Something Just Cracked in Spain’s Mortgage Market

Spain already witnessed one of the most spectacular housing bubbles and busts so far this century. As pressures in the mortgage market begin to grow, the government and banks are desperately trying to avoid a rerun. 

Following weeks of negotiations with bank associations and the Bank of Spain, Spain’s government has authorized a package of relief measures for the country’s most vulnerable mortgage holders. On Tuesday, the Sanchez government approved measures it said would cushion the blow of rising mortgage costs for more than 1 million households. The measures are subject to final negotiations with banking associations, which have a month to sign up ahead of their scheduled implementation next year.

As the FT pointed out Tuesday, Spain is one of the first European countries to introduce emergency measures to blunt the impact of rapidly rising interest rates on families already struggling with soaring inflation:

Spain is especially vulnerable to the ECB’s rate rises because about three-quarters of its mortgage holders have variable rate loan contracts linked to its monetary policy, although they are generally adjusted only once a year.

As data from Spain’s National Institute of Statistics shows, 72% of newly signed mortgages in August were fixed rate while 28% were variable rate. But this is a relatively new trend. In 2020, the ratio was roughly 50/50. In 2016, 90% of all new mortgages were variable rate and in 2009 it was a staggering 96%.

In other words, Spanish homeowners have been making the most of the ECB’s low, zero and ultimately negative interest rate policies while giving little thought to the potential risk of a sudden reversal. But it’s not just the borrowers who were reckless; so too were the lenders. As I reported for WOLF STREET in 2017, the biggest beneficiaries of the ECB’s ZIRP and NIRP were Spanish banks, which made sure to insert so-called “floor clauses” in their variable-rate mortgage contracts. These set a minimum rate, typically of between 3% and 4.5% but in some cases as high as 5.5%, for variable-rate mortgages, even when the Euribor dropped below zero.

As a result, most Spanish banks were able to enjoy all the benefits of virtually free money while avoiding one of the biggest drawbacks: having to offer customers dirt-cheap interest rates on their variable-rate mortgages.

While this was not strictly illegal, most banks failed to properly inform their customers that the mortgage contract included such a clause. In 2016, the European Court of Justice deemed the clauses abusive. At one point it looked as if the ECJ was going to demand that all of the Spanish banks that used the floor clauses would have to reimburse clients all the money they had surreptitiously overcharged them. In the end, that didn’t happen though the floor clauses have since been banned.

Now, Spain has roughly 5.5 million mortgage holders, roughly four million of whom have variable rate mortgages. Of those just over one million of them will qualify for the relief package.

The most vulnerable families, defined as those with annual income of less than €25,200, will be able to reduce their interest rates to Euribor minus 0.1 percentage points under the proposed measures. Many mortgage holders are paying 1 percentage point higher than Euribor, an interbank rate that anticipates ECB moves.

The pact also includes a new code of practice for struggling middle class families. This raft of measures, which will be in force for two years, is meant to help families adapt more gradually to the new interest rate environment. To qualify for the relief, a household must have annual income of less than €29,400. Their mortgage burden must also represent more than 30% of their income and their monthly installments must have increased by at least 20% due to the ECB’s recent rate hikes.

Those hikes have propelled the ECB’s deposit rate from -0.5% in July to 1.5% in late October, its highest level since 2011. The Euro Area’s 12-month benchmark, the Euribor, upon which many Spanish mortgages are based, stood at 2.84% on November 22, its highest level since January 2009. And the ECB is expected to continue hiking rates over the coming months.

For holders of variable-rate mortgages in the Euro Area’s 19 Member States, this has meant having to pay significantly more in monthly instalments, just as prices for the most basic of goods, including energy and food, are also soaring. In the case of an average 25-year Spanish mortgage of €150,000 with a 1% differential over the Euribor, the monthly installment would jump from around €535 to €750 — an increase of around 215 euros per month, or €2,580 per year.

The new relief package will mean that a family with a mortgage of €120,000 and a monthly repayment of €524 tied to recent ECB increases would see their the repayment halved to €246, says Spain’s economy minister Nadia Calviño. Eligible borrowers will also be able to extend the duration of their loan by up to seven years. However, as Spanish consumer protection agency ADICAE warns, that would lead to borrowers having to pay more interest in total — even though their monthly payments fall — as well as, in many cases, having to pay off their mortgage well into their retirement.

For Spanish banks, extending the duration of loans while maintaining the monthly repayment amounts for struggling borrowers will have a significant short-term benefit. It means they will not have to register — and thus provision for — loan delinquencies on their balance sheets.

There is also another major issue at stake: an average income of €29,400 might be enough to qualify someone for a 25- or 30-year mortgage in one of the more impoverished parts of Spain, such as Extremadura, parts of Andalusia, Castilla la Mancha, Murcia, Ceuta and Melilla, but it will not get you a mortgage in the main centers of economic activity such as Madrid, Barcelona, Bilbao, Valencia, Palma de Mallorca and San Sebastian. Many mortgage holders in these cities are also struggling with rising costs but they will not qualify for the mortgage relief — unless, of course, the relief package is expanded.

Of course, all of this defies all logic. The European Central Bank is rapidly hiking rates right now in a (most probably futile) bid to tame surging inflation, despite the fact that surging prices are largely the result of supply side-factors. They include European governments’ ongoing support for sanctions on their biggest provider of energy and other vital commodities, which has led to a massive surge in energy prices and overall inflation. In other words, European governments are largely to blame for the surging costs in Europe.

The ECB’s response has been to compound the emerging economic crisis. The more it hikes rates, the more economic pain it creates. And as that pain grows, European governments and commercial banks have begun scrambling to insulate borrowers from the effects of those rising rates. And those effects are only going to grow as the rates climb higher.

Writing on the Wall

Of course, the writing has been on the wall for some time. As Yves recently warned, a financial crisis is by now all but inevitable. The combination of a surging dollar, rapidly rising interest rates and decades-high inflation, on top of all the economic pain caused by the pandemic, is placing huge strains on heavily indebted households, companies and economies around the world.

In late September, the European Systemic Risk Board (ESRB), an advisory body set up in the wake of the Global Financial Crisis to monitor the macro-prudential risks bubbling below the surface of Europe’s economy, issued a “general warning” about Europe’s financial system. The ESRB speaks with the full authority of the EU’s two most powerful institutions, the Commission and the European Central Bank.

As I noted at the time, central banks are normally the last to admit that a crisis is around the corner. When they finally sound the alarm, it generally means the damage is already done and the crisis — which they invariably helped create — is already here. The first of the ESRB’s warnings reads as follows:

[T]he deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households.

This is what appears to be playing out right now in Spain, which, like the UK a couple of months ago, seems to be playing the role of canary in the coalmine. A couple of weeks after the ERSB released its first ever “general warning”, the European Banking Authority sounded the alarm on the cocktail of risks rising across Europe’s housing markets:

The macroeconomic environment has deteriorated abruptly, and the probability of a recession has increased. High inflationary pressures and resulting increases in interest rates have driven up living costs without corresponding increases in income. This is a challenge, particularly for lower income and highly indebted households. Geopolitical uncertainty and energy crisis weigh on consumer and business confidence. Although employment rates are still high, demand for housing and real estate markets could still be affected by these developments.

In October, Spain saw its sharpest fall in mortgage approvals since 2008. And this is just the beginning, according to the Bank of Spain. Per El Mundo (translation my own):

The deteriorating economic situation has led banks to begin to turn off the credit taps. This trend has been most pronounced in the mortgage segment, which in the third quarter suffered its largest fall since 2008, following six consecutive quarters of growth.

This sharp fall in mortgage approvals is due, on the one hand, to the fact that the banks have become more risk averse due to the worsening macroeconomic outlook, which has led them to be stricter, and, to a lesser extent, to the fact that bank customers are applying for fewer home loans due to the rise in interest rates and the cost of financing.

Another risk, of course, is that growing numbers of mortgage holders who don’t qualify for the debt relief (and other borrowers, including businesses) begin defaulting on their debts. Spain has already witnessed one of the most spectacular housing booms and busts so far this century, which by 2015 had resulted in over 600,000 foreclosures (and bear in mind that in Spain mortgages are recourse, meaning that banks can go after the borrower for all outstanding debt once the house is resold).

It also triggered the collapse of multiple savings banks and a system-wide bailout. It is perhaps no wonder the government and the banks are desperately trying to avoid another housing crisis. But as another (largely self-inflicted) economic crisis looms, which could be even worse than the last, that is likely to be a tall order.