Spanish Property: A New Perspective

It turns out that my unbridled optimism last week may have been either premature or misplaced, or both. I reasoned that the Metrovacesa debt for equity swap was a sure sign of the bank's confidence in a return to form for the company, and the Spanish property sector in general.

A Property Pulse subscriber kindly emailed to put me straight on the real reason banks do debt for equity swaps:

"I can't say exactly how Spanish banks make decisions and know no details of the Metrovacesa deal. However, having recently retired from a major UK bank (with lending to the Spanish construction sector!) after 33 years, I have plenty of experience of how things are done in the UK.

Debt for equity swaps are only undertaken when it is pretty clear the bank(s) have lost some money (i.e. there is very little chance of getting all their money back) but, the prospects for getting some money back are better if the borrower is kept afloat rather than going into administration / liquidation.

For example, if a business gets into difficulty owing €100m, the recovery specialists and accountants sit down and work out the best way to get their money back. These figures might show that, under the most likely scenarios, liquidation will get them €25m back, but if they keep the business going, they might get back €50m.

In these circumstances, €50m is lost. However, just forgiving €50m of the debt means that the shareholders of the company get a free gift! Moreover, there is always a possibility that there is some sort of upside or turnaround. Accordingly, in return for forgiving €50m of debts the banks take some equity so that they can participate in any upside.

However, when they do this, generally speaking, the equity is valued at zero (as would have been the related debt). Accordingly, swapping debt for equity doesn't really mean that the banks feel "warm and fuzzy" about the outlook - they are not expecting to make any return on the equity, they just want the business to remain alive for long enough to pay back some of the original debt owed.

Sometimes, debt for equity swaps work out very well (e.g. My Travel) but quite often the exercise gets repeated several times (e.g. Eurotunnel). The Metrovacesa deal might end up with the banks making a profit but the deal is probably more about minimising losses. Also it doesn't really mean that the banks believe everything will be going back to the way it was in the very near future.

However, keeping the company afloat does avoid the possibility of a load of property and land being dumped on the market. I would suggest that the recovery plan for Metrovacesa is good news - but I would not read too much into it. If the banks felt that good about the future they would have just refinanced the existing debt / lent the company more cash."

Hey ho, that makes sense - and I'm grateful to have my understanding of how things work in the world of finance re calibrated.

Another article caught my eye this week. It deals with the problems of cash drought, corporate bankruptcy, construction dependency, large scale contraction and price deflation in Spain.

It's a long and fairly complex article, but like the previous observations about debt for equity swaps, the writer clearly knows what he's talking about. He concludes as follows:

"What we need to think about is the impact Spain's financial problem is having on the housing bubble and the construction industry - since this is the way causality works in this case, and not the other way around .

Basically the housing boom had masked the enormous problem Spain had accumulated in terms of its current account deficit - because the funds which were happily flowing in to fuel the boom meant the books balanced each and every month.

But once people became just a little bit nervous about what was happening to that boom, and how sustainable it was, the flow of funds suddenly dried up, in September 2007, and the size of the national deficit suddenly became apparent.

Since that time, attempts by the ECB and others to provide liquidity to the Spanish banking system have not achieved any notable success.

While the IMF seem to be more aware of the scale of the problem than the Spanish government currently are, they do seem to be putting all of the emphasis for recovery on some much needed labour market reforms. Personally I don't think even these are playing in the right ball park - we need a big picture escape plan.

I don't pretend to understand the entire article about how the finances of a country work, but it seems to me that current policy-makers have little experience of solving problems of this magnitude.

What is most interesting is that he points to an underlying financial problem in Spain as the root cause of its current woes, not its property sector. In fact, the property boom served to conceal the poor state of Spain's finances - aided and abetted by the government's faulty house price data .

A further complication, highlighted in Spain: Acid Test for the Euro , is that before being tied-in to a common currency - and its restrictions - a country could always play with the value of its own money as a temporary solution.

As commentators question whether now is the right time for the UK to adopt the Euro, some countries who already have it are wondering whether they have made a rod for their own backs.

Martin Dell, Kyero.com

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