The results of a critical audit of Spain's banks by U.S. consultancy Oliver Wyman were due to be released Sept. 28. As of press time, the Spanish government has estimated that the system overall faces a capital shortfall of roughly €60 billion ($77 billion), well within the €100 billion pledged last June by European finance ministers to help the country heal its damaged financial sector.

Recommended changes based on the audit - how and which banks should be restructured, receive government aid, or be taken over by the Spanish Fund for Orderly Bank Restructuring (FROB) - are likely to reverberate among Spain's mortgage covered bonds.

Observers of the sector point out that the perceived creditworthiness of some of the 14 banks under review might worsen. In addition, compelling banks to sell troubled assets could eat into cover pools while simultaneously depressing real estate values. All are negatives for covered bonds.

On the other hand, re-capitalized banks will be stronger issuers, and markets have already priced in fairly grim scenarios for a number of beleaguered cajas, or savings banks, and even for stronger banks like Banco Santander and BBVA, which some feel have been unfairly bunched together with the others. What is more, covered bonds benefit from a solid legislative framework and the dual recourse that is their signature strength.

 

Decree Law Sets Stage

The Spanish government set out guidelines to follow in restructuring banks in a decree -law passed Aug. 31.

In a report, Fitch Ratings said that a major condition for receiving aid via FROB or restructuring is burden sharing on holders of subordinated debt and preference shares. But observers expect that as covered bonds were not mentioned in the decree law, the authorities will honor the senior and privileged debt status of these instruments.

The decree law will provide a basis for effective restructuring and orderly resolution of banks at varying levels of distress, according to analysts at Bank of America Merrill Lynch. Among the law's measures are the establishment of a bad bank - known more diplomatically as an ASM or asset management company - and a reinforcement of the powers vested in the FROB, which was established in mid-2009 to foster consolidation in the fragmented Spanish savings bank industry as well as to restructure non-viable institutions. The FROB can force entities receiving aid to sell their problematic assets.

As assets are sold en masse, this could cut into the value of the collateral backing mortgages in a cover pool.

In Spain, the entire loan book serves as collateral for a covered bond. There is also a minimum overcollateralization (OC) of 25% of mortgages deemed "eligible," which are those that have no arrears, with LTVs that are no higher than 80% for residential loans and 60% for loans to developers.

Jose de Leon, a senior vice president at Moody's Investors Service, said that the audit will have an impact on the valuation of mortgage assets, and thereby covered bonds, since all the mortgage assets on balance sheet are effectively collateral.

But for determining whether a mortgage is classified as "eligible" in calculating the required OC of 25% for outstanding covered bonds, de Leon said that newer mortgage valuations are irrelevant. "According to our understanding of the law, it has no implication because the valuation of this audit is not connected to the mortgage market regulation," he added. "The valuation that banks usually take into consideration in order to qualify an asset as covered-bond eligible is the valuation at the time of origination." Spanish issuers have no obligation to revalue assets, de Leon said.

"I'm waiting for the independent audit assessment at a bank level to understand with absolute clarity what is the volume and type of troubled assets recognized. Because the cover pool for mortgage covered bonds is the entire mortgaged loan portfolio within the balance sheet of the bank, such information is critical to establish which cover pool assets will be transferred to the asset management company," said Fitch Senior Director Juan David Garcia.

He added, however, that the expectation is for only troubled assets to be segregated, which are already given little credit by Fitch's analytic framework under scenarios of stress and are likely ineligible for the purposes of the required OC. "In theory, you have no need to transfer the performing assets to the bad bank," Garcia said.

De Leon said that even bad loans transferred to the bad bank have some value as collateral for a covered bond. On the other hand, the resulting recapitalization could more than offset the drop in the volume of this collateral of dubious value. "We have to wait and see, since we don't know which banks will be restructured and which assets will be transferred," de Leon added.

Regardless of the longer-term boon to the health of an institution - which plays a major role in the assessment of the risk of a covered bond as an instrument with recourse to the corporate as well as to the collateral pool - in the shorter term a bondholder will see the volume of mortgages diminish, even if the sold assets were distressed.

"If a bank has 200 million euros in assets, and the [bad bank] is going to buy 20 million euros, from a credit rating perspective, the impact isn't necessarily going to be significant since those are the worst loans in the pool," said a market source familiar with Spanish covered bonds. "But for an investor, his number [for collateral] was 200 million and now it's 180 million. It's a lower guarantee."

Most of the bad mortgage assets in Spain are languishing in the commercial sector, which was hit especially hard when the country's real estate bubble burst.

Alexander Batchvarov, international structured finance strategist at BofA Merrill Lynch Global Research, said that it was unclear what will happen to the covered bond if a bank is taken over by the FROB and its troubled assets are transferred to the bad bank.

He added that the Spanish idiosyncrasy of having the whole mortgage book back the covered bond would make it difficult to replicate what happened to an issuer like the U.K.'s Northern Rock, in which the covered bond was transferred to the good bank along with the ring-fenced cover pool featuring the required OC.

 

Origination Lags Amortization & Issuance

Covered bonds transferred to a good bank or held by an issuer that has been adequately re-capitalized may still face the issue of weak origination. Lending has to be healthy enough to maintain the covered bonds' required OC as loans amortize, according to Batchvarov.

And lending has been anything but healthy. The country's general economic woes - not to mention a jobless rate of about 25% and a real estate industry still struggling to regain its footing - has sent the pace of mortgage origination crashing down. At last count, overall mortgage lending was falling at an annual 27%. This has made it difficult for banks to maintain OC levels well above the minimum.

Since late 2010, there has been a steady drop in the eligible OC backing covered bonds, with a number of institutions flirting with the limit of 25%. Moody's believes the figure will continue sliding downward at least through the second quarter of 2013. (See graph above.)

Lackluster lending is not the only reason for this decline - issuance has been brisk, with nearly €50 billion in mortgage covered bonds placed up to June, according to Moody's. But the vast majority of the volume is not going to the market; it is being used as collateral against funding from the European Central Bank.

Tapping the ECB is basically the only option the vast majority of Spanish banks have. And the sector is facing high refinancing needs this year, apart from the threat that depositors might turn a trickle out of the system into a stampede.

There has yet to be a case where a Spanish bank that has breached the minimum OC for its covered bonds has not rectified the problem. Earlier this year, for instance, Banco CAM saw its eligible OC dip to 24%, which the bank quickly remedied.

 

Reasons to Stick Around

With all the potential risk facing covered bonds in Spain, they might seem like a bad bet, but a number of observers see potential post-audit for a variety reasons.

"Since [ECB head Mario] Draghi made his announcement, we've had a profound change in sentiment, and Spanish bonds in particular have been major beneficiaries," said Leef Dierks, head of covered bond strategy at Morgan Stanley, referring to a July 26 speech in which Draghi said he would do "whatever it takes to save the euro."

Dierks added that the benefits have even spread to the sector of multi-cedulas, covered bonds backed by the pools of various small entities, a product that has lost favor as the industry consolidates.

"Multi-cedulas, for instance, are yielding about 8% from 9.5% pre-announcement," Dierks said. "This change in sentiment vis-à-vis peripheral European countries could easily enough overshadow the results of the audit." Dierks added that spreads and prices in general already reflect a view that NLP ratios for Spanish mortgages will reach the 10% range. "We believe that this paper will be fully and timely repaid and that we currently aren't too far from European real money accounts having to re-enter Spain in order to generate sufficient yield."

Some observers see the audit as providing what has been lacking for investors - clarity about the health of each bank's mortgage book, all of which, again, serves as collateral for its covered bonds.

"There hasn't been clarity about collateral quality in some cases, and it's been difficult for people to differentiate intelligently [among the Spanish banks]," said Tim Skeet, managing director in the financial institutions group at Royal Bank of Scotland. But all the same, a more discerning buyer has emerged with the more risk-friendly mood that has prevailed since Draghi drew the line in the sand.

The audit, Skeet said, will hopefully justify this differentiation.

And for all the positive sentiment post- Draghi comment - which has dissipated to some degree in the last week of September - covered bonds have not appeared to have received the boost enjoyed by RMBS from Spain. This has BofA Merrill's Batchvarov scratching his head. "In Spain, covered bonds are in many cases trading wider than RMBS," said Batchvarov. "It's puzzling and it's not clear that a positive bailout for these banks is priced into covered bonds."

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