Torre Lugano, Spain's tallest residential tower

Torre Lugano, Spain's tallest residential tower, attracted buyers from here and abroad with glossy brochures promising a luxury building with a glass-walled elevator and sweeping views of this Mediterranean resort's turquoise waters.

The reality is very different. The garage floods, windows are drafty and backed-up toilets flood apartments with sewage. The glass elevator never materialized. Residents, some recently forced to shower in a communal rest room because the plumbing on their floors failed, are suing the developers for €28.2 million ($36.4 million), citing "construction defects."

Torre Lugano is a 420-foot-tall example of the gap between Spain's recent dreams of economic glory and its grim new reality. Some 1.5 million unfinished, unsold or unwanted residential units stand scattered across the country, products of a still-deflating housing bubble that threatens to undermine Spain's broader economy for years to come. It is the hangover after an epic fiesta, a period Spaniards now refer to as "cuando pensábamos que éramos ricos"—"when we thought we were rich."

Once hailed as early proof of the success of the euro, Europe's single currency, Spain's low interest rates from the mid-1990s and its proximity to richer neighbors ushered in a decade-long period of prosperity.

Now, as a recovery remains elusive across the continent, Spain's ability to revive growth is considered a vital test of the future stability of the currency and Europe's economic health.

With a $1.3 trillion economy, Spain is the fourth-biggest economy using the euro, accounting for about 11% of the zone's overall output. Europe's other teetering economies, Greece, Ireland and Portugal, together account for roughly 6%.

Uncertainty over Spain's capacity to recover has increased the pressure on Spanish stocks and bonds. Prime Minister José Luis Rodriguez Zapatero, having already slashed billions of euros from the national budget this year, has said he will unveil an even tighter 2011 budget in the coming weeks. Even the king and queen are feeling the pinch: This week, officials at Spain's Royal Palace announced that the royal family, whose income depends on appropriations from the government, were expecting a slimmer allowance next year.

As international markets have turned away from the country, Spanish banks have had to rely on the European Central Bank to keep vital credit flowing through the economy. Moody's Investors Service, the only one of the three major ratings firms not yet to have downgraded Spain's sovereign debt, in August said it was still considering a ratings cut.

Investors believe banks need to be more transparent about the number of bad loans and other assets they have on their books. Instead of disclosing troubled credit, many Spanish lenders have chosen to refinance loans that could still prove faulty and to report foreclosed or unsold homes as assets, often without posting their drop in market value. Even after many banks passed this summer's government-imposed "stress tests," economists believe such assets still pose a danger.

One risk, says Luis Garicano, an economist at the London School of Economics, is that Spanish lenders could follow in the footsteps of Japan's so-called zombie banks, "holding on to capital in order to cover their losses."

For years after the collapse of Japan's economic boom in the early 1990s, the country's banks held on to troubled properties and other non-performing assets as they lost value, in hopes that the market would recover. That kept capital tied up in a languishing sector, preventing lenders from financing more vital sectors of the economy. By 2002, 8.4% of all loans in Japan were non-performing, according to Japanese government figures.

In Spain, that figure hit 5.4% in June, up from less than 1% just three years ago. The Bank of Spain, the country's central bank, in a report earlier this year estimated that as many as €165 billion in loans, or about 37% of all Spanish credit with exposure to construction and real estate, could ultimately prove to be "problematic."


In recent months, the Bank of Spain adopted measures that require lenders to allocate more of their reserves, and to do so more quickly, for bad loans and real-estate assets lingering on their books. Regulators also spurred a rapid round of consolidation among savings banks, or cajas, regional credit institutions that have borne the brunt of the housing crisis. With the backing of a government fund to help refinance the sector, officials hope the merged cajas can better digest the losses and emerge after the crisis as stronger, more competitive lenders.

Any recovery will take time. Economists say in a healthy market it would take at least three years to sell all of Spain's unsold homes that were built during the boom. That's more than three times as long as new supply was expected to sit undigested during the worst of the U.S. housing glut.

It will take longer still for the broader Spanish economy to perk up. Saddled with 20% unemployment and sharp cutbacks from a newly-austere Spanish government, consumers are unlikely to take out their pocketbooks anytime soon.

The decade through 2007 was a heady one for Spain. Flush with foreign investment and cheap credit that came with the arrival of the euro, it saw ambitious projects sprout everywhere. This was in stark contrast to the conservative approach to development that long held sway here. Spain until recently was so frugal and had so little purchasing power that Spaniards referred to "Europe" as the continent beyond the Pyrenees.

Now, many Spaniards are bemoaning the folly of it all. In the town of Ciudad Real, a newly built airport goes largely unused and is saddled with millions of euros in debt. In Zaragoza, a mid-sized city between Madrid and Barcelona, cutting-edge fairgrounds, intended for use as a business park, sit empty two years after a world's fair.

The Benidorm tower, in the eastern region of Valencia, rises above a swath of coastline that over the past decade was transformed from a sunny strip of citrus groves and farmland into one of the most speculative housing markets on the planet. Spaniards enjoying easy mortgages were joined by Britons, Germans and other buyers from colder climes.

Construction along the Valencian coast outpaced the building boom elsewhere across Spain, and accounted for more than 12% of the region's economy in 2008—more than twice what it had a decade earlier. The industry created so many jobs that in 2006, near the peak of the boom, unemployment in the region, now a staggering 24%, dropped below the national average—a triumph in an area with big seasonal job swings. The demand for labor was such that foremen were known to travel from job site to job site at the end of the day, poaching entire crews from rivals by offering an additional euro per hour in wages.

The race to get in on the boom led some residents of Valencia to cash in. "How do you tell someone to keep their orange grove when a developer promises riches overnight?" asks Jorge Alarte, the leader of the region's Socialist party.

Haste sometimes led to shoddy construction, as developers drummed up deals and builders, frequently relying on subcontractors, rushed from one project to another. Nowadays, scenic hillsides and beachfront vistas sit occupied by empty scaffolding, unfinished cinder-block frames and garbage heaps from work suspended months ago.

Developers began marketing Torre Lugano in 2003. Offering commanding views of Benidorm's two crescent beaches, the tower's apartments ranged in price from €180,000 to €710,000 and were to have access to tennis courts, a pool, a playground and a gym.

The project is a joint venture between Acciona SA, one of Spain's biggest builders, and Caja de Ahorros de Valencia, Castellón y Alicante, or Bancaja, the biggest lender in Valencia. Bancaja is now in the midst of a seven-way merger with other regional savings banks amid the reordering of the troubled sector. Spokespeople for Acciona and Bancaja declined to comment on the dispute at Torre Lugano.

Problems started as early as 2006, when developers informed buyers that builders wouldn't meet the initial deadline for completion, mostly because the construction boom had led to a shortage of labor and materials. To encourage some to stick with the purchase, developers offered kitchen furnishings on the house, according to residents.

While some buyers backed out, some waited. "We were still excited and were happy to stick it out," says Alberto Sáenz, a bar owner and father of two young boys.

Tired of his hectic lifestyle in the northern city of Bilbao, Mr. Sáenz and his family had moved to Benidorm just as Bancaja was beginning to promote Torre Lugano. Though their move was driven by a desire to take lower-stress, lower-paying jobs, they were also lured by the building and were confident they could afford the €200,000 mortgage with additional income they earn by renting out the bar and a home they own back in Bilbao.

"This really was like a dream for us," says Mr. Sáenz, recalling a verdant path that would be carved from the adjacent playground into a hillside behind it. The long path was never actually built, though it remains visible in a mockup of the project still on display in a Bancaja window on Avenida del Mediterráneo, a busy thoroughfare in central Benidorm.

During the final year of the building's construction, the global downturn began to hit Spain hard. Some of the buyers who had agreed to wait on the building decided to drop out. More than a third of the tower went unsold.

That's when residents say they noticed builders beginning to cut corners. Instead of aluminum railings and fixtures in outdoor areas, where the salt air and moisture corrodes other metals quickly, builders fastened cheaper iron, now rusted. A polished facade that was supposed to look like marble is instead rough concrete painted white.

When residents finally moved in, they say, further defects became apparent. A faulty central fire alarm is now disconnected, having triggered itself erroneously dozens of times in a single day. A retaining wall and staircase alongside the swimming pool is roped off because part of the wall has buckled and recently began leaking water.

Some apartments go days without water because of defective pumps. Hollow plaster walls lack the sound-proofing that was advertised, allowing residents to hear conversations, arguments and creaking beds in neighboring apartments.

"You could understand an error or two in any building, but dozens?" asks Mr. Sáenz. The residents' association says it has spent €900,000 over the past two years making repairs to common areas and recently approved a budget that includes €400,000 more for repairs and costs associated with the lawsuit.

They are suing the developers, Acciona and Bancaja, and others involved in the project, in a regional court in Valencia for "construction defects" of €28.2 million. They say that's the difference in value between what they allege the building would have been worth had it been built as promised, and what it is now appraised at.

After more than 50 years of work, Vicente Villalba took his profits from the sale of a catering business and in 2004 bought a Torre Lugano apartment. He now hangs his clothes on children's hangers so that they fit in the narrow closets that were installed instead of the full-sized wardrobes advertised.

Recently, he toured a utility room that was originally supposed to be a clubhouse. He pointed in disbelief at a jerry-rigged joint between a large water pipe and a much smaller one. The second pipe, placed sloppily above electricity cables in a wiring tray, recently succumbed to the pressure from the bigger one, shorting out the circuits below and leaving entire floors without electricity.

"It's a giant rip-off," says Mr. Villalba of the tower. "It was all too good to be true."