Antonio Rivela and Ignacio de la Torre. Professors. IE Business School
2 June 2009
In spite of the real estate bubble, Spain has suffered relatively little fallout from subprime mortgages. Is that because they don’t exist? They exist alright, but they are well controlled.
When commenting on how a high-risk mortgage (subprime) was turned into a fantastic AAA-rated bond backed by prestigious rating agencies through the magical art of financial engineering, the prestigious North American investor, Warren Buffett, said "you can´t make a silk purse out of sow’s ear". A subprime mortgage is a mortgage loan awarded by banks to customers that have no credit record and, in many cases, no proven income. This process for converting "sow’s ears into silk purses" (the mutation of subprime mortgages into bonds with the highest possible credit rating) was implemented through securitisations and it is of key importance for understanding the financial debacle facing the West.
However, many foreign analysts are asking why the subprime hurricane has had hardly any effect on the Spanish market in comparison with its impact on the North American or British banking market if, in theory, Spain was on a similar track (housing price bubble, high credit penetration and runaway foreign deficit). Although many have responded to this question with apocalyptic visions, it is our opinion that the actual situation is much less dramatic. In this article, we will make a detailed analysis of this opinion as objectively as possible.
As was pointed out by Alfredo Sáenz, CEO of Banco Santander, subprime mortgages do exist in Spain. However, his statement needs to be explained: yes, they do exist, but to a much lesser extent than in other markets. Where do they come from? There are two basic ways in which the subprime disease can be caught: by awarding subprime mortgages or by buying securitisations linked to subprime risk. If we analyse the first of the phenomena, there are four very good reasons why hardly any subprime mortgages have been awarded in Spain: (1) in Spain, most loans have been awarded with a loan-to-value ratio of around 80%, whereas, in the United States, the percentage varied between 100% and 120%;
(2) in Spain, it is not very usual for a mortgage to be awarded if the customer is unable to prove that he/she has a stable salary or regular income, but in the United States, it was usual practice to award mortgages to individuals with no record, especially in the growing immigrant population segment, which was a source of good business for mortgage agencies since, by transferring the risk to third parties through securitisations, they had no reason to check whether or not the debtor could be trusted; (3) the default rate of Spanish banks has been traditionally kept at around 0.5% and in the worst-case scenario, it could increase to 2%, a level that is controllable and a long way from the almost 20% that affects the subprime mortgages; (4) the structure of the subprime mortgages in the United States has one or more subsidised initial quotas (very low) followed by a step-up to much higher payments (often 5 or 6 times the initial quota), which greatly increases the default rate; this type of scheme is almost inexistent in Spain.
There are also other fundamental reasons why the banks have purchased hardly any securitisations linked to subprime risk. On the one hand, Spanish banks were not hungry for this type of underlying North American risk due to the fact that Spain is a financially conservative country. On the other, the securitisations were in dollars, not in euros, which meant that they were not very attractive for many Spanish investors. In addition, many securitisations involved extremely complex structures (securitisations of securitisations), which were also not very attractive for the average Spanish investor.
Finally, special mention must be made of the brilliant role played by the Bank of Spain, probably one of the best bank regulators in the West. The Bank of Spain not only forced banks to maintain anti-cyclical (generic) funds to maintain their solvency ratios in view of a possible change in trends, but also completely prohibited the use of off-balance instruments (SIVs and conduits) that financed the purchase of sub-prime risk through promissory notes (these instruments have been a key factor in how the risk has affected British banks). In addition, the Spanish regulator was very strict with the booking of structured products, requiring any variation in the value of the said instruments to be included in the profit and loss statement, whereas, in other countries, such as the United Kingdom, these variations in value were included in vehicles that are easy on the accounts (liquidity facilities) and prevent the recognition of the loss, which explains their popularity in comparison with their near inexistence in Spain.
In short, Spain is undoubtedly facing formidable macroeconomic and financial risks, but we can be certain about one thing: very few sow’s ears have been passed off as silk.