The (wicked) rationale behind Spain’s tomato (a.k.a. bailout)

I could not resist starting out by somehow reusing Time’s ingenious header on Spain agreeing to receive up to €100 billion from its European partners: You Say Tomato, I Say Bailout: How Spain Agreed to Be Rescued.

The Men in Black, the troika representatives that so much scare Cristóbal Montoro, Minister of the Treasury, and a still bragging President, Mariano Rajoy, are indeed coming to town. Tough conditions will mostly be imposed on bailed out banks, as Angela Merkel herself asserted on June 12: the Spanish case is different from Greece’s or Portugal's. Technically, however, it should not be too different from the Irish situation, the main difference being that Ireland is a tiny country which could be bailed out and bullied and Spain is too big to fail, i.e. too big to bail out. Despite Dublin's plans to raise the issue during the next meeting of eurozone finance ministers, to be held June 21, the Irish Government's wishes will probably be quashed by the structure of Spain's bailout. We will not delve into that, however, as the scope of this post is quite different: we shall discuss the rationale behind the whole bailout/credit idea, which is only starting to get revealed.

It is also noteworthy that timing of the demand was astutely planned, although it ended up backfiring due to the clumsiness of the Government's PR strategy: just one day before Spain’s much-heralded debut in the football EURO 2012, as the reigning World and European champion vying to restore Spanish pride, and with Rafael Nadal all set to conquer his 7th Roland Garros title. The plan was clear: millions of Spaniards would fall into the government trap and quickly forget the implications of the measure, even downplaying that the President, the same person that was hiding until media and political pressure was too high to overcome, would briefly come out on Sunday morning to assert that the so-called “credit line” was a triumph of his Government and that he was ready to fly to Poland because “the problem had been solved.” Thank you, Mr. President, said most Spaniards… as well as international investors, which rewarded Spanish (and European) transparency with further rises of Spain’s sovereign debt risk premium, pushing interests of 10-year bonds to 6.8% on June 12, a 13-year high or a level never seen since the Eurozone was established (update: the rate climbed up to 7% just two days later).

We could spend a lot of time discussing the not-yet revealed details of the bailout package, with its speculated 3-4% interest rate for a 15-year credit to be satisfied by the Kingdom of Spain (i.e. 3-4 billion euro of extra deficit just in yearly interest payments) which, in its turn, will lend the money to needy banks at a 8.5% interest rate (a prohibitively high rate for troubled banks, meant to force them into selling assets), and the direct policy implications it might have, including VAT rate and other tax increases, extra spending cuts, speeding-up the planned progressive raise of the retirement age, etc. However, I believe that many media outlets have already explained all the kinks about the yet-to-be bailout package itself. Worthy and useful explanations can be found here (in Spanish), here and here.

In any case, no media outlet so far seems to explain the rational argument sustaining this bailout and why it could well be enough -- and why not. To put it shortly, it all hangs on restarting the housing market after the (too) slow bottoming-out process it has been undertaking for the last 4 years.

The key issue here is something which was already pointed out in the aforementioned Time Magazine article: this package will only cover the banks’ losses for 2012 and 2013, but not what is causing those losses. Those losses are caused by enormous quantities of money having been lent to construction industry companies and speculators during the boom years, accepting as collateral the very houses or apartment blocks they were building. Once the market crashes, development companies are struck with unsellable housing units, which are thus absorbed by the banks that find themselves unable to obtain monetary repayment of their loans.

This has been happening since 2008. Banks were reluctant to devaluate all those housing assets in their balances, hopeful to sell them at still overinflated market prices. However, as more and more loans are souring and both individuals and companies default on their payments, institutions whose exposure to the housing boom was higher -- the paradigmatic case is that of Bankia, but the cases of CatalunyaCaixa and CaixaNovaGalicia, among others, should not be forgotten either -- find themselves unable to satisfy the huge capital amounts the Spanish government, in a rare display of realism, recently asked them to set aside to hedge against housing-related credit losses. Then, hell breaks loose: the much-feared bailout ensues.

However, today’s rescue is only a first step. As already mentioned, it will cover short-time losses, but not potentially sour loans maturing later on. There is one key point to consider: although it has been modestly falling in the recent months (for obvious reasons: people are not buying houses and, therefore, not applying for new mortgages, and credit is scarce for businesses), overall private debt in Spain (including both companies and households) is still in excess of €2 trillion, i.e. 200% of Spain's GDP. Plus, government debt will be close to 90% of GDP by the end of 2012, assuming the bailout reaches the mark of €100 billion and counts against overall Spanish debt -- an instance already confirmed by Eurostat. According to the much-discussed IMF report on the Spanish banking sector, direct lending for construction projects still amounted 37% of GDP (or approximately €400 billion) by the end of 2011, slightly down from 42% of GDP in 2009. This figure neither includes the share of loans given to auxiliary companies providing construction-related services (plumbing, materials, etc.) nor the many mortgages held by unemployed or underwater homeowners. In other words, if the economy is not restarted somehow, and soon, a bailout amounting to just 5% of overall private debt will clearly not suffice.

Enter the strategy hidden behind the bailout plan, which is only starting to be revealed in the Spanish press: housing prices are going to continue to fall, and probably quite sharply. Banks hold up to 200,000 unsold housing units, according to IMF estimates. They must start substantially cleaning their balances as soon as possible (i.e. before a fresh round of sour loans appears by 2014 and they need to ask for a second European bailout), and this fresh capital injection, which they are eventually supposed to repay with hefty interest, will help them become more flexible in rating their assets and start writing out bad debt accumulated in their books. The latter has not taken long in materializing: Spanish banks have just accepted discounts of up to 45% in liabilities (news item in Spanish) accumulated by Sacresa, a former residential development giant, which had accumulated up to 1.8 billion euro in debt when it filed for bankrupcy protection almost two years ago. The former will soon be pretty visible: banks will offer plenty of houses and apartments at heavy discounts, be it 25% or even more.

The question is: who is going to buy? Unemployment hovers around 25%, and youth unemployment surpasses the dramatic 50% mark. Household debt is at dangerously high levels for a recession-stricken economy, and many families are still underwater from buying their homes at pre-2008 prices. One bet would point at foreign investors and families wishing to own a second home in sunny, tapas-rich and tourist-friendly Spain. High-end Russian tourism is booming, especially in the Catalonia region. However, the bulk of the empty property the Spanish market has to offer is not truly oriented at high-end foreign investors, and not even to middle-class families. Moreover, given the current state of the world economy, mired in uncertainty, as well as the probable economic slowdown that will even strike countries such as Germany or China, counting just on foreign money would maybe be too risky a bet. In other words, a sudden reversal of international capital and investment flight from Spain is probably not in the works. You can definitely bet on it, but you cannot count on it at all.

A second, more plausible bet would focus on local money, namely undeclared income that now the Government will try to funnel into the banks and housing markets via a (shameless) fiscal amnesty: you just deposit your undeclared income in any bank account, pay a 10% flat tax rate, fill out an online form… and you are done. In a country in which black economy accounts for up to 20% of GDP, such a move can help recapitalize cash-stripped banks and revitalize investment in property after due discounts are applied to already-devaluated prices. At least, that is the plan. A plan, however, that looks more like a bet with not much hedging -- such capitals can also be invested otherwise, or even be funneled away from shaky Spanish banks -- and which is also terribly unfair for law-abiding taxpayers. .

Moreover, a clear, rational objection to this plan can easily be made: the housing market will not be brought again into life unless credit is given to families and private investors. However, lending will be scarce while labor market instability continues: in other words, banks are not ready to accept the risk levels they happily accepted until 2007. Labor market instability will not disappear unless jobs are created, and not destroyed, as it is the case right now. However, fresh jobs will not easily be created because Spain built a whole generation around the construction industry, and now suffers from undereducated youth and long-term unemployment of a big mass of non-qualified workers. Then, is construction the answer? Should we enter a never-ending loop of housing booms and crashes?

Growth through business-friendly policies and a workforce ready for the challenges of today's global, knowledge-based economy should be the obvious way out of a crisis for a developed nation as Spain. But the current debt situation might be too desperate to follow this path, which requires patience and heavy investments. Severe budget cuts in education (which amounted to 4.9% of Spain’s GDP but will be cut to just 3.9%, all in the context of a falling GDP and thus way below of European and OECD averages) and research budgets (including painful statements, such as those by Carmen Vela, Spanish Secretary of State for Research, who asserted that there are too many researchers in Spain and that the focus is rather on quantity than on quality) are sadly showing the way forward: betting on a housing-based stabilization of the financial sector and see what happens next.

Should we be shocked? Sad? Depressed? Yes, Spain is (sadly) different in many aspects, but not as different as we might come to think, at least financially speaking. As this invaluable article argues (written by a fund manager, nonetheless), a big problem lurking behind Spain’s problems and decisions is rather a global malaise: a warped financial system that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad. Bankia, anyone?