Perhaps the best thing to do is to start off with a nice simple chart showing the essential structure of the Spanish cedulas market. Basically I want to start off right from the outset by explaining that I am in no way suggesting that anything improper has taken place in the expansion of the cedulas market in Spain (ill advised, possibly, but not improper). A need for cheap, accesible and well secured mortgages was felt - this was in the interest of all the participants, from those who bought the flats, to those who lent the money, to the builders who got to do the building, and the town halls who saw a boom in income and local employment, to the large banks who got to sell many of the financial services - without, it must be said, having to assume too much risk - to the regional cajas, who saw a throughput of income and activity that they could never have imagined even in there wildest dreams. But this whole process was posited on one straightforward, simple, but as it turns out probably erroneous, idea, namely that property prices in Spain would rise in a stable and sustainable fashion, as they had done in Germany since 1995, which was the secret of the success of the German Pfandbriefe on which the cedulas model was based.
There were, however, only two underlying yet unnoticed problems associated with this situation: the first was that Germany had had its maximum (demographically speaking) construction boom in the years up to 1995, while the Pfandebriefe really took off following the "correction" in Germany and not before it, and secondly Germany never had negative real interest rates over a sustained period of time in the way which Spain did in the years from 2002 to 2006.
Over the past decade covered bonds, or securities issued by financial institutions that are secured by dedicated collateral, have become one of the largest asset classes in the European bond market and an important source of finance for mortgage lending. The collateral, or “cover pool”, is usually put together so as to obtain the highest possible triple-A credit rating. As a consequence, covered bonds offer an alternative to developed country government securities for bond investors interested in only the most highly rated securities.
The defining feature of covered bonds is the dual nature of protection offered to investors. Covered bonds are issued by financial institutions, mostly banks, which are liable for their repayment. They are also backed by a special pool of collateral – mostly high-grade mortgages or loans to the public sector – on which investors have a priority claim.
The dual nature of protection offered by covered bonds sets them apart from both senior unsecured debt and asset-backed securities (ABSs). The fact that they are secured by a collateral pool in addition to the issuer’s creditworthiness results in a higher rating than “plain vanilla” bank bonds. In contrast to ABSs, the cover pool serves mainly as credit enhancement and not as a means to obtain exposure to the underlying assets. Cover pools tend to be dynamic in the sense that issuers are allowed to replace assets that have either lost some quality or have been repaid early.
The key question when valuing covered bonds is whether or not the cover pool will retain its value in the event of the bankruptcy of the originator. In principle, the insolvency of the originator could endanger the creditworthiness of covered bonds through two channels. First, the credit quality of the assets in the cover pool could deteriorate. Second, even if the cover assets retain their value, creditors of the originator could attempt to seize these assets in order to satisfy their claims. The covered bond legislation and contractual arrangements in place attempt to deal with both threats to the viability of the cover pool by imposing minimum standards for asset quality and by ensuring the bankruptcy remoteness of the cover pool.
Legislative frameworks tend to apply limits on the loan-to-value ratio (LTV) of mortgage loans as well as geographical and, in some cases, rating restrictions for public entities to ensure a high quality of the cover assets. These are sometimes complemented by mandatory stress tests. Such tests are also used by rating agencies to ensure the creditworthiness of the cover pool of bonds issued both inside and outside a legislative framework.
To date, covered bond systems are in place in 25 European countries. In most European countries, the issuance of covered bonds is regulated by specific covered bond legislation setting the standards for bondholder protection, the criteria for eligible assets and a number of other specific features. In some countries, like the UK and the Netherlands, the features of covered bonds are defined on the basis of contractual arrangements.
Spanish cedulas hipotecarias are a specific form of covered bond. In fact covered bonds are less complicated than they might seem to be at first sight and have more common characteristics than might be expected. The European Covered Bond Council (ECBC) has established a Technical Issues working group, where experts from a wide variety of countries work together to carry out a continuous comparative analysis of the different covered bond systems as they evolve. Achieving a common basis of understanding of covered bonds can help identify areas where regulators, issuers, intermediaries and investors can work together to enhance and advance the various covered bond systems already in place.
There seem to be three classes of common characteristics for covered bonds:
The status of the issuer: In all participating countries covered bond issuers are regulated institutions. These can be universal credit institutions (with or without a special covered bond issuance licence), specialised credit institutions or specialised financial institutions. The fact that issuers are regulated allows public supervisory authorities to monitor them closely and to steer the business activities of covered bond issuers. Furthermore, this kind of regulation should normally give investors some sense of security regarding the safety of covered bonds.
Exemption from general insolvency law: The full repayment of covered bonds should not be affected by insolvency procedures on the issuer. Moreover, covered bondholders should be protected against claims from other creditors in case of insolvency of the issuer. Those features establish the preferential claim of the covered bondholders and constitute the basis for the bankruptcy remoteness of covered bonds. These features can be found in all countries where covered bonds are issued.
Adequate cover: The covered bond system should be based on the notion of a cover pool and be operated in a way which ensures that the cover pool generates sufficient proceeds to repay covered bond interest and principal. This requirement is essentially an economic question and involves a variety of features such as the type of eligible assets, valuation of cover assets and Loan to Value (LTV) criteria, asset-liability guidelines, the role and position of derivatives and, last but not least, cover pool monitoring and supervision.
The need to find some cheap and efficient solution for the problem of mortgage funding has been specially important in Spain since large quantities of mortgage loans have been sought and issued. The problem has been that due to the presence of a negative real interest rate environment over an extended period of time bank deposits were not sufficient to meet ongoing demand. As a consequence Spain needed to find an effective supply of mortgage funding, in order to have sufficient cash available to lend.
The Spanish mortgage market law (Ley del Mercado Hipotecario 1981, LMH) served as the legal framework which made the creation of this market possible. According to article 47 of the Spanish Constitution (1978), a constitutional obligation was established of facilitating access to a dwelling for all citizens. The only real and evident downside to all of this was that the more effective and abundant the supply of mortgage funding became, and the cheaper the mortgage loans were the mortgage debtors. Logically this meant that for any given purchaser the quantity they could raise to pay for a house or flat on any given monthly quota went up and up, and with this the underlying value of the asset (or flat) they were trying to buy.
The process of mortgage funding differs from one country to another. Traditionally bank retail deposits have been used for this purpose (as they had been in Spain), but if what the credit institutions want (or need) is a medium or a long term source of sure cash, then one way to achieve this is to structure some kind of passive lending operation, based on a mortgage securities market. There are two great systems of mortgage securities markets today: the German model (Pfandbrief) and the Anglo-Saxon model (mortgage-backed securities), each of these has special characteristics, and its own advantages and disadvantages.
Both mortgage bonds and mortgage-backed securities have special features in Spain that make them unique in the European mortgage securities market (although please note that some at least of the longer term singularities of the Spanish situation have been resolved in the new mortgage legistlation of the autumn of 2007). The structure of the Spanish cédulas hipotecarias is rooted in the original LMH (Ley del Mercado Hipotecario, 1981) and follows basically the structure of the German model of the Pfandbrief, as can be seen in the chart below (which is a simpler form of the general chart I presented above).
Basically a land credit institution (in the Spanish case this was very often a consortium of regional cajas) concedes a number of mortgage loans that create a pool of mortgages with specific features. This pool of mortgages may be funded by issuing mortgage bonds whose value cannot exceed the 90% of the value of all the mortgages of the pool (and here of course we meet our first problem, since if property values drop in Spain, then naturally the value of any given pool will drop, and it will need "topping up"). The mortgage bonds represent debt to the issuing credit institution. The owners of the mortgage bonds (not only institutional but also retail) receive interest periodically until the security becomes amortised. The global amount of outstanding mortgage bonds is backed by all the mortgages owned by the issuer.
In general, there are two great Anglo-Saxon models to structure the securitisation of mortgages:
a) The pass-through securitisation model (USA): in this model, the MBS holders have a property right over the pool of mortgages, because their capital and interests pass through the mortgage debtor directly to the securities holders. In this model the trustee of the issue is at the same time the SPV.
b) The pay through securitisation model (USA and UK with the UK-mortgage-backed securities): in this model, the MBS holders have only a credit right against the pool of mortgages and the security of this credit (either a charge (USA) or a sub-mortgage (UK))is held in their benefit by the trustee of the issue.
The Spanish model is a hybridization of both models and it adapts their structure to the Spanish civil and commercial law.
The Spanish mortgage-backed securities do not securitise the mortgages directly as they are issued on their basis. Before the issue of MBS it is necessary to “participate” the mortgages, which means basically issuing another kind of mortgage security, called “mortgage participations” (participaciones hipotecarias), and these represent a percentage of each participated mortgage. This percentage determines the amount of each mortgage that may be securitised afterwards. The mortgage participations are also securities, and the holder of these becomes a co-mortgage creditor (co-mortgagee) along with the originator of mortgage. The mortgage participation holder receives the principal and interest corresponding to the percentage of the “participated” mortgage from the issuer (originator of mortgages), who has received them from the mortgage debtor (borrower of the mortgage loan). It is a true cession of a mortgage loan, which means that the mortgage participation holder may claim not only against the issuer of the mortgage participation (the land credit institution) but also against the mortgagor -against whom the mortgage participation holder may enforce the mortgage- depending on who has defaulted.
With the issue of the mortgage participations, the mortgage securitisation process has only begun and it does not end until the formation of a pool of mortgage participations (in fact, a pool of parts of mortgages) takes place. The mortgage participations may be issued not only to professional investors but also to the public in general.
Covered bonds are debt instruments secured against a pool of mortgages to which the investor has a preferred claim in the event of an issuer default. In EU countries, the issuance of mortgage covered bonds is regulated by laws that define the criteria for eligible assets as well as various other specific requirements. In most cases, assets are earmarked as collateral for the outstanding covered bond and are kept in separate cover pools. In some countries (such as Spain), all mortgages on the balance sheet of the issuer are acting as collateral for the bonds. Following the ‘cover principle’, the outstanding amount and interest claims on covered bonds must be covered by the amount of eligible cover assets.
The main transformation in the mortgage covered bond market which has taken place has been the issuance of jumbo or benchmark covered bonds. The jumbo model has become the European standard for the issuance of new bonds. It has also been the main driver for a very liquid secondary market, especially through bond standardization and listing on widely used electronic platforms. The jumbo model was first introduced by a syndicate of banks in Germany in 1995. Several features were added to increase liquidity and improve security in order to attract foreign institutional investors.
The main features of the jumbo model are: (i) the minimum size is Euro 1 billion; (ii) jumbos need to be plain vanilla bonds (fixed coupon, paid annually in arrears); (iii) buybacks are allowed; (iv) the bond must be officially listed on an organized market (typically an electronic platform); and (v) there must be at least 3 market makers that quote bid/ask prices simultaneously to maintain a liquid market. The total value of all issues in the jumbo covered bond market in Europe has grown rapidly to over Euro 500 billion by end-2004, about a half of which is accounted for by German and Spanish mortgage covered bonds.
For banks, mortgage loans have always been a mass-market product used to attract customers for subsequent cross selling of higher-margin products. Mortgage margins are fairly thin, so the refinancing of the mortgage book has a major part to play in ensuring profitability and in boosting a bank’s market share.
The arrangements in Spain are the biggest departure internationally from the German model. Any Spanish bank or savings institution may issue Cedulas secured solely by mortgage loans on domestic properties, but it is less demonstrable under Spanish law than under Pfandbriefe that investors would be able to lay their hands on their assets in the event of issuer insolvency.
The Spanish market has enjoyed meteoric growth, with around 240 billion euro worth of outstanding bonds (or 33% of the European total) at the end of 2007. This expansion has been made possible by pooling mortgages from a range of smaller savings banks into one arrangement, creating the euro market’s biggest player Ayt Cedulas at €14,300m. In 2005 the largest primary market contribution in the European covered bond market came from the Spanish Cédulas Hipotecarias segment where issuers launched benchmark bonds in an amount of nearly €54 billion (+48p.c. yoy), overtaking the German Jumbo Pfandbrief segment (€48 billion) for the first time ever. The very dynamic Spanish mortgage lending market was again the driving force behind the strong growth of Cédulas issuance, whereas new lending business of German Pfandbrief issuers hardly compensated maturing loans. As a consequence, most issuers launched Jumbo Pfandbriefe primarily to maintain their presence in the benchmark segment.
Over the past few years Spain has become the largest European issuer of Covered Bonds with the issuance of its “Cédulas Hipotecarias”. These debt instruments are based on Law 2/1981 of the Mortgage Market Regulations. The Mortgage Market Reform Law aims at modernizing the Spaniard legislation with respect to these Cédulas and at promoting mortgage bonds to continue competing in the European capital markets, where a number of changes and new laws have strengthened other similar instruments. Credit rating agencies are normally bound before investors to perform credit risk analysis of this type of debt and it's comparability against other instruments in the European market. This commitment becomes more significant since the buyers of Spanish Cédulas are mostly foreign institutions. In particular Moody's has analyzed the implications of the legal reform on the Cédulas Hipotecarias from a credit risk stand point and also the potential challenges of this type of mortgage bond. Moody's is the leading covered bonds rating agency, having rated all of the new European issuers in 2006, and all of the public issuers of Cédulas Hipotecarias in Spain.
Update Saturday 12 February 2007
I am still digging. When I reach some more definitive conclusions I will tidy all this mess up. Basically, reading through Bloomberg this morning I discovered that the Cajas Regionales are now keeping their own bonds on their balance sheets, and financing with temporary funds from the ECB.
Bloomberg 19 October 2007
Caja de Ahorro del Mediterraneo is leading a group of eight Spanish savings banks planning to retain a 1.57 billion-euro ($2.2 billion) sale of bonds on their balance sheets.
The 10-year securities are backed by covered bonds, according to a spokeswoman at Ahorro y Titulizacion, the Madrid- based investment unit used by the banks to sell the debt. The notes are part of a 200 billion-euro program, according to Moody's Investors Service.
Spanish lenders have kept at least 18.8 billion euros of asset-backed debt since September as investor concern that record U.S. home foreclosures will damage bank profits sent interbank borrowing rates to the highest in more than six years. Banks can use the bonds they keep as collateral for short-term borrowing from the European Central Bank.
The transaction is being carried out on behalf of Unicaja, Caja de Ahorros de Murcia, Caja General de Granada, Caja Duero and Caja de Ahorros de la Inmaculada de Aragon, Caja de Ahorros de Navarra and Caja General de Ahorros de Canarias, said the Ahorro y Titulizacion spokeswoman, who declined to be quoted by name.
A group of 17 savings banks last week bought 2.95 billion euros of their own notes backed by covered bonds, she said.
Covered bonds, known in Spain as cedulas, typically get the highest investment-grade ratings by requiring borrowers to set aside assets that can be sold to ensure repayment. The collateral backing the debt remains on the borrower's balance sheet.
September 12 2007
Ahorro Corporacion Financiera SV, the investment group owned by 43 Spanish savings banks, postponed its first sale of covered bonds in dollars.
Ahorro Corporacion planned to sell at least $2 billion of notes backed by home loans to U.S. investors, said Luis Sanchez- Guerra, head of capital markets in Madrid. It would be the biggest dollar-denominated offering of covered bonds from Spain.
The lender, based in Madrid, is the latest company to postpone or restructure debt sales totaling more than $100 billion as investors shun risky assets because of losses linked to the U.S. subprime mortgage market. Banco Popular Espanol SA, Spain's third-biggest bank, last week called off a sale of covered bonds
From Reuters Bonds, yesterday:
Investors took a conservative approach to covered bonds as the 1.7 trillion euro market reopened this week, with short-dated paper from the established German market finding most favour, analysts said.
The covered bond market has moved into sharp focus in recent months as it has faced unprecedented turmoil while also being expected to become an ever more important funding tool for banks eager to raise cash, particularly with the securitisation market effectively shut.
European banks agreed to suspend trading in the $2.8 trillion market for mortgage debt known as covered bonds on November 21 2007, to halt a slump that has closed the region's main source of financing for home lenders. The European Covered Bond Council, an industry group that represents securities firms and borrowers, recommended banks withdraw from trades for the first time in its three-year history. Banks are still obliged to provide prices to investors, according to the formal statement.
Covered bonds are backed by mortgage or public sector loans which remain on the borrower's balance sheet. They have historically been highly liquid and typically rated triple-A by ratings agencies thanks to the quality of the assets and legal support, making them appear a surrogate for government bonds.
UniCredit (HVB) credit analyst Florian Hillenbrand said there had been clear demand for instance for bonds maturing in 2009 and 2010 from German issuers, the mainstay of the covered bond market.
But the market in general remained caught up in the turmoil that started last year.
"The world did not change just because Christmas is over," Hillenbrand said.
That was acknowledged by the European Covered Bond Council (ECBC) on Friday when it eased trading conditions set at the start of the year, allowing for transactions trading at wider spreads to be quoted at triple the normal bid-offer spreads. [ID:nL11231767]
Only the previous week, the ECBC had recommended that covered bond market-makers should commit to trade between themselves at double the normal bid-offer spread on a deal of 15 million euros minimum for all bonds, an improvement from the triple bid-offer spread requirement set across the market late in 2007.
Moody's Investors Service said approved amendments to Spain's Mortgage Market Law, which are due to come into force shortly, will strengthen and clarify the credit position of holders of Spanish mortgage covered bonds (known as 'Cedulas Hipotecarias' or CHs) as well as the timely payment of these instruments following an issuer insolvency.
The amended law will improve the over-collateralisation of the CHs by limiting CH issuance to 80 pct of the bank's eligible mortgages, against 90 pct currently.
The law does not change one of the key strengths of the framework, that is that the whole pool of (non-securitised) mortgages supports the CHs in the event of issuer insolvency. This is in contrast to other European jurisdictions where covered bonds are backed by an earmarked portfolio, Moody's said.
The amended law will improve the asset eligibility criteria in a number of respects, including lowering the loan-to-value ratio for eligible non-residential mortgages to 60 pct from 70 pct, extending the geographical scope to European Union properties, permitting substitute assets up to 5 pct of the outstanding CHs and allowing financial derivatives to form part of the cover pool.
It will also enhance the timely payment of the CHs following issuer default and will oblige the issuer to maintain an internal cover register identifying eligible and non-eligible assets, thus improving transparency, Moody's said.
The amended law will also remove an administrative requirement that has to date impeded the issuance of another type of Spanish covered bond: the 'Bonos Hipotecarios', the rating agency said.
Moody's currently rates 15 mortgage covered bonds in Spain, corresponding to 11 to single issuers and four Spanish funds that pool CHs of multiple issuers.
Mortgage-backed Securities and Covered Bonds
Since Spanish bank deposits did not provide anything like the liquidity needed to fund mortgages during the key years of the boom, lenders increasingly resorted to securitisation. Such securitisation basically takes two forms in Spain: mortgage-backed securities (MBS) and mortgage bonds (cedulas hipotecarias). The difference between these two is basically as follows:
An investor in a “standard” MBS holds a dircet claim on the issuer of the security, and not on the mortgagee, even if he buys securities directly from the originator of the mortgages. However in the Spanish case at least one link in the investor chain has a stake in the original loans. This is because, in order to securitize mortgages, Spanish banks first issue participations, which are shares in each of the mortgages included in a pool. A holder of participations receives a percentage of the interest and principal of the mortgages from the originator, who in turn receives the payments from the mortgagees who obtained the mortgage loans. The participation holder has thus a claim on both the originator and the mortgagee. More importantly, the originator retains a certain fraction — 100 minus the percentage of the aggregate participation — of each and every mortgage created, turning both originator and participation holder into co-creditors. In a second step, the holders of the participations may form pools and then issue securities that represent stakes in those pools of participations.
Such a structure constitutes a form of risk-sharing between originators and participation holders, and this risk-sharing is normally thought to be conducive to higher lending standards (especially when contrasted with off balance sheet SIVs). Originators do not simply get themselves off the hook when they sell the participations, because they keep a share of each mortgage. This may well make them more careful when assessing the creditworthiness of mortgage applicants, and may reduce the chance of overly loose credit standards. And participation holders have a stronger incentive to keep an eye on individual mortgagees than if their sole claim was on the originating institution.
The second source of mortgage funding for originators is the so-called covered bond (in the Spanish variant of the cedula hipotecaria). These bonds are debt instrument issued by a credit institution and secured by a pool of mortgage loans or public debt or even MBS themselves. Such bonds pay coupons and principal, just like any other bond. The investor has a claim on the issuer of the bond and, if the latter defaults, on the pool of loans (not on individual loans). In most European countries, where covered bonds are popular, a set of cover assets is set aside for each bond issue. In Spain, however, all mortgages of the issuer constitute collateral for the bond.
One important reason why many observers felt the Spanish financial system was unlikely to suffer the fate of their US equivalents was the virtual absence of Special Investment Vehicles (SIV) and conduits in Spain. These entities allow banks to move mortgage-backed securities off their balance sheets, thus obscuring the exposure of individual institutions and escaping the normal capital requirements. But this did not happen in Spain. The Bank of Spain is right to say that as a result of the banking and financial crisis of the 1980s a condition was imposed that lenders post an 8% capital charge against SIV assets. This has resulted in a relative absence of off-balance mortgage risk. However, as we have been seeing above while the banking system is not exposed on one front it may well be on one or more other fronts.
Securitization in the broader sense (i.e. including covered bonds) has played, and continues to play, a fundamental role in the financing of Spanish mortgages. The proportion of resources which derive from issues on the mortgage market amounted to 37.3% of outstanding mortgage loans (residential or non) at the end of 2006 as against 35.3% at end 2005. At the end of 2006, total funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).
Bank liabilities represent an important underlying factor in Spanish securitizations: 27.7 billion euros in 2006, principally in the form of Cédulas hipotecarias (or covered bonds) (34.8% of new issues on the mortgage securities market). The direct securitization flow of mortgage debts (MBS) reached 48.5 billion euros in 2006 of which 38.9 billion was in the form of residential mortgagebacked securities (RMBS). In 2006, MBS’s represented 65.2% of new issues on the mortgage securities market. Outstanding amounts of residential mortgage loans constituted one of the principle supports of securitization in 2006, close to 41% of new issues taking the form of RMBS (38% of outstanding amounts). The growth of these latter has, nevertheless, significantly diminished (+31% of annual growth in 2006 compared to +57% in 2005), reflecting the slowdown in home loans and also the fact that an increasing number of loans no longer satisfyied the rule that loans should not exceed 80% of the estimated value of the property. Combining these two securitization techniques (covered bonds and MBS), mortgage loans (to households and other agents) represented, in 2006, the counterpart of close to 80% of new issues by securitization vehicles (and 83% of outstandings).
The Use of Mortgage Covered Bonds
Renzo G. Avesani, Antonio García Pascual, and Elina Ribakova, IMF Working Paper WP/07/20
The Funding of Mortgage Loans in Spain by the Issue of Mortgage Securities. Their Legal structure.
Dr. Sergio Nasarre-Aznar