The bust of Spain's construction boom has left some deep scars on the country's economy. To be sure, the crash has been a prime ingredient of the stubbornly high unemployment rate - currently at 21% - as well as of the mountain of troubled assets held by the country's savings banks, known as cajas.

Predictably, the RMBS sector suffered in tandem. Public issuance has been nonexistent since 2008, origination has tanked, downgrades have been widespread and collateral is widely expected to deteriorate.

Attention has shifted from actual issuance - Spain used to be one of the most vibrant RMBS markets in Europe - to how the market is handling the aftermath of a burst bubble. Structured finance players, for instance, are now looking at how transactions are dealing with the newest boom: foreclosures. In addition, consolidation in the banking sector and the approach to troubled assets will no doubt condition when and how the RMBS market returns.

Moody's Investors Service has a negative outlook on the Spanish RMBS sector, while Fitch Ratings has a declining outlook on assets in the sector. Three-month delinquencies have fallen since 2009, but the trend is likely to reverse thanks to the overhang of property, an expected rise in interest rates, a sticky jobless rate and the expiration of unemployment benefits for many workers.

Foreclosures Soar

Predictably, economic hardship for borrowers has pushed up home foreclosures and repossessions. Foreclosures reached 93,000 in 2010, up 260% from the 2007 figure, according to court data collected by Moody's.

This has meant that many SPVs in Spanish RMBS transactions are taking over properties, a relatively recent phenomenon. Loan modifications have also risen. And both trends are only picking up pace.

"We believe that both repossessions and loan modifications will increase in the near future, as expected interest rate increases generate additional distressed borrowers in a mortgage market dominated by floating-rate transactions," said Juan David Garcia, senior director at Fitch.

Up to December 2010, the cumulative number of properties repossessed by SPVs in the 137 Spanish RMBS that Fitch covers totaled 3,393. In a report, the agency said that this is remarkably low in light of the nearly quarter-of-a-million repossession cases that have hit the courts since 2008.

Fitch says originators are supporting deals by bidding for the underlying properties at auction.

Under Spanish law, the lender - in a structured transaction this would be the SPV - must purchase the property at 60% of the initial valuation amount when the foreclosure auction is vacant. In the case that the SPV repossesses the house, it would not, of course, receive any cash flow as it would if the originator were to buy the property.

While this form of originator support generates cash flow and helps the SPV avoid a drawn-out sales process, it might also conceal what the true performance of a deal would be were the property to be sold at market price.

"Originators supporting transactions is not sustainable," Garcia said. "You have to be prepared because if these assets had to be sold in the open market, the reality is that the volume of losses would be different."

Moody's analysts, in contrast, do not see that originators are bidding for properties from loans previously assigned to an SPV. Where the agency does see possible support from originators is in repurchases, which in some cases might be taking place when the volume of modifications has hit its limit in a pool.

"The Spanish banks have been very active in modifications," said Antonio Tena, an analyst at Moody's. He added that typically in Spanish RMBS structures there is a 10% cap on the volume of loans that can extend maturity. "We believe that a number of deals have already reached this 10% and what they are doing is repurchasing the loan, although full details are not typically reported," Tena added.

Fitch says that loan modifications and refinancing solutions that originators are offering borrowers are a source of concern. On average, about 3.2% of securitized loans within each transaction have undergone some form of loan modification, according to a report by the agency. Reducing the interest-rate spread for the borrower was the common approach, followed by extending the maturity.

"Loan modifications have to be assessed on materiality grounds" Garcia said. "For example, granting loan maturity extensions to weak borrowers of 80 months on average may not be sustainable."

The approach to modification and repossession appears to vary greatly among gestoras, the management companies that are analogous to trustees in Spanish RMBS. As the market deteriorates, these differences are becoming more and more evident.

"We were surprised by the significant difference in the total number of repossessed properties across transactions that share similarities in terms of seasoning and performance," Garcia said. "This appears to be dependent on the strategies of the fund management companies."

Gestoras tend to have broader powers within a transaction than trustees from other markets. They monitor the performance of each portfolio and make all the calculations, while in other jurisdictions these tasks are often done by a third entity, such as a calculation agent. Gestoras also have broad rights to accept or reject bids at auction.

In a report, Fitch outlined some of the differences the agency had observed in gestoras' approach to foreclosures.

GestiCaixa, for instance, tends to assign the property to the originator, which agrees to pay the auction price to the SPV, while Gestion de Activos Titulizados (GAT) assigns the property to the SPV, which will typically sell the property to a real estate firm within the GAT family.

These approaches can also vary within a gestora, depending on the originator of the structure with troubled loans. The gestora InterMoney Titulizacion, for its part, tailors its foreclosure approach to each originator, with some originators repossessing the property and cancelling the entire debt with the SPV.

While gestoras have varying approaches to a property, if it is kept by the SPV they often have to rely on the servicer - typically the originator - to manage the property. "The gestora normally doesn't have the staff to manage the house," Tena said. "Once the property has been repossessed by the SPV, it's the servicer who manages it, and the SPV pays the servicer for those activities."


Full Recourse to Debtor

The SPV, as the lender, also has full recourse to the borrower, a feature of the Spanish market that has helped shield deals from the losses seen in markets where buyers have fewer disincentives to walk away from a home that is underwater. "It's very positive for the willingness to pay," Tena said. "If you capped this, we'd think about the willingness to pay."

But the Spanish government is already nudging the law to be slightly less favorable to creditors. "There have been a number of recent initiatives pushing for legislative change to end or modify full recourse," said Alvaro Gil, director of Fitch's covered bond team in Madrid, in a release in mid-July.

The 60% value at which a lender (or SPV in the case of securitized loans) repossesses a property in a vacant auction was 50% before the law governing mortgages was amended earlier this month. This shifts potential losses from the debtor to the creditor. Another change was to raise the minimum salary a defaulted borrower must earn in order for the lender to be able to garnish his or her wages. The threshold is now 150% of the minimum monthly wage of €961 ($1,381), from 110% (€705) previously.

Moody's argued that ultimately the impact will be minor on the performance of RMBS and mortgage recoveries in general.

"As we have commented, personal liabilities have a very minor impact on the recovery amount of mortgage loans, especially when the main driver of the default is unemployment," said Moody's in a report.

Fitch said the changes could compromise a borrower's willingness to pay under a delinquent loan, but the agency had not modified its recovery assumptions as a result, since it considers only proceeds from the open-market property sale in estimating recoveries.

A third amendment to the law in early July could actually have a minor credit-positive impact by reducing the amount a bidder in a property auction has to deposit upfront, Moody's said in a report. The figure is now 20% of the foreclosed property value, from 30% previously. This might breathe a little life back into listless property auctions, although it is unlikely that it will make much of a difference.

One thing is certain: financial institutions and gestoras as managers of SPVs are picking up more and more repossessed properties, as the housing bust has years to run its course. The Bank of Spain estimated that about one million new homes remain empty, while the number of foreclosed homes that have ended up with financial institutions through deed in lieu arrangements is unknown, according to a Fitch report. Everyone agrees: there is more pain ahead.

Caja Consolidation

Meanwhile, the originators of many of these deals, the savings banks known as cajas, are going through an epochal consolidation process, guided by FROB, the government's Fund for Orderly Bank Restructuring, set up in 2009 to help capitalize the troubled sector. It is difficult to see the RMBS sector returning to anything approaching its former vitality until this process is complete.

Cajas differ from regular commercial banks in terms of ownership, said Alberto Postigo, senior analyst at Moody's. The former are not listed in the stock market and therefore must find other ways to raise capital. The economic decline has exposed cajas' dependence on limited funding sources - such as deposits - and they have found restricted access to wholesale financing, as their books are smarting from loans that have gone bad, especially in the collapsed commercial real estate sector. "The Bank of Spain has said that these banks need capital, and the Spanish government prefers that this money is raised in the markets rather than [through] public funds," Postigo said.

Results of these efforts appear mixed so far. To name just one example: Bankia, a bank formed by a merger of seven cajas, raised €3 billion in an IPO on July 19. This was 60% of the bank's stated book value, lower than the initial price of the shares by about 25%, according to some news reports.

Some of the savings banks, such as Catalunya Caixa and CAM, have opted to receive capital injections from the FROB, effectively becoming partly nationalized.

It was no surprise that tapping equity markets would be a challenge for a Spanish bank apart from the big international names, given that in the past few weeks the sovereign's risk premium has been hovering at the highest levels since the creation of the single currency as investors fretted over Greek contagion and the severity of Spain's economic malaise.

In addition, five Spanish cajas and a commercial bank failed the European Union stress tests this summer, basically failing to show they had enough capital to survive a deep recession.

The consolidation has already whittled down the number of cajas to 18 banking groups from 45. Some of these banking groups are still cajas, but others are actually standard commercial banks, with the savings banks as the stakeholders.

While the recapitalization is expected to help shore up the banking sector, mortgage origination is unlikely to bounce bank anytime soon, another prerequisite for the RMBS sector to revive. Just as the crisis has spurred on consolidations, it has tightened underwriting criteria.

Spanish financial institutions originated 37,619 mortgages in May, a 32% drop from the figure in May of 2010. In May of 2005, when the market was far more active, the number was 108,000.

The volume of loans has likewise tanked, totaling €4.1 billion last May, a 35% year-on-year decline.

While supply languishes, demand for RMBS remains lackluster.

"We don't see value now [because] there's very little liquidity," said Ignacio Gutierrez, a managing partner at Madrid-based Aguila Capital, a shop that advises international institutional investors on performing and distressed assets. "The prices from our point of view are very elevated," he added.

Bloomberg recently reported that JPMorgan Chase & Co. was looking to arrange a Spanish RMBS this year, but it is unclear how strong the appetite will be among the product's traditional buyers.

Distressed Assets:


Where there is inarguably plenty of supply is in distressed assets. Spain, argues Gutierrez, could be a "dreamland" for investors in this area.

Moody's Postigo said that the agency calculated, as of year-end 2009, that the Spanish banking system overall had still to recognize €176 billion in losses as a result of the crisis. "The bulk of these losses comes from the real estate sector, but there are also losses from other asset categories," he added.

If expectations that real estate prices will fall about 30% from peak to trough prove true, there should be another 15%-20% drop.

So far at least, the Spanish government has chosen not to create a "bad bank" in the mold of Ireland's National Asset Management Agency (NAMA), set up in 2009 chiefly to purchase property development loans. Observers have said that Spanish authorities want to avoid NAMA's purchasing real estate assets at huge discounts, which forced prices down.

There has been discussion about cajas setting up good bank/bad bank structures, after La Caixa and the group led by Caja Madrid went this route. But Moody's pointed out in a recent report that in practice the schemes have not gone far enough to make more than a marginal difference on either side, largely because recourse on the bad bank side still exists. "Full protection would require a no-recourse solution such as, for example, the purchase of problem assets by Ireland's NAMA from Irish banks," the agency said. "This transaction fully removed these assets from the banks' balance sheets."

Essentially, then, in Spain there does not exist anything approaching a viable market in distressed assets that could become fodder for securitization.

"Nothing systematic has happened yet on the bad asset side by local players and only non-local players like GMAC have sold any loan portfolios in size," said Alejandro Gonzalez-Ruiz, managing director at StormHarbour Securities in London, which brokers, structures and originates structured finance deals. "The Spanish banks are dealing with this stuff on a case-by-case basis through their real estate subsidiaries and offering attractive financing terms, but they haven't done large sales of residential loan or property portfolios. So far the only portfolio transactions have involved retail bank offices and office buildings through sale lease-back transactions."

Gonzalez-Ruiz said that the authorities and the banking system are focused on consolidation. "There is a lot on their plate just in terms of restructuring the institutions themselves," he added.

Aguila's Gutierrez said that due to provisioning regulations that Spanish banks must follow, the true market value of nonperforming loans and real estate assets is not reflected on their balance sheets. "If this were to be done indiscriminately, I think most banks could go bankrupt," he said. "The distressed market is not developed in Spain [because] if the financial entities sell their assets at market value, they'd have to recognize losses so big their solvency would be severely impaired."

On the other hand, Gutierrez said that selling these assets should somehow form a part of the banks' efforts to raise liquidity, especially given how difficult it has proven in the equity and other markets.

Gonzalez-Ruiz said that he expected there to be sales of distressed real estate assets at some point. "But I don't think it's going to be anything massive," he added. "They're already doing this in an orderly fashion."

Other conditions are not ripe for NPL securitization either. "What you need to start a market are assets, and we have that requirement with NPLs," said Tena from Moody's. "But the success of NPLs is very linked to expectations in the real estate market, since 100% of your cash comes from the collection on properties."

Tena pointed out that Italy was able to produce a few mortgage NPL deals - Italy is the only market to have done them outside of Germany in Europe - because the time to repossess a house can take five to six years from the first missed payment. This is the window in which a loan is most suitable for an NPL securitization. "In Spain, the legal system timing is much shorter," he said. "Maybe you could securitize loans that are one year in arrears." - FO

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