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IFR Covered Bonds Report 2012
6 min read

Spanish banks are locked out of the covered bond market as spreads remain prohibitive and the LTRO has made the prospect of paying up for public funding unappealing. The fact remains that public issuance sends a positive signal to a market that continues to be dogged by negative headlines.

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Spanish banks are facing an uncertain future in the covered bond market. Grappling with a capital shortfall anywhere from €62bn to €100bn, the country’s banks are now shut out of the covered bond market, their only source of public funding, for the foreseeable future.

In spite of the pledging of eurozone bailout funds to address their capital shortfalls, Spanish banks are facing an uncertain future in the covered bond market – their only source of public funding in the recent past.

In June, Moody’s issued a stern warning to the market that the increase of Cedulas issuance accompanied by a drastic decline in mortgage lending would affect overcollateralisation levels, which would have a negative effect on existing covered bondholders.

“This issuance surge diminishes the overcollateralisation enjoyed by covered bondholders, a credit negative. The decline in Spanish mortgage lending will further reduce the overcollateralisation,” the ratings agency said.

Moody’s estimates that during the next 18 months there will be an average 30% decline in overcollateralisation.

Barclays also took a view that dwindling collateral levels spell bad news for a country that is desperately trying to repair its banking system that was overly exposed to the now crippled real estate sector.

Analysts at the UK-headquartered bank noted that the issuance reduces overcollateralisation to the legal minimum of 25% and increases asset encumbrance. “All this is bad news for existing Cedulas holders,” they said.

The fact that Spanish banks’ mortgage lending business has declined means there are fewer mortgages to replenish cover pools to protect bondholders in the event of a bank insolvency.

Spanish banks were largely trading through government bonds, which Barclays’ analysts said reflected the resilience of the investor base. However, they expect this to change.

“High spread volatility in Spanish government bond markets, combined with negative rating actions on the sovereign, the senior rating of Spanish banks and, more recently, covered bonds, have started to affect Spanish covered bonds,” Barclays said.

Hope fades

Early in the first quarter, market participants were hopeful that a high stockpile of LTRO cash, the introduction of bank reforms in Spain and a tightening of spreads would continue to allow the country’s banks to access the covered bond market.

For a time they were correct. Spain’s banks sold €7bn worth of covered bonds to both domestic and international investors during two months of relatively energetic issuing activity.

Santander was the first to take advantage of this growing demand – it broke the seal on the peripheral bond market and sold the first Spanish transaction in more than eight months in February. It priced a €2bn three-year issue at mid-swaps plus 210bp via Barclays, Citigroup, Natixis and Santander.

Banco Popular, Bankia and Sabadell followed suit and highlighted just how supportive the country’s domestic investor base is. Analysts were convinced that despite ongoing uncertainty in Spain domestic investors would support their financial sector.

“Despite a noticeable drop in the current assessment score, Italian and Spanish investors still have the biggest confidence in their domestic markets,” said Florian Eichert, head of covered bond research at Credit Agricole CIB in April as the market door slammed closed.

Using four covered bond deals that priced earlier this year as a sample, international investors accounted for an average of 60% of the distribution, down 13% from the total received from the borrowers in the past 18 months. In the case of BBVA’s senior unsecured bond, the international take-up was significantly larger, with more than 72% sold to non-Iberian investors.

However, this confidence and initial optimism from domestic investors around Spain’s ability to lead its banks out of financial ruin faded fast as those who steered clear of the country’s bank credit as they believed the LTRO changed nothing and its problems would continue for the foreseeable future were proved right.

Declining demand

Indeed, demand for bank paper has been steadily declining as was evidenced by the Cedulas’ door slamming shut in April. At the time of writing, Spain’s 10-year borrowing costs have soared to 7%, an unsustainable level of borrowing for a country desperately trying to balance its budget.

For the coming months, treasury officials at the country’s banks are quick to point out that they are currently shrinking their balance sheets and are unlikely to issue new transactions once some of the bonds redeem.

And covered bond bankers are keen to highlight the sophistication of Spanish bank investors who have begun to feel more comfortable with some of the country’s more robust credits.

“Some investors have been reducing their Spanish exposure due to the constant headline news from Spain, “says Ted Lord, managing director and head of European covered bonds at Barclays.

“Other investors, however, are spotting value plays as there are some Spanish banks that have not borrowed any money under the LTRO from the European Central Bank. Also, banks such as BBVA and Santander have a majority of their earnings from healthy growth markets outside of Spain.”

Meanwhile, Bernd Volk, head of covered bond analysis at Deutsche Bank, suggested that the product has good protection. Using the example of AyT Cedulas, he said that as much as €354.4bn worth of residential mortgages backed €223.4bn of outstanding bonds.

In the past year, the majority of Spanish banks have become reliant on covered bonds as their only source of public funding, as the eurozone sovereign crisis has effectively shut all but the best out of the senior market.

However, syndicate officials expect ongoing volatility, collateral issues and uncertainty around the country’s bank bailout to affect even the strongest issuers over the coming months.

“Weaker banks will continue to be locked out of the market and even the best credits are likely to have to wait until September when there is more certainty around the independent audit,” said a banker.

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