The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (35 page)

The unlucky few were the ones who in 2007, before the crash, shelled out (according to local estate agents) something like €185,000 euros for an apartment. Only 5,000 of the planned 13,000 properties were ever completed. Of those, many of the flats were left without the required certificates for water and other utilities. Between the empty blocks, the eerily desolate streets take their names – with a certain hollow irony – from the Old Masters who hang in the Prado, not forty-five minutes’ drive away: Velázquez, Goya, El Greco, Titian, Rubens. The street called Calle Rafael has a gaping hole where a residential block should have been. Public transport is inadequate, and there aren’t enough schools, roads or hospitals, despite a long-running argument with the local authorities. But there is a swimming pool in each block, an athletics stadium, and a park named after el Pocero’s mother.

Part of the problem was the quarrel between el Pocero and the local mayor, who was reluctant to grant the development a full licence even after work had started. The mayor, noting that el Pocero had acquired the land just days before the previous mayor had changed its zoning classification from farmland to greenfield development site, called for an inquiry. Why, people wondered, had the old mayor suddenly come into the money? But no charges arose, the old mayor explaining his apparent windfall as a win on the lottery. The developer was defiant. ‘When I arrived here nine years ago,’ he told
El Pais
newspaper, ‘all Seseña had was a man with a cart and donkey. The land was here for anyone who wanted it.’ A war of attrition arose between el Pocero and the new mayor. The local newspaper, owned by the developer, attacked the mayor, while el Pocero’s workers demonstrated outside the municipal office, demanding the mayor issue the necessary licences.

In other places, there was clear corruption. A 1997 law had loosened most constraints on development, opening the floodgates to corruption. ‘Where there’s construction, there’s crime,’ admitted the urban planning coordinator in Prime Minister Zapatero’s Socialist government, which was in office through the boom and the subsequent bust. On the coast, from Marbella to Valencia, tens of thousands of homes were completed without planning permission after bribes were paid to local officials. Only the construction companies benefited. Where it was not explicit, there was a tacit form of corruption. Town halls relied on building permits for up to a half of their revenues. Regional governments were funded by property taxes. Spanish regional and local governments had every incentive to join in the party.

‘Land planning in Spain is designed by local municipalities,’ explains José Luis Ruiz Bartolomé, a Spanish property expert and author of
Bye Bye Brick
. ‘There isn’t a big strategy made by the province or the region – even though it is the region which, in the end, allows the local plan. So, town mayors have the magic wand to decide what is buildable and what is not. That’s the origin of corruption: the monopoly of the land that every town hall exerts in its municipality.’

So what were the banks, the cajas, doing? Well, they too were being sucked into the web of political patronage, investing in property and development themselves, and even setting up as estate agents, while maintaining their more traditional role as mortgage lenders. In UK terms, the whole of the Spanish savings-bank system seemed to turn into one giant HBoS, with a Northern Rock to fund the mortgages. The cajas became an all-in, one-way bet on property prices never falling. Yet they also funded the very over-developments that ensured that the bet would fail and prices would fall. This was tacit corruption, combined with what appears to be monstrous stupidity.

What is particularly remarkable is the fact that the government in charge during the boom, Zapatero’s Socialists (the PSOE), was well aware of the dark underside of ever-rising house prices. They did not buy into New Labour’s tacit encouragement of rising house prices in the UK. In their 2004 election manifesto, the PSOE promised to end the housing bubble. The manifesto expressed concern about company and household debt, and promised to change the Spanish economy, ‘which is highly indebted and geared towards bricks and mortar’.

José Manuel Campa, who was deputy finance minister in Zapatero’s second government, puts it like this: ‘Back in 2004, the main economic agenda of the Zapatero government at that time was to change the growth model away from real estate. The manifesto said to stop the bubble in real-estate prices, so there was some recognition. The diagnosis was there,’ he told me. In 2004 the Bank of Spain even started an annual assessment of the overvaluation of Spanish property, calculated at 30 per cent even then, a time when there were already over 100,000 unsold Spanish homes.

Here’s what actually happened in Prime Minister Zapatero’s bubble-bursting first four years at the Palace of Moncloa. House prices surged, up by 36 per cent in cash terms, and 23 per cent after accounting for inflation. The longer-term international comparisons are telling. Overall property prices rose 115 per cent in real terms in the decade before the boom. Although the bubbles in Ireland (160 per cent) and the UK (140 per cent) were bigger, Spain was well out of kilter with the rest of the Eurozone (40 per cent).

Zapatero’s big play was that mass house-building would temper prices. Between 2004 and 2007, credit to the construction sector grew at an annual rate of 24.6 per cent. For the real-estate sector it was 43.1 per cent per year. By 2007 property development loans were 30 per cent of Spain’s GDP, and construction loans were 14.5 per cent. Credit to both sectors was worth nearly half of Spain’s entire economy, when the two sectors only represented a fifth of the economy. Between 2001 and 2008, Spain increased its overall stock of housing by over a fifth to 25 million, an extra 4.3 million homes. If there had been no domestic population growth, Spain could have re-housed every household in Portugal, and still be left with some empty properties. In the entire decade before the crisis, Spain built a total of 5.3 million extra homes, which could have accommodated the population not only of Portugal, but that of Ireland as well (although it would have been a bit cramped). As it happened, there was a large influx of 5 million migrants into Spain in the decade before the crash, with 3 million arriving between 2003 and 2009. This soaked up some, though not all, of the excess house-building. Perhaps the best measure is that by 2011 the number of dwellings in Spain, which has a population of 45 million, nearly overtook the number of dwellings in the UK, with its population of 63 million.

The cajas boomed. Even the most casual amble down a Spanish high street would have revealed the curious excess of bank branches in amongst the tapas bars. Every municipality with at least 5,000 residents had a caja branch, and there were over a thousand villages where cajas were the only bank branches. In bigger cities, sometimes entire high streets were filled with competing cajas and banks. In fact Spain’s total branch network (including conventional banks) peaked in 2008 at 46,221 branches – half the number of branches in the whole of the USA. In a decade and a half the caja branch network doubled in size – at a time when the number of normal bank branches was being cut. At the peak of the bubble, Spain had one bank branch for every 952 Spaniards. In America, that number is one for every 2,857, while in Britain it is one for every 3,846.

‘The cajas had three inherent disadvantages,’ says José Manuel Campa, now a professor of financial management at the IESE Business School. ‘They were purely domestic institutions channelling their growth domestically, unlike Spain’s multinational banks. Institutionally they were structured as foundations and did not have the ability to raise equity. And their governance was complex and likely to have problems with conflicts of interest.’

The last of these points was reflected in the way politically appointed representatives conspired to direct caja funding towards their own pet infrastructure projects. It might have started with ‘Guggenheim envy’, the urge by other cities to imitate Bilbao’s iconic regeneration, epitomised by the opening of the striking new Guggenheim Museum in 1997 in the city’s derelict dock area. It may even stretch back to 1992, when Barcelona played host to the summer Olympics and found itself in the world’s spotlight. Such developments prompted copycat schemes in regions across Spain that needed debt-funding. Another pattern involved banks granting loans for megaprojects such as airports or theme parks – but the loans only covered the construction and not the long-term viability of the projects. The result? A series of white elephants. Again, only the construction companies seemed to benefit. One caja appointed a ballet dancer to its board.

Political dominance of the banking system was nothing new. In the Franco era, the dictatorship practised a form of credit intervention that directed savings to investments declared as ‘qualifying’ by the Junta de Inversiones. This essentially forced Spanish caja savers to lend money to Franco’s government and preferred companies at below market rates. It was a type of tax, a form of financial repression that helped Franco’s treasury to avoid having to fund its deficits on the markets. The system only ended in 1977, two years after Franco’s death. At this point, Spain’s cajas began funding small business and housing loans. Although founded back in the 1830s, in proper credit-market terms Spain’s cajas were born at the same time as those young Spaniards whom they would plunge the deepest into debt.

The transformation of private-sector indebtedness was astounding. In the pre-crisis decade mortgage loans as a percentage of Spain’s economy ballooned from 28 per cent to 103 per cent. The average Spanish household’s stock of private debt rose from 53 per cent of disposable income in 1997 to a peak of 132 per cent in 2007.

Given their lack of capital, and the broadly fixed amount of savings from the pueblos of Spain, how did the cajas provide this tsunami of funding? Meet the
cédula
(pronounced thed-u-la) – also known as a covered bond. This amazing piece of financial engineering, known in German as the
Pfandbrief
, was invented in 1769 by Frederick the Great of Prussia as a way to fund rebuilding after the Seven Years War. In its long history, this type of bond has not seen a single default. The key innovation was that the loan was secured or ‘covered’ by assets, normally property, and so offered cheap wholesale funding to financial institutions. The bonds quickly spread throughout Europe. Spanish covered bonds or
cédulas
were around in the nineteenth century, but only really took off in 2000 as an alternative to raising deposits from ordinary Spaniards. In particular it was the jumbo
cédula hipotecaria
, or billion-euro-plus mortgage covered bond, which grew from a market of just €7 billion in 2000 to €57 billion by 2003. And by 2007 Spain had overtaken Germany with €267 billion of outstanding
cédulas
. The public sector also joined in, issuing
cédulas
for large projects, leaving the total outstanding in 2011 at €402 billion, of which €369 billion was covered by mortgages. Cajas alone were responsible for €250 billion of that. Even smaller cajas could get in on the act by clubbing together to form a ‘multicedula’.

That €369 billion is a massive sum. In total it represented 55 per cent of the value of the outstanding mortgage stock of Spain. To put it another way, outstanding residential mortgage balances in Spain increased between 2003 and 2011 by €354 billion. Outstanding
cédula hipotecarias
increased by €312 billion in the same period. As much as 80 per cent of the growth of Spanish household mortgage debts in the go-go years of the boom were funded in this way. Over the same period in Germany, the biggest issuer of covered bonds until 2004, mortgage
Pfandbriefs
outstanding fell by over €50 billion. Meanwhile, the boom raged in Denmark, France, Sweden, the UK and Spain. Especially in Spain.

It all sounds a little like the Northern Rock model. But there were some crucial differences.

Covered bonds of this type were kept on the balance sheets of the banks and the cajas. The security for the lender was the portfolio of mortgages on the balance sheet. No funny business with offshore, off-balance-sheet financing, no hiking up the loan-to-value ratios. Eligible mortgages could not be worth more than 80 per cent of the value of the property. For this reason, Spanish mortgage lending tended to require at least a 20 per cent deposit. Even during the boom, average Spanish mortgage loan-to-value ratios never went above 65 per cent. For this reason, the funding costs were low, even for a small caja with nothing in the way of genuine capital. So the
cédulas
naturally got high credit ratings. The model was markedly superior to the opaque, complex off-balance-sheet mortgage securities favoured in the USA and UK. Indeed, after the crisis the former US Treasury secretary Hank Paulson implored American banks to copy this German-Spanish model. Spanish bankers even flew to Hong Kong to present the idea to China’s booming banking sector.

So what was the ultimate source of this river of credit? Not much of it came from Spain itself. One Spanish bank said two-thirds of
cédulas
were sold abroad. The biggest buyers were banks in Eurozone nations with healthy surpluses, such as the Netherlands and especially Germany, looking to make a return. At this time the German economy was depressed, mortgage demand was weak, and German banks were racing to lend somewhere to take advantage of expiring government guarantees. Where better than in the covered-bond market, itself the invention of one of the greatest Germans in history? An investment yielding a return, with no currency risk – and as safe as Spanish houses. ‘Fundamentally,’ says José Manuel Campa, ‘in aggregate it was institutional savings from Germany and the Netherlands, which, even now, still have large surpluses, channelled in two different ways: the banking sector and the financial markets.’

Effectively Germany and other creditor nations were the source of the euros that ultimately added a third to Spanish household debt. Germany had, through intermediaries, lent people like Kelly and Nelson the boom-time cash. But they had left the credit risk with the Spanish banks. This method of lending turned out to be a very important factor during the bust.
Cédulas
were not a form of credit alchemy that had disappeared default risk, despite the German engineering. This was a zero-sum game. All the covered bonds did was to shift risks around. The additional security offered to the
cédula
-holders was at the expense of other unsecured lenders to the cajas. As Spanish credit quality declined, more high quality assets were sucked in to secure the interests of the holders of covered bonds. Ultimately the sheer size of the market, over a third of Spanish GDP, must have hastened the demise of the cajas. The ultimate sources of the credit, in northern Europe, got away scot-free. Eventually, as it was clear that the cajas were heading for bankruptcy, the risk was transferred to the Spanish taxpayer. It was for this reason that the Dutch Central Bank, among others, limited the issuance of covered bonds for Dutch mortgages in the Netherlands.