Pfandbriefe/Covered Bonds 2005 - Overcollateralisation falling
Spanish cedulas overcollateralisation continues to fall, and in the case of smaller savings banks appears to be getting close to the legal minimum. Willliam Thornhill asks whether cedulas holders should be concerned, what rating agencies are looking at, and the prospects for future supply.
I f net outstanding mortgage growth in Spain is anything to go by, it is difficult to envisage a material near-term fall in overcollateralisation (OC) of cedulas hipotecarias (CH).
From February 2004 to February this year, figures from the Asociacion Hipotecaria Espanola show net mortgage growth rose by €119bn to €602bn, or 25% year-on-year. This compares to 13.2% in 1985 and 11.1% in 1995.
That the rate was steady in the 10 years to 1995 but has since accelerated sharply, probably has less to do with the falling birthrate than changing owner occupation. Despite the emergence of democracy in the mid 1970s, the birthrate fell by one-third from 21 to 13 per 1,000 in the 20 years to 1985.
In the absence of a rising birthrate, stunning growth in net mortgage lending would seem to have been due to a fall in the average household size along with greater home ownership per capita. According to the European Environment Agency, household occupancy fell by about 15% to 2.45 in the decade to the year 2000. At 85% of the population, Spain is second only to Ireland in the proportion of the population which owns homes.
While there is little sign of this trend faltering, it seems probable that at some point the falling birthrate and more static employment growth will act to at least stabilise mortgage growth – and by association, issuance will need to level off if OC levels are to remain healthy.
Notwithstanding that, the mood remains distinctly upbeat. Roberto Higuera, chief financial officer at Banco Popular, said, "Most Spanish banks and savings banks have only recently come to the covered bond market, and at the beginning they had all their mortgage portfolios as collateral – which was excessive. As they have tapped the market, the percentage of collateral has somewhat decreased but the current average level is still very high. Spanish issues will continue to be among the most collateralised in Europe."
Higuera’s point is illustrated by charting OC levels for AyT Cedulas Cajas I. Back in June 2003, the OC stood at an absurdly high 936%, by December the same year its OC fell to 700% and by June 2004 it stood at 579%. Three months later it rose back up to 611%, then fell back a bit to 570% by December last year. This compares to 102% OC stipulated under German law.
Popular's Higuera nevertheless conceded that investors would probably start to differentiate. "Investors will prefer those issues with more collateral, particularly the higher rated, more solvent issuers – investors might become more selective."
He went on to note that "the rate of mortgage production and the size of the mortgage portfolios of most banks is still very high and sufficient to back the funding requirements of Spanish banks. There are also funding sources that many banks are not yet tapping with sufficient determination.”
Jose Luis Domingez, BBVA's director of funding, pointed out that under Spanish law, investors also have a claim against the bank and not just the qualifying assets. "Overcollateralisation is based on the whole mortgage portfolio, not just those that qualify. Clearly it will decrease due to increasing supply over the last two to three years, and we expect to see a further gradual fall. However, not all new mortgages are funded. Last year we issued €9.4bn cedulas but approved €13bn mortgages," thereby maintaining a decent OC level.
He also cited market rumours suggesting that the ratings agencies might adopt a more stricter interpretation, allegedly looking at 115% rather than the 111% that is stipulated in the law.
Juan Pablo Soriano, Moody’s' structured finance managing director, reiterated Domingez's point. "Although legal overcollateralisation levels have decreased, cedulas hipotecarias bondholders are backed by the entire mortgage portfolio of the issuer, not solely the eligible portfolio."
He also warned, "Moody’s believes that the current OC levels support the assumption of a full recovery of interest and principal under any of the CHs, in the event of any issuer default. However, any decrease in these levels or any substantial change in the pool composition could lead to a review of the previous assumptions and could consequently impact negatively on the rating of the notes."
In light of increased transparency requirements that would be needed to assess pool composition, Soriano pointed out that "since late 2004/early 2005 we have encouraged issuers (through their management companies – Sociedades Gestoras – and arrangers) to report OC levels on a monthly basis and collateral composition data on a quarterly basis. Issuers appear to be committed to these information requirements, reproducing them in the offering circulars for the most recent transactions."
He added that, "Moody’s will be stringent in its requests for the reporting of collateral data, and expects that all management companies and issuers involved in structured covered bonds in Spain will be at the same reporting level by the end of 2005."
In any case, borrowers can access alternative sources of funding. BBVA's Dominguez explained that "funding in form of senior deals, subordinated, preferred, short-term instruments and securitisation" could be pursued. But if the 111% level is hit, then "really there are only two options: grant less mortgages or slow cedulas supply."
He agreed that, in theory, issuers could increase bankruptcy-remoteness by enhancing the structure of their issues, thereby potentially offsetting the need to overcollateralise to such a large extent.
Caja Madrid's managing director and head of capital markets, Carlos Stilianopoulos, conceded that OC would continue to fall but pointed out that the decline would follow an exponential downward slope and not a linear drop. "OC keeps falling but the curve is exponential. The mortgage market is still growing at a huge level so the degree of fall in OC will become smaller and smaller. Most issuers have OC of around 200% to 300%; even if we didn’t approve new mortgages we could still issue many billions of cedulas and remain above the 111% legal minimum."
AyT's Alex Sanchez Pedreño Kennaird felt falling OC was "not such a problem – the concern is likely to be felt more for holders of senior debt. The more you pledge in cedulas, the more senior debtors theoretically stand to suffer, so falling OC is more likely to result in a downgrade of the senior debt rating.”
However, he felt that in light of AyT's structure, diversification and liquidity line this was unlikely to happen. "Single-issuer entities are more likely to suffer, but in any case Moody's is moving away from the notching approach. AyT has individual caja issuers of A– yet we get Triple A as the structure is far more robust. The rating migration does not affect the rating of cedulas as much."
As with BBVA's Dominguez, AyT's Sanchez Pedreño Kennaird also pointed out that rating agencies "do not say what level of OC will affect the senior debt rating – it could be 115% to 118% but we are guessing." He also re-iterated Stilianopoulos's point that, "As you issue incrementally more, it represents a diminishing percentage of total outstanding, therefore theoretically, the bigger the issuer, the more likely OC levels will decline more gradually."
But not all market participants are so upbeat. Covered bond analyst Claudia Vortmueller at Commerzbank believes, "The cédulas growth rate hit a peak last year and we will see less issuance from Spain over the next few years.
“The development might differ for Spanish savings compared to commercial banks," and, “There are two ways to mitigate OC decline. The most obvious would be to come with smaller sized benchmark cédulas once a year (€1bn–€1.5bn). An alternative would be to originate mortgages internationally. However, this option would only be open to commercial banks with access to international distribution chains, such as Santander through its UK subsidiary Abbey National.
Vortmueller felt that, "Cédulas issuance from the savings banks would definitely decline in the coming years. For commercial banks, this process should start later and could be mitigated by higher market share or, if profitable, the potential expansion into international commercial lending."
Falling OC would already seem to have taken root with some of the smaller specialised savings banks that featured within the last AyT Cedulas Caja IX, already close to their 111% legal minimum overcollateralisation levels.
At the time AyT IX was launched, Fitch research suggests Caixanova's eligible mortgage portfolio to the outstanding balance of CH stood at 119.9%, and on the same basis Caixaterrassa stood at 114.7%. However, it should be pointed out that this is against the eligible portfolio. Against the total mortgage portfolio, Caixanova still has a healthy OC of 215.6% while Caixaterrassa's OC stands at 248.5%.
Although these two savings banks cannot issue much more cedulas, investors still have a preferential claim against the entire mortgage portfolio to which the higher OC numbers apply. Ineligible collateral usually has a higher LTV. In Germany, pfandbriefe issuers would still be able to use high LTV collateral but would apply a 40% haircut to the value. In contrast, the OC level in Germany is just 2%, or expressed in Spanish terms, 102%.
AyT's Alex Sanchez Pedreño Kennaird questioned why the CH sector was not trading far tighter or inside pfandbriefe given the considerably larger OC levels.
"If I was a CH investor in these two savings banks I would be very happy. Their OC (against the total mortgage portfolio) is two and two and a half times, respectively, but they can't issue much more."
However, Fitch's Raimon Royo cautioned that there is "no ‘one-size-fits-all’ minimum OC figure; you need to take into account diversification regionally along with the commercial/residential property mix.
"The larger the preferential claim enjoyed by cedulas holders, the weaker the position of the remaining creditors."
“It is important to know the proportion of mortgage lending relative to the entire balance sheet and how risky the issuer's other activities are – these ratios only show the ratio of cedulas lending to the mortgage business but don’t tell you what is left."
For example, Santander's mortgage cover pool is small versus its total asset size. The lower the mortgage business represents as a percentage of the entire balance sheet, the less significant is the problem of super seniority when analysing the trade off between an issuer's secured and unsecured ratings.
In contrast to the large commercial banks, some of the small savings institutions are focussed to a greater extent on mortgage lending which accounts for a significant part of their balance sheet.
Fitch's Royo illustrated by hypothetical example; "If 5% of a balance sheet is mortgages and an entity issues 4.5%, it has used up most of its eligible assets, so cedulas OC is very low and this will have an impact for its cedulas rating, but for its senior unsecured rating it is not so relevant because the mortgage business is so small relative to the entire balance sheet.
"However, if an entity has 95% of its balance sheet assets in mortgages and it has issued 50% of that as cedulas, then unsecured debt holders only can claim on the 5% that is left. The secured debt holders have a preferential claim on 95% of the balance sheet."
Unsecured debt holders of specialist mortgage institutions are probably in the riskiest position. Given the multitude of business profiles of the various institutions and the fact that there is no one-size-fits-all OC level, Fitch provides its own minimum desired OC level, which in the case of Cedulas Caja IX is higher than the actual for three of the 26 constituent savings banks.
The fact that a case-by-case analysis must be adopted was also echoed by S&P's Angela Cruz, who explained that a very different analysis could be arrived at using the same OC level.
"Each issuer has very different characteristics. When judging OC, quantitative analysis doesn't give you the full picture; qualitative analysis is also needed. Cedulas have the issuer's entire mortgage pool as a guarantee, therefore we need to take into account the specific underwriting standards and criteria of each issuer. It is a live pool that is constantly changing – there is no specific underwriting criteria or standard that all issuers abide to, therefore the quality of cédulas collateral may vary from issuer to issuer."
Regarding speculation that higher levels of OC might be needed, Cruz said, "We may request more than the legal minimum to have comfort that enough OC is available to ensure full and timely post-insolvency payment of cédulas even in stress scenarios. We really cannot express what that level is on a general basis – we can only look at it after analysing a specific issuer's portfolio characteristics. With the same proportion of collateral to cédulas, the OC assessment can be different between issuers."
Following a change in the insolvency law last year, S&P revised its rating methodology. CH issues may now be rated up to five notches above an issuer's counter-party rating versus two previously. Despite that, S&P says, "Cédulas remain exposed to potential post-insolvency liquidity shortfalls given the structural maturity mismatches." As such, S&P is unable to apply a completely de-linked approach.
However, in the event the law changes to allow for substitution assets such as cash or government bonds, post-insolvency liquidity concerns could be mitigated. “There is no alternative source to the loan portfolio cashflow for immediate post-insolvency liquidity, like substitute collateral (eg cash or liquid bonds)," said Cruz.
Should a future change in the Spanish law allow for a broader definition of post-insolvency substitution assets, rating agencies might take be encouraged to adopt a de-linked approach.