In 2008 the financial crisis hit modern economies. However, not all countries were affected the same way. If we focus on Spain, the unemployment rate in 2013 was nearly 23%. This extremely delicate situation triggered huge social dramas. The most well-known of these social problems in Spain is eviction. We talk about eviction when financial institutions force a family to leave its house because it is not paying the mortgage. So far, other European countries proceed the same way. The particularity of Spain is that evictions do not cancel debts, and as a consequence families must pay their mortgages even if they have turned over the house to the bank. The worst year was in 2010 with 93,636 families getting evicted from their homes. In other words, more than 10 families per day got evicted. This social drama affected mainly middle and low social classes. At this stage and after observing this data, one may ask oneself, why did this happen? Why did banks give mortgages to insolvent agents? Why did institutions not notice anything?
Before answering these questions, one must look at how the Spanish housing bubble was created. Most economists agree that the Spanish bubble started in 1998 and crashed in 2007 and that it was partially caused by the incentives agents had to buy houses. Among these incentives are the following: low interest rates; tax reductions made by the Spanish Government, until 2013, for all households that had a mortgage; and the “belief” that prices would rise because of the increase in immigration and in wages. All bubbles are speculative and are based in “beliefs” as stated before. However, were these “beliefs” right? Were the prices increasing for economic reasons? The fact is that they were not. For example, it is true that Spain experienced a wave of immigration around 1998, but in 2006 the situation was out of control: there were more than 800,000 houses built for 200,000 new households. It might also be true that prices increased in 1998 because of the “euro effect.” After Spain joined the euro zone in 2001, some economic agents bought houses with undeclared money. In any case, in 1998 there were good reasons to believe that prices would increase but these reasons only lasted for a couple of years. The economic situation in 2006 was completely different.
Focusing on financial institutions, an interesting question to answer is what made the banks give loans to all kinds of households. Answering this question requires an understanding of how mortgages are structured in Spain. The risk of a mortgage is computed through the loan to value (LTV) ratio between the value of the mortgage, which is given, and the value of the house. It is important to note that the value of the house is the one that appraisal companies computed. Recall that appraisal companies give prices to houses according to certain characteristics. The Bank of Spain has estimated that an LTV equal or inferior to 80% is a good mortgage, because of the fact that 20% of the value of the house has already been paid. However, the closer an LTV is to 100% the riskier the mortgage is, and the higher the probability of not paying back the debt. If the bank was facing a mortgage with an LTV higher than 80% it was unlikely that the Bank of Spain would accept it.
In a recent working paper titled “What is the right price of Spanish residential real estate?” published by two professors from Pompeu Fabra University, Jose María Raya and Jose García Moltavo, the conclusion is that banks actually managed to give mortgages that were not following the policies of the Bank of Spain. Here is what happened: if a worker in a financial institution was in front of a family whose LTV was equal to 100%, they called to the appraisal company and asked it to change the price of the house in order to get a lower LTV. Consequently, the appraisal company raised the price of the house, the bank could then give the mortgage, the buyer could happily enjoy his new home and the Bank of Spain was none the wiser. The two professors got to this conclusion by calculating the LTV with the market prices instead of the appraisal value. They observed that all real LTV were greater than 100%. This shows that banks gave mortgages to insolvent clients and prices were extremely high because of the distortions between appraisal firms and financial institutions. However, as the institutions did not notice, financial firms continued to give mortgages to insolvent clients. This lending practice led to the so-called Spanish bubble, which burst as thousands of families were unable to pay back their debts.
Another important estimator that contributed to the increase of the bubble was the poor data for housing prices. The Department of Work used the appraisal prices, which, as mentioned above, were not a good reflection of the real housing prices. First of all, they were not connected with market fluctuations. Another important fact to remember is how financial entities had high incentives to tell the appraisal companies to distort prices. What is even worse was how this housing price index was computed by the administration. The housing price index was calculated by taking the average. There is a popular Spanish saying that “you cannot compare apples with pears.” It is quite obvious that housing prices should be compared according to certain characteristics. Fortunately, in 2008 the Spanish National Institute of Statistics of Spain (INE) elaborated another index that takes into account the critiques exposed above.
The Spanish housing bubble is a clear example of the consequences that bad incentives, interferences on price formation, and poor statistics can have in the economy of a country. We can understand what happened like a series of distorted behaviours. That is, agents were buying houses according to some “beliefs” that were not rational, financial institutions and appraisal companies were manipulating prices in order to get more profits, and the administration was computing a price index that was far from reflecting real house prices. But behind this economic reasoning, there were thousands of Spanish households. The Spanish housing bubble has devastated families: people committed suicide because of evictions, elderly ladies were forced to leave their homes, and children have suffered from poverty. This is why it is important to know if something has been done in order to give the appropriate incentives to all agents. The Bank of Spain, for instance, no longer computes the LTV with the appraisal value but with the price that is registered in the notary. In this context, appraisal companies would not raise the price of the house in order to help buyers get a lower LTV. If they did, buyers would have to pay more taxes to the Government. However, the construction industry has been growing since 2013 and recent news has shown this sector will keep growing in 2017. Could Spain make the same mistake again? Have all the bad incentives been removed?
by Alea Muñoz Guisande