Spanish 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, which I have covered in much more detail here). The principal differences between these two are 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 institutions which form the core of the Spanish financial system were unlikely to suffer the fate of their US counterparts was the virtual absence of Special Investment Vehicles (SIV) and conduits in Spain. Such entities make it possible for 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.