Economic Research: Spain's Housing Market May Need Four More Years To Rebalance. Table Of Contents

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1 June 14, 2012 Economic Research: Spain's Housing Market May Need Four More Years To Rebalance Credit Market Services: Jean-Michel Six, EMEA Chief Economist, Paris (33) ; Sophie Tahiri, Economist EMEA, Paris (33) ; Table Of Contents The Supply Overhang Continues To Depress Prices Household Deleveraging Is A Precondition For A Real Estate Recovery Market Fundamentals Also Point To A Further Decline In Prices The Sharp Rise In Unemployment Is Weighing On The Household Sector Related Criteria And Research 1

2 Economic Research: Spain's Housing Market May Need Four More Years To Rebalance House prices in Spain are a key variable in the performance of the country's economy. The housing boom built up unsustainable imbalances, such as an oversupply of dwellings, which will need to fully correct before a sustainable recovery takes place. The unwinding has begun: House prices have dropped 22% in nominal terms between first-quarter 2008 and first-quarter 2012, according to the Organization for Economic Cooperation and Development. That's more than in any other eurozone country except for Ireland. However, the magnitude of the decline has to be juxtaposed against the 150% rise in prices in Spain between 2000 and the peak in We note that prices climbed 116% in Ireland and 60% in the eurozone on average over the same period. Overview For Spain's housing market to recover, household debt, which is still high, needs to come down further, implying years of weak credit demand. Because of the heavy weight of unsold housing stock, we believe that the correction in housing prices is likely to be deeper and more prolonged than in the previous cycle, taking up to four more years for the market to absorb the glut. A look at fundamentals--price to income and price to rent ratios--leads us to expect a further 25% drop in housing prices. Investment and employment in the construction sector is now down to 12.7% and 6.8% of GDP, close to half of 2006 and 2007 levels, respectively. The bursting of the real estate bubble is visible in Spain's dire economic prospects: Standard & Poor's expects GDP to contract in real terms by 1.5% this year and by 0.5% in A look at each of the major trends affecting Spain's residential real estate market--the housing overhang, household debt, housing price ratios, and unemployment--indicate that the correction is likely to take up to four more years. In addition, price fundamentals show that a further 25% drop in housing prices could be in order. The Supply Overhang Continues To Depress Prices The Spanish housing market has been saddled with excess supply since the late 1990s. Demographic trends, particularly the country's relatively large number of immigrants, stoked demand for housing, but they didn't fully offset the increase in supply. According to Eurostat and yearly since 2000, Spain has consistently reported one of the largest numbers of immigrants, averaging 650,000 persons each year and accounting for more than 20% of all immigrants into EU member states. At the same time, housing starts have exceeded 500,000 units a year with a peak of 760,000 in This figure exceeds housings starts for Germany, Italy, France, and the U.K. combined in that same year. The volume of new homes built amounted to 4.4 million between 2000 and 2007, although the number of Spanish households grew by Standard & Poors RatingsDirect on the Global Credit Portal June 14,

3 "only" 3.2 million over that same period. While housing starts began to ease in early 2007, housing completions remained high, creating a big buildup of unsold housing (chart 1). According to the latest data, estimations of the stock of unsold houses range from 680,000 units (Spain's Ministry of Housing, data as of Dec. 31, 2011) and 818,000 units (CatalunyaCaixa, Sept. 30, 2011). These figures represent between 2.6% and 3.2% of Spain's total housing stock, according to Ministry of Housing estimates for Chart 1 This sizable chunk of idle stock is preventing an early recovery in residential property prices: We note that annual demand for housing currently averages 300,000 units a year, according to estimates from the International Monetary Fund's July 2011 country report. When we take into account the currently low level of housing completions (about 80,000 per year), the existing oversupply of about 800,000 dwellings, and new demand for housing (about 300,000 per year), we calculate that it should take up to four additional years for supply and demand to balance out. Household Deleveraging Is A Precondition For A Real Estate Recovery Home mortgages, which currently account for 75% of household debt, have risen 2.5 times from 2003 to 2010 (chart 2). There has been a close correlation between increased lending and house prices. The increased borrowing 3

4 capacity of households, which underpinned housing prices, was supported by an extension in average mortgage durations, which helps reduce the monthly service payment burden for borrowers. The maturity of new mortgages climbed from an average 12 years in 1990 to 22 years in 2000, and peaked at 28 years in Chart 2 Lending contracted significantly between 2007 and 2010, when it stabilized on the back of supportive measures by the government. The following year, however, the contraction resumed, contributing to a steeper downturn in the housing market. While housing prices had been falling at a 6% average annual pace between 2008 and 2010, they dropped by 9% in In contrast to this rather quick adjustment in credit flows, household debt has decreased more gradually. Total household debt to GDP stands at 81%, down by 6 percentage points from its peak in June Deleveraging has been less pronounced in Spain than in other countries, in the U.S in particular. U.S. household debt has dropped to 86% of GDP in fourth-quarter 2011 from a peak of 99% in first-quarter 2009, mainly due to the higher level of defaults but also to a rise in disposable income. In Spain, the gross savings rate rose momentarily in 2008 but then declined rapidly in 2010 and 2011 in line with the contraction in real disposable incomes. This decline in the savings rate has so far limited the scope of the drop in the household debt ratio. Further household deleveraging in Spain will have to be achieved before credit demand can resume, allowing a stabilization in house prices. The long-term average debt ratio between 1999 and 2011 was 66% of GDP. Standard & Poors RatingsDirect on the Global Credit Portal June 14,

5 Considering that since it peaked in June 2010 at 87% of GDP, and that the ratio has declined at an annualized pace of 4 points per year, we reckon it could take about 3.5 to 4 years for this ratio to return to its long-term average. Market Fundamentals Also Point To A Further Decline In Prices Price to income and price to rent ratios in Ireland and the U.S. now stand below or nearly below their long-term average--but that is not the case for Spain. The country's price to income ratio has dropped from its peak in fourth-quarter 2006 but is still higher than its long-term average, and the same observation can be made about the price-to-rent ratio (chart 3). Looking at just these measures, Spanish house prices still need to adjust by nearly 25% for them to return to their long-term averages. Chart 3 The Sharp Rise In Unemployment Is Weighing On The Household Sector We expect Spain's economy to contract by 1.5% in 2012 and 0.5% in 2013 because of deteriorating private consumption, fiscal retrenchment, and weak credit conditions--coupled with flimsy external demand for Spanish products. High unemployment has been a drag on private consumption since the reversal of the housing and construction boom. The construction sector's share of GDP climbed from 15% at the end of 1999 to 22% in 2006, compared with 6% on average in the eurozone over the same period. With the real estate bust, Spain's construction 5

6 sector has shrunk, representing only 12.7% of GDP in The contraction of the construction sector triggered a loss of 1.5 million jobs between 2008 and March Employment in the sector, which was one of the highest in the EU with 14% of total employment in 2007, declined to 6.8% in March In comparison, this sector in France accounted only for 6.5% of employment in The surge in unemployment is reflected in higher doubtful loans, as households find it more difficult to service their mortgages (see chart 4). Yet low interest rates have provided some relief to borrowers. Spanish households are very sensitive to changes in interest rates, since variable-rate loans comprise 90% of mortgages in Spain. That compares with 40% in the eurozone. In February 2012, as the unemployment rate reached 24%, doubtful loans reached 2.8% of total housing loans, a ratio that appears still reasonably low. But as the economy continues to weaken, we will continue to watch that indicator carefully as a potential harbinger of additional financial difficulties in the household sector. Chart 4 Standard & Poors RatingsDirect on the Global Credit Portal June 14,

7 Related Criteria And Research Scenario Analysis: What's Driving Spanish Mortgage Arrears? April 13, 2012 The Timing Of Recognition Of Mounting Loan Losses Could Push Spanish Banks Over The Edge, June 7,

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