Thursday, May 10, 2012

As Spain demonstrates, covered bonds are not a panacea

Bloomberg ran an interesting article discussing how the collapse in Spanish real estate prices is undermining Spain's banks that relied on covered bonds to secure funding from the ECB.

Covered bonds are perhaps the oldest form of structured finance security.  They have a reputation for safety of principal as the bonds are backed first by a pool of mortgages on the bank's balance sheet and second by the bank itself.

However, this reputation for principal safety comes at a cost to the issuing bank.  Specifically, the bank must have mortgages that meet the requirements for inclusion in the mortgage pool or it must set aside a higher quality asset, say cash, for the benefit of the covered bond holders.

This requirement to post qualifying collateral for the covered bond sets up the risk of a funding death-spiral.

The trigger for this death spiral would be the contraction in the value of the mortgages that qualify for inclusion in the mortgage pool.  As a result, the bank must post other high quality assets.  Assets that could otherwise be used as collateral to attract low cost funding from sources like the ECB.

So exactly when a bank needs earnings to support the losses on their assets (there is a reason the mortgages no longer qualify for the covered bond pool), its ability to access low cost funds and the related earnings is restricted.

Protections are also being eroded for investors in 367.6 billion euros of Spanish mortgage covered bonds even as they’re in a better position to recover from potential losses than unsecured creditors.

Asking prices for homes in Spain have dropped about 30 percent since the first quarter of 2008, according to a survey by real-estate website and IESE Business School. 
New mortgages awarded are at the lowest level since at least 2004, after total capital lent for all type of mortgages fell almost 50 percent from a year earlier, the government said April 24. 
Under Spanish law, lenders can only issue covered bonds against home loans with loan-to-value ratios of 80 percent or less, or 60 percent if the loans are secured by other types of properties. Outstanding covered bonds shouldn’t surpass 80 percent of banks’ eligible mortgages, and a lenders whole book of mortgages can be called to repay the debt ahead of the rest of the creditors. 
“The decline of house prices plus the negative net production of mortgages mean that if banks are updating their loan-to-value ratios they face shortages of eligible collateral,” said Alexander Batchvarov, the London-based head of structured finance research at Bank of America Merrill Lynch. “We think the asset encumbrance could be a serious issue in Spain.” 
Santander and BBVA, the country’s two largest banks, have increased issuance of covered bonds to 80 percent of their eligible mortgages, the maximum allowed under the Spanish law. 
Banco Santander has 27.81 billion euros of outstanding Spanish covered bonds, according to the prospectus of its 2 billion euros of 3.25 percent 2015 bonds due sold in February. That’s up from 23.5 billion euros of the outstanding debt at the end of 2010, according to an Oct. 18 prospectus filed with the Spanish market regulator. 
BBVA had 44.7 billion euros of covered bonds at the end of the year, according to the company’s website. They account for 49 percent of the total 85 billion euros of the lender’s wholesale funding, more than other type of debt, according to a company presentation.

Bankia Group’s ability to increase mortgage covered bond issuance declined almost 40 percent to 6.5 billion euros at the end of 2011 down from 10.6 billion euros, a year earlier, according to a May 4 report from the company. That compares with 20.3 billion euros of maturing debt this year, including 9 billion euros of bonds that have the backing of the Spanish government. 
The ECB applies a discount on top of the market valuation of as low as one percentage point on a covered bond, compared with at least 6.5 percentage points for an unsecured bank bond, or 16 percent for asset-backed securities, according to the central bank. The so-called haircut can be increased when banks pledge their own bonds. 
“Banks in the euro region have the incentive to pledge covered bonds more than any other type of bank debt due to the lower haircuts the ECB applies to those instruments,” Jose De Leon, a Madrid-based analyst at Moody’s Investors Service said in a telephone interview. 
“That is prompting Spanish banks to issue, in some cases, close to the legal limits, which in practical terms means the erosion of protection for the covered bond investors, and for the rest of creditors including depositors and unsecured bondholders.”

Banks are also using their holdings of mortgage-backed securities for central bank loans after investor demand for debt pooling Spanish assets disappeared in 2007 following the collapse of the U.S. subprime-mortgage market that froze credit markets globally. 
The Bank of Spain values senior bonds backed by residential mortgages issued by Madrid RMBS IV, created in 2007 by Caja Madrid, the largest lender integrated into Bankia, at 59.7 cents on the euro. That means the securities would yield 11.9 percentage points more than the euro interbank offered rate, according to data compiled by Bloomberg based on the repayment rate of the underlying mortgages in the last three months. 
That compares with 90.9 cents net on the euro that the Bank of Spain is willing to provide against Bankia’s 1.6 billion euros of mortgage covered bonds due 2019. The central bank valuation implies a spread of about 453 basis points more than the asset swaps rate, according to Bloomberg data.

Spanish banks have 167.5 billion euros of outstanding mortgage-backed securities, according to Spanish Mortgage Association data at the end of the year. Lenders in the country, which stopped selling the debt in 2007, had retained about 145 billion euros of the debt, which mostly are being used to build their reserves of assets potentially accepted by ECB as collateral to raise loans, according to JPMorgan Chase & Co (JPM) data. 
Investors demand 565 basis points above the euro interbank offered rate, or euribor, to buy a senior bond backed by Spanish home loans compared with 25 basis points in July 2007, according JPMorgan Chase & Co. data. That’s four times the spread for comparable debt backed by British home loans. 
Mortgages are considered better collateral than other types of loans as arrears typically are lower than the average, and recovery levels in a default are higher than for consumer loans. 
Spanish banks’ non-performing loans as a proportion of total lending increased ten-fold since June 2007 to 7.8 percent at the end of last year, according to data compiled by the Spanish Mortgage Association. That compares with a six-fold increase to 2.7 percent for home loans, which account for 60 percent of collateral backing Spanish mortgage covered bond programs, according to Moody’s data.

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