A “drastic” decline in Spanish residential mortgage lending will erode overcollateralisation protecting covered bond investors, with cover pools shrinking or not increasing at the same pace as issuance despite options available to increase OC levels, said Moody’s analysts today (Monday).

Spanish residential mortgage lending fell 41.3% year-on-year based on January figures, according to figures from the Spanish National Statistics Institute reported last week, said Moody’s senior vice president José de Leon and associate analyst Tomas Rodriguez-Vigil.

This is mainly because of real estate price declines, stricter underwriting criteria and persistently high unemployment, they said, warning of adverse consequences for cédulas investors.

“Such a drastic decline in mortgage lending will erode the overcollateralisation that protects covered bondholders, particularly those whose bonds are from issuers that are close to their statutory limits,” they said.

This is because of a combination of high covered bond issuance and new mortgage lending not being sufficient to generate new eligible assets to replenish the loan redemptions and write-offs of defaulted loans within a cover pool, according to the analysts.

Spanish mortgage covered bonds are backed by an issuer’s entire mortgage book, excluding securitised assets, with issuers needing to provide a minimum of 25% overcollateralisation of the proportion of a cover pool made up of what are considered to be eligible assets.

Banks tend to issue cédulas hipotecarias up to the legal limit, said de Leon and Rodriguez-Vigil, to minimise their overall funding costs, given that the asset class receives lower haircuts than other debt eligible for repo with the European Central Bank.

“Furthermore, cédulas hipotecarias have been the cheapest funding instrument that banks have been able to place with investors in recent years because investors perceive [them] as safer than unsecured debt,” they said.

Major Spanish banks such as Banco Santander, Banco Bilbao Vizcaya Argenataria, and CaixaBank have issued near the legal limit, meaning their eligible overcollateralisation is close to 25%, according to the analysts (see last column in the chart below).

The analysts estimated that weighted average weighted-average overcollateralisation over total cover pools would drop to nearly 100% from the prevailing level of 132% in 18 months (see graph), assuming a 35% drop in mortgage lending, scheduled repayments, annualised prepayments of 3.5%, annual write-offs of 1.75% and maintenance of the prevailing level of outstanding Spanish mortgage backed covered bonds.

“If banks issue cédulas hipotecarias up to the statutory limit, overcollateralisation would drop further, to 94%,” they said. “Furthermore, the weighted average overcollateralisation based on the eligible pool would drop to nearly 30%, which would mean that many issuers would reach the statutory issuance limit.”

And while banks have options to expand issuance capacity, de Leon and Rodriguez-Vigil also said that they believe overcollateralisation levels will decline as cédulas issuance increases despite any such options being implemented, with cover pools shrinking or not increasing at the same pace.

The options they cited as expanding issuance capacity involve increasing overcollateralisation levels by cancelling retained cédulas hipotecarias or securitisations held on balance sheet for ECB-liquidity purposes, and/or overcollateralisation being made available for certain issuers as a result of mergers.

Cancellation of retained securitisations would enable issuers to expand their issuance limits by making those securitised assets available for the cover pool, but are “more unlikely”, said de Leon and Rodriguez-Vigil, “given that issuers’ current incentive is to hold sufficient cheap liquidity buffers and not to increase investors’ protection over and above minimum legal requirements”.

Mergers between banks will enable some issuers with limited overcollateralisation to benefit from linking up with those banks with excess overcollateralisation, they added, but concluding: “Despite these measures, we believe over-collateralisation will decline as cédulas hipotecarias issuance increases, but cover pools will shrink or not increase at the same pace.”

Source: Moody’s