Why Europe’s debt crisis isn’t over

Why Europe’s debt crisis isn’t over

Brett Arends
MarketWatch
April 12, 2011

LONDON — Political leaders in Europe have spent the last few days telling everyone who will listen that the credit crisis here is over.

Portugal, they say, will be the last country to need a bail out. And Spain, the next weak link in the chain, will be OK.

“Spain isn’t a problem,” French finance minister Christine Lagarde told my colleagues at The Wall Street Journal. Read “EU Finance Ministers Expect Spain Won’t Follow Portugal.”

“Now I do not see any risk of contagion,” said Spain’s Finance Minister Elena Salgado. “I think we are totally out of this.”

And Olli Rehn, the European commissioner of economic and monetary affairs, said he was “certain” Spain’s tough budget measures would ensure it avoided a bailout. It “will not need external financial assistance.”

Are they right?

They had better be.

Europe cannot afford a Spanish bailout.

Forget Greece. Ireland. Portugal. Those are tiddlers. Spain is a big economy. The fourth biggest in the eurozone. Its government debts exceed all those of Greece, Ireland and Portugal put together.

If Spain breaks, the system probably breaks.

Take a look at the numbers. From the International Monetary Fund, Greece’s gross government debts total 324 billion euros -- about $470 billion. Ireland’s 154 billion euros, and Portugal’s 150 billion euros.

Spain? It’s 747 billion euros, $1.1 trillion.

What are the prospects?

As usual, nobody really knows.

For the moment, there’s an uneasy calm in the markets. Spanish bonds cost about 2% of principal a year to insure against default, according to market data firm CMA DataVision. (By contrast, Irish and Portuguese bonds cost more than 5%, and Greek bonds more than 9%.)

Allan Von Mehren, strategist at Danske Bank, noted that on the surface things look OK. “If you look at the public finances at the moment, and how the market is trading, it seems sustainable,” he said.

But, he added, that may not mean very much. “There’s one big unknown in Spain,” he said. “That’s how big the losses will be in the banking sector. And it depends on how much further house prices have to fall.”

How big will those losses be? Everyone here is guessing. Some put it as low as 20 billion euros. Others put it as high as 150 billion euros. Get a dart board. Your guess may be as good as anyone’s.

Von Mehren thinks Spain could escape a bailout if its banking losses total less than 75 billion euros. We shall see.

Spain’s government debt is a reasonably moderate 70% of GDP. But private sector debt is off the charts — nearly twice the size of GDP, according to Standard & Poor’s.

The big problem: The country’s economy was built on top of a housing bubble bigger than Florida’s. And it is still deflating — very slowly.

This is more than ominous. One thing we have learned from the past few years is that you cannot rely on the banks and property developers to give you reliable and current information about a real estate bust — especially when they are in it up to their necks.

In the late spring of 2008, a few months before the implosion of Lehman, Fannie, Freddie and the whole shebang, I drove all around Florida, looking at the real estate bust up close. Real estate brokers kept showing me a market that was much worse than the banks were admitting to anyone on Wall Street. And in these days of stretched budgets, too few of us reporters were getting away from our computer screens and stomping around abandoned housing developments in places like Cape Coral to see for ourselves.

“Homes sit empty and isolated and they are gradually — or not so gradually — falling into disrepair,” I observed at the time. “I hate to imagine which banks are still carrying them on their books, and at what value.”

And so it proved.

Is Spain the next Florida? It could be.

The country went through one of the biggest housing bubbles in the world. From 2001 through 2007 prices rocketed 150%, according to data tracked by property firm Tinsa. That’s more than they rose in Miami.

How far have Spanish prices fallen since?

By less than 20%, says Tinsa.

That’s hard to credit. Everyone admits vast numbers of homes are sitting empty. Unemployment is 20%.

Meanwhile Miami prices have basically halved, and other bubble markets, such as Las Vegas, have done even worse.

Edward Chancellor, at fund firm GMO, has argued Spanish prices need to fall by nearly a half, in relation to household incomes, to reach fair value.

As it happens I spoke to a fund manager in London on Monday — he manages $14 billion, mostly in European debt — who had just driven across Spain, and was able to view the economy at ground level.

(I can’t quote him by name because his firm has just been taken over by a U.S. company, and, in line with the usual American M.O. these days, they’ve clamped down on employees talking to reporters.)

In the big cities, he said, life in Spain seemed “pretty reasonable.” That’s probably what most analysts see. But when he went out into the smaller towns and the countryside, the economy appeared much bleaker. There was very little economic activity. There were a lot of unemployed. Maybe the most alarming sights were to be seen driving along the highways. “You can see the slowdown in construction,” he said. “You can see cranes, building sites and half-finished properties — but there are no workers.” The sites have simply been abandoned.

Yet the banks and the government insist the losses will be survivable. Even though they don’t know what these losses will be.

The money manager’s conclusion makes an eerie echo of Florida a few years ago, as well as of Japan in the 1990s. Spanish banks, he said, are keeping “zombie” property developers alive with generous loans. After all, so long as short-term interest rates stay low, and central banks flood the world with free money, you can keep hiding the losses.

It’s a game that ends sooner or later.

Meanwhile one can say with certainty: The debt crisis is not over.