Seeking Alpha

According to the Central Bank of Spain, there are €298 billion of real estate loans and €655 billion of real estate mortgages outstanding today. These are the loans held by Spanish banks. The original Bank of Spain estimate was that Spanish banks needed extra capital of €37 billion to cover the losses for their real estate exposure. This represents 3.9% of total real estate loans and mortgages. After the weekend meetings, the total has now been upped to a maximum €100 billion. This represents a more realistic 10.5% of domestic real estate loans. The question is - does this represent a realistic estimate of losses on a real estate loan portfolio of €955 billion? Absolutely no way is my answer.

Looking at the Bank of Spain's record of forecasting, the first question must be - is the total of loans given correct? I am sure that the 4 auditors that have been tasked with the job will answer that query. One of the companies is a German auditor and they will get somewhere close to the correct assessment of the total of the loans.

Putting aside the total of the loans, the question then becomes - what is the correct estimate of loan losses?

Note: all data from the Bank of Spain, unless specified otherwise

Looking first at the real estate loans portfolio. €180 billion or 60% of the total of loans are presently distressed. The present default rate on real estate loans is 21%. This rate has risen from 1.9% in the first quarter of 2008 to 18.97% at the end of the third quarter 2011 and to 20.9% at the end of 2011. I would suggest that eventually 30% of these loans will not be repaid. The recovery rate on these loans is presently not known. Let's assume a 40% recovery rate after expenses.

Assuming a 40% recovery rate on 30% of €298 billion gives €54 billion of losses. I would consider this to be an optimistic estimate of the losses, as it only represents 18% of the total outstanding. However this is just the real estate corporate debt, which at the end of 2011 represented 58.7% of all defaults of corporate borrowing. If we assume that this relationship remains constant, €54 billion will represent 58.7% of the total losses from the Spanish corporate sector. The estimate for all corporate losses would therefore be 54/.587 or €92 billion. The recovery rate on these non-property loans may well not be 40%, but I will let this pass.

Corporate losses €92 billion

In relation to the stock of mortgages, I would suggest the following. All Spanish mortgages are full recourse mortgages. This has kept the default rates much lower than would be expected, for an economy with an unemployment rate of over 22%. Approximately 70% of households are owner occupied, but only 35% of properties have a mortgage secured on them (data from Kyero.com). This also lends support to a low mortgage delinquency rate. The present rate of delinquencies is only 2.7% (as at end 2011). This has risen from under 1% in the first quarter of 2008. Of the €655 billion of mortgages, €65 billion are sub-prime. It is estimated that the present payments of sub-prime mortgage interest consumes 60% of the income of the household (Kyero.com). The Bank of Spain has estimated the losses from this sector at €17 billion or 26% of subprime mortgages. This looks very low considering how much income is being consumed to service the debt. How long would you be able to afford the mortgage if it consumed 60% of your income? Balancing this is the full recourse nature of the Spanish market. Let's go with the estimate.

Sub-prime mortgage losses €17 billion

The remaining portfolio of mortgages is therefore 655 - 65 = €590 billion. Depending on which index you look at, Spanish house prices have fallen between 22-29%. In April 2012, they fell at an annual rate of 12.5%, according to Tinsa. Irish house prices have fallen over 50% and this is regarded as the likely outcome in Spain. Moody's latest report suggests price drops of 52%. The fall is likely half done. BNP Paribas suggest:

An average family still needs 6.2 years of its combined annual income to buy a house, well above the long-run average and more than double the U.S. ratio.

This reinforces the likelihood of falls of 50%. Houses in Spain have still not reached their long term average prices. There truly was a bubble in Spanish housing.

Default rates are 2.7%, but where will they end up? Debt service for all mortgages was 39% of income in 2011 (Kyero.com), which is stretching the affordability of mortgages. With the high unemployment rate, it is likely that the income to debt service ratio has risen. It is clear that the present 2.7% default rate will not last. If we estimated a 6% default rate and a loss of 40% on all defaulted properties, the losses are 590x.06x.4 = €14.16 billion. I have assumed a greater recovery on residential property than for corporate real estate, as it is more saleable at market prices.

As a check on this assumption, I looked at the position of the banks. At present there are 1 million empty homes in Spain. Banks own 200,000 of these, due to foreclosures. The average house price in Spain at the end of 2011 was €253,000 (kyero.com). The banks have €50.6 billion of empty properties. Assuming losses of 40% on these properties would give an estimate of losses of €20.24 billion. It is also clear that foreclosures will rise substantially in the future and 200,000 does not reflect the total number of foreclosures that the banks will take.

This makes the default rate method above seem low. Averaging the 2 figures gives a total of 14.16+20.24/2= €17.19 billion. Let's assume this as the loss.

Non subprime mortgage losses €17.19 billion

The last section of defaults will be on other household debts. Mortgage debt accounts for 80% of all household debts, according to the Bank of Spain. Assuming the same rate of loss and recovery rate on other household debt, the loss is 17.19/.8-17.19= €4.3 billion.

Other household debt €4.3 billion

Conclusion

The very conservative total of losses that the Spanish banking system will have to absorb are:

Corporate losses €92 billion

Sub-prime mortgage losses €17 billion

Non sub-prime mortgage losses €17.19 billion

Other household debt €4.3 billion

TOTAL €130.49

Fitch recently reported, when they downgraded Spain's credit rating, that their base case for losses is €100 billion. S&P goes for losses between €80-112 billion. Neither of these estimates looks realistic. Just the back of the envelope calculations above, come to €30 billion more than the bank rescue package. It seems clear to me that politicians in the eurozone have once again come up well short. Hopefully the audit will uncover a figure that at least resembles the truth, rather than the fiction we are presently getting. The audit results are due by the start of July.

The investment implications are that the eurozone problems are going to roll on during the summer. If not before, the audit results will provide the next shock to confidence. I cannot understand the constant covering up of bad news, with ludicrous estimates of losses. Confidence must surely be negatively effected by this incompetence. Expect more bad news coming out of Spain to negatively effect markets in the next 2 months. I am presently short the market and will add to those positions, if we approach the 50 day moving average at 1355 on the S&P 500.