Morgan Stanley issues alert on Spanish banks

The Spanish appeared to have ensured greater discipline in their
banks and escaped the worst of the sub-prime debacle . But their
bankers have devised a different version of the dodgy mortgage by
deliberately inflating house valuations so as to grant 80% mortgages
on an inflated valuation - or 100% plus of its true value. .

But Spain has had an inflation rate above the ECB’s interest rates so
it is being crucified for being in the Euro.

Something - as the song says - has gotta give! And it will. And
remember who owns here Abbey and Alliance & Leicester. !!! BAA too
is in difficulties with its financing

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TELEGRAPH Business News 5.8.08
Morgan Stanley issues alert on Spanish banks
By Ambrose Evans-Pritchard

Morgan Stanley, the investment bank, has issued a major alert on the
health of Spanish banks, warning that a replay of the ERM crisis in
the early 1990s could wipe out the capital base of weak lenders
exposed to the property crash.
"A momentous economic slowdown is now under way. We believe the
deterioration in Spain is just in the beginning stages. The bulk of
the pain will be suffered in 2009," said the report, by Eva Hernandez
and Carlos Caceres. "The probability of a crisis scenario similar to
the early 1990s is increasing. If the ERM (Exchange Rate Mechanism)
scenario were to become reality the main concern would not be
earnings, but capital," it said.
"We estimate that a non-performing loan ratio of 10pc to 15pc for
developers' loans would fully erase earnings in 2009 and would
represent between 20pc to 30pc of the current tangible capital base
of Banco Popular, Sabadell and Banesto," they said.

The grim report comes amid a fresh flurry of horrendous data from
Spain. The ICO consumer confidence index has plunged to a record low
of 46.3. Lay-offs continued to surge in July as the building industry
- 13pc of Spain's workforce - stepped up its job purge. Unemployment
has risen by 457,000 over the last year, pushing the rate to 10.4pc.
"These figures are very disturbing", said employment chief Maravillas
Rojo.

Finance minister Pedro Solbes told El Pais that the outlook had
darkened dramatically over recent weeks as the global oil shock and
rising interest rates combined with Spain's home-grown housing
crisis. "The economic situation is worse than we all predicted. We
thought it would happen slowly but instead it has hit fast," he said.
Mr Solbes admitted that the property boom had degenerated into a
"bubble" but said there was little the government could reasonably do
about it. "What was the state supposed to do? Stop people building
houses? That wouldn't be reasonable. Tell the banks who they can lend
money to? We couldn't do that either. We warned that building 800,000
homes a year was not sustainable: and that granting mortgages for 40
years was folly, but there are certain things the government cannot
prohibit," he said.

The root cause of the bubble was the extremely lax monetary policy
imported by Spain after it joined Europe's monetary union. Interest
rates were slashed on EMU entry, and then fell to 2pc until late 2005
- far below Spain's inflation rate. However, Mr Solbes has been
reluctant to link the crisis to Spain's euro membership. As Europe's
economics commissioner at the launch of the euro, his career is
inextricably tied up with the whole EMU experiment.

For now, smaller Spanish banks are getting by on funding from the
European Central Bank, in many cases issuing mortgage bonds with the
express purpose of using them to secure loans from Frankfurt. ECB
loans have tripled to €47bn over the last year, causing rumblings of
concern among regulators. The ECB is not allowed to prop up banks
with long-term funding under EU treaty law.

Morgan Stanley said there was 40pc chance of a "bear scenario"
leading to a 0.5pc contraction of the Spanish economy next year, with
a mounting risk of an even more extreme case that replicates the ERM
crisis (or worse) and leads to a 1.4pc contraction in 2009.

The report said construction investment made up 18pc of GDP last
year, much of it funded by foreign investors. The concern is that a
"sudden reversal of capital inflows" could leave the economy unable
to finance its current account deficit, now 10pc of GDP - the world's
second biggest after the US in absolute terms. The corporate sector
has debts equal to 130pc of GDP. This too requires foreign funding.

Morgan Stanley said it had become concerned about the banks after the
€5.1bn (£4bn) collapse of Martinsa-Fadesa, the country's biggest
builder. Loans to developers make up 26.1pc of total lending for
Sabadell, 21.9pc for Banesto, and 19.4pc for Popular.
This leaves them highly vulnerable to an ERM-style bust that could
push non-performing loans for developers to 14pc. "Such a scenario
cannot be disregarded, in our view," it said, adding that the
developers may face an even more drastic challenge than they did in
the early 1990s.

The "extreme bear" case would lead to further dramatic falls in bank
shares: Banco Popular (-61pc), Sabadell (-56pc), Bankinter (-51pc),
Banesto (-42pc), and BBVA (-35pc). The report based its estimates on
a stress test that replicates what happened in Britain in the early
1990s, as well as Spain's own travails during that period. It said
BBVA enjoys a solid client base and is likely to be a "winner" once
the storm passes.

The condition of Spain's lenders is a source of intense controversy,
and the Spanish officials bridle at claims by foreign critics that
there is any problem. The banks certainly dodged the US sub-prime
debacle, thanks to restrictions by Bank of Spain on the use of off-
books investment vehicles. Home equity withdrawals and "piggy back
loans" are rare. Mortgages were mostly limited to 80pc of house
prices, at least in theory. The great unknown is whether those price
estimates bear much resemblance to reality. Ramon Lobo, a former bank
auditor, said valuations were routinely inflated by as much as 25pc,
allowing the sub-prime-style abuses through the back door. The Bank
of Spain denounced the use of inflated appraisals in 2006.

If the practice was as widespread as feared, the default rate on
€320bn of Spanish mortgage paper sold to investors worldwide could
prove higher than expected.

Spanish house sales fell 34pc in May from a year earlier, and
mortgages were down 40pc. The consultancy Facilismio said yesterday
that prices had fallen 6.7pc in July from a year earlier, but
anecdotal reports suggest a much steeper drop. With gallows humour,
Spanish journalists have begun using the term "Costa del Crash". The
UK estate agent Savills said Britons are having to accept price cuts
of 20pc to 30pc if they need to sell their villas in a hurry.

The vultures are starting to circle around the hapless Mr Solbes.
Critics are calling for his head, accusing him of covering up the
true scale of the downturn before the re-election of the Socialists
in March. This seems unfair. Mr Solbes continued to dismiss warnings
of a crisis as "enormously exaggerated" long afterwards. He appears
to be genuinely astounded by what has occurred.