Spain's Inflated Home Values Infect Mortgage Bonds

By Ben Sills and Esteban Duarte

uly 31 (Bloomberg) -- Jose Maria Gonzalez is struggling to unload a four-bedroom apartment in Madrid so he can pay for the 480,000-euro ($750,000) house he now lives in. His problem may wind up hurting investors in Rome and Hong Kong he's never met.

That's because mortgage-backed bonds issued by Gonzalez's lender are held by funds run by Pacific Investment Management Company LLC and Pioneer Investments. Property appraisal firms, working in the interests of the banks who controlled them, regularly inflated home values, says Josep Prats, a fund manager at Ahorro Corporacion in Madrid. Such assets are behind as much as 320 billion euros of that paper sold to savers worldwide.

Those estimates helped Spanish banks boost lending by supporting the sale of mortgage-backed bonds that fueled Europe's biggest homebuilding boom. The strategy turned sour after the U.S. subprime crisis triggered more than $470 billion in losses and writedowns worldwide. As Spanish assets are reassessed, the country may become a fresh source of losses.

``Valuations aren't realistic,'' says Prats, who heads a team managing about 11 billion euros. ``Valuation companies issue reports for whatever amount the bank managers are prepared to lend.''

Gonzalez's lender, Caja de Ahorros de Gipuzkoa y San Sebastian SA, a savings bank in northern Spain known as La Kutxa, has sold 2.5 billion euros of mortgage-backed bonds since the end of 2005.

Pimco, based in Newport Beach, California, and Pioneer Investments bought Kutxa bonds for funds sold to investors around the world.

Hong Kong Investors

Pimco's Euro Bond Fund, sold to savers in Hong Kong, is the biggest investor in Kutxa's 2007 issue with a 20.6 million-euro holding, according to a March 31 regulatory filing. Pioneer Investments' CIM Euro Fixed Income Fund, which is sold to Italian savers, holds 11 million euros of the bonds.

Pimco, majority-owned by Munich-based Allianz SE, runs the world's largest bond fund and has $829.5 billion under management on behalf of corporate pension plans, public retirement funds and foundations. Pioneer Investments is the fund-management arm of Italy's largest bank, Milan-based UniCredit SpA, which oversees 190.5 billion euros for 40 million customers in 23 countries.


Krishna Prasad, senior fund manager for asset-backed securities at Pimco in London, declined to comment on the fund's holdings. Spokeswoman Mary Zerner said Pimco had no comment for this story.

Pioneer's Estimate

Raffaele Bertoni, the Dublin-based head of fixed income for Pioneer Investments, says the Kutxa bond is backed by solid collateral: homes in the wealthiest areas of Madrid, Barcelona and the Basque Country. The mortgages account for an average of 78 percent of the properties' value, and the large number of borrowers also spreads the risk of default, he says.

``The Spanish market is not the U.S. property market,'' Bertoni says. ``We don't have the famous subprime. Generally speaking, the collateral for each loan is always quite high.''

That hasn't prevented Kutxa's bond from losing 8 percent since it was issued in February last year. That contributed to the Pioneer fund underperforming the JPMorgan EMU Bond Index by 2.7 percentage points over the past 12 months.

One concern is that the real worth of many Spanish homes is far below official values, meaning the so-called loan-to-value ratio, which underpins Bertoni's view of the investment, understates the risk, according to Prats of Ahorro Corporacion.

A Kutxa spokesman said no one ever raised the issue of home estimates with the bank. Kutxa's mortgage-backed bonds have been successful because of the quality of their loans, said the spokesman, who can't be identified because of company policy.

Developer Bankruptcy

This month's collapse of Martinsa-Fadesa SA, a developer with more than 5 billion euros in bank debts, suggests investors are beginning to share Prats's concerns about Spanish house values. The company sought protection from creditors after failing to raise 150 million euros even though its property and land holdings were valued at 10.8 billion euros.

Spanish house prices fell for the first time in a decade in the second quarter, and the volume of transactions dropped by a third in May from a year earlier.



Yet Bertoni's view is echoed by the Spanish government and the central bank: Spain has no subprime.


``Subprime lending, meaning poorly documented, very long- term, increasing-interest mortgage loans where repayment by the debtor depends sometimes critically on the ability to refinance, simply does not exist in Spain,'' Deputy Finance Minister David Vegara said in an Oct. 24 conference speech.

Property Fever

Still, in 2006 and 2007 many banks allowed three or four people to sign for mortgages when the buyers didn't qualify on their own, said a spokesman for Banco Bilbao Vizcaya Argentaria SA, Spain's second-biggest bank.

Banks also granted variable-rate loans to families at the financial limit when interest rates were close to the lowest in a generation. Kutxa even offered a 50-year mortgage in 2007.

Concerns about the way valuation companies operate aren't new. In 2006, the Bank of Spain cautioned four home valuers against making baseless appraisals, or using a methodology for their calculations that didn't meet legal requirements. The bank didn't identify the companies involved.

``There was a fever in the real estate business, and it was the banks who set the terms,'' says Ramon Lobo, who worked as an auditor at BBVA during the boom.

Valuing Spanish homes ``is not a 100 percent mechanical process,'' says Luis Leirado, managing director of the biggest home valuer, Tasaciones Inmobiliarias SA, known as Tinsa.

`Tricks' of the Valuer

``The tricks of a seasoned valuer include constant visits, models -- any method is valid,'' Leirado says. ``In the end it's about imagination and knowledge. It's not a question, as it is in some other countries, of passing information from a public office to the statisticians.''

In recent years, existing safety measures failed to rein in the appraisers. Under Spanish law, valuers are obliged to provide a so-called mortgage valuation -- at a discount to the market price -- when there is a significant risk a property will cost less within the next three years.

In 2005, less than 1 percent of estimates applied such a discount, according to a report by the Bank of Spain. The central bank was already warning that housing was overvalued by as much as 30 percent then.

Tinsa was still applying the discount to less than 1 percent of home assessments in June this year, Leirado says.

``Not every house that could fall in value has to be included,'' says Leirado, who is also head of the 41-member Spanish valuers industry association. ``It has to meet certain criteria: that there has been an exceptional gain, that there are objective reasons for a decline and that the decline could last more than three years.''

Owned by Banks

Many home-valuation companies are owned by banks. Kutxa gives most of its business to Servatas, in which it holds a 35 percent stake. Tinsa is owned by 36 savings banks and the Spanish Savings Banks' Confederation.

During the credit boom, valuers understood that clients would welcome inflated estimates, says Lobo, the former BBVA branch auditor.

Between 2005 and 2007 it was ``very common'' for valuations to exceed the transaction price by 25 percent, Lobo says. That allowed banks to treat loans for 100 percent of a property as if they were closer to the 80 percent limit for regular mortgages when they sold them to investors.

In December 2007, the government passed a mortgage law limiting the amount of business appraisers can take from clients with ownership stakes.

``If the valuation agency belongs to the bank then you may have a conflict of interests and that has to be addressed,'' Finance Minister Pedro Solbes said July 22. If the mortgage law ``had been introduced earlier we may have avoided some of the excesses.''

One Year Later

Gonzalez, a 36-year-old telecommunications engineer, bought a new home outside Madrid last year. He took out a bridge loan to tide him over until the sale of his apartment, reassured by an estimate that it was worth 450,000 euros.

After a year on the market, he dropped his asking price to 435,000 euros from 510,000 euros and is still getting no interest. Payments on the bridge loan are set to begin in October on top of 1,300 euros a month for his mortgage.

``I don't see a way out,'' he says. ``There's no way we can pay them both, and practically no one has been to look at the place.''

Mortgage bonds issued in 2006 and 2007 ``are probably the most dangerous at the moment,'' Bertoni says. He says he sold Spanish mortgage-backed bonds from those years, while retaining his holdings of Kutxa paper.

Debt Downgraded

Spanish AAA-rated mortgage debt is judged to be the riskiest on the continent. Investors demand as much as 240 basis points more than Euribor, the benchmark for interbank lending in the euro zone, up from 85 basis points at the end of last year, according to Dresdner Kleinwort prices. That means it costs borrowers an extra 15.5 million euros in annual payments for every billion euros of bonds.

Caja Madrid, Spain's second-largest savings bank, had 262 million euros of mortgage-backed bonds downgraded by Fitch Ratings in June after the default rate on the underlying home loans doubled in a year.

That happened before Solbes on July 24 cut his forecast for economic growth next year by more than half to 1 percent and said that at least 450,000 people will join the ranks of Spain's 2.38 million jobless residents.

Holding Out Hope

House sellers are still holding out hope that their expectations will be met.

When Borja Fernandez, a 32-year-old advertising executive, bought his two-bedroom apartment in Madrid in 2005 it was valued at 530,000 euros even though he only paid 486,000 euros. That allowed Caja Madrid to overstate the amount of home equity backing his 450,000-euro mortgage.

After two months on the market, the best offer he's received is for 540,000 euros, meaning his mortgage is still more than 80 percent of the property's value.

With Sociedad de Tasacion SA estimating that property values locally have increased 22 percent since 2005, suggesting that the apartment is worth 100,000 euros more than the best offer, he's not ready to cave in yet.

``It starts to weigh on you,'' he says. ``People say prices will start to rise again in 2010, but then you think: What if they're wrong?''

To contact the reporter on this story: Ben Sills in Madrid at bsills@bloomberg.netEsteban Duarte in Madrid at


eduarterubia@bloomberg.net
Last Updated: July 31, 2008 02:48 EDT