Spain: The Next European Flashpoint

04/06/2012 8:45 am EST

Focus: GLOBAL

John Mauldin

Chairman, Mauldin Economics

Now that Greece has been sorted out, there are some bigger problems the global financial system has to deal with now, and Spain is right next in line, writes John Mauldin of Thoughts from the Frontline.

A country (or a family) can face two different types of crises. A cyclical crisis is typically temporary and due to a business-cycle recession. When the problem that caused the recession is dealt with, the economy comes back and employment returns to normal.

Structural problems are more difficult to deal with. Structural unemployment is a more permanent level of unemployment that’s caused by forces other than the business cycle. It can be the result of an underlying shift in the economy that makes it difficult for certain segments of the population to find jobs. It typically occurs when there is a mismatch between the jobs available and the skill levels of the unemployed.

Structural unemployment can result in a higher unemployment rate long after a recession is over. If ignored by policymakers, it can then even lead to a higher natural unemployment rate.

Structural unemployment can be created when there are technological advances in an industry. This has happened in manufacturing, where robots have been replacing unskilled workers. These workers must now get training in computer operations to manage the robots and employ other sophisticated technology, in order to compete for fewer jobs in the same factories where they worked before.

But structural unemployment may also be caused by government policies that make it difficult or even uneconomic for businesses to hire workers. Typically these policies are put in place by well-meaning if economically ignorant politicians (nobody wants to create unemployment), but the problems are there no matter what the intentions were. Let’s look at a few Spanish structural problems.

The first is a rather poisonous employment environment. The graph below was created by The Bank Credit Analyst to discuss structural employment problems in France, but the country that is even higher on the employment protection index is Spain. Note that both countries are higher than 3rd and 4th place Greece and Portugal.

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In an open market, the large majority of jobs are created by small businesses. But when you make it difficult and more expensive for small businesses to hire workers, it is not surprising that you get fewer jobs.

In the US, our experience is that when the minimum wage rises, youth unemployment rises as well, even in times of recovery. This has been consistent over the last few decades, when statistics have been kept.

There are a lot of reasons for this, which we will not go into today, but there is every reason to believe that Spain in particular and Europe in general would be no different in that respect from the US.

The Mother of All Housing Bubbles
Spain had its own housing bubble, in most ways worse than that of the US. In 2006, the Guardian wrote that 50% of new EU jobs had been created in Spain during the previous five years. But in 2011, housing starts were down by 94%, and new mortgages by 81% (IMF, 2011).

The IMF notes that "The stock of unsold units may take around another four years to clear. The lowest estimates of the stock of unsold units are at close to 700,000 units, with considerable regional variations, but with a downward adjustment that has only started at the end of 2010. These only include newly completed units, and do not fully include units repossessed by financial institutions, unsold secondary market houses, or unfinished units."

The Wall Street Journal suggests the number may be more than double that:

"Some 1.5 million unfinished, unsold, or unwanted residential units stand scattered across the country, products of a still-deflating housing bubble that threatens to undermine Spain’s broader economy for years to come. It is the hangover after an epic fiesta, a period Spaniards now refer to as "cuando pensábamos que éramos ricos"—’when we thought we were rich.’"

Let’s put that in context. The US has about 6.5 times more people than Spain. There are 2.43 million existing homes for sale plus shadow inventory in the US, estimates of which vary. Using the WSJ number, this would suggest Spain has the equivalent of 15 million-plus homes for sale.

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That in a country where unemployment is more than double ours, and where population growth and household formation is certainly slower than in the US. Only Ireland can rival Spain for the largest housing bubble.

The number of homes being foreclosed on is estimated to triple in Spain. About 120 evictions take place every day. Those who default on their mortgages cannot walk away from the debt, as in the US.

A story is out about one resident who lost her job and is being foreclosed on. She will still owe over about half her debt, or more than €100,000, plus court costs and penalties. From the Huffington Post:

"If the bank manages to sell a foreclosed home, that amount is struck off the remaining debt. But the norm these days is that the property is put up for auction and nobody bids. That has meant the bank then takes over the house for just half its originally assessed value, and wipes the amount off the remaining debt—leaving the borrower still owing a bundle. The legislation passed last week raises the proportion the bank has to effectively pay in the event of non-sale to 60%."

Home prices have fallen just 10% to 20%, as banks cannot afford to write down mortgages (more on that later). Realistic estimates assume a 40% to 50% total drop is more likely, and anecdotal evidence suggests it could be even more if the economy does not recover soon. And as we will see, that is going to be tough.

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Spanish Banks en Bancarrota
I am not sure if the Spanish term for bankrupt is en bancarrota or quebrado, as Google didn’t make it clear.

(Sidebar: The former sounds suspiciously Italian, as it is the term for "broken bench," which was the medieval term for what happened when a merchant bank went under. Its bench was literally broken. Our guide pointed to a spot in Siena where she said the first banks and the term originated. And it is where the English word bankrupt comes from.)

In any event, there is widespread agreement that the regional Spanish banks, the cajas, are bankrupt, as they made massive loans for construction and mortgages. The government has taken some action, forcing 45 caja savings banks that were threatened by bankruptcy due to bad property loans to consolidate down to 14.

But although bank regulators have estimated that Spanish banks will need €26 billion in extra capital, many skeptics believe this severely underestimates future losses, and that the government may have to step in with a much larger bailout for the financial sector. The Bank of Spain contends that construction debt to banks stands at some €400 billion, of which repayment of €176 billion is questionable, with €31.6 billion of those considered nonperforming.

Spanish private debt is 220% of GDP, dwarfing government debt, which is high and rising. So not only are banks being forced to raise capital and reduce their loan books, consumers and businesses are also overextended.

The government wants to increase taxes or reduce spending by 17% to get the deficit down from over 8% to 5.5%, a combination that is not geared for growth. €12.3bn will be raised in new taxes, with €5.3bn coming from corporations, and €2.5bn is projected to come from a temporary amnesty on tax evasion (you’ve got to love the optimism).

We have seen how such policies worked in Greece. They meant lower, not increased, revenues. Note that Britain also raised taxes on "the rich" and saw revenues fall in that category, not increase as projected.

Further, as we go along this year, watch for "breaking" news that off-balance-sheet guarantees by the Spanish government will be huge, adding multiples of 10% to total debt-to-GDP. Spain’s admitted government debt is over 70% of GDP, which in comparison to other European countries is not all that bad.

Except that is not the extent of the problem. There is regional debt, bank-guaranteed debt, sovereign guarantees, etc. that take it to roughly 85%.

And then we add the guarantees that Spain has made to the EU for all the stabilization funds, ECB liabilities, etc., at which point Mark Grant suggests that Spanish debt may be closer to 130% of GDP. (Of course, if we count all debt and guarantees, something that a normal bank would make you or me do if we wanted a loan [at least since the subprime debacle], then Italy has over 200% debt-to-GDP. Just saying.)

Spain is going to have an uphill struggle to keep its deficit down to 5.5%. Unemployment is still rising, as Spain is after all in a recession, and costs will be up and revenues down. But the current budget buys time and what will amount to goodwill from the rest of Europe, as Spain will be seen to be trying, conducting yet another experiment in austerity.

When those deficits come in higher, then what will Europe do? With each piece of bad news, the problem of funding Spanish debt will grow.

Right now, Spanish banks are buying Spanish government debt with everything they can muster, which is to say, ECB loans at 1% for three years, invested in 5.5% bonds. With 30 times leverage. All the while trying to cut losses and reduce their loan books—a trick worthy of Houdini.

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