Shelter Island Capital Management

“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
Ernest Hemingway, “The Sun Also Rises”

The Financial Crisis and the Pandemic evidence that the competency of government officials the world over runs a large gamut. Sadly, Spain ranks very close to the bottom of these aptitude rankings and regrettably, unlike it is the case in most developed economies Spaniards cannot count on civil society institutions to make up for the shortcomings of their politicians. Since 2008, the ratio of total Public Sector debt to GDP has nearly doubled from 64% to 123%, and counting. Credit to the non-financial sector i.e. the combined debts of households, corporates, and the public sector remains nearly unchanged at 300% of GDP, still very close to the top of the charts. The latest bright idea coming out of Sanchez’s Hydra government may prove to be its last salvo before he calls a snap election.

The Communists in the government coalition have drawn a line in the sand. They will not support the 2022 Budget law unless their housing law bill passes, or so they say. The new bill introduced last week is a marvel among modern financial weapons of mass destruction. It undermines wantonly the value of the largest source of collateral in this over indebted and slow growing economy. It also discriminates ad hominin against the same real estate investment companies and funds that have been buying tens of billions of euros of toxic real estate assets from insolvent savings and loans and domestic banks for nearly a decade. Initially, the communists intended to discriminate between large and small property owners, somebody from the State’s legal counsel must have pointed out the vagueness of that concept in legal terms and they now plan to discriminate between private individuals and corporate landlords instead. The new bill also aims at restricting creditors’ ability to perfect securities interest on a foreclosed property. It is remarkable that these sworn enemies of Franco’s regime so often adopt similar interventionist policies. Property laws that undermined landlords’ rights are one of the reasons Spain’s credit and capital markets were under developed under Franco and the country remained poor in relative terms when compared to the EU’s large economies.

The bill also intends to penalize property owners who hold empty dwellings with a surcharge of up to 150% in property taxes. The drafters of this bill seem to ignore that a large number of dwellings in rural Spain are owned by absentee landlords who moved to Spain’s large cities decades ago and use their homes in their ancestral village sporadically. Ironically, many of these working class families probably voted for the current government. For a party who supports development programs for “Empty Spain” these people seem to have a very poor grasp of the facts around this issue. This bill also sets a national government umbrella, which will give legal protection to all kinds of shenanigans that regional governments are bound to concoct. This will contribute further to the dismemberment of the Spanish State.

If these politicians really wanted affordable housing, all they need to do is reform the zoning laws to increase the supply of developable land from public sector and private land banks. This well-tested strategy works as well in practice as it does in theory. It is simple, efficient, market driven and bereft of potential for corruption if properly developed. It is shocking that whenever Spanish politicians discuss the plight of those left out of the property ladder, this simple option is not part of the discussion. Thus in addition to the energy crisis that sees electricity spot prices hit new records every day, we will soon have a housing crisis.

Of course, these people are with the same government that sent utility stock prices tumbling with the hare brained and possibly illegal clawbacks with which they wanted to fix a problem they had created in the first place by following blindly a decarbonisation policy, which unintended consequences they failed to grasp. They fail to grasp pretty much everything it would appear. Yet thanks to an astute combination of lack of scruples, which allows Sanchez to form alliances with, among other sub-optimal options, apologists for terrorists who not very long ago were assassinating his fellow party members, and sheer will to remain in office, these people are the legitimate government of Spain.

Financial markets seem to have entered a new paradigm where nobody is responsible for anything and no harm can ever come from even the most terrible decisions or circumstances. No better example comes to mind than the latest dash for trash that has taken hold of macro investors. Eurozone bank stocks are once again the punt du jour. It is a well-known fact that financial investors have short-term memories. Jim Grant observed long ago “scientific knowledge is cumulative while financial knowledge is cyclical”. Some observers are downfounded, as this is not the first time that a wall of cash piles on this capital destroying industry since the euro area Sovereign and Banking crises of the early 2010s. Even as returns on the capital raised by these banks since 2013 are shockingly poor, investors have thrown caution to the wind and are back in. Should anybody have concerns about the alleged arbitrary nature Chinese regulators, perhaps they should remember their recent experiences in the euro zone.

The bespoke EU Bank Resolution directive, which came out just in time to create havoc on an already difficult situation, was applied exactly once in the case of banco Popular because the Spanish authorities chose not provide this bank access to the ELA funding facility. Italy has circumvented state aid rules with the blessings of the EU Commission. Greek banks still have NPL ratios above 25% ten years on, and so on… At the end of the day, all that matters to investors today is that these banks are reporting improving earnings, as they have been able to transfer most of their bad loans to Government schemes, because this time around it is OK for the taxpayer to pick up the check. Thus in the case of Spain, €140 billion of mostly dud loans have been transferred to a government sponsored lender. Similarly, you should not express any concerns about the ballooning Sovereign debt. It is so 2010s!

It would appear that any problem could now be solved with a printing press. Fretting about surging inflation is also not something one does in polite company either. If you allow for the possibility that the losses on the aforementioned €140 billion in sour loans could add another 7 to 10% to the debt to GDP ratio. If in addition, you observe from recent downward revisions to GDP growth that economic recovery in Spain is not quite as robust as was advertised. Then, soon we may be worrying about the contagion of a sovereign debt crisis to the banking system and vice versa. Let us hope that this is not the case because very few people are positioned for bad news. Certainly, a crisis of that magnitude is not something for which Sanchez’s cabinet is ready.

When we were growing up in the 1970s and early 1980s, inflation seemed to be an exogenous problem that nobody could tackle. This problem was particularly acute in Spain as the Arab countries’ oil embargo of 1973 came just a couple years before Generalissimo Franco’s death. The early years of the great political transformation from authoritarianism to a democratic parliamentary monarchy were fraught with stagflation i.e. low growth and very high inflation rates, rising unemployment, and a relentless wave of terrorist violence. By the early 1980s, the misery index – the sum of the inflation and unemployment rates – hit nearly 30 and stayed above 20 for nearly 20 years. We still remember how very serious looking men, for they were all men at the time, would go on long TV interviews to discuss the problem of inflation. Yet none seemed to know the cure, notwithstanding the fact that the Bank of Spain held real rates negative or that it freely financed the Treasury directly. (No need for the highly choreographed Treasury auctions held today so that a few investors may pick-up a few basis points before selling newly issued bonds to their central banks). We would ask our parents and our teachers as well and while everybody agreed inflation was bad, nobody seemed to know what to do to make it go away. Luckily, we got the answer in a freshman Macroeconomics 101 class in 1984.

For a few weeks now, the Spanish media are having a field day reporting new record-breaking electricity prices on a daily basis. Power prices are going up and nobody is quite sure exactly why either. The marginal producer sets wholesale electricity prices in EU countries, including Spain. This has been the case for many years and yet we have not had such parabolic spikes before. Currently, combined cycle gas turbine power plants (CCGTs) set the marginal wholesale price for peak demand. The most common explanation is that gas prices have spiked as Russia holds back supplies to the EU and thus electricity prices soar. However, this is only part of the answer. The media are leaving out the real reason for this crisis because it is politically incorrect.

The real reason why prices are spiking is that the EU’s decarbonisation policies have led to the early decommissioning of most coal thermal power plants in Spain and elsewhere. There were 21 coal thermal plants in Spain in 2011, which generated 60TWH, which was 23% of total electricity demand for the year. Today only six such power plants are still in operation, they will all close by 2022 at the latest. Thus in 2020, coal was the source of just 5TWh, by the end of 2022 coal would account for 0TWh. Therefore, no matter how high gas prices rise; there is no possible substitution from other power sources for peak demand because for now, all renewable energy sources have dispatch priority and therefore at any point in time this source is at 100% capacity utilization. Demand substitution can only be achieved through higher prices that will destroy demand, especially industrial demand. Commodities’ spot prices are a reflection of activity levels. Currently, there is a supply deficit, inventories are near lows, and winter looms around the corner. Gazprom is rationally rationing gas volumes exports; this will be the winter of our discontent.

This self-inflicted new energy crisis is only the most recent example of the layover of costs to households and industry emanating from EU environmental policies. Let us not forget that in the early 1990s, the Spanish Government prioritized natural gas as a clean source of energy, at least compared with coal thermal plants. Although, reports form the US National Academy of Sciences and the Environmental Protection Agency had been warning about greenhouse warming since 1982, the local environmental movement was targeting acid rain stemming from sulphur dioxide emissions from coal thermal plants. Thus, Natural Gas, of which Spain has none, was the focus of a new National Energy Plan for the 1991-200 period. Conveniently, Spain had no connection to the gas pipeline network in Europe and was free to choose from whom and how it would get its gas supplies. We are sure that the gas pipeline from the Algerian fields that comes to Spain through Morocco was a great business opportunity for some, it turned to be a huge cost to all other Spanish households and businesses. The balance of imports is shipped in as Liquefied Gas Natural Gas and regasified at six terminals along the coast. (By the way, this is six more terminals than Germany has today).

Spanish utilities dutifully spent tens of billions in these new plants and infrastructure to no avail because the Government of Jose Luis Rodríguez Zapatero (also a socialist) decided that a middle-income OECD member country needed to be at the forefront of subsidizing the learning curve of new renewable energy technologies. The Green credentials of the Socialist party were long standing. In 1982, the Socialist party opposed nuclear power plants, then, they ordered the mothballing of those nuclear plants that were under construction when they came to power. The Spanish electricity consumer paid for that policy through a 3.17% surcharge on their electricity bill for many years. This was in fact a tax on which consumers paid VAT and other excise taxes, to boot. Sub sequentially; in the 2000s, Spanish households paid not just for the stranded costs associated with the no-longer green-enough CCGT plants, but also for some of the most generous subsidies for renewable energy sources anywhere on the planet.

So generous indeed, that the Government had to lower these subsidies retroactively a few years later. This became the source of significant ill will from foreign and domestic investors and countless lawsuits in international courts of arbitration. Shutting down thermal plants before having cost effective storage for renewable source electricity is going to prove very expensive as well. For the time being, the Government has yielded to the public’s outcry by reducing or eliminating taxes on electricity generation, which is very heavily taxed with activity taxes on top of VAT. This is the case as well for other industries and services that cannot relocate abroad and are easily taxed through monthly invoices. The government has again retroactively established a windfall tax and other charges that the utilities will fight in court for years. Not a single press article mentions the impact on the fiscal deficit of any of these tax cuts either. Some people may be led to believe that the Government has fixed the problem, but not it is not likely to be many.

As you may conclude from the chart above, Spaniards are a pretty hardy bunch. Notwithstanding the fact that they have endured for decades with one of the highest misery indices of any OECD country, most still believe that there is no better place to live anywhere in the world. May this be the result of lack of information?