Research house Variant Perception highlighted last week how Spanish property prices might be being artificially supported via the role banks play in the valuation process in Spain — the report essentially raising questions over whether assets were being fairly valued or not.
On Tuesday, economist Edward Hugh over at A Fistful of Euros blog, sheds some more light on the mechanisms involved. First, he points out, banks currently have a contractual incentive to value properties at least at the sum of the loans extended. As he explains:
Basically Spanish “escrituras de hipoteca” (or mortgage agreements) require that the “valor de tasacion” as well as the amount secured is specified in the deed. The “valor de tasacion” is in effect the valuation of the property and it is put in the deed so that the amount of the debt can never actually exceed the value of the assets being mortgaged.
However since the banks don’t know when they might need to “exercise” (or recover) the mortgage, they don’t really want to compromise themselves in advance, and the typical way of handling the problem legally is to state in the “escritura” (or title deed) that it is agreed that the “valor de tasacion” for purposes of “exercising” the mortgage will be equal to the total amount of the debt outstanding plus the rolled-up interest.
This is a very convenient solution for the banks, since it gives outsiders the impression that there is what one might call a valuation in the UK or US sense, when what is really involved is simply a formula applied in order to structure legal documentation.
And here’s the key point (our emphasis):
The same thing happens when it comes to the time to “ejecutar una hipoteca” by auction, there being no other way in Spain. Since judges tend to give banks a really hard time if the asset is valued below the amount of the mortgage debt (ie the individual who owes the money has a debt even after the auction) banks normally take the easy way out and value the property at the amount of the debt rather than have the judge cancel the auction. Banks then theoretically have to pay tax on the transfer price to the registry (assuming they end up “adjudicando” the asset to themselves, i.e. taking possession), and the tax office – Hacienda – won’t accept anything other than the price at which the asset has been “adjudicado”.
The whole point here is that it ends up being very difficult for a bank to transfer an asset to itself in settlement of a debt at a figure which is substantially different from the amount of the debt unless there is a real possibility of getting the borrower to pay the balance.
In that sense, Hugh points out, valuation processes in Spain differ significantly to those in the UK or US, being as they are the outcome of a machine-like calculating process more than anything else. Meanwhile, he adds, no one in their right minds would ever equate the values arrived at with the sums they would plausibly pay for the assets themselves.
Nevertheless, as Spanish daily Expansion reports, it is these valuations that are being used to calibrate the solvency of the financial system as whole. In which case the health of Spain’s entire economy, says Hugh, is based on an entirely ad hoc and potentially inadequate modelling system. A comparison with the situation just before the US subprime blowout therefore is not unjustifiable, according to Hugh. As he concludes:
In a way all of this reminds me of the structured CDOs in the US case. Most of these got valued by computer programme simply because they were never traded. No-one ever really thought the valuations represented what they could be sold for even if that’s what hedge fund investors were told they were worth. Hence many were in the uncomfortable position of having them valued at 99.98 one minute and getting a bid at 30 the next.
The similarity is partly because there is little in the way of an early warning system available. The fact that the Bank of Spain’s foreign exchange reserves are merely academic means that many professional bank analysts lack the early warning signs of an imminent balance of payments type crisis, and the mechanical and artificial system for valuing the growing number of homes accumulating in the banks’ real estate portfolio means there may well be no small amber flashing light to watch for before all the dials suddenly luch over to red.