report released last month.

Banking Sector Transforms

Despite this backdrop, Spain’s big banks like Banco Santander (NYSE:STD) appear to be in better shape than the largest U.S. banks like Citigroup (NYSE:C) were during the 2008 crisis. That’s because these large Spanish banks are well diversified and don’t have the same level of mortgage-related derivative exposure.

“The largest banks appear sufficiently capitalized and have strong profitability to withstand a further deterioration of economic conditions,” the IMF said in the April report.

On the other hand, Spain’s regional savings banks, remain troubled. Known as cajas, these lenders used to comprise half of the country’s financial sector but were often influenced by regional politicians.

“They’re very strange creatures” that have been “used as political footballs by local governors on an empire-building mission,” said Randolph.

In a major revamp, the number of these lenders has been slashed to 11 from 45 through interventions, mergers and takeovers, the IMF said. By the end of 2012, institutions representing about 15% of the system and with assets equaling more than 50% of GDP will have been resolved, the IMF said.

Last week Spanish authorities seized Bankia, which has about 38 billion euros of real-estate loans on its books and is the country’s No. 4 lender by market cap.

Randolph called the move a positive one, saying “Bankia is like a bad apple and it needs to be cleaned up in order to restore confidence in the system.”

Fitch predicted the measures unveiled last week will spark another wave of consolidation in the banking system. The decision to require banks to transfer foreclosed commercial real estate loans to a third-party that resembles a bad bank “provides banks with a stimulus to sell property at lower prices, and could push property prices down,” Fitch said.

Public vs. Private

Efforts to clean up the banking system are complicated by the incestuous nature between private and public in Spain, a situation that has only increased with the European Central Bank’s one trillion euro long-term refinancing operations.

After gobbling up a record 23 billion euros of Spanish government bonds in January, banks in Spain added an additional 20.1 billion euros in March to give them a record 263.3 billion euros.

While the stepped up bond buying helped lower Spanish bond yields, it also increasingly ties the fates of the two sides in a vicious circle. After all, if government bond prices plunge due to the need for increased bailouts for banks, banks will need to write down the value on those holdings.

“The market fears that the bank debt will become the government's debt,” Chandler said.

For Spain to restore its health, the IMF said Spanish banks need to continue to build their capital buffers, while the government must beef up its regulatory framework.

“It appears that Spain has not yet fully adjusted to the collapse of its enormous housing bubble, which propelled its economy on an unsustainable path until 2008,” CEPS warned. “House prices have to fall further and the construction sector as to shrink further.”